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FRM Part I · FRM Exam Part I · How Do Firms Manage Financial Risk?

A treasurer hedges jet fuel purchases with heating oil futures because no jet fuel futures contract exists. Which risk is most directly the result of this choice and cannot be removed simply by adjusting the number of contracts?

Cross-hedge basis risk is the main consequence. Jet fuel and heating oil prices are correlated but not perfectly, so the hedge leaves residual variance even at the optimal hedge ratio. Adjusting contract numbers reduces but cannot eliminate this risk unless correlation equals one.

  1. ACross-hedge basis risk from imperfect correlation between the two pricesCorrect
  2. BCounterparty default risk from exchange margining
  3. CLiquidity risk from daily settlement
  4. DInterest rate risk on the futures price

Explanation

Using a related but different asset creates basis risk because spot jet fuel and heating oil futures do not move perfectly together. The hedge ratio can minimise variance but the residual risk remains whenever correlation is below 1. Exchange-traded futures have little counterparty risk due to margining.

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