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Answer: Basis risk exists because, when the hedge is closed, there is uncertainty about the difference between the spot and futures price
**Correct answer: D** Basis risk is the uncertainty about the relationship between the spot price and the futures price when the hedge is lifted or closed out. If basis changes unexpectedly, the hedge may not perfectly offset the exposure. Why the others are false: - **A:** A hedge is primarily for risk reduction, not to increase expected profits. - **B:** Shareholders generally do not want firms to hedge every risk; some risks may be better left unhedged depending on costs, diversification, and investor preferences. - **C:** A hedge can still be well designed even if the hedged outcome turns out worse than the unhedged outcome, because hedging is evaluated by risk reduction, not by whether it always improves realized profit.
Author: Manit Arora
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Q-21.13.1. There exist three categories of derivatives traders: hedgers, speculators, and arbitrageurs. Non-financial firms use futures contracts to either hedge or speculate. In regard to hedging with futures contracts, which of the following statements is TRUE?
A
The purpose of a corporate hedge is to increase corporate profits
B
Shareholders prefer their company hedge all of its material financial risks
C
If the outcome with hedging is worse than the outcome without hedging, then the hedge was poorly designed
D
Basis risk exists because, when the hedge is closed, there is uncertainty about the difference between the spot and futures price
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