Suppose you are a derivatives trader specializing in creating customized commodity for- ward contracts for clients and then hedging your position with exchange-traded futures contracts. Your latest position is an agreement to deliver 100,000 gallons of unleaded gasoline to a client in three months.
a. Explain how you can hedge your position using gasoline futures contracts.
b. In calculating your hedge ratio, how must you account for the different valuation procedures used for forward and futures contracts? That is, what difference does it make that forward contracts are valued on a discounted basis while futures contracts are marked to market without discounting?
c. If the only available gasoline futures contracts call for the delivery of 42,000 gallons and mature in either two or four months, describe the nature of the basis risk involved in your hedge.