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?

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BlackTom AI · Accepted Answer

We start by restating the scenario to ensure clarity: 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. The question asks which of the following is true.

Option 1 (provided): a. The hedger’s position improves.

First, we consider what a short futures hedge means in the context of hedging a sale. If you are hedging a sale (a short position in the underlying asset) and you use a short futures contract, you are off the standard hedge alignment. The conventional hedge for a sale (to protect against price declines) is to use a long futures position, because when futures rise you gain on the futures hedge to offset the lower spot you might realize. Using a short futures position to hedge a sale typically constitutes a reverse hedge and tends to increase basis-related risk rather than reduce it.

Now, interpret a basis increase. Basis = spot − futures. An increase in basis means the difference between spot and futures widened in the direction of spot being higher relative to futures (or futures falling relative to spot). In practical terms, if futures fall (which would drive the basis higher), a short futures position loses value, while a sale hedge would have wanted futures to rise to offset potential declines in spot prices. Therefore, a basis increase in this setup would generally worsen the effectiveness of the hedge and could worsen the hedger’s net position, not improve it.

Why this makes option 1 incorrect: If the basis widens (basis increases) while the hedger is using a short futures hedge on a sale, the futures leg tends to move against the hedger’s target risk reduction. The cash (spot) side and futures side do not align to produce a net improvement; instead, the reverse hedge and the basis movement reduce hedge effectiveness and can amplify risk.

Why the other options are not provided here: The given answer options list only one statement (a) with a note 'cross out' and there are no additional choices to compare. Since the basis increase in this specific reverse-hedge setup does not improve the hedger’s position, the statement claiming improvement is incorrect in this context.

In summary, with a basis increase and a hedge that uses a short futures position to cover a sale, the hedge generally becomes less effective and the hedger’s position is not improved; instead, it tends to deteriorate or require reassessment of the hedging strategy.

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?

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