Question

Generous Dynamics maintains an inventory of 4000 ounces of gold. The company is interested in protecting the inventory against daily price changes. The correlation of the daily change in the spot and futures price is 0.4, the standard deviation of the daily spot price change is 26 percent, and the standard deviation of the daily change in the futures price is 14 percent. Futures contract size is 1000 ounces. How many contracts should GD buy or sell to hedge its inventory?

Answer 1

Answer: Sell 0.86154

Step-by-step explanation:

The hedge ratio helps in making comparision between the value of a position which the hedge protects and the whole position itself.

The above question can be calculated as follows:

When 1000 ounce of gold are to be sold, the hedge ratio will be:

= 0.4 × 14 ÷ 26

= 0.215384

Therefore, when 4000 ounce of gold are to be sold, the hedges will be:

= 4 × 0.215384

= 0.86154 contracts

GD should sell 0.86154 contracts to hedge its inventory.