Question41 What is basis risk? In the context of a hedging problem, what effect can basis risk have? It improves the correlation between hedged and underlying assets It ensures a perfect hedge with no risk It reduces the effectiveness of the underlying asset It refers to the difference between spot and futures prices and can result in imperfect hedging outcomes ResetMaximum marks: 1 Flag question undefined

Question

BlackTom AI · Accepted Answer

When evaluating basis risk in hedging, it helps to parse what each statement is claiming about the relationship between the hedge instrument and the underlying asset.
Option 1: 'It improves the correlation between hedged and underlying assets.' This is incorrect because basis risk arises precisely when the hedge and the underlying do not move perfectly in sync; the correlation is not improved by basis risk, it is modeled as imperfect correlation.
Option 2: 'It ensures a perfect hedge with no risk.' This is the opposite of what basis risk means. A perfect hedge would imply zero basis risk, whereas basis risk is the potential for hedging errors due to imperfect alignment between futures and spot movements.
Option 3: 'It reduces the effectiveness of the underlying asset.' This phrasing is a bit vague and somewhat misleads. Basis risk is about the hedge’s performance relative to the underlying, not about reducing the inherent effectiveness of the asset itself. The focus is on hedging effectiveness, not on the intrinsic value of the asset.
Option 4: 'It refers to the difference between spot and futures prices and can result in imperfect hedging outcomes.' This is the correct conception of basis risk: the spread between current spot prices and futures prices causes hedges to deviate from perfectly offsetting movements, leading to potential hedging errors.
In summary, understanding basis risk centers on the gap between spot and futures prices and recognizing that this gap can cause hedges to be imperfect rather than flawless. This aligns with the common definition in hedging theory, where the basis is the mechanism through which hedges can underperform when the basis changes unfavorably.

Similar Questions

What reflects the degree to which the rate on the option's underlying asset moves relative to the spot rate on the asset or liability that is being hedged?

Which of the following increases basis risk?

The basis is defined as spot minus futures. A trader is hedging the sale of an asset with a short futures position. The basis increases unexpectedly. Which of the following is true?

Which of the following increases basis risk?

The basis is defined as spot minus futures. A trader is hedging the sale of an asset with a short futures position. The basis increases unexpectedly. Which of the following is true?

Is the following statement true or false? In the products of methylation-hydrolysis, every -OH group corresponds to the position of a glycosidic bond in the starting polysaccharide.

More Practical Tools for Students Powered by AI Study Helper

Homework AI Solver

Stylized AI Paper Writer

Plagiarism Checker Assistant

Citation AI Academic Writing Tool

In-Class Translation Assistant

AI Note Generator

AI Quiz Answers

Past Exam Questions from University Test Bank

Smart Practice Assistant

Adaptive Practice

Making Your Study Simpler