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

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BlackTom AI · Accepted Answer

Question41 asks about basis risk in a hedging context and the effects it can have. 
Option 1: 'It ensures a perfect hedge with no risk' — This is incorrect. Basis risk is the risk that the hedge will not move perfectly in tandem with the underlying asset, so it does not guarantee a perfect hedge.
Option 2: 'It reduces the effectiveness of the underlying asset' — This phrasing is odd, since basis risk concerns the hedge's imperfect correlation between the hedge instrument (often futures) and the spot asset, not a reduction in the inherent effectiveness of the asset itself. It misstates the concept.
Option 3: 'It improves the correlation between hedged and underlying assets' — On the contrary, basis risk arises precisely because the correlation is imperfect or changes over time; it does not improve correlation. This option describes the opposite of what basis risk entails.
Option 4: 'It refers to the difference between spot and futures prices and can result in imperfect hedging outcomes' — This is correct. Basis risk is about the difference (basis) between the spot price of the asset and the futures price, and because that basis can widen or narrow unpredictably, hedges may be imperfect.
Thus, the most accurate statement is the last option, which correctly identifies basis risk as the spot-futures price difference and its potential to yield imperfect hedges.

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