Question

What is basis risk?

1) The risk that the underlying asset in the futures contract and the asset that is to be hedged move perfectly together
2) The risk that the underlying asset in the futures contract and the asset that is to be hedged do not move perfectly together because they are not identical
3) The risk that the underlying asset in the futures contract and the asset that is to be hedged do not move at all
4) The risk that the underlying asset in the futures contract and the asset that is to be hedged move in opposite directions

Answer 1

Basis risk is the risk that the underlying asset in a futures contract and the asset being hedged do not move in perfect correlation. In the context of currency hedging, if the value of the euro in dollars declines, the hedging contract protects against this basis risk.

Step-by-step explanation:

Basis risk refers to the risk that the underlying asset in a futures contract and the asset that is being hedged do not move perfectly together because they are not identical. It is the risk that the hedging instrument does not fully offset the risk of the underlying asset. In the context of the example provided, if the value of the euro in dollars declines, the U.S. firm would be protected by the hedge against this basis risk. However, if the euro increases in value, the hedging contract would be unnecessary and the firm would have paid a fee for nothing.