Question:
A company uses an alternative energy source called Liquid X. The recent movements on the price of oil have caused volatility in the price of Liquid X and so the company wishes to hedge its exposure to Liquid X. The price changes of liquid X have a 0.7 correlation with gasoline futures price changes.
The company will lose $500,000 for each 1 cent increase in the price per gallon of Liquid X over the next two months. Liquid X has a standard deviation that is 50% greater than price changes in gasoline futures prices. Futures contracts on Liquid X are non-existent and the company uses gasoline futures to hedge its exposure to Liquid X. Assume each gasoline futures contract is on 40,000 gallons.
Two months later, the price of Liquid X rose by 2 percent from US$2.50 per gallon.
Required:
a. What should be the hedge ratio in the use of gasoline futures to hedge its exposure?
b. What is the company's exposure measured in gallons of Liquid X?
c. What position measured in gallons, what is the type of position should the company take in gasoline futures to hedge its exposure?
d. How many gasoline futures contracts should be traded in this hedging strategy?
e. After two months, what is the gain/loss in the spot market and the trading gain/loss on the futures contracts in part d?