You are a potato farmer. In 6 months, you will harvest 10,000,000 lbs of potato. There is currently no active potato future contract, and you want to hedge the price of potato. You did some research and found that corn future can be a good hedge for potato. A corn future is for 5,000 bushel and each bushel weighs 60lbs. The current 6-month corn future contract is trading at $6.45 (each contract is multiple of 5000 bushel, hence each contract is worth 6.45*5000 = $32,275). Daily corn future price has a .94 correlation with potato price; daily corn future volatility/standard deviation is 1.24% and daily potato price volatility/standard deviation is 1.36%. 1. How can you hedge your potato price? 2. Calculate the hedge ratio? 3. Calculate the number of contracts you will need to hedge, assuming you can transact fraction of a contract.
You are a potato farmer. In 6 months, you will harvest 10,000,000 lbs of potato. There is currently no active potato future contract, and you want to hedge the price of potato. You did some research and found that corn future can be a good hedge for potato. A corn future is for 5,000 bushel and each bushel weighs 60lbs. The current 6-month corn future contract is trading at $6.45 (each contract is multiple of 5000 bushel, hence each contract is worth 6.45*5000 = $32,275). Daily corn future price has a .94 correlation with potato price; daily corn future volatility/standard deviation is 1.24% and daily potato price volatility/standard deviation is 1.36%.
1. How can you hedge your potato price?
2. Calculate the hedge ratio?
3. Calculate the number of contracts you will need to hedge, assuming you can transact fraction of a contract.
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