Basis risk in
finance
Finance refers to monetary resources and to the study and Academic discipline, discipline of money, currency, assets and Liability (financial accounting), liabilities. As a subject of study, is a field of Business administration, Business Admin ...
is the
risk
In simple terms, risk is the possibility of something bad happening. Risk involves uncertainty about the effects/implications of an activity with respect to something that humans value (such as health, well-being, wealth, property or the environ ...
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 before expiration, namely b = S - F. Barring idiosyncratic influence by the other aspects to be enumerated just below, by the time of expiration this simple difference will be eliminated by arbitrage. The other aspects that give rise to basis risk include:
# Quality (grade) arising when the hedge in place has a different grade which is not perfectly correlated with the basis;
# Timing arising due to mismatch between the expiration date of the hedge asset and the actual selling date of the underlying asset;
# Location (leading to Transportation Costs) arising due to the difference in the location of the asset being hedged and the asset serving as the hedge, and which typically includes a premium to cover the risk these transportation costs may rise, causing a negative impact on the hedger.
Definition
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 = Spot price of hedged asset - Futures price of contract.
Basis risk is not to be confused with another type of risk known as
price risk.
Examples
Some examples of basis risks are:
# Treasury bill futures being hedged by two year bonds, there lies the risk of not fluctuating as desired.
# A foreign currency exchange rate (FX) hedge using a
non-deliverable forward
In finance, a non-deliverable forward (NDF) is an outright Forward contract, forward or futures contract in which counterparties settle the difference between the contracted NDF price or rate and the prevailing spot price or rate on an agreed not ...
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.
See also
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Financial risk
Financial risk is any of various types of risk associated with financing, including financial transactions that include company loans in risk of default. Often it is understood to include only downside risk, meaning the potential for financi ...
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Financial risk management
Financial risk management is the practice of protecting Value (economics), economic value in a business, firm by managing exposure to financial risk - principally credit risk and market risk, with more specific variants as listed aside - as well ...
*
List of finance topics
A list is a set of discrete items of information collected and set forth in some format for utility, entertainment, or other purposes. A list may be memorialized in any number of ways, including existing only in the mind of the list-maker, but ...
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Uncertainty
Uncertainty or incertitude refers to situations involving imperfect or unknown information. It applies to predictions of future events, to physical measurements that are already made, or to the unknown, and is particularly relevant for decision ...
References
Notes
External links
Understanding Derivatives: Markets and Infrastructure - Chapter 3, Over-the-Counter (OTC) DerivativesFederal Reserve Bank of Chicago, Financial Markets Group
Market risk
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