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What is Basis Risk – Full Understanding

What is Basis Risk

Basis Risk is a type of systematic risk that arises where perfect hedging is not possible. When there is a variation between hedge/futures price and cash/spot price of the hedged underlying at any given point of time, that variation is called ‘Basis’ and risk associated with it is called Basis Risk.

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The basis is simply the relationship between the cash price and future price of an underlying, and its variation happens when the asset in the existing position is often not the same as that underlying the futures or the hedging horizon may not match perfectly with the maturity of the futures contract.

Basis = spot price of the asset being hedged – futures price of contract used in hedge

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. When the hedged asset and the asset underlying the hedging instrument are the same, the basis will be zero at maturity.

Basis Risk

Different types of  Risk:

  • Price basis risk: The risk that occurs when the prices of the asset and its futures contract do not move in sync with each other during the start and end of the trade.
  • Product quality basis risk: When the properties or qualities of the underlying asset are different from the relative underlying asset. Example, crude oil futures used to hedge fuel price of Aviation Company
  • Location Basis Risk: This happens typically in the commodities market, where the futures market delivery location (on which hedging is done) is different from that of the actual spot market (for which hedging is done). For example, crude oil futures price for Mumbai location is different from crude oil prices for Singapore Spot.
  • Calendar Basis Risk: In this case, the selling date of the spot market trade can be different from the expiry date of the futures market contract. For example, the date of selling HDFC Bank shares is 15 days prior to the expiry date of HDFC Bank futures contract on the NSE.

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Example: A portfolio manager who wants to temporarily eliminate the market exposure of a diversified stock portfolio might short NIFTY 50 futures. If the composition of the portfolio does not exactly mirror the NIFTY 50, the hedge will not be perfect, and the portfolio manager will be taking basis risk.

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.

In most cases, this kind of basis risk is taken deliberately, because the imperfect hedge is cheaper, more liquid, or more convenient.

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