Basis risk is an inherent risk from hedged financial position differences. This risk develops when a futures contract (or hedge) price differs from the market (or cash) price of the asset being hedged. The difference between two prices is called 'basis,' and the risk connected with it is called 'basis risk.' The basis represents the correlation between the cash price and the futures price of an asset. This difference typically surfaces when the asset covered by a hedge doesn't align with the asset underlying the futures contract. This mismatch can also occur if the timing of the hedge doesn't perfectly coincide with the maturity of the futures contract. Especially in substantial investments, basis risk can significantly sway the ultimate profit or loss.

The gap between the futures and cash prices, which might either decrease or increase, plays a critical role from the start of a hedge position until its closure. Ideally, if the hedged and baseline assets are identical, at maturity the basis should be zero. Traders commonly employ futures contracts to protect themselves against fluctuations in market price. By so doing, they exchange price risk for basis risk--a systematic source of uncertainty arising from the sheer volatility of financial markets. When a futures contract nears maturity, its price tends to converge on the cash market. Yet, one should observe that the foundation for convergence can never be taken as a given.

Basis risk isn't limited to securities trading but is widespread in the insurance market. Basis risk is the possibility that when submitting an insurance claim for compensation of a loss, the amount paid out falls short of compensating one's actual losses. Put more simply, it means the risk that an insurance payment will be less than expected.

Basis Risk Calculation

To determine basis risk, an investor needs to perform a simple calculation: Subtract the value of a futures contract from this amount. Under this condition, the price on the market differs from that of a futures contract and is not yet close to expiration. This difference is the core of basis risk. In short, basis risk is the difference between futures and spot prices.

Formula for Basis Risk:

Basis = Futures Price of the Contract - Spot Price of the Hedged Asset.

Types of Basis Risk

Basis risk in derivatives can be categorized into four distinct types of basis risk, each arising from different conditions:

• Calendar Basis Risk: This risk comes when there's a disparity between the expiry time on the futures and the transaction date in cash. This discrepancy in dates can lead to variations in price movements, thus creating risk.
• Location Basis Risk: Commonly encountered in the commodities market, location basis risk occurs when the delivery location specified in the spot market transaction differs from that of the futures market. This geographical difference can affect the pricing and logistics, thereby introducing risk.
• Product Quality Basis Risk: This risk becomes evident when a financial asset's quality or characteristics differ from those specified in the derivatives contract. The inconsistency in the asset's attributes can lead to a mismatch in valuation, thus creating risk.
• Price Basis Risk: Price basis risk is observed when the price trends of the financial asset and the corresponding futures contract are not aligned at the beginning and the end of a trading period. This misalignment can cause the hedging strategy to be less effective, introducing risk to the investor or trader.

Each of these types of basis risk underlines the complexities involved in derivatives trading, emphasizing the need for careful assessment and strategy while engaging in such financial instruments.

Examples of Basis Risk

Example #1: Transition from LIBOR to Alternative Rates

In the financial sector, however, the transition from LIBOR to alternative rates, such as the Secured Overnight Financing Rate (SOFR), has already been running smoothly. Fitch Ratings said there's plenty of time to sort out any transition problems before the June 30, 2023 deadline. However, certain securities, like those in the Federal Family Education Loan Program (FFELP) student loan asset-backed securities, remain vulnerable to basis risk in this context.

The Federal Reserve Board sought feedback on draft rules that did not necessitate changes for adopting a replacement rate. The draft proposed several SOFR configurations with tenure-spread adjustments for various financial instruments. For example, derivatives use SOFR compounded in arrears, while cash products and consumer loans employ the term SOFR. This setting discrepancy between bonds and derivatives could result in basis risk for bonds dependent on cash flows from derivatives contracts.

Example #2: Hedging a Stock Portfolio with Dow Jones Futures

Consider a scenario where a portfolio manager, Ryan, aims to mitigate risk in a diversified stock portfolio. To achieve this, he decided to short Dow Jones futures. However, if the composition of his portfolio doesn't precisely align with the components of the Dow Jones index, the hedge won't be perfect. This misalignment means that Ryan's strategy will expose him to basis risk, as the performance of his portfolio may not move in tandem with the Dow Jones futures he's using to hedge.

Frequently Asked Questions (FAQs)

What Causes Basis Risk?

The basis risk inherent in most derivative instruments comes from the fluctuation between a futures price and that of an underlying asset.

Is Basis Risk a Type of Credit Risk?

No, basis risk is not the same as credit risk. Loss risk Credit loss refers to the possibility of a borrower defaulting on his loan. In contrast to basis risk, credit risk is classed as unsystematic.

How Can Basis Risk Be Managed?

Effective management of basis risk requires careful analysis of market trends. For example, during harvest time, the discount in the local market might be greater than in the futures market, leading to later narrowing of the basis.

What is Basis Risk in the Energy Sector?

In the energy market, basis risk can manifest as the difference between the hub and nodal prices where electricity sales occur. This risk surfaces when the cost of purchasing electricity to resell to a hedge provider exceeds the price received for selling electricity into the grid.