Residual Hedge Risk and Basis Risk in Commodity Futures
Summary
The document compares two descriptions of risk remaining around a commodity futures hedge. It describes “basic risk” as residual exposure after hedging, including the difference between futures and spot prices if a futures position is closed early. The cited passage also lists commodity-specific costs that can contribute, such as preparing local grade for delivery, transportation, and storage with insurance.
The second passage defines basis as spot price minus the futures price and frames basis risk as exposure when those prices do not move together. It highlights a hedge that must be closed before maturity and the possibility that spot and futures prices may fail to converge at maturity. The document itself is a terminology question and provides no answer resolving whether “basic risk” is an established synonym or a distinct term. The excerpts come from the same book, so they establish how that source uses the phrases but do not settle broader industry usage.
Key ideas
- The cited text describes basic risk as residual risk after a futures hedge is established.
- Commodity basis risk can include costs of grade conversion, transportation, and storage.
- Basis is defined in the excerpt as the spot price minus the futures price.
- Basis risk arises when spot and futures prices move differently or fail to converge as expected.
- The document raises, but does not resolve, whether basic risk and basis risk are synonymous.
Tags
Full text
# Difference between "basic risk" and "basis risk" # Difference between "basic risk" and "basis risk" > Returning to Futures contracts, basic risk refers to the risk remaining after the hedge has been put in place and essentially represents the difference between the Futures price – should the Futures position be closed prematurely – and the spot price. It also includes other components such as: . The price of cleaning the local grade of the commodity into a grade deliverable in a Futures contract (or the premium for a superior grade). . The price of transportation to or from the delivery point in the Futures contract. . The physical cost of storage, including insurance, between the time of the harvest and the delivery date of the Futures contract. -- Page 7, Commodities and Commodity Derivatives: Modeling and Pricing for Agriculturals, Metals and Energy While in the same book: > 1. Understanding basis risk is fundamental to hedging. Basis is defined as: Basist,T = Spot pricet - FT(t) is usually quoted as a premium or discount: the cash price as a premium or discount to the Future price. The basis is said to be one dollar "over" Futures if the spot price is one dollar higher than the Futures price. 2. There are several types of basis risk: (a) In the case of a trading desk which needs to cut at date t (e.g., to avoid negative margin calls) – a position in Futures which was meant to hedge a position in the spot commodity – the basis risk is represented by the quantity defined above. (b) More generally, basis risk exists when Futures and spot prices do not change by the same amount over time and, possibly, will not converge at maturity T -- Page 14, Commodities and Commodity Derivatives: Modeling and Pricing for Agriculturals, Metals and Energy I feel confused about the terminology used here. I have never run across basic risk before. And I don't think it's a typo because the index of the book indeed also explicitly references basic risk. Are basic risk and basis risk the same?
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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.