Question

Consider a cross hedge, for example using heating oil futures to cross hedge the price risk of jet oil. Suppose the measure of hedge effectiveness is 0.7. Which of the following is true?

A. It means that the optional amount of futures should be 70% of the underlying assets to be hedged

B. It means that the uncertainty in the value of the hedged portfolio is 70% lower than the uncertainty in the unhedged portfolio

C. It means that the uncertainty in the value of the unhedged portfolio is 30 % lower than the uncertainty in the unhedged portfolio

D. It means that the uncertainty in the value of the hedged portfolio is 30% lower than the uncertainty in the unhedged portfolio

E. It means that the uncertainty in the value of the unhedged portfolio is 70% lower than the uncertainty in the unhedged portfolio

Answer 1

B. It means that the uncertainty in the value of the hedged portfolio is 70% lower than the uncertainty in the unhedged portfolio

Hedging effectiveness is a measure of correlations between the underlying asset and the asset used for hedging. A hedge effectiveness of 0.7 means than after hedging, the uncertainty is decreased by 70% of the unhedged uncertainty.

A is incorrect as optional amount of futures depends on the standard deviation of the undelying asset and the underlying in the futures contract. Option E and C are self-contradictory as it talks only about unhedged portfolio uncertainity.