(a)Pear, Inc. is a manufacturer that is heavily dependent on plastic parts shipped from Malaysia. Pear wants to hedge its exposure to plastic price shocks over the next 7 1?2 months. Futures contracts, however, are not readily available for plastic. After some research, Pear identifies futures contracts on other commodities whose prices are closely correlated to plastic prices. Futures on Commodity A have a correlation of 0.85 with the price of plastic, and futures on Commodity B have a correlation of 0.92 with the price of plastic. Futures on both Commodity A and Commodity B are available with 6-month and 9-month expirations. Ignoring liquidity considerations, identify and discuss the contract that would be the best to minimize basis risk.

(b) A German housing corporation needs to hedge against rising interest rates. It has chosen to use futures on 10-year German government bonds. Which position in the futures should the corporation take, and why?

(c) On Nov. 1, a fund manager of a USD 60 million US medium-to-large cap equity portfolio, considers locking up the profit from the recent rally. The S&P 500 Index and its futures with the multiplier of 250 are trading at 2,110 and 2,120, respectively. Instead of selling off the holdings, the fund manager would rather hedge two-thirds of this market exposure over the remaining two months. Given that the correlation between the portfolio and the S&P 500 Index futures is 0.89 and the volatilities of the equity fund and the futures are 0.51 and 0.48 per year, respectively, what position should the manager take to achieve the objective?

(d) A risk manager wishes to hedge an investment in zirconium using futures. Unfortunately, there are no futures that are based on this asset. To determine the best futures contract to hedge with, the risk manager runs a regression of daily changes in the price of zirconium against daily changes in the prices of similar assets that have futures contracts associated with them. Based on the results, futures tied to which asset would likely introduce the least basis risk into the hedging position? Explain.

Change in Price of Zirconium = a + (Change in Price of Asset) Asset R A 1.25 1.03 0.62 B 0.67 1.57 0.81 C 0.01 0.86 0.35 D 4.56 2.30 0.45