What is 'Basis Risk'

Basis risk is the financial risk that offsetting investments in a hedging strategy will not experience price changes in entirely opposite directions from each other. This imperfect correlation between the two investments creates the potential for excess gains or losses in a hedging strategy, thus adding risk to the position.

BREAKING DOWN 'Basis Risk'

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 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 the price of oil is $55 per barrel and the future contract being used to hedge this position is priced at $54.98, the basis is $0.02. When large quantities of shares or contracts are involved in a trade, the total dollar amount, in gains or losses, from basis risk can have a significant impact.

Other Forms of Basis Risk

Another form of basis risk is known as locational basis risk. This is seen in the commodities markets when a contract does not have the same delivery point as the commodity's seller 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 arises when a contract of one product or quality is used to hedge another product or quality. 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 expire on the last calendar day of the month prior to delivery. Thus, a contract deliverable in May expires on April 30. Though this discrepancy may only be for a short period of time, basis risk still exists.

RELATED TERMS
  1. Buying Hedge

    A buying hedge is a transaction used by commodities investors ...
  2. Rolling Hedge

    A rolling hedge is a strategy for reducing risk that involves ...
  3. Double Hedging

    Double Hedging refers to a trading strategy in which an investor ...
  4. Long Hedge

    A long hedge is a situation where an investor has to take a long ...
  5. Short Hedge

    A short hedge is an investment strategy utilized to protect against ...
  6. Hedge

    A hedge is an investment to reduce the risk of adverse price ...
Related Articles
  1. Trading

    Hedging basics: What is a hedge?

    Hedging is a widely misunderstood strategy, but it's not as complicated as you might think.
  2. Trading

    A Beginner's Guide to Hedging

    Learn how investors use hedging strategies to reduce the impact of negative events on investments.
  3. Investing

    Taking A Look Behind Hedge Funds

    Hedge funds can draw returns well above the market average even in a weak economy. Learn about the risks.
  4. Managing Wealth

    Practical And Affordable Hedging Strategies

    Hedging offers a cost-effective way to transfer risk.
  5. Investing

    Are Hedge Funds Chasing Performance?

    Learn why hedge funds have performed worse than the S&P 500 Index in 2016, and why they may overweight equities to play catch-up in the second half of 2016.
  6. Investing

    Corporate Futures: Big Names, Big Risk

    We don't often think of Disney and derivatives, but it is one of many companies that use derivatives to hedge risks.
  7. Managing Wealth

    HF Performance Report: Did Hedge Funds Earn Their Fee in 2015?

    Find out whether hedge funds, which have come under tremendous pressure to improve their performance, managed to earn their fee in 2015.
  8. Financial Advisor

    4 Reasons to Still Consider Traditional 2 & 20 Hedge Funds

    Find out why traditional 2 & 20 hedge funds are still worth considering as an investment, even though they have underperformed for the last several years.
  9. Managing Wealth

    Offset Risk With Options, Futures And Hedge Funds

    Though all portfolios contain some risk, there are ways to lower it. Find out how.
RELATED FAQS
  1. What is the difference between hedging and speculation?

    Hedging and speculation are very different in purpose, function and risk profile. Find out how and why investors use both. Read Answer >>
  2. Are there publicly traded hedge funds?

    See why a privately arranged hedge fund may decide to take its fund public, and how the investing public at large can gain ... Read Answer >>
Hot Definitions
  1. Gross Profit

    Gross profit is the profit a company makes after deducting the costs of making and selling its products, or the costs of ...
  2. Diversification

    Diversification is the strategy of investing in a variety of securities in order to lower the risk involved with putting ...
  3. Intrinsic Value

    Intrinsic value is the perceived or calculated value of a company, including tangible and intangible factors, and may differ ...
  4. Current Assets

    Current assets is a balance sheet item that represents the value of all assets that can reasonably expected to be converted ...
  5. Volatility

    Volatility measures how much the price of a security, derivative, or index fluctuates.
  6. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
Trading Center