What is Basis Risk?
Basis risk is the financial uncertainty that arises when offsetting investments in a hedging strategy do not exhibit perfectly inverse price movements. This lack of complete correlation between the two investments introduces the possibility of extra gains or losses, thereby heightening the risk within the hedging position.
Understanding Basis Risk
Off-setting financial instruments often closely resemble the investments they are intended to hedge. However, they are different enough to present calculable risks. For example, while trying to hedge a two-year bond with the acquisition of Treasury bill futures, the risk remains that the Treasury bills and the bonds may not exhibit identical fluctuations in their respective prices.
To measure basis risk, you merely subtract the futures price of the contract from the current market price of the asset being hedged. For instance, if oil is priced at $55 per barrel and the future contract is valued at $54.98, the basis risk amounts to $0.02. When large transaction volumes are involved, basis risk can significantly impact overall gains or losses.
Key Takeaways
- Basis risk represents the potential risk that arises from mismatches in a hedged position.
- An imperfect hedge results in basis risk, as losses in an investment are not exactly countered by the hedge.
- Certain investments lack good hedging instruments, increasing basis risk concerns.
Other Forms of Basis Risk
Locational Basis Risk
Locational basis risk manifests in the commodities markets when the contract’s delivery point differs from the seller’s requirement. For example, if a natural gas producer in Louisiana uses contracts deliverable in Colorado to hedge against price risk, there is locational basis risk. If Louisiana contracts trade at $3.50 per one million British Thermal Units (MMBtu) and Colorado contracts at $3.65/MMBtu, the locational basis risk is $0.15/MMBtu.
Product or Quality Basis Risk
Product or quality basis risk occurs when a contract for one type or quality is used to hedge another. A common scenario involves using crude oil or low-sulfur diesel fuel contracts, which are more liquid, to hedge jet fuel. Companies typically accept this product basis risk, choosing it over not hedging at all.
Calendar Basis Risk
Calendar basis risk happens when a hedging contract does not expire concurrently with the hedged position. For example, RBOB gasoline futures on the New York Mercantile Exchange (NYMEX) expire on the last calendar day of the month prior to actual delivery. A contract deliverable in May would expire on April 30, introducing a short-term but significant period of basis risk.
By comprehending these facets of basis risk, investors can make informed hedging decisions, better protecting their positions and optimizing their strategies. Basis risk, in its various forms, presents complexities that must be managed carefully to competently navigate the financial markets.
Related Terms: Hedging, Risk Management, Futures Contract, Derivative.
