Basis Risk

An adviser hedges a client holding in a single mid-sized company by selling broad index futures. The principal limitation of this hedge is that

1. A.the holding and the index may not move together, so the hedge can miss entirely.Correct. Company-specific news is exactly the risk an index instrument leaves untouched.
2. B.index futures may not be sold short by anyone who is not an exchange member.Wrong. Either side of a futures contract is open to any customer of a clearing member.
3. C.the hedge removes all risk, which is not permitted in an advisory account.Wrong. No such prohibition exists, and this hedge is far from removing all risk in any event.
4. D.index futures settle physically, so the client would have to deliver shares.Wrong. Broad index futures settle in cash, since delivering an index is not possible.

Why: Hedging one exposure with an instrument on a different underlying leaves basis risk, the risk that the two do not move together. A single company can fall on news specific to itself while the index is flat or rising, in which case the hedge pays nothing and the futures leg may even lose money at the same time as the shares do. The narrower the relationship between the hedged item and the hedging instrument, the larger this residual risk becomes. A hedge using options or futures on the company itself, where they exist, removes the mismatch but is usually more expensive.

A client asks his adviser for a way to remove the downside of his portfolio while keeping the whole of the upside and paying nothing at all. The adviser should explain that

1. A.such a structure exists, in the form of a costless collar.Wrong. That structure is costless in cash only, having sold the upside to pay for the floor.
2. B.such a structure exists, in the form of a protective put funded out of dividends.Wrong. Paying the premium from another source settles the cost rather than removing it.
3. C.the request can be met with index futures, which require no premium to enter.Wrong. Futures cost no premium but remove the upside and the downside together.
4. D.every transfer of risk is paid for, in premium, in forgone upside, or in imperfect cover.Correct. It names the three currencies a hedge can be paid in and insists that one of them applies.

Why: Every hedge transfers risk to a counterparty, and no counterparty accepts risk without compensation, so the question is never whether there is a cost but what form it takes. A purchased put costs a premium, a collar costs the appreciation above the ceiling, a futures hedge costs the entire favourable direction, and a cheaper mismatched hedge costs the client in basis risk when it fails to cover the loss it was bought for. Naming which of those currencies is being paid is the substance of the advice. A structure that appeared to violate this would simply be one whose cost had not yet been identified.