Basis risk — quick definition
– Basis risk is the danger that a hedge will not move perfectly opposite to the exposure it is intended to offset. In other words, the price difference between the asset being hedged (the spot price) and the hedging instrument (usually a futures contract) can change unpredictably, producing residual gains or losses.
Why it matters
– A hedge reduces exposure but does not eliminate it if the two instruments are not perfectly correlated. When basis changes, the hedger can end up with unanticipated profit or loss. For large positions, even a small per‑unit basis change can produce material dollar effects.
Core concepts and formula
– Spot price: current market price of the asset being hedged.
– Futures price: the price of the futures contract used to hedge.
– Basis = Spot price − Futures price.
– Basis risk = the risk that this basis will change in an adverse way between hedge initiation and settlement/position close.
Worked numeric example (simple)
– Situation: You hold 10,000 barrels of crude oil you want to hedge.
– Spot price today = $55.00 per barrel.
– Futures contract used for hedging = $54.98 per barrel.
– Basis = 55.00 − 54.98 = $0.02 per barrel.
– Dollar exposure to basis (if the basis moves to zero or widens by $0.02 against you) = 0.02 × 10,000 = $200.
– Takeaway: Small per‑unit basis changes can still matter when volume is large.
Common types of basis risk (brief)
– Locational basis risk: Occurs when the futures contract’s delivery point or price hub differs from the seller’s physical delivery location. Example: a Louisiana natural‑gas producer hedging with contracts deliverable in another hub may face a persistent price spread.
– Product / quality basis risk: Happens when a hedge uses a related but not identical commodity or grade (e.g., jet fuel hedged with crude oil or low‑sulfur diesel). The price relationship between products can shift.
– Calendar (timing) basis risk: Results when the futures contract’s expiration date does not line up exactly with the timing of the exposure (for example, a contract that expires at month‑end for a delivery in the following month).
Practical checklist to assess and manage basis risk
1. Confirm contract specification: delivery point, grade/specification, contract size, and delivery months match your exposure as closely as possible.
2. Calculate current basis: Spot − Futures for the nearest relevant contracts.
3. Scale exposure: Multiply basis per unit by the number of units to see potential dollar sensitivity.
4. Check liquidity: Prefer more liquid contracts to reduce execution and rollover slippage.
5. Analyze historical basis behavior: Look at historical average basis and standard deviation for relevant pairs and months to gauge typical variability.
6. Decide hedge ratio: Choose a hedge ratio (fraction of exposure to hedge) that balances reduction of spot risk against residual basis risk.
7. Set monitoring and exit rules: Define triggers for adjusting or closing the hedge (e.g., basis widening beyond a threshold).
8. Account for costs: Include transaction costs, margin, and potential delivery/transportation costs that affect net outcomes.
9. Use stress tests: Model scenarios where basis shifts materially to see P&L consequences.
10. Document assumptions and limits: Keep written rationale for the hedging approach and tolerable basis risk.
Step‑by‑step calculation and monitoring routine
1. At hedge initiation: record spot price, futures price, units, basis, and intended hedge ratio.
2. Daily/weekly: update spot and futures prices, recompute basis, and track cumulative unrealized basis P&L = (current basis − initial basis) × units × hedge ratio.
3. If basis moves beyond pre‑set limits, review whether to adjust the hedge (roll contracts, change ratio, or close).
4. Before contract expiry: confirm any locational or delivery mismatches and evaluate cash‑settlement vs. physical delivery implications.
Assumptions and caveats
– The simple basis formula excludes transaction costs, margin calls, and carry costs (storage, financing), which may affect net hedging outcomes.
– Historical basis behavior is only a guide; structural changes in supply/demand, transport constraints, or regulation can alter relationships.
– Hedging reduces some risks but introduces others (liquidity, basis, operational).
Short numeric locational example
– Producer exposure: 100,000 MMBtu of natural gas in Louisiana.
– Louisiana hub price = $3.50/MMBtu; Colorado deliverable futures = $3.65/MMBtu.
– Locational basis = 3.50 − 3.65 = −$0.15/MMBtu (i.e., Colorado contracts are $0.15 higher).
– Potential basis exposure = 0.15 × 100,