Hedging refers to managing financial risk with the use of derivatives. Any investor can take a specific position using futures contracts and options and another investor will take the opposite position in the market to complete “the hedging transaction and ensure a certain amount of gain on a certain trade”.

Organizations use hedging to enhance the expected future cash flows and manage risk related to particular market variables such as the price of oil or a foreign exchange rate. Most hedgers aim for a perfect hedge to perfectly eliminate the risk. However, perfect hedges are rare because hedgers have to know for sure the precise transaction date, delivery date and the asset price. As this information is not always straightforward, hedgers craft proper strategies to reduce or eliminate investment risk.

**The Concept of Basis Risk**

Basis risk is defined as the risk that arises when the asset to be hedged and the underlying asset are not the same and therefore the change in price of the hedge does not match the change in the price the hedged asset. The imperfect correlation between the two investments creates investments opportunities for gain in a hedging strategy or losses if investment risk is not properly managed.

Basis risk = Spot price of the asset to be hedged (So) – Futures price (Fo)

* If the asset to be hedged and the underlying asset are the same, then So = Fo and the basis risk is zero at the expiration of the contract.

* If the spot price (So) increases more than the futures price (Fo), the basis risk increases. This is known as the strengthening of the basis.

* If the spot price (So) decreases less than the futures price (Fo), the basis risk decreases. This is known as the weakening of the basis.

**Example of Basis Risk**

To better illustrate how basis risk functions we assume the following:

S1: Spot price at time t1 = $2.70

S2: Spot price at time t2 = $2.30

F1: Futures price at time t1 = $2.40

F2: Futures price at time t2 = $2.10

b1: Basis risk at time t1

b2: Basis risk at time t2

At the time the hedge is initiated, spot price (S1) is $2.70 and futures price (F1) is $2.40 and at the time the hedge is closed out spot price (S2) is $2.20 and futures price (F2) is $2.10.

Therefore, basis risk is:

b1 = S1 – F1 = $2.70 – $2.40 = $0.30

b2 = S2 – F2 = $2.20 – $2.10 = $0.10

Basis risk can lead to an improvement or worsening of hedge position and functions differently with a short and a long position.

In particular:

**Short hedge basis risk**

Short hedge is the appropriate hedging strategy when the hedger owns the asset and expects to sell it at sometime in the future. We assume that the hedger knows that the asset will be sold at t2 and takes a short hedge at t1. The spot price realized at t2 is S2 and the profit on futures position is F1 – F2. Therefore, by taking a short position with hedging the effective price realized is S2 + (F1 – F2) = F1 + b2.

- If the basis strengthens, the hedger’s position improves because So > Fo
- If the basis weakens, the hedger’s position worsens because So

**Long hedge basis risk**

Long hedge is the appropriate hedging strategy when the hedger wants to lock a price today for an asset that will be purchased in the future. We assume that the hedger will buy the asset at t2 and takes a long hedge at t1. The price paid for the asset is S2 and the loss on the hedge is F1 – F2. Therefore, by taking a long position with hedging the effective price paid is S2 + F1 – F2 = F1 + b2.

- If the basis strengthens, the hedger’s position worsens because So > Fo
- If the basis weakens, the hedger’s position improves because So

**Factors Affecting Basis Risk**

Basis risk increases or decreased because of several factors. These are:

**a) Factors that increase basis risk**

- Interest rates, freights, storage costs, and transportation costs between the location and the futures delivery point.
- Delivery method
- Market risk

**a) Factors that decrease basis risk**

- Deficiency of local supply for the commodity on the spot market
- Deficiency of local supply for competitive commodities on the spot market
- Dividends paid by the underlying asset of the futures contract
- Cash flows generated by the underlying asset of the futures contract

Because basis risk is associated to the risk that arises from unanticipated changes in the basis between the time a hedge is initiated and the time that a hedge is closed out, it may fluctuate significantly. Moreover, basis risk cannot be eliminated with hedging.

Sources:

http://www.investopedia.com/terms/b/basisrisk.asp

Hull , J.C. (2005). Options, Futures and Other Derivatives (6th Edition), Prentice Hall

http://www.ericbenhamou.net/documents/Encyclo/Basis%20risk.pdf