Chartered Financial Analyst Level 2

Explanation

This scenario describes a Basis Swap:

Basis Swap Definition: A basis swap involves exchanging the returns of two different but related assets. In this case:

• The investor has exposure to an illiquid commodity
• They use a liquid, correlated commodity as a hedging instrument
• The swap helps manage the basis risk - the risk that the relationship between the two commodities changes

How it works:

• The investor pays the return on the illiquid commodity
• Receives the return on the liquid commodity
• This hedges their exposure while using a more liquid instrument

Other options:

• Variance swap: Based on volatility, not commodity price correlation
• Total return swap: Provides exposure to a single asset's total return

Therefore, this is best described as A: basis swap.