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Answer: Asset B
The explanation provided in the file content indicates that to determine the best futures contract to hedge an investment in zirconium, one should look for the asset with the highest correlation to zirconium's price changes. This is measured by the R-squared (R2) value from the regression analysis. The R2 value represents the proportion of the variance in the dependent variable (in this case, the change in price of zirconium) that is predictable from the independent variable (the change in price of the asset being considered for hedging). According to the regression results presented in the file content, Asset B has the highest R2 value of 0.81, which suggests that it has the strongest correlation with the price changes of zirconium. Therefore, futures tied to Asset B would likely introduce the least basis risk into the hedging position. Basis risk refers to the risk that the price of the underlying asset being hedged will not move in the same direction or by the same amount as the price of the futures contract used for hedging. In summary, the futures contract tied to Asset B is the best choice for hedging an investment in zirconium as it has the highest correlation with zirconium's price changes, as indicated by the highest R2 value in the regression analysis. This would result in the least basis risk for the hedging strategy.
Author: LeetQuiz Editorial Team
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A risk manager is attempting to hedge an investment in zirconium using futures contracts. Since there are no available futures contracts specifically for zirconium, the risk manager needs to identify the most suitable alternative futures contract. To achieve this, the risk manager has performed a regression analysis to compare the daily price changes of zirconium with the daily price changes of other assets that do have associated futures contracts. The results of this regression analysis are summarized in the table below:
| Asset | α | β | R² |
|---|---|---|---|
| A | 1.25 | 1.03 | 0.62 |
| B | 0.67 | 1.57 | 0.81 |
| C | 0.01 | 0.86 | 0.35 |
| D | 4.56 | 2.30 | 0.45 |
Given the regression results in the table, which asset's futures contracts would likely minimize the basis risk when used for hedging the zirconium investment?
A
Asset A
B
Asset B
C
Asset C
D
Asset D
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