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Company EFG wants to buy 100,000 units of asset A in three months. Suppose that the standard deviation of the quarterly changes in the price of asset A is $2. The standard deviation of quarterly changes in the futures price for a contract on an underlying asset B which similar to asset A is $2.5. The correlation between the quarterly changes in the price of asset A and the quarterly changes in the futures price for the contract on asset B is 0.85. One futures contract is on 3,000 units of asset B.
(a) Should EFG enter long or short futures positions in order to hedge its exposure? Explain.
(b) What is the minimum variance hedge ratio in this case? What does this hedge ratio mean?
(c) How many futures contracts on asset B should be traded?
(d) What is the hedge effectiveness? How can you interpret this number?
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