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Answer: Futures on Commodity B with 9 months to expiration
## Explanation To minimize basis risk in hedging, two key factors must be considered: 1. **Correlation**: Higher correlation between the hedging instrument and the underlying exposure reduces basis risk. Commodity B has a correlation of 0.92 with plastic prices, which is higher than Commodity A's correlation of 0.85. 2. **Maturity Matching**: The futures contract should expire after the hedge period (7.5 months) to avoid the need for rolling over contracts. The 9-month contract provides better maturity alignment than the 6-month contract. **Analysis:** - Commodity B (0.92 correlation) is superior to Commodity A (0.85 correlation) - 9-month expiration is better than 6-month expiration for a 7.5-month hedge period - Therefore, Futures on Commodity B with 9 months to expiration provides the optimal combination of high correlation and appropriate maturity timing This combination minimizes the potential divergence between the futures price movements and the actual plastic price movements during the hedge period.
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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 7.5 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
C
Futures on Commodity B with 6 months to expiration
D
Futures on Commodity B with 9 months to expiration
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