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The question is specified as hedging exposure to oil prices using forward contracts on oil) My idea is that we can just purchase one forward contract for each asset,then it should be perfectly hedged, but I don't know if this is correct.

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  • $\begingroup$ Are you trying to protect yourself from oil prices going up or down? $\endgroup$ – Bob Jan 9 '18 at 1:29
  • $\begingroup$ Using forwards, the optimal hedge ratio is 1, as you stated. $\endgroup$ – noob2 Jan 9 '18 at 19:17
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If you goal is to by perfected hedges then purchase one forward contract for each asset make sense to me. Is that really the right goal?

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You are not clear on the objective of hedging. The key to hedging I think is to find a forward contract that:

  • Matches the exposure to the quantity of your asset
  • Matches the duration you want to hold your asset

If one can find a forward contract that matches exactly on these two dimensions, then you have a perfect hedge for a certain period. The hedge ratio simply tells you how many forward contracts you need for this.

For example, if you hold 105 barrels of oil, and you can only find a forward contract that represents 100 barrels of oil for 3 months, you need to short 1.05 contracts. You might not be able to get that 0.05 contract you want, and you are net long oil by 5 barrel. You don't have a perfect hedge in this case. Even if you can find a contract that matches the quantity, you are only perfectly hedged for 3 month, and 3 months later, you will want to roll for the new contracts of the desired duration.

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