Basis risk
Basis risk in finance is the risk associated with imperfect hedging. It arises because of the difference between the price of the asset to be hedged and the price of the asset serving as the hedge, or because of a mismatch between the expiration date of the hedge asset and the actual selling date of the asset (calendar basis risk), or—as in energy—due to the difference in the location of the asset to be hedged and the asset serving as the hedge (locational basis risk).
Definition
Under these conditions, the spot price of the asset, and the futures price, do not converge on the expiration date of the future. The amount by which the two quantities differ measures the value of the basis risk. That is,
Basis = Spot price of hedged asset - Futures price of contract
Examples
Some examples of basis risks are:
1. Treasury bill future being hedged by two year Bond, there lies the risk of not fluctuating as desired.
2. Foreign currency exchange rate (FX) hedge using a non-deliverable forward contract (NDF): the NDF fixing might vary substantially from the actual available spot rate on the market on fixing date.
Over-the-counter (OTC) derivatives can help minimize basis risk by creating a perfect hedge. This is because OTC derivatives can be tailored to fit the exact risk needs of a hedger.[1]
References
Notes
See also
External links
- Understanding Derivatives: Markets and Infrastructure - Chapter 3, Over-the-Counter (OTC) Derivatives Federal Reserve Bank of Chicago, Financial Markets Group