Financial Risk Manager Part 1
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A risk manager seeks to hedge an investment in zirconium by using futures contracts. However, there are no existing futures contracts specifically for zirconium. To select the most appropriate futures contract for this purpose, the manager has performed a regression analysis summarizing how daily price changes in zirconium correlate with daily price changes in other assets that have available futures contracts. The regression results are shown 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
Using the regression data provided, which asset's futures contract is likely to minimize basis risk when employed to hedge the zirconium investment?
A risk manager seeks to hedge an investment in zirconium by using futures contracts. However, there are no existing futures contracts specifically for zirconium. To select the most appropriate futures contract for this purpose, the manager has performed a regression analysis summarizing how daily price changes in zirconium correlate with daily price changes in other assets that have available futures contracts. The regression results are shown 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 |
Using the regression data provided, which asset's futures contract is likely to minimize basis risk when employed to hedge the zirconium investment?
Explanation:
The correct answer is B, Asset B. When selecting a futures contract to hedge an investment in an asset for which there is no direct futures contract available, such as zirconium in this case, the risk manager must choose a contract that is highly correlated with the price movements of zirconium to minimize basis risk. Basis risk is the risk that the price of the hedged asset and the price of the hedging instrument (in this case, the futures contract) will not move perfectly in tandem.
The regression analysis provided in the table shows the relationship between the daily changes in the price of zirconium and the daily changes in the prices of four other assets (A, B, C, and D) that have associated futures contracts. The regression equation is given as:
Change in Price of Zirconium = α + β*(Change in Price of Assett) + t
Where:
- α is the intercept of the regression line.
- β is the slope of the regression line, which represents the hedge ratio or how much the price of zirconium is expected to change for a unit change in the price of the other asset.
- R2 is the coefficient of determination, which measures the proportion of the variance in the dependent variable (zirconium price changes) that is predictable from the independent variable (price changes of the other asset).
The R2 value is a key indicator of how well the regression model fits the data. A higher R2 value indicates a stronger correlation between the price changes of zirconium and the price changes of the other asset. Among the assets listed, Asset B has the highest R2 value of 0.81, suggesting that it has the strongest correlation with zirconium's price changes.
Therefore, choosing futures tied to Asset B would likely introduce the least basis risk into the hedging position because it has the highest correlation with zirconium's price changes, as indicated by the highest R2 value. This means that the price movements of Asset B are most closely aligned with those of zirconium, making it the best choice for cross hedging in this scenario.