Answer: Futures on Commodity B with 9 months to expiration

To minimize basis risk in hedging, it is essential to select a futures contract that has the highest correlation with the price of the commodity being hedged and a maturity that closely matches the duration of the hedge. In this case, Pear, Inc. is looking to hedge its exposure to plastic price shocks and has identified two commodities with futures contracts that are correlated to plastic prices. Commodity A has a correlation of 0.85 with plastic prices, while Commodity B has a higher correlation of 0.92. This indicates that Commodity B's futures contract would be more effective in hedging against plastic price fluctuations due to its stronger correlation. Furthermore, the maturity of the futures contract should ideally expire after the duration of the hedge. Pear is hedging for a period of 7.5 months, so a 9-month contract would be more suitable than a 6-month contract, as it would provide coverage for the entire duration of the hedge. Considering both the correlation and the maturity, the best choice for Pear, Inc. would be the futures on Commodity B with a 9-month expiration. This selection offers the highest correlation to plastic prices and the appropriate maturity to cover the hedge period, thereby minimizing basis risk. Hence, the correct answer is D. Futures on Commodity B with 9 months to expiration.

Author: LeetQuiz Editorial Team