Explanation

The optimal hedge ratio (h*) is calculated using the formula:

$h^* = \rho \times \frac{\sigma_S}{\sigma_F}$

Where:

• $\rho$ = correlation between spot and futures price changes = 0.3876
• $\sigma_S$ = standard deviation of spot price changes = 0.57
• $\sigma_F$ = standard deviation of futures price changes = 0.85

$h^* = 0.3876 \times \frac{0.57}{0.85}$ $h^* = 0.3876 \times 0.6706$ $h^* = 0.2599$

Therefore, the optimal hedge ratio is 0.2599, which corresponds to option D.

This hedge ratio represents the proportion of the spot position that should be hedged using futures contracts to minimize risk.