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Dear Sir, In this question it says that there is no basis risk. Basis risk is the difference between the spot and futures price. if there is no basis risk both future price and spot should be the same.
But the question also says that basis risk diminishes to zero at the end at a constant rate. So when calculating the futures price on transaction date the answer script shows deducting 0.18 as unexpired basis from the 100-LIBOR.
Actually I’m confused on what is this constant rate. I calculated futures price as 100-LIBOR.
Nowhere in the question does it say that there is no basis risk!
The basis risk currently is the difference between the current futures prices and the current LIBOR (expressed as a futures price).
We always assume that this falls linearly to zero over the life of the future (which is the same as saying it falls at a constant rate).
Because they are using June futures, the basis will fall linearly over the 6 months to the end of June.
Therefore on the date the loan starts in 4 months time, the basis will have fallen by 4/6 (or there will be 2/6 of it left).You do need to watch the free lectures on interest rate risk, where all of this is explained in detail.
b) question asks ‘ Based on the three hedging choices Alecto Co is considering and assuming that the company does not face any basis risk, recommend a hedging strayegy’
What is meant by assuming the company does not face any basis risk here?
The answer does take into acc the basis of 0.18
The basis risk is the fact that the basis changes over time.
If there is no basis risk, it means that the basis does not change and therefore remains at 0.18.
@johnmoffat said:
The basis risk is the fact that the basis changes over time.If there is no basis risk, it means that the basis does not change and therefore remains at 0.18.
I thought this way as well after seeing your lecture ”Lock-in Rate” . The basis was initially 0.54 on 1/Jan/2012
Transaction date 1/May/2012-June Future- BPP answer shows unexpired basis as 0.18(2/6*0.54)- Shouldn’t it be 0.54 if the company didn’t face any basis risk?
That is true and strictly they should not have done this.
Just state your assumption in the exam and you will get full marks if you then do everything correctly on your assumption.
Hi John
I was going through Dec 2013 Q.2 AwanCo and happened to read a similar line. The last line of the question states ” Assume there is no basis risk”
But the examiners answer shows a basis of 1.15 initially which then reduces to 0.45 🙁
What exactly do they mean by ”no basis risk” then ?
Actually, I have realised that I answered too fast before without thinking properly – sorry 🙁
The current examiner interprets “no basis risk” differently from the previous examiner.
We assume in exams that the basis falls linearly over the life of the future, but in practice there is no reason for it to be linear. The current examiner is using the term ‘assume no basis risk’ to mean that it will fall linearly and that there is no risk of it actually falling differently.
(Having said that (and therefore in the exam do assume it falls linearly) it is poor English on his part and you would have to get the marks if you assumed the basis stayed unchanged provided you stated your assumption.)
Thank you John!
Yes the English has been really bad in some of the previous exams i wrote as well. I feel the examiner is doing it to confuse us 🙁
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