I went back and re-read the section on duration risk in Reading 30 b/c of this thread. My conclusion would be that the answer is B. Per the CFAI text, “basis” is the difference between the cash price and the futures price, and “basis risk” is when that basis changes in an unpredictable way. “cross hedging” is when the underlying bond is not identical to the bond underlying the futures contract, and significantly increases basis risk because not only can the price of both instruments change, but the relationship between the instruments can change as well. A hedged position substitutes basis risk for price risk. Solution A has a time mismatch, but in the 2 months until the needed wheat is delivered, the difference between the cash price and the futures price should not change all that much, and while the time disconnect allows for a change in the relationship between the wheat spot price and the wheat futures contract, the relationship is not likely to change as much as the currency crosses in solution B. The problem didn’t indicate the company wanted to hold the contract until expiration, it was just assuming the relationship would hold for 2 months until they could purchase at the spot price. IMO Solution B is the answer because by using a pound/ futures contract to hedge a payment in Euros, the firm needs the relationship of the pound/euro (cash price) and the pound/ (futures price) exchange rates to remain unchanged. The 2 places where basis risk manifests are (1) the change in relationship between the CTD (Cheapest to deliver) security and the futures contract, and (2) the relationship between the underlying security and the CTD security. Looked at in this perspective I think we can clearly see that because of currency fluctuations, Solution B has much a greater risk of change in the relationship between the underlying security and CTD security (#2), than Solution A. I don’t see #1 being a greater risk for one than the other. Solution C is a good hedge with little price or basis risk, and is not the answer. That’s my $0.02 FWIW. thanks for the discussion.
Sorry guys was away for the Easter break. Will double check the answer tonight
Answer was b. Explanation was: Basis risk arises when the futures contract differs from the asset underlying the contract. In other words the futures contract is not a perfect representation of the underlying being hedged. The British Exporter will collect payments in euros, but is hedging using the pound/US Dollar exchange rate. The is representative of a cross hedge, which presents the highest basis risk of the choices given because the relationship between the pound and the US dollar is not necessarily indicative of the relationship between the pound and the euro.
As quite a few peeps posted the answer as A) see explanation for why this isn;t the answer below: The underlying asset on the KCBT wheat contract is hard red winter wheat, so basis risk is mimimized. The fact that the manufacturer needs the wheat in 2months but the contract used to hedge matures in 3 months does add basis risk, but this is still deemed to be less risky than a cross hedge.
Thanks man.
naze_duck Wrote: ------------------------------------------------------- > As far as the concept of basis risk is concerned > (because in the beginning, you asked for an > explanation): Basis refers to the difference of > the spot price (of the thing you’re trying to > hedge) and the futures price (of the thing you’re > using to hedge). These prices may not move in > parallel due to several reasons: > > a) they’re not exactly the same asset (for > example, the corn you will deliver might not be > the same grade as the one the future contract > specifies). Other example: The guy in B above > tries to hedge euros with pounds - now the > question is how much these are correlated. > b) the delivery dates might not match, as in > option A above. > c) the delivery might be at a different location. > For example, the farmer in option C above might > have sold futures that call for delivery in > Chicago, but he is based in Iowa. > > These differences cause the prices of the asset / > liability and its hedge to move differently. So > although you’ve hedged to some degree, the hedge > is not perfect - and that’s called basis risk. > > That said I stick to B because in A, at least the > guy has a contract on roughly the same thing that > he’s trying to hedge. 2 months down the road he > will have to sell the futures contract and buy > spot, but the futures contract will have a return > that’s similar to the movement of the spot price. > Whereas the guy who’s trying to hedge euros with > pounds could have a loss on his future contract > _and_ the euro could have depreciated relative to > the pound, which would mean a double loss. Thats a really good explanation thank you