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The correlation between the monthly changes of the spot price and futures price of a commodity is 0.95. The standard deviations of monthly changes of the spot price and futures price are 0.25 and 0.30 respectively. Each futures contract represents 1000 units of the commodity. A company needs to purchase 50,000 units of the commodity in 1 month, and wants to use the futures contract hedge the price risk. How many futures contracts should the company long or short

User Akemi
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Answer and Explanation:

Given that correlation between the monthly changes of the spot price and futures price of a commodity = 0.95

standard deviations of monthly changes of the spot price = 0.25

standard deviations of monthly changes of the futures price = 0.30

Futures contract =1000 units of commodity

To calculate how many futures contracts long or short if company needs to purchase 50,000 units of the commodity in 1 month using the futures contract hedge the price risk:

We calculate Hedge ratio = correlation * Spot price changes Standard deviation/ Futures contract price changes standard deviation

= 0.95 * 0.25/0.30

=0.7917

=79.17%

Calculate how many futures contracts the company should short =

50000 * 79.17%/1000

=39.58

= -39 contracts(negative shorts as from question)

User Vanto
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