# Currency Risk Mgmt: Basis risk

Hi all, I dont see the following LOS answered by Schweser, and I am probably too stupid to figure it out myself from the CFA material: LOS 14.41.c: “Evaluate the effect of basis risk on the quality of a currency hedge” So, what IS the effect of basis risk?? As far as I understand it, this refers to a change in the differential in spot/forward rates, it is normally assumed to be (some of these interest rate parities): F(D/L) / S (D/L) = (1 + i_D) / (1 + i_L) F(D/L) … current futures rate (domestic per local) S(D/L) … current spot rate (domestic per local) i_D … domestic interest rate i_L … local interest rate where “local” refers to “foreign” (Schweser notation). So, what is basis risk? The probability that this equilibrium is violated? And what is its effect on the quality of a currency hedge? Higher basis risk => lower quality of hedge? Why? Is there a way this differential can move in a favorable direction from the point of view of the hedge? How? Thanks, OA

I believe that basis risk refers to the impossibility of perfectly hedging an investment. You cannot eliminate all risk to something because its value will fluctuate. To eliminate basis risk you would have to continually rebalance a hedged position, which would be impractical, cost prohibitive, and probably impossible.

basis risk is basically created at the ending of the term you want to hedge and it is caused by a fluctuating spread over the asset you want to hedge. basis risk can create a favorable effect - because for example gain in the futures position can more than offset loss in the spot position

It’s mainly referring to the fact that you may purchase a futures contract that is dated past your intended holding period. When you reverse out of your current futures position, the basis (spread) could be different that when you originated the position. Basis risk would be eliminated if the futures contract expired at the same time as the hedged security. This is my take on it… could be way off

Can basis risk for FX also include the question of: How much currency do I hedge? Say you’re hedging a foreign equities portfolio, do you use a notional value equal to your starting portfolio value, some expected future portfolio value, or some minimum portfolio value?

my 2 cents Basis risk boils down to the interest rate differential and the interest rate differential determines the price of the furtures instrument you are using as a hedge. The shorter the time to maturity of the futures hedge, the closer it is to the current spot rate and the less affected it will be from interest rate movements. The longer the duration of your hedge, the more possibility of the interest rate differential changing from what it was initially when you executed the hedge and higher is the basis risk. Higher the basis risk, less the quality of your hedge. The optimal hedge ratio you calculated initially will no longer hold as the basis risk increases.

i’m with yodhava - basis risk is the risk is the risk that interest rate differentials (the basis) changes over the term of the hedge. In the long run IRP holds in theory and Fwds will provide the perfect currency hedge - but that is just theory and that is just the long run. (10+ years) The more the likelihood of interest rate differentials changing over the term -> the higher the basis risk and the lower the quality of the hedge. Can reduce basis risk by using a series of shorter term Fwds (so Fwd rates stay close to the spot rates) instead of one Fwd contract for the whole term you want to hedge. + I guess higher interest rate volatility (in either FC or DC or both) would also lead to higher basis risk and lower quality hedge. Solultion would also be to use shorter term Fwds, or a currency swap with frequent settlements.

this thread inspire me a question: Which of the following is/are example(s) of basis risk? 1. Using 6-month Brent Crude futures to hedge WTI crude oil price with the same term. 2. Using 6-month Brent Crude futures to hedge Brent crude oil price in 3-month. Thank you in advance.

as i understand it “basis risk” just refers to the risk that interest rate differentials move during the Fwd term - not any mismatch between terms (periods) (ie term of the exposure to be hedged -v- term of hedging instrument) (in your example 2), - nor any mismatch in the nature of the exposure (ie exposure hedged -v- hedging instument) (in your example 1)

It is 2. Basis risk refers to having to close out of your position before the expiration date. If you go long a futures contract and hold it until delivery date, you know exactly what the position will be worth, however if you purchase a 6 month futures contract to hedge a 3 month holding period, you will have to close out your position by taking an opposite position in a futures contract, which now exposes you to basis risk (the interest rate differential)

YYK6221 I’m quite sure that both are basis risks. Your counterpart to example 1 in Currency Risk is when you invest in a currency A. Now currency A has no futures/options on it. However, currency A is Strongly correlated to Currency B ( assume r = 0.9) . Thus you can hedge your investment in currency A by buying ffutures in currency B. This is better than having no hedge at all , however basis risk remains. For example 2 same as Lance TX.

bhaiyyu Wrote: ------------------------------------------------------- > YYK6221 > > I’m quite sure that both are basis risks. > > Your counterpart to example 1 in Currency Risk is > when you invest in a currency A. Now currency A > has no futures/options on it. However, currency A > is Strongly correlated to Currency B ( assume r = > 0.9) . Thus you can hedge your investment in > currency A by buying ffutures in currency B. > > This is better than having no hedge at all , > however basis risk remains. > > For example 2 same as Lance TX. I agree with you. Thanks a million!