LOS c: Evaluate the effect of basis risk on the quality of a currency hedge.

Q1. In the hedging of currency risk, the issue of basis risk is:

A)   not a concern when using either futures contracts or options.

B)   a concern when using options and not futures contracts.

C)   a concern when using futures contracts and not options.

Q2. An analyst is managing a portfolio denominated in a foreign currency, and he plans to hold the portfolio one year. The analyst computes the hedge ratio of the portfolio to be equal to one, and he plans to implement the appropriate hedge. Which of the following actions will reduce basis risk?

A)   Taking a futures position that matures in one year.

B)   Nothing; since the hedge ratio equals one the basis risk is zero.

C)   Taking successive one-month futures contracts for the upcoming year.

Q3. An analyst in Europe manages a portfolio denominated in yen. The hedge ratio for the portfolio is equal to one, but the futures exchange rate is greater than the spot exchange rate, where the exchange rate is Euro/yen. If there is an increase in the European interest rate relative to the Japanese interest rate, then according to interest rate parity:

A)   the basis will narrow.

B)   the basis will widen.

C)   the basis will remain unchanged.

Q4. An analyst is managing a portfolio denominated in a foreign currency. In her analysis, she estimates that the hedge ratio of the portfolio is equal to one, and she implements the appropriate hedge. She also forecasts that there will be a negative correlation between the interest rate in her country and the interest rate associated with the foreign currency. This relationship of the interest rates:

A)   will reduce but not eliminate the basis risk of the hedged position.

B)   will introduce basis risk to the hedged position.

C)   is unrelated to basis risk.

LOS c: Evaluate the effect of basis risk on the quality of a currency hedge. fficeffice" />

Q1. In the hedging of currency risk, the issue of basis risk is:

A)   not a concern when using either futures contracts or options.

B)   a concern when using options and not futures contracts.

C)   a concern when using futures contracts and not options.

Correct answer is C)

Basis risk is the difference between the forward or futures price and the spot price. The variability of this measure is a source of risk in a futures or forward hedge where the maturity of the derivative is different from the horizon. Basis risk is not an issue in hedging with options.

Q2. An analyst is managing a portfolio denominated in a foreign currency, and he plans to hold the portfolio one year. The analyst computes the hedge ratio of the portfolio to be equal to one, and he plans to implement the appropriate hedge. Which of the following actions will reduce basis risk?

A)   Taking a futures position that matures in one year.

B)   Nothing; since the hedge ratio equals one the basis risk is zero.

C)   Taking successive one-month futures contracts for the upcoming year.

Correct answer is A)

An investor must be aware of basis risk anytime a futures hedge will be lifted prior to the futures maturity date. To avoid basis risk the investor would have to match the maturity of the futures contract with the intended holding period.

Q3. An analyst in ffice:smarttags" />Europe manages a portfolio denominated in yen. The hedge ratio for the portfolio is equal to one, but the futures exchange rate is greater than the spot exchange rate, where the exchange rate is Euro/yen. If there is an increase in the European interest rate relative to the Japanese interest rate, then according to interest rate parity:

A)   the basis will narrow.

B)   the basis will widen.

C)   the basis will remain unchanged.

Correct answer is B)

Thus, an increase in i_D relative to i_L will widen the basis.

Q4. An analyst is managing a portfolio denominated in a foreign currency. In her analysis, she estimates that the hedge ratio of the portfolio is equal to one, and she implements the appropriate hedge. She also forecasts that there will be a negative correlation between the interest rate in her country and the interest rate associated with the foreign currency. This relationship of the interest rates:

A)   will reduce but not eliminate the basis risk of the hedged position.

B)   will introduce basis risk to the hedged position.

C)   is unrelated to basis risk.

Correct answer is B)

Basis is the difference between the spot and futures exchange rates at a point in time. The magnitude of the basis depends upon the spot rate and the interest rate differential between the two economies. Interest rate parity describes the relationship between spot and futures exchange rates and local interest rates:

Hence, if the interest rates move in the opposite direction, then the basis will change.

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