Which of the following involves an additional source of basis risk due to the difference between the asset being hedged and the asset underlying the futures?
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A. B. C. D.C
The answer to this question is C. Cross hedge.
A cross hedge is a type of hedging strategy in which an investor tries to hedge the risk of a particular asset by using a futures contract that is based on a different, but related, asset. In a cross hedge, the asset being hedged and the asset underlying the futures contract are not the same, which creates an additional source of basis risk.
Basis risk is the risk that the price of the asset being hedged will not move in the same direction as the price of the futures contract. For example, suppose a farmer wants to hedge the price of wheat that he is growing by selling wheat futures contracts. If the price of wheat falls, the farmer will make money on the futures contract, but lose money on the wheat he is growing. This creates basis risk.
In a cross hedge, the basis risk is even greater because the asset being hedged and the asset underlying the futures contract are not the same. For example, suppose a company wants to hedge its exposure to the price of copper by using a futures contract that is based on gold. There may be some correlation between the price of copper and the price of gold, but there is no guarantee that the two prices will move in lockstep. This creates an additional source of basis risk that the company must manage.
In contrast, a long hedge and a short hedge involve hedging the price risk of an asset by taking a long or short position in a futures contract that is based on the same asset. In a long hedge, an investor takes a long position in a futures contract to hedge against the risk of the price of the asset increasing. In a short hedge, an investor takes a short position in a futures contract to hedge against the risk of the price of the asset decreasing. These strategies are simpler and involve less basis risk than a cross hedge.
A stack hedge is not a commonly used term in finance, but it may refer to a hedging strategy that involves layering different types of hedges to manage risk. This strategy may involve using a combination of long and short futures contracts or options contracts to hedge against multiple sources of risk. However, without more information about how a stack hedge is being used in a particular context, it is difficult to say whether it involves additional basis risk.