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

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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.

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