If memory serves, basis is defined as the interest rate differential between a domestic and foreign rate… and according to Covered Interest Parity, interest differential is equal to the forward premium…so these seem to be interchangeable terms…Basis risk is the risk associated with imperfect hedging using futures whereby the spot and futures prices fail to converge at expiration of the contract, causing under/over-hedging from the hedgers perspective
Basis risk is nonexistent if the investment strategy you use ends at futures contract expiration. Basis risk exists when they don’t match up because the futures contract is stil outstanding, or when you have to roll futures contracts over.
For a currency forward, the basis is the forward differential, which is equal to interest rate differential?
CFAI B5, Page 301:
In futures jargon, we say that the basis equals the interest rate differential.
Basis risk is not just based on time of contact but can be due to different risk characteristics. Any time you hedge a security with another security that is sensitive to different risks and moves in value differently than the underlying, you are going to have basis risk.
The question is psecific for Currency Forward.
It’s a different story for other forward contacts, such as Commodity Forwards.
I am confused… isnt this the answer? If it’s the forwards vs futures thing you are worried about here…it probably doesnt make a difference whether you are locking in a rate with the exchange as a counter party or some OTC party…i think…hmmm
I do not intend to confuse anyone.- Basis is not a strict term, and it’s simply the difference between futures(forward) exchange rate and spot exchage rate. The sign does not matter.
Strictly speakng basis is nothing more than the different between the spot and future price at a point in time. Basis risk is the possibility that that relationship may change during that life of the forward contract. And yes the reason that relationship would change is because a change in the rate differential (in the case of FX) and this only represents a risk, as noted here, if the maturity is other than the currency settlment date because your exposed to the extent of the new forward differential (or earlier spot rate if applicable)