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Basis risk in finance is the risk associated with imperfect hedging due to the variables or characteristics that affect the difference between the futures contract and the underlying "cash" position. It arises because of the difference between the price of the asset to be hedged and the price of the asset serving as the hedge namely b = S - F, before expiration, any difference at expiration will be offset by arbitrage. Other examples of aspects that may cause basis risk to arise:
a) Quality - the hedge in place may have a different grade (which may not be perfectly correlated with the basis)
b) Timing - a mismatch between the expiration date of the hedge asset and the actual selling date of the asset
c) Location/Transportation Costs - due to the difference in the location of the asset to be hedged and the asset serving as the hedge, an unforeseen rise in transportation costs may cost the producer who hedges more money.
Under these conditions, the spot price of the asset, and the futures price, do not converge on the expiration date of the future. The amount by which the two quantities differ measures the value of the basis risk. That is,
Basis = Futures price of contract − Spot price of hedged asset.
Some examples of basis risks are:
- Treasury bill future being hedged by two year Bond, there lies the risk of not fluctuating as desired.
- Foreign currency exchange rate (FX) hedge using a non-deliverable forward contract (NDF): the NDF fixing might vary substantially from the actual available spot rate on the market on fixing date.
- Over-the-counter (OTC) derivatives can help minimize basis risk by creating a perfect hedge. This is because OTC derivatives can be tailored to fit the exact risk needs of a hedger.
- "Basis risk - Financial theory - Moneyterms: investment, finance and business explained". moneyterms.co.uk. Retrieved 2017-05-15.
- "HEDGING WITH GENERALIZED BASIS RISK: Empirical Results" (PDF). sta.uwi.edu. Retrieved 15 May 2017.
- Understanding Derivatives: Markets and Infrastructure - Chapter 3, Over-the-Counter (OTC) Derivatives Federal Reserve Bank of Chicago, Financial Markets Group
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