(The attached PDF file has better formatting.)
Some exam problems test the optimal hedge ratio in varioushedges. Know the basic formula and its relation to CAPM betas and bond durations.Exercise 1.2: Cocoa Hedges A cocoa merchant with inventory of cocoa worth $10 million at present prices of $1,250 per metric ton is considering a risk-minimization hedge of the inventory using the cocoacontract of the Coffee, Cocoa, and Sugar Exchange.
The volatility of returns for the cocoa inventory is 27%.
The futures contract size is 10 metric tons.
The volatility of the cocoa futures is 33%.
For the grade of cocoa in the inventory, the correlation between the change in thefutures price and the change in the spot cocoa price is 85%. A.What is the risk-minimization hedge ratio?B.Should the cocoa merchant be long or short the futures contracts?C.How many contracts should be traded?
The optimal hedge ratio equals
the correlation between the hedged good and the hedging instrument (
×the standard deviation of the hedged good (
÷the standard deviation of the hedging instrument (
hedge ratio =
The optimal hedge ratio equals 0.85 × 0.27 / 0.33 = 0.6955.
The volatility is the standard deviation times the square root of time. The ratioof volatilities equals the ratio of standard deviations, since the square root of time appearsin both numerator and denominator.
The cocoa merchant now owns the cocoa inventory. The merchant’s risk is that ahigher supply of cocoa or a lower demand for cocoa will reduce the price of cocoa. Themerchant must be short the cocoa futures contract.
A party that owns an asset or commodity faces a risk that its price will decline.
The long position pays a fixed price and gains if the price increases.