Basis Risk in Futures Hedges and Location Mismatches
Summary
The document explains why a futures hedge can leave meaningful risk even when the contract was intended to lock in a price. A hedger may retain an asset, such as a bond or stock basket, and take an offsetting position in a correlated futures contract rather than selling the asset. If the futures price changes differently from the hedged position, the two positions will not offset as intended; that mismatch is basis risk.
The examples show that the mismatch can arise from differences in the instruments or in their delivery locations. A liquid commodity contract may reference a delivery point far from the hedger's actual supply needs, so a sharp local price move may not be reflected in the futures contract. A hedge can therefore behave like an additional position when the underlying exposure and hedge instrument diverge. The discussion is explanatory and gives no method for quantifying or minimizing basis risk; the effectiveness of any hedge depends on how closely the contract tracks the exposure over the relevant period.
Key ideas
- A futures hedge works only to the extent that the hedge instrument moves with the exposure being hedged.
- Basis risk is the risk that changes in the hedge instrument and the underlying position diverge.
- A hedger may use futures while retaining an asset because of trading costs or portfolio constraints.
- Commodity delivery locations can create price differences that weaken a futures hedge.
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# Basis Risk for Futures/Options # Basis Risk for Futures/Options I am just reading about basis risk. It is being described as risk of the price of the hedging instrument not fluctuating the same as the instrument itself. I was just wondering, if we bought a future to lock in a price, why would it matter what the price of the future is? Only unless we decide to sell the contract it would matter right? ## Answer by Richi Wa (score 1, accepted) https://quant.stackexchange.com/a/12671 If you look e.g. in Hull's book in the section about hedging then you get more details. In short: You have a position of $X$ (thousand) Euros in a bond/basket of stocks and you want to hedge this position by shorting $N$ futures contracts that correlate to these instruments (Bund/Treasury futures or equity index futures). You hedge because you think that there is some difficult time in the next say week. You don't simply sell your position (the bond/the stocks) for various reasons (could be: you are not allowed to have too much cash in the portfolio, transaction costs are too high ...) so you short a derivative. If the change in price of the derivative has little to do with your bond/stock then this will not be a good hedge but just another position. This risk is called basis risk. ## Answer by PatternMatching (score 0) https://quant.stackexchange.com/a/12678 In the context of commodities, the spread between the price as delivered and the price of the liquid forward/futures contract is very much a risk. More often than not, you are not fixing the price at the liquid point and the future can only be used as a dirty hedge to the risk you are attempting to hedge. For example, say I'm a power plant operator attempting to hedge the cost of natural gas to run my plant. This past winter, the price of NG in the northeast blew out and was delivering for \$50-60/MMBtu over NYMEX prices of high \$4, low \$5/MMBtu. Hedging with NYMEX Henry Hub gas (which delivers near Louisiana) wouldn't really have done you much good.
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