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What Is Basis Risk?
Basis risk is when investments meant to offset each other do not move in opposite directions. This imperfect correlation can cause unexpected gains or losses, adding risk to the hedging strategy.
Basis risk can affect investment decisions, particularly in hedging strategies where price movements differ from expectations. For example, when hedging against a bond with Treasury bill futures and the products move in different directions. Product, locational, and calendar mismatches are specific forms of basis risk that investors might encounter, especially in commodity markets.
Key Takeaways
- Basis risk arises when hedging strategies do not result in perfectly offsetting price changes, leading to potential gains or losses.
- It can be quantified by subtracting the futures price from the current market price of the hedged asset.
- Locational basis risk occurs when the delivery point of a contract differs from what the seller needs, such as hedging in different regions.
- Product basis risk happens when a product is hedged with contracts of another product, often due to liquidity considerations.
- Calendar basis risk emerges when the expiration dates of a hedge do not align with the underlying position’s timeline.
How Basis Risk Affects Hedging Strategies
Offsetting vehicles are generally similar in structure to the investments being hedged, but they are still different enough to cause concern. For example, in the attempt to hedge against a two-year bond with the purchase of Treasury bill futures, there is a risk that the Treasury bill and the bond will not fluctuate identically.
To quantify the amount of the basis risk, an investor simply needs to take the current market price of the asset being hedged and subtract the futures price of the contract.
For example, if oil is $55 per barrel and the future contract is $54.98, the basis is $0.02. With large quantities, basis risk can greatly affect gains or losses in a trade.
Types of Basis Risk: Location, Product, and Calendar
Another form of basis risk is locational basis risk. This occurs in commodities markets when contract delivery points differ from the seller’s needs.
For example, a natural gas producer in Louisiana has locational basis risk if it decides to hedge its price risk with contracts deliverable in Colorado. If the Louisiana contracts are trading at $3.50 per one million British Thermal Units (MMBtu) and the Colorado contracts are trading at $3.65/MMBtu, the locational basis risk is $0.15/MMBtu.
Product or quality basis risk occurs when a contract hedges a product or quality different from the original. An often-used example of this is jet fuel being hedged with crude oil or low-sulfur diesel fuel because these contracts are far more liquid than derivatives on jet fuel itself. Companies making these trades are generally well aware of the product basis risk but willingly accept the risk instead of not hedging at all.
Calendar basis risk arises when a company or investor hedges a position with a contract that does not expire on the same date as the position being hedged. For example, RBOB gasoline futures on the New York Mercantile Exchange (NYMEX) expire on the last calendar day of the month prior to delivery. Thus, a contract deliverable in May expires on April 30. Even if the time period is short, this discrepancy creates basis risk.
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