Question

Suppose that the standard deviation of monthly changes in the price of jet fuel is $2. The standard deviation of monthly changes in crude oil (which is similar to jet fuel) is $3. The correlation between jet fuel and crude oil is 0.9. What position in crude oil futures should be used by Southwest to hedge the purchase of 50,000 gallons of jet fuel at the end of one month. The multiplier for crude oil futures contracts is 1,000. Group of answer choices Sell 0.6 contracts. Buy 0.6 contracts. Sell 30 contracts. Buy 30 contracts.

Answer 1

Answer:

d. Buy 30 contracts.

Explanation:

Correlation between jet fuel and crude oil = 0.9

Standard deviation of spot price = $2  Jet fuel

Standard deviation of futures prices = $3 Crude oil

Minimum variance hedge ratio (h) = Correlation * Standard deviation of spot price / Standard deviation of futures prices

Minimum variance hedge ratio (h) = 0.9 * 2/3

Minimum variance hedge ratio (h) = 0.6

Size of position being hedged = 50000

Size of one futures contracts = 1000

Number of contracts to be used for hedging = Minimum variance hedge ratio * Size of position being hedged / Size of one futures contracts

Number of contracts to be used for hedging = 0.6 * 50000 / 1000

Number of contracts to be used for hedging = 30

=>> 30 contracts = Go long = Buy