Basis risk is the financial risk that traders assume when they hedge a position by holding an opposing position in a derivative, like a futures contract.
This risk arises when a hedge cannot or does not sufficiently stop investment losses.
Traders must subtract the futures price from the market price of the financial asset being hedged to calculate the risk.
The three fundamental types of basis risk are location, pricing, and calendar risk.
A different hedging approach would work better when this risk is present. To protect themselves against price risk, traders are willing to take this risk.
Any possible risk brought on by mismatches in a hedged arrangement is referred to as base risk.
The difference between the current spot or cash price of the underlying asset and the futures or hedging price is another definition of the basis, which is the basis. The linked basis risk is the basis risk.
As a result, the basis is the similarity between the underlying asset's cash and future values.
There is a separation when the security in the hedged asset is separate from the financial assets supporting the futures contract.
There can be a mismatch if the hedging horizon and the futures contract maturity time are different.
Between the beginning of a hedging position and the time the trader liquidates it, the price spread, or the difference between futures and cash prices, may alter.
The basis will be zero upon maturity if the underlying assets of the hedging instrument and the hedged asset are the same.
Traders enter into futures contracts as a hedge against price fluctuations in the market.
Basis risk, a type of systematic risk, is created when price risk is changed.
Because financial markets are unpredictable, there is a possibility of systemic instability.
The cost of a futures contract frequently approaches the cash or spot price as the expiration date draws near.
What is basis risk in finance?
Both stock trading and insurance are in danger. When it comes to insurance, this risk is the possibility that a policyholder will purchase coverage, but the reimbursement they get in the case of a claim will be less than the whole cost of the specific claim event.
It only implies that there's a chance the compensation under an insurance policy will differ from the sum that's compensated.
On this Basis meaning, the risk is the chance that a futures contract or an OTC hedge's value won't completely cancel out an underlying position.
Depending on the historical period or product, the sources of this risk may vary, and they may only be important under specific circumstances.
Basis Risk types:
Price basis risk develops when the prices of the underlying asset and the underlying futures contract remain constant.
On this basis, there is a risk if the underlying asset is situated outside of the area where the futures contract trading venue is situated.
Actual crude oil sold in Mumbai and crude oil futures traded on a futures exchange in Dubai may have different bases than actual crude oil sold in Mumbai and crude oil futures trading in Mumbai.
Calendar risk: A futures market contract's expiration date and the selling date of a spot market position could disagree.
The risk associated with product quality basis comes when the characteristics of the asset diverge from those represented by the futures contract.
Basis risk meaning
When a trader tries to offset a market position in an asset by taking a counter position in one of the asset's derivatives, like a futures contract, basis risk is created.
The assumption of basis risk is established to remove price risk. The trader will have effectively hedged his market position if his basis stays constant until he closes out both of his holdings.
He will probably see greater gains or losses if the basis has changed significantly.
Producers will benefit from hedging their market position with a reducing basis spread, whilst buyers will benefit from a broadening basis spread. This is broadly the basis risk meaning.
By opening a second position, traders can reduce their risk exposure in the first position by using the hedging method.
The strategy can involve maintaining a futures position that is completely at odds with one's position in the market for the underlying asset.
For instance, a trader could offset a long buy position in the underlying asset by selling short futures.
The approach assumes that gains in the hedging futures position would offset any potential losses in the underlying asset position.
Basic Risk Components
In investment, risk can never be completely avoided. Risk, however, can be at least significantly reduced.
Thus, when a trader buys a futures contract to hedge against potential price changes, they are at least partially converting some of the underlying "price risks" into a different kind of risk known as "base risk."
Systematic risk, on this basis meaning known as market risk, includes basis risk as one of its subtypes.
Systematic risk refers to the danger posed by the markets' innate unpredictability.
Unsystematic risk, also known as non-systematic risk, is the risk related to a specific investment.
A common illustration of systematic risk is the possibility of a depression or substantial economic downturn. Apple
Basis risk formula:
An investor calculates basis risk by subtracting the contract's futures price from the asset's current market price.
The asset's market price and the futures contract price do not correspond in this scenario, and the contract has not yet expired. The difference between the two figures denotes the fundamental risk value.
The basis is the difference between the futures price of the contract and the spot price of the hedged asset.
Basis = The futures price of the contract - spot price of the hedged asset.
Example
- Assume Sam, a portfolio manager, wishes to reduce the risk exposure of a diversified stock portfolio. As a result, he decides to sell Kenichi futures.
If the portfolio's composition differs from that of Kenichi, the hedge will be ineffective.
As a result, Sam will be exposed to basic risk.
1. Locational basis risk is yet another category of basis risk. When a contract specifies a different delivery location than the commodity seller prefers, this occurs in commodity markets.
Locational basis risk exists, for instance, if a natural gas producer with operations in Louisiana decides to hedge price risk with contracts that must be fulfilled in Colorado.
The locational basis risk is $0.15/MMBtu if the Louisiana contracts are trading at $3.50 for one million British Thermal Units (MMBtu) and the Colorado futures are trading at $3.65/MMBtu.
2. Although two-year bonds protect Treasury bill futures, there is still a possibility that their fluctuations will be less than anticipated.
3. The PDF fixing may differ significantly from the market's true spot rate on the fixing date when utilizing a non-deliverable forward contract (PDF) to hedge foreign currency rates.
4. Over-the-counter (OTC) derivatives can lower basis risk by producing an ideal hedge. This way, OTC derivatives can be tailored specifically to a hedger's risk preferences.
Also Read,
Plan Design and Implementation
Feasibility Study and Bench Marking
Conclusion
Basis risk and basis risk meaning, in the context of finance, is the threat of inadequate hedging brought on by factors or characteristics that affect the difference between the underlying "cash" position and the futures contract.
Before expiration, it arises from the price difference, or b = S - F, between the asset that needs to be hedged and the asset serving as the hedge.
Except for any idiosyncratic influence from the other factors that will, by the time the agreement expires, this minor difference will have been arbitraged out.
FAQ’s Related to Basis Risk
1. Why does basis risk exist?
When there is no foreseeable relationship between the price of a futures contract and the price of the financial instrument being hedged, basis risk in derivatives occurs.
2. A credit risk is basis risk?
It's not a credit risk, no. The likelihood that a loss would occur as a result of the borrower's inability to meet contractual obligations or repay a loan is known as credit risk. It is an illustration of unsystematic risk, as opposed to foundation risk.
3. How can basis risk be managed?
Traders and portfolio managers must thoroughly understand market patterns to manage this risk effectively. For instance, during harvest season, the local market typically offers a greater discount than the futures market. The base then becomes more limited.
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