A multinational corporation is about to embark on a major financial restructuring pro- gram. One critical stage will be the issuance of seven-year Eurobonds sometime within the next month. The CFO is concerned with recent instability in capital markets and with the particular event that market yields rise prior to issuance, forcing the corporation to pay a higher coupon rate on the bonds. It is decided to hedge that risk by selling
10-year Treasury note futures contracts. Notice that this is a classic cross hedge wherein 10-year Treasury notes are used to manage the risk of 7-year Eurobonds.
Describe the nature of the basis risk in the hedge. In particular what specific events with respect to the shape of the Treasury yield curve and the Eurobond spread over Treasuries could render the hedge ineffective? In other words, under what circumstances would the hedge fail and make the corporation worse off?