Final answer:
Basis risk increases with a large difference between the spot price and futures price of the underlying asset, and when there's a disparity between the underlying asset of the futures contract and the hedger’s exposure. Option 1 is correct answer.
Step-by-step explanation:
The question addresses how certain factors can impact basis risk, which arises when using hedging strategies with financial derivatives like futures contracts. Basis risk is the risk that the value of a hedge will not move in line with the value of the underlying exposure, leading to a less effective hedge.
A significant difference between the underlying asset's spot price and futures price increases basis risk because the futures contract may not accurately represent the current market value of the asset.
Disparity between the underlying asset of the futures contract and the hedger’s exposure also increases basis risk, as the price movements of the hedge might not correspond perfectly to the price movements of the exposure. However, a reduction in the time between the date when the futures contract is entered and its delivery month typically decreases basis risk because there is less time for the two prices to diverge.