Basis Risk

Basis risk refers to the inherent risk faced by a trader when they hedge a position by taking an opposing position in a derivative, like a futures contract, of the asset.
EXPLORE FUNDS
Basis Risk
EXPLORE FUNDS
3 min
26-August-2024
Basis risk is the potential risk that arises when the price of an asset and the price of its corresponding derivative do not move in perfect correlation. This disparity can result in unexpected gains or losses. Basis risk is particularly significant in hedging strategies, where it can affect the effectiveness of the hedge. The degree of basis risk can vary depending on the assets involved, with some assets exhibiting higher levels of basis risk than others.

In this article, we will explore the concept of basis risk in detail, what is basis risk, basis risk definition, basis risk meaning examining its causes and implications for investors and hedgers. We will explore how basis risk can impact various financial instruments and hedging strategies, and discuss the types and components of basis risk.

What is the basis risk?

Basis risk is the risk that arises when the price of a hedged asset and the price of the derivative used to hedge it do not move in perfect correlation. This risk is significant in markets where derivatives, such as futures or options, are used to hedge positions in physical assets. In India, basis risk is often encountered in commodity markets, such as agriculture and energy, where price fluctuations in the spot market may not align perfectly with the futures market. This misalignment can lead to unexpected gains or losses, affecting the effectiveness of hedging strategies.

How does basis risk work?

Basis risk works by creating a discrepancy between the prices of a hedged asset and its corresponding derivative. For example, if a farmer in India hedges the price of wheat using futures contracts, any divergence between the spot price of wheat and the futures price at the contract's expiration introduces basis risk. This discrepancy can result from factors like changes in demand and supply, transportation costs, or market inefficiencies. Effective risk management requires monitoring these factors and adjusting hedging strategies accordingly to minimise the impact of basis risk.

Formula of basis risk

Basis risk can be quantified using the basis, which is the difference between the spot price of an asset and its corresponding futures price. The formula for basis is:

Basis Risk = Spot Price−Futures Price


Understanding this difference is crucial for entities like farmers, traders, and companies involved in commodities trading. Monitoring the basis helps in assessing the effectiveness of hedging strategies and making informed decisions to manage potential discrepancies in pricing. For instance, in the National Commodity and Derivatives Exchange (NCDEX), tracking the basis helps traders optimise their positions and mitigate risks.

Types of basis risk

Basis risk can be categorised into several types, each affecting hedging strategies differently:

1. Location basis risk

This arises due to the geographical difference between the spot market and the futures market. For example, wheat prices in Punjab may differ from those in a national futures market.

2. Quality basis risk

This occurs when there is a difference in the quality of the asset being hedged and the quality specified in the futures contract. For instance, different grades of a commodity can lead to basis risk.

3. Time basis risk

This type arises due to the mismatch in the timing between the spot price and the futures price. It typically occurs when the spot price is realised before or after the futures contract matures.

Example of basis risk

An example of basis risk can be seen in the agricultural sector in India. Suppose a farmer in Maharashtra grows cotton and uses cotton futures to hedge against price fluctuations. If the spot price of cotton in Maharashtra falls while the futures price remains steady, the farmer faces basis risk. The divergence between the local spot price and the futures price results in an ineffective hedge, potentially leading to financial losses despite the hedging strategy.

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Components of basis risk

Basis risk comprises several components that contribute to the overall risk:

  • Price fluctuations: The difference in the movement between spot prices and futures prices.
  • Market volatility: High volatility can increase the unpredictability of basis risk.
  • Delivery costs: Costs associated with delivering the physical asset can impact the basis.
  • Timing differences: Mismatched timing between spot market transactions and futures contracts.

Conclusion

Understanding basis risk is crucial for investors and businesses involved in hedging. It helps in developing strategies to manage the discrepancy between spot and futures prices, ensuring better risk management and financial planning. By being aware of the types, examples, and components of basis risk, market participants can make informed decisions to mitigate potential losses.

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Frequently asked questions

What is the basis risk?
Basis risk is the potential risk that arises when there is a difference between the spot price of an asset and the futures price of the same asset. This discrepancy can lead to hedging inefficiencies and is more significant with certain assets.

What is the formula for basis risk?
The formula for basis risk is: Basis = Spot Price of hedged asset - Futures Price. It represents the difference between the spot price of an asset and the futures price used to hedge the asset.

What is the rate basis risk?
Rate basis risk occurs when there is a mismatch between the floating interest rate on a loan or bond and the floating rate received from the swap counterparty. This can lead to financial inefficiencies and exposure to rate changes.

What is the difference between yield curve risk and basis risk?
Yield curve risk involves changes in the yield curve affecting asset values, while basis risk refers to the risk arising from discrepancies between the spot and futures prices of the same asset. Both affect financial performance but in different ways.

How to remove basis risk?
To mitigate basis risk, one can hedge using options on liquid, actively traded regional indices. This approach helps align hedging instruments more closely with the underlying asset, reducing discrepancies.

What is a negative basis risk?
Negative basis risk occurs when the basis is negative, meaning the spot price of the asset is lower than the futures price. This can happen due to changes in supply and demand dynamics affecting the underlying asset.

Why is it called basis risk?
It is called basis risk because it involves the risk that arises from variations in the basis, which is the difference between the spot price and the futures price of an asset. These variations can affect the effectiveness of hedging strategies.

What is cost basis risk?
Cost basis risk refers to the potential for the cost basis of a financial instrument, like a Virtual Power Purchase Agreement (VPPA), to diverge from the expected value due to differences between market prices and contract prices. This can affect financial outcomes and profitability.

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