Explanation:
Linda Farris's response to Togo Barrio's question about basis risk in hedging with futures contracts is accurate and relevant. All three factors she mentioned can affect basis risk:
Statement I is correct: Basis risk arises because the futures price and the spot price of the underlying asset may not converge as expected at the expiration of the futures contract. This divergence can be due to various factors like changes in market expectations, supply and demand imbalances, or unforeseen events affecting the asset's price.
Statement II is correct: Costs such as transaction fees, storage costs, or financing costs can impact the overall cost of hedging. Variations in these costs can alter the expected returns from the hedge and contribute to basis risk.
Statement III is correct: When the maturity of the futures contract does not align perfectly with the timing of the exposure of the cash asset, basis risk is introduced. This mismatch can occur because futures contracts have standardized expiration dates, which may not coincide with the specific timing needs of the hedger.
Q.631 Togo Barrio, a portfolio manager at Mexico Asset Management Inc., is interviewing Linda Farris for the position of risk analyst in the firm's derivatives unit. To one of Barrio's questions related to the basis risk involved in hedging with futures contracts, Farris replied with the following three factors that affect the basis risk:
I. Interruption in the convergence of the futures prices and spot prices
II. Changes in the component of costs involved in hedging transactions
III. A mismatch between the maturity of the cash asset and the hedged asset
Which of the factors provided by Linda affect the basis risk?
A
Reason I only.
B
Reasons II and III.
C
Reasons I and III.
D
Reasons I, II, and III.
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