Question

a company wishes to hedge its exposure to a new fuel whose price changes have a 0.6 correlation with gasoline futures price changes. the company will lose $1 million for each 1 cent increase in the price per gallon of the new fuel over the next three months. the new fuel's price change has a standard deviation that is 50% greater than price changes in gasoline futures prices. if gasoline futures are used to hedge the exposure (each contract is on 42,000 gallons), what should be the hedging strategy (i.e., long or short how many futures contracts)? 4

Answer 1

To hedge its exposure to the new fuel, the company should go short on gasoline futures contracts. The number of contracts needed can be calculated using the standard deviation of the new fuel's price changes and the value at risk (VaR).

Step-by-step explanation:

To hedge its exposure to the new fuel, the company should go short on gasoline futures contracts. Since the correlation between the new fuel and gasoline futures is 0.6, the company should take a position opposite to the price changes in gasoline futures. By going short on gasoline futures, the company can profit from any drop in the gasoline futures price, which would offset the loss from the increase in the price per gallon of the new fuel.

Since the company will lose $1 million for each 1 cent increase in the price per gallon of the new fuel, the number of gasoline futures contracts needed to offset this loss can be calculated as:

1. Calculate the standard deviation of the new fuel's price changes by multiplying the standard deviation of gasoline futures prices by 1.5 (50% greater).
2. Calculate the value at risk (VaR) for the new fuel as the product of the calculated standard deviation and the critical value of the standard normal distribution corresponding to a desired confidence level (e.g. 95% confidence level).
3. Divide the VaR by the amount of loss per 1 cent increase in the price per gallon of the new fuel and round up to the nearest whole number to get the number of gasoline futures contracts needed to hedge the exposure.

For example, if the calculated VaR is $5 million and the loss per 1 cent increase is $1 million, then the company would need to short 5 gasoline futures contracts to hedge the exposure.