When a mutual fund employs derivative contracts for hedging or portfolio rebalancing, what is 'Basis Risk'?

[ A ]The risk that the clearing corporation of the stock exchange will become insolvent during market hours

[ B ]The risk that the AMC's compliance officer will reject the quarterly audit report

[ C ]The risk that all cash dividends paid by underlying companies will be doubled automatically

[ D ]The risk arising from a difference in the price movement of the derivative contract vis-a-vis the underlying cash market security being hedged[ CORRECT ]

Takeaway

Option D is correct: The risk arising from a difference in the price movement of the derivative contract vis-a-vis the underlying cash market security being hedged

Derivation

In derivative strategies, Basis Risk arises when the price movement of the derivative instrument (e.g., Nifty futures or stock futures) does not perfectly mirror or correlate with the price movement of the cash market underlying asset being hedged. This divergence can lead to imperfect hedges where gains on the derivative fail to fully offset losses on the underlying cash asset. This question tests candidate understanding of specialized derivative risk factors. A common pitfall is confusing basis risk with counterparty settlement default risk.

Why the others fail

A — The risk that the clearing corporation of the stock exchange will become insolvent during market hours

The risk of exchange clearing failure represents counterparty/settlement risk, not basis risk between cash and derivative prices.

B — The risk that the AMC's compliance officer will reject the quarterly audit report

Rejection of internal audit reports is an operational compliance risk, completely unrelated to market derivative basis dynamics.

C — The risk that all cash dividends paid by underlying companies will be doubled automatically

Dividend announcements relate to corporate corporate action policy, not pricing divergence between derivatives and cash markets.