What is Basis Risk
Definition: Basis Risk is a type of systematic risk that arises where perfect hedging is not possible. When there is a variation between hedge/futures/relative 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.
Basis is simply the relationship between the cash price and future price of an underlying, and its variation happens when there is a difference in delivery location, quality and date/time. To mitigate the price risk of an acquired underlying trading in one market, a trader usually takes a counter or similar position in a relative or derivative market to give it a perfect hedge. But when there is imperfect hedging, basis risk arises. This happens mainly when proper matching or correlation testing of the underlying price and relative price or its properties is not done.
Basis = Spot price of hedged underlying 每 Hedged derivative (futures) price of the same underlying
Description: Basis Risk is the most important risk, which every hedger or trader considers while trading in the derivative market. It typically occurs when there is non-convergence of spot price and relative price on the offset date of trade due to an imperfect hedging strategy. When the offsetting properties are different, they add market risk to the trade, which is basically Basis Risk. And that non-convergence amount between cash price of the hedged underlying and price of the relative hedged underlying thus gives the numerical value for the basis risk, which can be negative or positive.
There are different types of Basis Risk in case of an imperfect hedging, which are listed below:
a) Price Basis Risk: This occurs when there is a difference between spot price and relative future price or they do not move in tandem during the start and end of trade. Example, gold futures price is not changing as much gold spot price.
b) 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). Example, crude oil futures price for Mumbai location is different from crude oil price for Singapore Spot.
c) 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
d) 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 ATF spot price
Example:
Support, the Tata Motors stock is trading at a spot price of Rs 355 while March futures are quoting at Rs 355.40. Now on the date of expiry, the stock falls to Rs 340 and futures to Rs 350. So, the basis weakened as it fell from -0.40 to -15, giving a profit of Rs 9.60 ((Rs 355-340)-(Rs 355.40-Rs 350)).
Had the stock price gone up to Rs 380 and the futures were at Rs 370; the basis would have strengthened from -0.40 to 10 but it would have led to a loss of -10.40 ((Rs 355-Rs 380)-(Rs 355.40-Rs 370)).
Further, Basis Risk is classified as strong basis or weak basis. As the basis varies during the course of the trade, at any point of time it strengthens when it gains in value and weakens when it loses value. Here are some of the cases which can explain this in detail.
I. When the hedger is doing a short hedge, that would mean locking the price of the underlying which is sold but to be delivered in the future in order to avoid price fluctuation during that time.
﹞ Case 1 - Spot Price slides more than the futures price, in this case weak basis
Loss = ((Start date Cash Price 每 End date Cash Price) 每 (Hedge start price 每 Hedge end price))
﹞ Case 2 - Spot Price gains more than the Futures Price, again weak basis
Gain = ((Start date Cash Price 每 End date Cash Price) 每 (Hedge start price 每 Hedge end price))
﹞ Case 3 - Futures Price falls more than the Cash Price, case of strong basis
Gain = ((Hedge start price 每 Hedge end price) 每 (Start date Cash Price 每 End date Cash Price))
﹞ Case 4 - Futures Price gains more than the Cash Price, case of weak basis
Loss = ((Hedge start price 每 Hedge end price) 每 (Start date Cash Price 每 End date Cash Price))
﹞ Case 5 - Futures Price gains or lose in tandem with the Spot Price, zero basis and no change
﹞ Case 6 - No change in spot price and futures price, zero basis and no change
II. When the hedger does a long hedge, that means locking the price of the underlying which is bought but to be delivered in future, so as to avoid price fluctuation during that time.
﹞ Case 1 - Spot Price slides more than the Futures Price, in this case weak basis
Gain = ((Start date Cash Price 每 End date Cash Price) 每 (Hedge start price 每 Hedge end price))
﹞ Case 2 - Spot Price gains more than the Futures Price, case of strong basis
Loss = ((Start date Cash Price 每 End date Cash Price) 每 (Hedge start price 每 Hedge end price))
﹞ Case 3 - Futures Price falls more than the Cash Price, case of strong basis
Loss = ((Hedge start price 每 Hedge end price) 每 (Start date Cash Price 每 End date Cash Price))
﹞ Case 4 - Futures Price gains more than the Cash Price, case of weak basis
Gain = ((Hedge start price 每 Hedge end price) 每 (Start date Cash Price 每 End date Cash Price)
﹞ Case 5 - Futures Price gains or lose in tandem with the Spot Price, zero basis and no change
﹞ Case 6 - No change in spot price and futures price, zero basis and no change
Over-the-counter (OTC) derivatives fit the requirements of a hedger, as they can be tailor-made as per the hedging strategy, thus minimising the basis risk.
