The dragon’s revenge


Last time in Quant Talk we looked at basis risk. We found that if your hedging asset isn’t perfectly correlated to your exposure, the risk can be a lot more severe than might be expected. The message was that you can’t expect to slay the dragon of risk. You might just try to give it some sleeping pills and keep a fire extinguisher on hand for when it wakes up.

This time we look at a case where we do have perfect correlation between our potential liability and our hedging asset –

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