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Dear tutor:
I came up with another question: if the question tells us that
1. “basis risk may be assumed to be zero at the time the contracts are closed out”
does it meaning the at the time the contract is closed, the spot exchange rate is the same as the future rate?
2. “basis risk may be assumed to derease linearly”, does it meaning that we can calculate as we usually do: we use spot rate of contract closing date plus or minus basis risk we calculated?I am not sure if I explain my question clearly or not, anyway, if it looks confusing to you, pls just help to tell me the difference of these 2 assumptions. Thanks
If the question says that basis risk is zero at the time the contracts are closed out, then the futures price and the spot rate will be the same on the date of the transaction (which is when the contracts would be closed out).
If basis risk is assumed to decrease linearly it means it decreases linearly up to the last day of the future and so you can calculate the basis risk at the date of the transaction. This basis risk gives you the difference between the spot and the futures prices on the date of the transaction.
Hi, Sir:
If the question says: “you may assume that basis diminishes to zero at contract maturity at a constant rate over time and that time intervals can be counted in months”,
what does it mean? does it mean basis risk decreases linearly up to the day of the future? (it seems that it is the assumption of the question, because the answer did not assume same spot rate on the date of the transaction)
or does it mean the basis risk is zero at the time the contracts are closed out? ( my understanding) .
Pls advise, thanks
‘Contract maturity’ is the last day of the future (so for example June 30th if it is a June future).
The contracts are closed out (the deal is finished) on the date of the transaction.
We assume that the basis risk falls linearly between now and the last day of the future, and so by counting the months you can estimate the basis risk on the date of the transaction.
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