What Is Basis Risk?
Let me explain basis risk directly to you: it's the financial risk that comes up when the offsetting investments in your hedging strategy don't see price changes in completely opposite directions. This lack of perfect correlation between those investments opens the door to extra gains or losses in your hedging approach, which ultimately adds more risk to your overall position.
Understanding Basis Risk
You need to know that offsetting vehicles are usually similar in structure to the investments you're hedging, but they're different enough to create issues. For instance, if you're trying to hedge a two-year bond by buying Treasury bill futures, there's a real risk that the Treasury bill and the bond won't move in sync.
To measure basis risk, just take the current market price of the asset you're hedging and subtract the futures price of the contract. Say oil is at $55 per barrel, and the futures contract for hedging is at $54.98—that gives you a basis of $0.02. When you're dealing with large quantities of shares or contracts, even small basis differences can lead to significant dollar impacts in gains or losses.
Key Takeaways
- Basis risk is the potential risk from mismatches in a hedged position.
- It happens when a hedge is imperfect, meaning losses in an investment aren't fully offset by the hedge.
- Certain investments lack good hedging instruments, so basis risk becomes a bigger issue than with other assets.
Other Forms of Basis Risk
Another type you should be aware of is locational basis risk, which shows up in commodities markets when a contract's delivery point doesn't match what the seller actually needs. Take a natural gas producer in Louisiana hedging with contracts deliverable in Colorado: if Louisiana contracts are at $3.50 per MMBtu and Colorado ones at $3.65, the locational basis risk sits at $0.15 per MMBtu.
Product or Quality Basis Risk
Product or quality basis risk comes into play when you use a contract for one product or quality to hedge something different. A common case is hedging jet fuel with crude oil or low-sulfur diesel fuel contracts, since those are more liquid than jet fuel derivatives. Companies often know about this risk but choose to accept it over not hedging at all.
Calendar Basis Risk
Calendar basis risk occurs when the contract you're using to hedge doesn't expire on the same date as the position you're protecting. For example, RBOB gasoline futures on the NYMEX expire on the last calendar day of the month before delivery, so a May delivery contract ends on April 30. Even if the mismatch is brief, basis risk is still there.
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