Introduction

In this Chapter, we will discuss the concepts of basis risk and its implications when using futures contracts for hedging. Basis risk is an important consideration for hedgers as it measures the potential deviation between the price of the futures contract and the actual underlying asset being hedged. Understanding basis risk and its various sources is crucial for effective risk management and making informed hedging decisions. In this chapter, we will define basis, explore different sources of basis risk, and explain how basis risks can arise when hedging with futures contracts.

Definition of Basis

Basis, in the context of futures contracts, refers to the difference between the spot price of the underlying asset and the futures price. It represents the cost or benefit of holding the underlying asset compared to holding the futures contract until its expiration.

It is calculated as:

$$ \text{Basis = Spot Price − Futures Price} $$

A positive basis implies that the spot price is higher than the futures price, while a negative basis indicates the opposite. Basis can fluctuate over time due to various factors.

Sources of Basis Risk

There are several sources of basis risk that hedgers should be aware of:

Time to Expiration: Basis risk can arise due to the difference in the time remaining until the futures contract expires and the time horizon of the hedging position. As the expiration date approaches, the basis might converge to zero, but until then, it could deviate and cause uncertainty in the hedging outcome.

Delivery Locations: Futures contracts are often tied to specific delivery locations, and if the actual delivery location of the underlying asset differs from that of the futures contract, basis risk can emerge.

Quality and Grade: For assets with varying quality or grades, the basis risk arises when the hedger’s asset quality differs from the underlying asset defined in the futures contract.

Seasonal Factors: Some assets exhibit seasonal price patterns. As futures contracts have standardized expirations, hedging against seasonal price changes can lead to basis risk if the futures contract’s expiration does not align with the seasonal demand or supply periods.

Understanding Basis Risks in Futures Hedging

Hedgers use futures contracts to lock in prices and protect against adverse price movements in the underlying asset. However, basis risk introduces the possibility that the futures price and the actual spot price of the asset will not perfectly align at the time of hedging or when closing the position. This can result in a gain or loss for the hedger, in addition to the effects of price movements.

Example: Let’s consider a corn farmer who wants to hedge against falling corn prices. They decide to use corn futures to lock in a selling price for their corn crop at the time of planting. The current spot price of corn is USD 4.50 per bushel, and the corn futures contract for delivery in three months is priced at USD 4.60 per bushel. At the end of three months, the spot price of corn is USD 4.55 per bushel. In this case, the basis risk for the corn farmer would be USD 0.05 per bushel (4.60 - 4.55).