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.

As a bond approaches maturity, its value will be driven less by the time value of money or its coupons, and more by its redemption value, ie the par. Therefore as maturity approaches, its value converges to its par value and this phenomenon is called pull to par.

When assets are uncorrelated, variances are additive. But volatility (which is standard deviation) is not. In the given situation, the total variance of the portfolio will be equal to the the square root of the sum of the variances of the assets in the portfolio weighted by the square of their weights. Its volatility will be the square root of this variance. Thus Choice 'c' is the correct answer.

(This is because V(cA + dB) = c^2 V(A) + d^2 V(B) - refer tutorial on combining variances.)

Choice 'a' is incorrect as it describes the calculation of variance, not volatility. Also, the presence of a large number of uncorrelated assets does not create a portfolio with volatility equal to zero or that of the market. The other choices are therefore incorrect.