Basis risk

Sch Book 3, LOS 22e, Pg 80

Dear all,

Can anyone explain the below with an example. I am unable to see/visualise the flow.

Note that the hedge ratio and hence the number of contracts should be estimated for the time at which the hedge is lifted (i.e., the hedge horizon), because this is when the manager wishes to lock in a value. The manager should also have an estimate of the price, because the effect of changes in risk will vary as price and yield vary

Thank you


I am unclear on this part of the para

’ at which the hedge is lifted (i.e., the hedge horizon)’.

Think about a PM who expects a cash inflow in e.g. three months but wants to lock in the performance. Basis risk arises when futures price and underlying do not have the same correlation. The number of contracts must suit to the maturity date of the futures. At maturity, the PM cashes in the futures performance and then switches into the underlying…