Basis Risk
Basis risk is the risk that a hedge will not perfectly offset the price movements of the underlying exposure because the two instruments are not perfectly correlated. When the asset being hedged and the hedging instrument move differently, the hedge can leave residual gains or losses.
How basis risk affects hedges
Hedging typically uses a similar—but not identical—instrument to offset exposure (for example, futures, swaps, or related securities). Differences in product characteristics, delivery location, or contract timing can cause imperfect offsetting. Even small basis differences can materially affect results when positions are large.
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Examples:
* Hedging a two-year bond with Treasury bill futures may fail if the two instruments respond differently to interest-rate or credit events.
* Oil spot at $55 and a futures contract at $54.98 produce a basis of $0.02 per barrel; with large volumes that small basis matters.
Measuring basis
The basis is commonly defined as:
basis = spot (or cash) price − futures price
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The basis can be positive or negative. Changes in the basis (basis risk) are what create residual gain or loss after a hedge is closed.
Common types of basis risk
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Locational basis risk
Occurs when the deliverable point in the contract differs from the seller’s location. Example: a Louisiana natural gas producer hedging with contracts deliverable in Colorado faces a locational basis equal to the price difference between the two locations. -
Product (quality) basis risk
Happens when the hedge uses a different but related product because the exact product’s derivatives are illiquid. Example: jet fuel exposure hedged with crude oil or low-sulfur diesel contracts—traders accept some mismatch in behavior in exchange for liquidity. -
Calendar (timing) basis risk
Arises when the hedge’s contract expiry does not match the timing of the underlying exposure. Example: RBOB gasoline futures that expire at the end of the month before delivery can create a mismatch if the exposure extends into the delivery month.
Managing and reducing basis risk
- Use the most closely matched contract available (product, location, and delivery month).
- Cross-hedge carefully: quantify historical correlation and expected deviations before relying on a proxy instrument.
- Stagger or roll positions to align contract expiries with exposure timing.
- Use options, basis swaps, or customized OTC contracts when available to better match the exposure.
- Monitor basis behavior and volatility; adjust hedge ratios and position sizes to reflect residual risk.
- Maintain contingency plans for large basis moves (e.g., stop-loss rules, reserve capital).
Key takeaways
- Basis risk is the residual risk that a hedge will not perfectly offset the underlying exposure due to imperfect correlation or mismatches in product, location, or timing.
- It is measured as the difference between spot (cash) and futures prices; changes in that difference drive unexpected gains or losses.
- Effective management involves choosing close matches, monitoring correlations, and using complementary instruments when necessary.