Which of the following increases basis risk?

Question

BlackTom AI · Accepted Answer

To approach this question, we first recall the concept of basis risk: it is the risk that the hedge between a futures position and the underlying exposure does not move in perfect tandem, causing the hedge to be imperfect.

Option presented: 'b. Dissimilarity between the underlying asset of the futures contract and the hedger’s exposure.' This option attributes basis risk to a mismatch between the asset underlying the futures contract and the hedger’s actual exposure. When the underlying futures contract does not perfectly mirror the asset being hedged—for example, hedging a stock index with futures that include dividend differences, or using commodity futures that do not track the exact quality or location of the asset—the price movements may diverge, increasing basis risk. In other words, greater dissimilarity typically elevates basis risk because the hedge is less perfectly aligned with the exposure being hedged.

If we were to consider other, unlisted options (which we can’t see here), we would evaluate them against the same principle: anything that would make the futures hedge more aligned with the exposure (such as using a futures contract on the exact same asset, maturity, quality, and delivery specifications) would reduce basis risk, while anything that adds mismatches across asset type, quality, location, or timing would increase it.

In summary, the core idea is that greater dissimilarity between the hedge instrument and the hedged exposure tends to raise basis risk because it weakens the hedges’ price correlation and alignment.

Note: The provided question text lacks multiple distinct answer options beyond the one listed line, so the analysis focuses on this option and the general reasoning about basis risk in the context of hedging.

FIN 413 (LEC B01 B02 B03 Winter 2025) Quiz 2

Which of the following increases basis risk?

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