8006 Exam Dumps : Exam I: Finance Theory Financial Instruments Financial Markets - 2015 Edition

The effectiveness of the hedge is solely determined by the correlation between the position being hedged, and the position being used as the hedge. A hedge can be perfect when correlation is 1, and will be less than perfect when it is anything other than 1.The effectiveness of the optimal hedge is given by the formula √(1-ρ2), where ρ is the correlation between the two. Therefore Choice 'c' is the correct answer. Standard deviations affect the hedge ratio, not the effectiveness of the hedge.

The fair price for the futures contract should be [1000 x ( 1 + (2%-1%)/2)] = 1005. This means the futures contract is 'rich' at 1020. The trader should therefore short the futures contract, and buy the index spot. To buy the spot index, he will incur a borrowing cost of 2%, which will be partly offset by the dividend yield of 1%, and at the end of six months he will owe a net amount of 1005 and hold the index. At the same time the futures contract would expire too, and he would be able to sell at the agreed price of 1020, making a risk free profit of 15.

All the choices list inputs into the determination of futures prices. Therefore volatility in any of them affects the volatility of futures prices. Of course, the largest contributor to the volatility is the volatility of the spot price of the underlying. Choice 'd' is the correct answer.