The correlation between changes in price of a spot asset and futures asset is 90%. The standard deviation of changes in spot prices is $2, and that of futures prices is $2.50. The hedge ratio that minimizes hedge variance is
A) 0.70
B) 0.72
C) 0.80
D) 0.85

Question

Quizplus · Accepted Answer

The hedge ratio (h) is given by the formula:
h = Correlation * (Standard deviation of spot price / Standard deviation of futures price)
Using the given values, we get:
h = 0.9 * (2 / 2.5) = 0.72
Therefore, the hedge ratio that minimizes hedge variance is 0.72.

The Correlation Between Changes in Price of a Spot Asset