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?

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BlackTom AI · Accepted Answer

Let's parse the question carefully: it asks for the term that reflects how much the rate on the option's underlying asset moves in relation to the spot rate of the asset or liability being hedged.
Option a: Credit risk. This concerns the possibility that a counterparty will default on its obligations, not the relationship between movements in underlying and hedged item. So this is not the right concept here.
Option b: Interest rate risk. This refers to the risk that changes in interest rates will affect values, typically for debt instruments or derivative pricing, but it does not describe the relative movement between an option’s underlying and the hedged asset's spot rate.
Option c: Volatility. While volatility affects option pricing and the magnitude of price swings, it does not specifically capture the relative movement between the underlying asset used in the option and the hedged item’s spot movement. This is more about overall price variability than hedging alignment.
Option d: Basis risk. This is the term used to describe the risk that the hedge instrument (such as an option) will not move in perfect sync with the item being hedged, i.e., the rate on the underlying asset does not move identically to the spot rate of the hedged asset or liability. This directly matches the described concept.
Option e: Delta. Delta measures the sensitivity of the option’s price to small moves in the underlying asset’s price, but it does not by itself describe the degree of co-movement between the hedged item and the hedge instrument; it’s a factor in pricing and risk management rather than the definitional concept of the question.
In summary, the choice that best captures the described relationship is the one that denotes imperfect alignment between movements of the hedge instrument’s underlying and the hedged item, i.e., basis risk.

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?

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