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

An airline hedges its jet fuel purchases with futures and estimates the minimum variance hedge ratio by regressing monthly changes in jet fuel spot prices on changes in futures prices. Which statement about the regression is correct?

The slope of the regression of spot price changes on futures price changes is the minimum variance hedge ratio, and the R-squared shows the proportion of spot variance eliminated by hedging. The slope equals the correlation only when the two volatilities are the same.

  1. AThe slope coefficient is the estimated hedge ratio and the R-squared measures hedge effectivenessCorrect
  2. BThe intercept is the estimated hedge ratio and the R-squared measures basis risk in dollars
  3. CThe slope coefficient equals the correlation between spot and futures changes in all cases
  4. DThe hedge ratio must always equal 1 if the futures contract matches the asset exactly in maturity

Explanation

Regressing spot changes on futures changes gives a slope equal to rho x sigma_S / sigma_F, which is the minimum variance hedge ratio, and R-squared is the proportion of variance eliminated. The slope equals correlation only when the two volatilities are equal.

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