What Is Basis Risk?

Basis risk is the financial risk that offsetting investments in a hedging strategy will not experience price changes in entirely opposite directions ꦚfrom each other. This imperfect correlation between the two investments creates the potential for excess gains or losses in a hedging strategy, thus adding risk to the position.

Understanding Basis Risk

Offsetting vehicles are generally similar in structure to the investments being hedged, but they are still different enough to cause concern. For example, in the attempt to hedge against a two-year bond with the purchase of 澳洲幸运5官方开奖结果体彩网:Treasury bill futures, there is a risk the Treasury bill and the bond will not fluctuate identically💧.

To quantify the amount of the basis risk, an investor simply needs to take the current market price of the asset being hedged and subtract the futures price of the contract. For example, if the price of oil is $55 per barrel and the澳洲幸运5官方开奖结果体彩网: future contract being used to hedge this position is priced at $54.98, the basis is $0.02. When large quantities of shares or contracts are involved in a trade, the total dollar amount, in gains or losses, from basis risk can have a significant im♓pact.

Other Forms of Basis Risk

Another form of basis risk is known as locational basis risk. This is seen in the 澳洲幸运5官方开奖结果体彩网:commodities markets when a contract does not have the same delivery point as the commodity's seller needs. For example, ℱa natural gas producer in Louisiana has locational basis risk if it decides to hedge its price risk with contracts deliverable in Colorado. If the Louisiana contracts are trading at $3.50 per one million British Thermal Units (MMBtu) and the Colorado contracts are trading at $3.65/MMBtu, the locational basis risk is $0.15/MMBtu.

Product or quality basis risk arises when a contract of one product or quality is used to hedge another product or quality. An often-used example of this is jet fuel being hedged with crude oil or low sulfur diesel fuel because these contracts are far more liquid than 澳洲幸运5官方开奖结果体彩网:derivatives on jet fuel itself. Companies making these trades are generally well aware of the product basis risk but willingly accept the risk instead of not ♔hedging at all.

Calendar basis risk arises when a company or investor hedges a position with a contract that does not expire on the same date as the position being hedged. For example, RBOB gasoline futures on the 澳洲幸运5官方开奖结果体彩网:New York Mercantile Exchange (NYMEX) expire on the last calendar day of the month prior to delivery. Thus, a contract delive𒐪rable in May expires on April 30. Though this discrepancy may only be for a short period of time, basis risk still exisꦿts.