Can someone explain the differences between basis risk and cross hedging. Specifically, it seems that both are a result of a mismatch between the forward contract and the underlying being hedged. Am I missing something?
cross hedging is when you hedge a asset when a similar asset because you cannot buy/sell the first asset (eg: cross hedge cad$/us$ with cad/chy and chy/us). basis risk is when the spot - futures is not the same as when the futures were entered and when you lift the futures. this is a risk as you could lose money on the futures.
And I would add that bill’s is just an example of basis risk and that basis risk is the risk that results from divergence of the hedging security from the hedged security. Cross-hedging is one way to make that really likely, but it happens despite your best efforts.
Thanks Joey, makes sense.
In the Stalla materials on CD, David Hetherington said that Joey’s definition of basis risk is the general understanding of “basis risk” by day-to-day practitioners. He said, however, for purposes of scoring points on CFAI’s exam, basis risk is only the risk that that [(spot price of the future’s underlying - futures price) <> 0] when you remove the hedge. Basically, according to CFAI’s material, the only way you can eliminate this risk is by removing the hedge at expiration (though I’m sure Joey can mention reasons why this might not be true, even if you hold to expiration). Anyway, I’m going to double-check that section (later), just to make sure.
" basis risk is only the risk that that [(spot price of the future’s underlying - futures price) <> 0] when you remove the hedge" is not really the goal. You want delta spot = delta futures.