Question
Suppose a one year oil forward price is $60 per barrel. Suppose further that there are two equally likely outcomes in one year---an oil spot
Suppose a one year oil forward price is $60 per barrel. Suppose further that there are two equally likely outcomes in one year---an oil spot price of $50 and an oil price of $70. If the oil price is $50, the firms revenue will be $100 million with 75% probability and $200 million with 25% probability. If the oil price is $70, the firms revenue will be $180 million with 40% probability and $260 million with 60% probability. What position in oil forward contracts minimizes the variance of the firms revenue (with the underlying asset being a barrel of oil)? Be careful calculating variances and covariances---notice that the states are not equally likely, so standard Excel formulas may not be applicable.
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