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What hedge ratio should be used

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Question - Company XYZ wants to sell 10 million units of an asset in three months. Suppose that the standard deviation of the quarterly changes in the price of this asset is $5. The standard deviation of quarterly changes in the futures price for a contract on an underlying asset similar to the hedged asset is $6. The correlation between the quarterly changes in the price of the hedged asset and the quarterly changes in the futures price for the contract on the similar asset is 0.91. One futures contract is on 35,000 units of the underlying asset.

(a) What hedge ratio should be used when hedging a quarterly exposure to the price of the hedged asset? What does this hedge ratio mean?

(b) How many futures contracts on the underlying asset should be traded?

(c) Should XYZ enter long or short futures positions in order to hedge its exposure? Why?

(d) What is the hedge effectiveness in this case? What does this hedge effectiveness mean?

Reference no: EM133173265

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