Explanation:
To minimize basis risk when hedging with futures contracts on correlated commodities, we need to consider two key factors:
Analysis:
Basis risk minimization:
Therefore, the best contract to minimize basis risk would be Futures on Commodity B with 9 months to expiration (though this option isn't explicitly listed in the provided choices, based on the correlation data, Commodity B with 9-month expiration would be optimal).
However, since the question only provides options for Commodity A, and given that the 9-month contract better matches the 7.5-month hedging period than the 6-month contract, Option B (Futures on Commodity A with 9 months to expiration) would be the better choice among the given options.
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Pear, Inc. is a manufacturer that is heavily dependent on plastic parts shipped from Malaysia. Pear wants to hedge its exposure to plastic price shocks over the next 7 ½ months. Futures contracts, however, are not readily available for plastic. After some research, Pear identifies futures contracts on other commodities whose prices are closely correlated to plastic prices. Futures on Commodity A have a correlation of 0.85 with the price of plastic, and futures on Commodity B have a correlation of 0.92 with the price of plastic. Futures on both Commodity A and Commodity B are available with 6-month and 9-month expirations. Ignoring liquidity considerations, which contract would be the best to minimize basis risk?
A
Futures on Commodity A with 6 months to expiration
B
Futures on Commodity A with 9 months to expiration
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