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When a futures contract is used for hedging, the price movements in each day should in theory be hedged separately. This is because the daily settlement means that a futures contract is closed out and rewritten at the end of each day. From (b) the correct hedge ratio at any given time is, therefore, S/ F where S is the spot price and F is the futures price. Suppose there is an exposure to N units of the foreign currency and M units of the foreign currency underlie one futures contract. With a hedge ratio of 1 we should trade N / M contracts. With a hedge ratio of S/ F we should trade

contracts. In other words, we should calculate the number of contracts that should be traded as the dollar value of our exposure divided by the dollar value of one futures contract (This is not the same as the dollar value of our exposure divided by the dollar value of the assets underlying one futures contract.) Since a futures contract is settled daily, we should in theory rebalance our hedge daily so that the outstanding number of futures contracts is always (SN)/(FM). This is known as tailing the hedge.