University of Central Florida (UCF) FIN4243 Debt and Money Markets Practice Exam 3

Basis risk occurs when there is a divergence between the futures prices and the spot prices of the underlying asset. This scenario arises because the futures price reflects the expected future price of the asset, while the spot price is the current market price. If these two prices do not move in tandem as expected, it creates a situation where a hedger, for example, may not achieve the desired level of protection against price fluctuations. This divergence can lead to unexpected losses or reduced effectiveness in managing price risk, thereby highlighting the concept of basis risk.

The other scenarios presented do not typically illustrate basis risk. For example, stability in interest rates does not indicate a risk associated with the difference between future and spot prices. Similarly, low volatility usually implies a lower level of uncertainty in prices, which does not directly relate to the risk associated with basis disparities. Lastly, the relationship between market and limit orders focuses on market dynamics rather than the price relationship crucial to understanding basis risk. Thus, the correct answer effectively highlights the essence of basis risk as it pertains to the relationship between spot and futures pricing.