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It is June and a U.S. airline company wishes to hedge its exposure to a new fuel whose price changes have a 0.7 correlation with WTI crude oil futures price changes. The airline company expects that the fuel price will rice in the next 6 months (December the same year). The airline company will lose $1 million for each 1 cent increase in the price per gallon of the new fuel over the next six months.
The airline company considers using West Texas Intermediate WTI crude oil futures contract traded on CME Group. The contract size for the WTI futures is 1,000 barrels or 42,000 gallons for each contract. The minimum tick (price fluctuation) is $0.01 per barrel and the dollar value of one tick is $10 per barrel.
The new fuel's price change has a standard deviation that is 25% greater than price changes in WTI crude oil futures prices.
How many WTI crude oil futures contracts should be traded?
Hint: The airline company should take a long position (buying December WTI oil futures contract). Firstly. find the hedge ratio. Secondly, calculate the airline company's exposure measured in gallons of the new fuel. Then you can approximate the number of futures contracts needed.
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