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Answer: Futures on Commodity B with 9months to expiration
The best contract to minimize basis risk, as per the provided information, is option D: Futures on Commodity B with 9 months to expiration. This is because the futures contract on Commodity B has a higher correlation (0.92) with the price of plastic compared to Commodity A (0.85), which makes it a more suitable hedge. Additionally, the 9-month expiration period is closer to the 7.5 months that Pear, Inc. is looking to hedge, thus reducing the risk associated with the mismatch between the hedge duration and the contract's expiration. The higher the correlation and the closer the maturity to the hedge period, the lower the basis risk, which is the risk that the price of the hedged item will diverge from the price of the hedging instrument over time.
Author: LeetQuiz Editorial Team
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Pear, Inc., a company that heavily depends on plastic components imported from Malaysia, aims to manage the risk posed by potential fluctuations in the price of plastic over the next 7.5 months. Unfortunately, it finds that direct futures contracts for plastic are not readily available. After conducting thorough research, Pear identifies alternative futures contracts on commodities that have a strong correlation with the price of plastic. The futures for Commodity A have a correlation coefficient of 0.85 with the price of plastic, while those for Commodity B have a correlation coefficient of 0.92. Moreover, both commodities offer futures contracts with expiration periods of 6 months and 9 months. Ignoring concerns related to market liquidity, which contract should Pear select in order to most effectively mitigate the risk of basis variation?
A
Futures on Commodity A with 6 months to expiration
B
Futures on Commodity A with 9 months to expiration
C
Futures on Commodity B with 6 months to expiration
D
Futures on Commodity B with 9months to expiration