Source: Bionic Turtle
Basis is simply the relationship between the cash price and future price of an underlying, and its variation happens when there is a difference in delivery location, quality and date/time. To mitigate the price risk of an acquired underlying trading in one market, a trader usually takes a counter or similar position in a relative or derivative market to give it a perfect hedge. But when there is imperfect hedging, basis risk arises. This happens mainly when proper matching or correlation testing of the underlying price and relative price or its properties is not done.
Basis = Spot price of hedged underlying 每 Hedged derivative (futures) price of the same underlying
Description: Basis Risk is the most important risk, which every hedger or trader considers while trading in the derivative market. It typically occurs when there is non-convergence of spot price and relative price on the offset date of trade due to an imperfect hedging strategy. When the offsetting properties are different, they add market risk to the trade, which is basically Basis Risk. And that non-convergence amount between cash price of the hedged underlying and price of the relative hedged underlying thus gives the numerical value for the basis risk, which can be negative or positive.
There are different types of Basis Risk in case of an imperfect hedging, which are listed below:
a) Price Basis Risk: This occurs when there is a difference between spot price and relative future price or they do not move in tandem during the start and end of trade. Example, gold futures price is not changing as much gold spot price.
b) 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). Example, crude oil futures price for Mumbai location is different from crude oil price for Singapore Spot.
c) 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
d) 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 ATF spot price
Example:
Support, the Tata Motors stock is trading at a spot price of Rs 355 while March futures are quoting at Rs 355.40. Now on the date of expiry, the stock falls to Rs 340 and futures to Rs 350. So, the basis weakened as it fell from -0.40 to -15, giving a profit of Rs 9.60 ((Rs 355-340)-(Rs 355.40-Rs 350)).
Had the stock price gone up to Rs 380 and the futures were at Rs 370; the basis would have strengthened from -0.40 to 10 but it would have led to a loss of -10.40 ((Rs 355-Rs 380)-(Rs 355.40-Rs 370)).
Further, Basis Risk is classified as strong basis or weak basis. As the basis varies during the course of the trade, at any point of time it strengthens when it gains in value and weakens when it loses value. Here are some of the cases which can explain this in detail.
I. When the hedger is doing a short hedge, that would mean locking the price of the underlying which is sold but to be delivered in the future in order to avoid price fluctuation during that time.
﹞ Case 1 - Spot Price slides more than the futures price, in this case weak basis
Loss = ((Start date Cash Price 每 End date Cash Price) 每 (Hedge start price 每 Hedge end price))
﹞ Case 2 - Spot Price gains more than the Futures Price, again weak basis
Gain = ((Start date Cash Price 每 End date Cash Price) 每 (Hedge start price 每 Hedge end price))
﹞ Case 3 - Futures Price falls more than the Cash Price, case of strong basis
Gain = ((Hedge start price 每 Hedge end price) 每 (Start date Cash Price 每 End date Cash Price))
﹞ Case 4 - Futures Price gains more than the Cash Price, case of weak basis
Loss = ((Hedge start price 每 Hedge end price) 每 (Start date Cash Price 每 End date Cash Price))
﹞ Case 5 - Futures Price gains or lose in tandem with the Spot Price, zero basis and no change
﹞ Case 6 - No change in spot price and futures price, zero basis and no change
II. When the hedger does a long hedge, that means locking the price of the underlying which is bought but to be delivered in future, so as to avoid price fluctuation during that time.
﹞ Case 1 - Spot Price slides more than the Futures Price, in this case weak basis
Gain = ((Start date Cash Price 每 End date Cash Price) 每 (Hedge start price 每 Hedge end price))
﹞ Case 2 - Spot Price gains more than the Futures Price, case of strong basis
Loss = ((Start date Cash Price 每 End date Cash Price) 每 (Hedge start price 每 Hedge end price))
﹞ Case 3 - Futures Price falls more than the Cash Price, case of strong basis
Loss = ((Hedge start price 每 Hedge end price) 每 (Start date Cash Price 每 End date Cash Price))
﹞ Case 4 - Futures Price gains more than the Cash Price, case of weak basis
Gain = ((Hedge start price 每 Hedge end price) 每 (Start date Cash Price 每 End date Cash Price)
﹞ Case 5 - Futures Price gains or lose in tandem with the Spot Price, zero basis and no change
﹞ Case 6 - No change in spot price and futures price, zero basis and no change
Over-the-counter (OTC) derivatives fit the requirements of a hedger, as they can be tailor-made as per the hedging strategy, thus minimising the basis risk.
Source: Bionic Turtle
