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Basis Risk is the risk that the difference (basis) between a Futures contract price and the spot price of an asset will change unpredictably, affecting hedging effectiveness.
It occurs because Futures prices and spot prices do not always move in perfect sync due to factors like supply/demand, interest rates, and market conditions. Understanding Basis in Futures Trading Basis = Spot Price – Futures Price Can be positive (futures price is lower than spot) or negative (futures price is higher than spot). Basis tends to converge to zero at expiration (since futures and spot prices align at contract settlement). Example:
What Causes Basis Risk? 1. Market Supply & Demand Shifts – Unexpected events (e.g., weather, geopolitical risks) can cause spot and futures prices to diverge. 2. Interest Rates & Carrying Costs – Storage costs (e.g., for commodities) or interest rates (e.g., bond futures) impact price relationships. 3. Expiry & Contract Differences – Different contract months may behave differently due to liquidity and roll-over effects. 4. Regional & Quality Differences – Local supply shortages or different asset grades can create discrepancies. How Basis Risk Affects Hedgers & Traders Hedgers (Producers, Farmers, Corporations) Goal: Lock in future prices to reduce uncertainty. Risk: If basis moves unpredictably, the hedge may not fully protect against price changes. Example: A wheat farmer hedges by selling wheat futures at $6.00 per bushel, expecting spot and futures to align.
Traders (Speculators, Arbitrageurs) Goal: Profit from changes in futures prices. Risk: If basis moves unpredictably, spread or arbitrage strategies may fail. Example: A trader bets on a narrowing basis by going long spot crude oil and short crude oil futures.
Managing Basis Risk 1. Monitor Historical Basis Patterns – Check seasonality and past trends to anticipate movements. 2. Use Closely Related Contracts – Select futures contracts that closely match the hedged asset (e.g., using Brent crude futures for Brent crude oil, not WTI). 3. Roll Over Contracts Cautiously – Pay attention to expiration effects when rolling positions. 4. Use Spread Trading Strategies – Calendar spreads can reduce exposure to basis fluctuations. Key Takeaways Basis = Spot Price – Futures Price Basis risk occurs when this difference changes unpredictably Affects hedgers by making hedges less effective Impacts traders by altering spread relationships Managed by selecting the right contracts, monitoring trends, and using spread strategies |
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