I came across this practice question: Let’s assume that Futures exchange rate is greater than spot rate and therefore there exists basis risk. Now when domestic IR increases relative to the foreign IR, what will happen to the basis risk? Answer: It will widen. From IR parity, S0/F0 = (1+Rf)/(1+Rd) so when Rd increases, F0 increases and hence spread widens.
My question is what will happen when the domestic IR rises when the spot rate is greater than the future rate? Does the basis narrow down? In this case the increase in domestic IR increasees the future rate and this should narrow the spread down right?
I think there is some misunderstanding on the part of basis and basis risk. If there is a price difference b/w futures price and spot price there is a price basis. Basis risk refers to the change in basis as time past.
This can be in terms of going into a futures contract and then rolling over in 6 months time. The rolling over of contract is subjected to basis risk as basis will change.
However in terms of hedging a receipt of foreign currency in 6 months and selling foreign currency futures maturing in 6 months. This will result in no basis risk as the exchange rate has already been locked in.