Problem
Company Tallman wants to sell 5 million units of an asset in one month. Suppose that the standard deviation of the monthly changes in the price of this asset is $4. The standard deviation of monthly changes in the futures price for a contract on an underlying asset similar to the hedged asset is $5. The correlation between the monthly changes in the price of the hedged asset and the monthly changes in the futures price for the contract on the similar asset is 0.88. One futures contract is on 45,000 units of the underlying asset.
1. Should Teller&Penn enter long or short futures positions in order to hedge its exposure? Why?
2. What hedge ratio should be used when hedging a monthly exposure to the price of the hedged asset? What does this hedge ratio mean?
3. How many futures contracts on the underlying asset should be traded?
4. What is the hedge effectiveness? What does this hedge effectiveness mean?