I understand that basis risk is the difference between forward price and spot price. So if the maturity of the hedged asset and the term of forward contract are the same there would be no basis risk? How is basis risk related to interest rate differentials? In short, please explain in plain words what you need to know about basis risk for the exam. Thanks a lot!

Transportation cost is an example that will introduce basis risk for commodity as the cost of transportation is usually not known in advance.

Same thing for interest rate differentials. If your spot is different than your forward price, there is basis risk. For commodities, you have the same issue as above + the storage costs mentioned above. if your over/understimate the storage costs, then your price in the future will not be what you envisioned aka basis risk.

With the interest rates, I believe there will be basis risk in the beginning but as the contract gets closer to expiration then the basis risk should decrease?

bpdulog Wrote: ------------------------------------------------------- > With the interest rates, I believe there will be > basis risk in the beginning but as the contract > gets closer to expiration then the basis risk > should decrease? If the contract matches the duration, basis risk should decrease…

* Basis Risk: LADG – Location – Amount/Quantity – Date – Grade/Quality

The Basis Risk is the risk that the amount you considered hedge may not turn out to be the exact amount of hedge required and as a result you are on the hook for certain unintended “unhedged” amount. All the examples given lease rate etc.) may cause Basis Risk.

You guys seem to confuse between basis and basis risk. Basis in a hedging situation is defined as: basis = spot price of asset to be hedged - futures price of contract used. Basis risk refers to the risk/uncertainty associated with the basis, i.e., whenever you are not certain the value of the basis will be when you lift the hedge. When asset to be hedged and the asset underlying the futures contract are the same, the basis should be 0 AT THE EXPIRATION of the futures contract. Before that, the basis may be positive or negative. Important to note that basis can be <>0, but still there is NO basis risk as in the case of currency hedging in a very liquid market and you lift the hedge at expiration --> you know exactly the basis going to be: over the long term, the return of the hedged portfolio will differ from the portfolio return achieved in foreign currency by this forward basis= interest rate differential, even with a hedge ratio of 1 --> basis <>0, but no basis risk. If you lift the hedge before expiration, there will be basis risk because there is uncertainty what the basis going to be, especially in an illiquid market. Same thing applies with commodities, stock/bond futures: there is a basis risk whenever there is an uncertainty concerning what the basis going to bedue to - a mismatch between underlying asset of the futures/forwards and asset to be hedged. - a mismatch between expiration and time when the hedge will be lift. Hope it is clearer

elcfa Wrote: ------------------------------------------------------- > You guys seem to confuse between basis and basis > risk. > > Basis in a hedging situation is defined as: > > basis = spot price of asset to be hedged - futures > price of contract used. > > Basis risk refers to the risk/uncertainty > associated with the basis, i.e., whenever you are > not certain the value of the basis will be when > you lift the hedge. > > When asset to be hedged and the asset underlying > the futures contract are the same, the basis > should be 0 AT THE EXPIRATION of the futures > contract. > > Before that, the basis may be positive or > negative. > > Important to note that basis can be <>0, but still > there is NO basis risk as in the case of currency > hedging in a very liquid market and you lift the > hedge at expiration --> you know exactly the basis > going to be: over the long term, the return of the > hedged portfolio will differ from the portfolio > return achieved in foreign currency by this > forward basis= interest rate differential, even > with a hedge ratio of 1 --> basis <>0, but no > basis risk. > > If you lift the hedge before expiration, there > will be basis risk because there is uncertainty > what the basis going to be, especially in an > illiquid market. > > Same thing applies with commodities, stock/bond > futures: there is a basis risk whenever there is > an uncertainty concerning what the basis going to > bedue to > > - a mismatch between underlying asset of the > futures/forwards and asset to be hedged. > - a mismatch between expiration and time when the > hedge will be lift. > > Hope it is clearer Thanks. Ya basis always threw me off.

thanks, elcfa.