Can sb explain this in layman terms? If I have an foreign currency investment that has been hedged with a forward, how is the basis risk affecting my local currency return? thanks. - sticky
If the hedge is unwound BEFORE the maturity of the futures contract or if you are using a proxy hedge, then we have a basis risk. Basically, hedging replaced price risk by basis risk. Suppose you have an asset valued S1 at t = t1 that you would sell at some yet to be determined t=t2. To protect against the price risk, you take a short ffutures position with forward contract price F1 and maturity t = T> t2. At t=t2, you sell the asset. You also take an offsetting position in the futures market, i.e. go long a contract expiring at t= T. So the selling price you get = (S2 - F2) + F1. Now look at this equation - when you entered the hedge at t = t1, you knew the F1. However, you had no idea where S2 and F2 would be. If the spot price and futures price did not move to offset each other, you have an uncertainty of (S2-F2) in the price you are going to realize when you enter the hedge at t=t1. This is the basis risk and (S2-F2) is called the basis of the hedge. The derivation of basis risk for proxy hedge is slightly more complex, but there you introduce an additional term (S2A-S2B) and the basis risk is (S2A-S2B) + (S2B-F2B), where A is the asset you hold and B is the proxy asset used to hedge the price exposure. The second term here is the same as above. The first term relates to differing evolution of spot prices of the asset and the underlying for the hedge. Now for currency assets, Ft = St * exp(rd-rf)t. This gives you the last piece of information as to why F and S prices may evolve so that St - Ft is not equal to zero. It is because the interest rate differential between the domestic and local currency may change.
thanks very much, CFAAtlanta! That’s a very good one. - sticky
sorry but I get confused aaain after reading other posts on basis risks 
Questions below. CFAAtlanta Wrote: ------------------------------------------------------- > If the hedge is unwound BEFORE the maturity of the > futures contract or if you are using a proxy > hedge, then we have a basis risk. Basically, > hedging replaced price risk by basis risk. 1. In the context of currency management (of, say, a foriegn currency investment), why are we getting a futures contract that is longer (or shorter) than the relevant time horizon? 2. If the futures contract is expiring exactly at the time of end of the relevant time horizon (oh, do we call this perfect hedge?), is there any basis risk? (whatever +ve/-ve correlation relationship between the foreign currency and my currency) - sticky
Let me take a shot (don’t claim to understand it perfectly) 1. With forwards you are free to choose the time horizon you like, with futures you have to go with one that’s on offer. If you close the contract before the expiry you have a basis risk. 2. Yes, if you hold till expiry there should be no basis risk (provided the future and spot security are the same)
Thanks, CareerChange. I would like to extend this a bit. Can we say that it is very unlikely that we have perfect hedge for the commodities? What I am trying to say is that there are often basis risks in terms of storage, transportation costs, quality difference … even if date and amount are “matched”. See “Basis Risk” section, p.424, CFAI vol 4. - sticky CareerChange Wrote: ------------------------------------------------------- > Let me take a shot (don’t claim to understand it > perfectly) > > 1. With forwards you are free to choose the time > horizon you like, with futures you have to go with > one that’s on offer. If you close the contract > before the expiry you have a basis risk. > > 2. Yes, if you hold till expiry there should be no > basis risk (provided the future and spot security > are the same)
- There is almost nothing that a futures contract hedges perfectly because we have a floating rate margin account and gains MTM daily. That means if I buy a CME Euro contract, the price of the contract has to do with interest rate differentials, but changes in the US interest rate affect my margin account P/L. 2) If two things are certain to be of the same value at time T, they are always of the same value prior to T unless it’s not certain that they can both be held to time T. You can absolutely get closed out of a futures contract and any foreign investment can go away. 3) Forward contracts in currency require you to enter the Interbank market which is huge, but requires you to be an institution with serious credit. Anybody can trade futures contracts (I think FX has 8% yearly vol. A $150K contract has $12K of vol/year which isn’t that much). 4) Hedging commodities works ok if you are making arrangements to buy and sell commodities that you actually have. Thus, if you are selling corn in your field ahead in the futures market, you can hedge price risk fine (of course you just took on MTM risk and huge crop destruction risk).
sticky Wrote: ------------------------------------------------------- > Thanks, CareerChange. I would like to extend this > a bit. > > Can we say that it is very unlikely that we have > perfect hedge for the commodities? What I am > trying to say is that there are often basis risks > in terms of storage, transportation costs, quality > difference … even if date and amount are > “matched”. See “Basis Risk” section, p.424, CFAI > vol 4. > > - sticky You have to expand the definition of commodity to include delivery options, quality grade, etc.