What is Basis Risk?
Basis risk is defined as the inherent risk a trader takes when hedging a position by taking a contrary position in a derivative of the asset, such as a futures contract. Basis risk is accepted in an attempt to hedge away price risk.
As an example, if the current spot price, or cash market price, of gold is $1190, and the price of gold in the June gold futures contract is $1195, then the basis, the differential, is $5.00. Basis risk is the risk that the futures price might not move in normal, steady correlation with the price of the underlying asset, and that this fluctuation in the basis may negate the effectiveness of a hedging strategy employed to minimize a trader’s exposure to potential loss. The price spread (difference) between the cash price and the futures price may either widen or narrow between the time when a hedging position is initiated and the time when it is liquidated.
A hedging strategy is one where a trader adopts a second market position – here we’re talking about adding a market position in futures to a market position in the underlying asset – for the purpose of “hedging”, or minimizing, the risk exposure in the initial market position. The strategy involves taking a futures position contrary to one’s market position in the underlying asset – for example, selling futures short to offset a long, buy position in the underlying asset. The idea behind the strategy is that at least part of any potential loss in the underlying asset position will be offset by profits in the hedge futures position.
When large investments are involved, basis risk can have a significant effect on eventual profits or losses realized. Even a modest change in the basis can potentially make the difference between bagging a profit and suffering a loss. The inherently imperfect correlation between the cash price and the futures price means that there is potential for both excess gains and excessive losses. This risk that is specifically associated with a futures hedging strategy is the basis risk.
Components of Basis Risk
Risk can never be altogether eliminated in investments. However, a risk can be made to take another form, or its impact can be at least somewhat mitigated. Thus, when a trader enters into a futures contract to hedge against possible price fluctuations, they are at least partly changing the inherent “price risk” into another form of risk, known as “basis risk”. Basis risk is considered a systematic, or market, risk. Systematic risk is the risk arising from the inherent uncertainty of the markets (as opposed to unsystematic, or non-systematic, risk, which is the risk associated with a specific investment). The risk of a general economic turndown, or depression, is the systematic risk. The risk that Apple may lose market share to a competitor who develops superior technology is the unsystematic risk.
As stated above, between the time when a futures position is initiated and the time when the hedger decides to close out the position, there is a chance that the spread between the futures price and the spot price may widen or narrow. As the visual representation below shows, the normal tendency is for the basis spread to narrow, with the futures price more closely approaching the spot cash market price, as the futures contract nears expiration. This logically happens as the futures contract becomes less and less “future” in nature. However, this common narrowing of the basis spread is not guaranteed to occur.
Hedging with Futures Contracts
Suppose a rice farmer wants to hedge against possible price fluctuations in the market. For example, in December, he decides to enter into a short-sell position in a futures contract in order to limit his exposure to a possible decline in the cash price prior to the time when he will sell his crop in the cash market. Assume that the spot price in the physical market, per unit of rice, is $50 and the prevailing futures price for a March futures contract is $55. The basis, then, is $5.00 (the futures price minus the spot price). In this situation the market is in contango, i.e., the spot price is less than the futures price.
Suppose the farmer decides to lift the hedge in February, due to falling prices. At the time he decides to close out his market positions, the spot price is $47 and the March futures price is $49. He sells his rice crop at $47 per unit and lifts his hedge by buying futures to close out his short sell position at $49. In this case, his loss in the cash market of $3.00 ($50 – $47) per unit of rice is more than offset by his $6.00 gain from short selling futures ($55 – $49). Therefore, his net sales revenue becomes $53 ($47 cash price + $6.00 futures profit). The farmer has enjoyed extra profits as a result of the basis narrowing from $5.00 to $2.00.
If the basis had remained constant, then the farmer would not have enjoyed any extra profit but neither would he have incurred any additional loss. He would have sold his rice for a $47 cash price, but since the basis between futures and cash remained steady at $5.00, the futures contract when he closed out his position would only have netted $3.00 per unit, as a steady $5.00 basis would mean the futures contract would be priced at $52 when the cash price was $47. So his $3.00 profit in futures would have exactly offset the $3.00 loss in the cash market. It’s important to note, however, that while his short sell hedge in futures didn’t generate any additional profit, it did successfully protect him from the price decline in the cash market. If he had not taken the futures position, then he would have effectively suffered a $3.00 per unit loss as the cash price declined from $50 to $47.
The other possible scenario would be one where the cash market price declined white the futures price increased. If at the time the farmer decided to take his crop to market and close out his short sell futures hedge, the cash price was $47 but the futures price was $57, then he would have lost $3.00 per unit in the cash market ($50 – $47) and lost an additional $2.00 in his short futures trade ($57 – $55), resulting in a net sales revenue of only $45 per unit. Why the extra loss? – Because in this instance the basis widened, as opposed to narrowing or remaining constant, which was the opposite of the basis pattern the farmer was looking for to successfully hedge his cash crop. In this case, the farmer took the basis risk – the risk that the basis might move unfavorably against him – and lost.
It’s also worth noting that a buyer of rice, looking to hedge against a possible cash market increase in the price of rice, would have bought futures as a hedge. That hedger would have realized maximum profit from the unprofitable-for-the-farmer, third scenario outlined above – the one where the basis widened from $5.00 to $10.00.
Different Types of Basis Risk
Different types include:
- Price basis risk: The risk that occurs when the prices of the asset and its futures contract do not move in tandem with each other.
- Location basis risk: The risk that arises when the underlying asset is in a different location from the where the futures contract is traded. For example, the basis between actual crude oil sold in Mumbai and crude oil futures traded on a Dubai futures exchange may differ from the basis between Mumbai crude oil and Mumbai-traded crude oil futures.
- Calendar basis risk: The selling date of the spot market position may be different from the expiry date of a futures market contract.
- Product quality basis risk: When the properties or qualities of the asset are different from that of the asset as represented by the futures contract.
Basis risk is the risk that is inherent whenever a trader attempts to hedge a market position in an asset by adopting a contrary, or opposite, position in a derivative of the asset, such as a futures contract. Basis risk is accepted in an attempt to hedge away price risk. If the basis remains constant until the trader closes out both of his positions, then he will have successfully hedged his market position. If the basis has changed significantly at the time the trader closes out his positions, then he will likely experience extra profits or increased losses. Producers looking to hedge their market position will profit from a narrowing basis spread, while buyers will profit from a widening basis.
Thank you for reading this guide to basis risk. CFI is the official provider of the Financial Modeling & Valuation Analyst (FMVA)™ certification. To prepare for the FMVA curriculum, these additional resources will be helpful: