The Existence of Basis Risk — OpenTuition Forums

EPEsther Pang14y ago

Hi sir,

I want to ask about basis risk that may exist in Interest Rate Futures. If the question says, assume now is 31/12/2011, we need to borrow $5million in three months' time for a six month period. So, i understand that loan will be taken out on 31/3/2012, which is the future closed-out date. In this case, I would definitely choose March futures contract to set up the hedge (contract matures at the end of the relevant month). Since the future closed-out date is 31/3/2012 which is also the maturity date of the contract, does it mean that there would be no basis risk exist? and therefore, we are not required to calculate basis risk.

Hope to hear from you soon. Thank you so much, sir

John MoffatTutor14y ago#1

There will still be basis risk because as of now (31/12/2011) the interest rate will not be equal to the equivalent future price. But at the 31 March the interest rate and the equivalent futures price will be the same (the difference will be zero). And so the future price will not move by the same amount as the interest rate.

EPEsther Pang14y ago#2

Hi sir, thank you for your reply.

so that is to said, opening basis, on 31/12/2011 is still exist if the interest rate and future price is not same. but there would be no remaining basis because the futures closed-out date is also the maturity date. Therefore, the effective lock-in rate will just be the opening futures price.

In addition to this, As I know, on maturity date, both the implied LIBOR rate and futures price will be the same in value. so, on closed-out date, which is also maturity date, lets say the future LIBOR rate is 8%, implies a futures price of 92.00. the closing futures price will also be 92.00 irrespective of the opening basis. But still, because of the existence of opening basis, the gain or loss on futures will not be exactly matched the loss/gain on the underlying transaction in the cash market. am i right, sir?

Thanks in advance.