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2. You must select a futures contract with which to hedge a portfolio. The six available...

2. You must select a futures contract with which to hedge a portfolio. The six available contracts all have the same variability, but their respective correlations with your portfolio are: -0.85, -0.25, 0, 0.50, 0.75, and 0.95. Rank these six contracts with respect to basis risk , from highest to lowest basis risk.

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Answer #1

Basis risk is the risk arising due to imperfect hedging.

So higher the imperfect hedge, higher the basis risk.
So higher the perfect hedge, lower the basis risk.

Where There is a negative correlation between the portfolio and the future contracts.
It means if the market portfolio falls the future contract rises and vice versa.

There is a rate of change in the opposite direction.

So negative correlation future contracts should be held in the portfolio to act as a hedge.

So the most negative correlation future contract creates a better Hegde and hence less basis risk.


Basis risk from highest to lowest:
0.95,0.75, 0.50, 0, -0.25 and -0.85

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