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Answer: Futures on Commodity B with 9 months to expiration
To minimize basis risk in hedging, it is crucial to select a futures contract that has the highest correlation with the price of the underlying asset being hedged, which in this case is plastic. Additionally, the maturity of the futures contract should be as close as possible to the duration of the hedge, ideally expiring after the hedge period. According to the information provided, Commodity B has a higher correlation of 0.92 with the price of plastic compared to Commodity A's correlation of 0.85. Furthermore, since Pear is looking to hedge its exposure for 7.5 months, the 9-month expiration contracts are more suitable than the 6-month contracts, as they extend beyond the hedge period. Therefore, the best contract to minimize basis risk would be the futures on Commodity B with 9 months to expiration, which is option D.
Author: LeetQuiz Editorial Team
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Pear, Inc. is looking to hedge against the volatility in plastic prices over the next 7.5 months. Given that the correlation between Commodity A's futures and plastic prices is 0.85 and the correlation between Commodity B's futures and plastic prices is 0.92, and considering both commodities offer futures contracts with 6-month and 9-month expirations, which futures contract would provide the most effective hedge, assuming liquidity issues are not a concern?
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 9 months to expiration
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