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What is basis risk in terms of interest rate future?
This concept is making me cry. Can you explain me this in laymen language with example? I don’t understand a thing even after watching your video. I know it results into imperfect hedge but other than that clueless.Interest rates stand to change between ‘now’ and the date the loan or deposit starts.
At the same time, futures prices change between between ‘now’ and the date the loan or deposit starts.
If they were both to change by exactly the same amount, then we could hedge (i.e.eliminate) the risk of interest rate changes completely.
However, in the real world they will not both change by exactly the same amount which means we cannot eliminate the risk completely and this is the basis risk.
You state that you watched the lectures on this, but had to watched the lectures on foreign exchange risk management first? I ask because the logic of the basis risk is exactly the same with foreign exchange futures and because I explain it in detail in the foreign exchange lectures I do not need to explain it in the same detail in the later interest rate lectures.
(Obviously you cannot be asked calculation questions on interest rate futures although you are expected to be able to describe them – calculations on them are not examined until Paper AFM.)
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