April 2019

[rlsrachaellouisesmith]

Hi

Q2)iii) why is basis risk increased if positions are rolled indefinitely?

Basis risk I thought had the biggest impact if need to close out early, because at the time of closing out basis might be higher/lower than the hedge created on which could cause a loss.

Whereas if rolled indefinitely the hedge is calculated based on the expected difference between the u/l portfolio and the hedging index/portfolio. Or are we saying that the basis cannot be predicted with certainty and therefore if it fluctuates over time it is even less likely we can predict with certainty meaning it is likely the hedge will be imperfect?

Thank you

 

[Colin McKee]

Rolling the hedge forward involves continuously closing out one position and replacing it with a longer derivative. Each time you deal in either the one you are closing or the one you are opening, there is a chance that the basis will be volatile and you may lock in a loss/profit. So the hedge is less perfect.

 

[rlsrachaellouisesmith]

Thank you Colin, that makes a lot of sense.