What must be the daily interest rate (expressed in continuously-compounded and annualized terms)for the tailed hedge ratio to be 90% of the untailed one for a one-year hedge? Assume a hedging horizon of 365 days.
A)10%
B)15%
C)20%
D)25%

Question

Quizplus · Accepted Answer

The tailed hedge ratio being 90% of the untailed one implies a reduction due to the effect of daily compounding interest over a year. The formula relating the tailed and untailed hedge ratios involves the exponential function of the continuously compounded rate times the hedging horizon. To achieve a 10% reduction (i.e., to 90% of the original), a specific rate must be chosen that, when applied continuously over 365 days, results in this exact reduction. A 20% annualized continuously compounded rate is the one that fits these criteria, as it provides the necessary exponential decay factor over a year to reduce the hedge ratio to 90% of its original value.

What Must Be the Daily Interest Rate (Expressed in Continuously-Compounded