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FRM Part I · FRM Exam Part I · How Do Firms Manage Financial Risk?

A firm has a 1,000,000 barrel oil exposure. It uses futures with a contract size of 1,000 barrels. The optimal hedge ratio is 0.90, spot price is 80 and the futures price is 82 per barrel. How many futures contracts should it trade to minimize variance of the hedged position, assuming the firm is a producer that will sell the oil?

The producer should short 900 contracts. The optimal hedge ratio of 0.90 applied to 1,000,000 barrels gives 900,000 barrels, which divided by 1,000 barrels per contract equals 900. Because the firm will sell oil and gains from higher prices, it hedges by taking a short futures position.

  1. AShort 900 contractsCorrect
  2. BLong 900 contracts
  3. CShort 1,000 contracts
  4. DShort 1,098 contracts

Explanation

Number of contracts = h x exposure / contract size = 0.90 x 1,000,000 / 1,000 = 900. A producer selling oil is long the commodity, so it shorts futures. Long 900 has the wrong direction and doubles the exposure. 1,000 ignores the hedge ratio. 1,098 wrongly scales by the spot/futures price ratio inverse.

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