# Cant get my head around basis risk

Would someone be able to explain it to me? I know its something to do with the difference in the spot price and futures price, but there I am lost and confused! I’ve seen two questions on it now, read the answers and still not got it! Here’s the qn: Basis risk is deemed to be highest under which of the following? a. A manufacturer needing 40,000 bushels of hard red winter wheat in 2 months purchases 8 KCBT wheat contracts (5,000 bushels each) maturing in 3 months. b. A British exporter who will receive payments in euros in 3 months hedges using a futures contract on the pound/US dollar exchange rate maturing in 3 months c. An Iowa farmer with 500 acres who expects to produce 170 bushels of corn per acre over the next 3 months sells 17 corn futures contracts (5,000 bushels each) maturing in 3 months.

C? Post the answer here. Basis is spot- futures.

I would say the basis risk is highest where what is traded on spot is least like what is traded in futures. Definitely not C, because the 170 * 500 bushels of corn in 3 months correspond to 17 * 5000 bushels in 3 months. Hedging a Euro payment in 3 months with a futures contract on Pound / US seems crazy, I would have gone for B. Most of that risk is called cross-hedge risk though, and I’m not 100% sure that’s part of basis risk.

A.

A - it’s the timing difference - 2 months vs. 3

I think it’s A. I believe the risk come from the need/availability mismatch. In A, you need it in 2 months, but won’t receive until 3. (major risk!) In B, the maturities match up. (no risk) In C, you will sell in 3 months, and you can accumulate your stockpile ‘over the next 3 months.’ (Relative to A, smaller risk) What’s the answer?

As far as the concept of basis risk is concerned (because in the beginning, you asked for an explanation): Basis refers to the difference of the spot price (of the thing you’re trying to hedge) and the futures price (of the thing you’re using to hedge). These prices may not move in parallel due to several reasons: a) they’re not exactly the same asset (for example, the corn you will deliver might not be the same grade as the one the future contract specifies). Other example: The guy in B above tries to hedge euros with pounds - now the question is how much these are correlated. b) the delivery dates might not match, as in option A above. c) the delivery might be at a different location. For example, the farmer in option C above might have sold futures that call for delivery in Chicago, but he is based in Iowa. These differences cause the prices of the asset / liability and its hedge to move differently. So although you’ve hedged to some degree, the hedge is not perfect - and that’s called basis risk. That said I stick to B because in A, at least the guy has a contract on roughly the same thing that he’s trying to hedge. 2 months down the road he will have to sell the futures contract and buy spot, but the futures contract will have a return that’s similar to the movement of the spot price. Whereas the guy who’s trying to hedge euros with pounds could have a loss on his future contract _and_ the euro could have depreciated relative to the pound, which would mean a double loss.

CHedges - where you at?

A Longer maturity of futures contract.

B . Basis risk is greater when you cross hedge with things that are barely related

olivier Wrote: ------------------------------------------------------- > B . Basis risk is greater when you cross hedge > with things that are barely related I think it is proxy hedge therefore less risk. Instead of pound/euro he is using pound/\$.

> I think it is proxy hedge therefore less risk. > Instead of pound/euro he is using pound/\$. Of course you can say it’s a proxy hedge - but the dollar is probably just as uncorrelated to the euro as the pound. In other words, why not just leave the position unhedged.

naze_duck Wrote: ------------------------------------------------------- > > I think it is proxy hedge therefore less risk. > > Instead of pound/euro he is using pound/. \> \> Of course you can say it's a proxy hedge - but the \> dollar is probably just as uncorrelated to the \> euro as the pound. In other words, why not just \> leave the position unhedged. I agree, in the absence of information regarding correlation between & Euro it is difficult to say how effective this hedge is. I was comparing existing ccy contract with cross hedge (e.g Euro/\$) or any other currency other than pound. Where British exporter would still be exposed to foreign ccy risk & risk on cross hedge. As you explained earlier all 3 options have element of basis risk… I still think it is A. Chedges…please post the ans & thanks for posting this question.

^ Yeah, definitely a good question… and a useful discussion. And we’re all just waiting for chedges to come back…

i say B

b is a proxy hedge - using correlated currencies to hedge

A: Due to maturity mismatch.

B. Basis risk when you hedge with futures (say short futures) and over the period of time price of underlying and future don’t move in tandem. So on this basis B.

The easiest way to explain the concept is using 2008 when the SEC banned short selling of financials. So let’s say you were short a book of financials and had a market neutral hedge on using long S&P futures. This has historically worked well. They ban short selling of financials - the market continues down, but the financials rally. Basis risk - your hedging was nullified right there.