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Answer: Asset B
## Explanation When hedging with futures, the **R² (coefficient of determination)** from the regression analysis is the key metric for determining which asset will introduce the least basis risk. **Key Points:** - **R² measures** the proportion of variance in the dependent variable (Zirconium price changes) that is explained by the independent variable (asset price changes) - **Higher R² values** indicate stronger correlation and better hedging effectiveness - **Lower basis risk** occurs when the hedging instrument closely tracks the price movements of the asset being hedged **Analysis of Options:** - **Asset A**: R² = 0.62 (62% of variance explained) - **Asset B**: R² = 0.81 (81% of variance explained) **← Highest R²** - **Asset C**: R² = 0.35 (35% of variance explained) - **Asset D**: R² = 0.45 (45% of variance explained) **Conclusion:** Asset B has the highest R² value (0.81), meaning it explains 81% of the variance in Zirconium price changes. This indicates the strongest correlation and would introduce the least basis risk when used for hedging.
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You wish to hedge an investment in Zirconium using futures. Unfortunately, there are no futures that are based on this asset. To determine the best futures contract for you to hedge with, you run a regression of daily changes in the price of Zirconium against daily changes in the prices of similar assets which do have futures contracts associated with them. Based on your results, futures tied to which asset would likely introduce the least basis risk into your hedging position?
Change in price of Zirconium = α + β (Change in price of Asset)
| 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 |
A
Asset A
B
Asset B
C
Asset C
D
Asset D