Basis Risk

CFA Level III Derivatives
#1

a few questions…

at time 0 S(0) = $1/euro, F(0)=$1.1/euro ---------------Basis = 1-1.1= -$0.1/euro

at time T S(T) = $1.2/euro, F(T)=$1.5/euro------------Basis = 1.2-1.5 = -$0.3/euro

Am i right?

second…lets say i SOLD a 90 day currency future at $1/euro…and i wish to lift the hedge at day 65…i can only close out my position by buying another future? can i just buy enough spot to deliver or is it just the delivery mode that counts? sorry if this example seems a bit too blur.

I saw an example in Schweser showing that the investor who sold a currency forward close out with another future. investor also lifted the hedge before expiration. but the point is at the time of lifting the hedge, the spot rate would be more favorable for him to close out the position. why would the investor not choose the spot rate instead and use the future? unless of course he cannot use it…comments??

Now lets say the investor holds the hedge position all the way till the end. the spot is $1/euro at the time he invested and the future rate is $1.1/euro. at expiration, the spot rate is $1.2/euro and future is $1.5/euro. can i now say that the investor is perfectly hedged? recall that perfect hedge is when the future price locks in the initial basis & the initial spot rate plus basis. which is fulfilled by 1.1 = 1 + 0.1…correct??? the spot and futures rate at expiration has nothing to do with it???

on a side note…GIPS and alternative investments - just the benchmark construction is already killing me! -------will they be out on the AM session??? this test recall so much till i can literally puke…i think L3 is the stage where anything can show up anywhere. is this true???..hope to get some insight on this

THANKS AND KEEP FIGHTING ON!!!

#2

“I saw an example in Schweser showing that the investor who sold a currency forward close out with another future. investor also lifted the hedge before expiration. but the point is at the time of lifting the hedge, the spot rate would be more favorable for him to close out the position. why would the investor not choose the spot rate instead and use the future? unless of course he cannot use it………….comments??”

Theoretically the Futures price is only equal to the spot on expiry . If you close before expiry ,the long is not ready to accept delivery or the price may be higher than you’d get if you wait for expiry. If you wait all the way to expiry , there is no choice anyway , you have to buy at spot and deliver ( or financially settle , which is equivalent to buying spot ( equal to futures) and delivering or buying a futures contract to offset the short)

Either way the proper price to exit the trade is the futures price and the way to do it is to buy the futures contract

#3

hope to get more replies!