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FRM Part I · FRM Exam Part I · Using Futures for Hedging

A firm hedges with futures and the minimum-variance hedge ratio is 0.80 with correlation 0.80 between spot and futures price changes. What proportion of the variance of the unhedged position is eliminated by the optimal hedge?

The optimal hedge eliminates 64% of the variance. Hedge effectiveness is the square of the correlation between spot and futures price changes, so 0.80 squared equals 0.64. The remaining 36% of variance is unhedged residual risk.

  1. A64%Correct
  2. B80%
  3. C36%
  4. D20%

Explanation

Hedge effectiveness equals rho squared = 0.80^2 = 0.64, so 64% of variance is removed. 80% mistakes correlation for effectiveness, 36% is the remaining variance (1 - 0.64), and 20% is 1 - rho.

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