what exactly is basis and basis risk?

came across the term a few times in different sections. there is cost basis, basis in futures, basis risk.

just what exactly do they mean?


basis = difference between the spot and the futures prices. (futures price - Spot price)

basis risk = risk that the basis will move adversely.

Cost basis = what you originally paid for an investment.

well-said cpk123

We should get you to write the textbooks, seriously.

I agree, some of the fixed income and derivative topics are by far the worst I have read in my CFA curriculum. (CFA l2 Quants was another)!!

Lets get CPK, SMagician2000 to write books :slight_smile: mighty less stressful to study then :slight_smile:

cpk is a legend

Is someone able to give an (easy) example of basis risk ie. the risk that the difference between futures and spot prices moves adversely?

The way I think about it is if a hedge worked wonderfully then the spot price would converge perfectly to the futures price at expiration. But what if other factors (macro shocks perhaps) got in the way of the spot converging to your orignally locked in futures price ? Your hedge is imperfect.

Futures Price = Spot Price * (1 + rf) ^ T + FV of Costs - FV of Benefits.

Costs can be storage costs

Benefits can be convenience benefits

Assuming basis risk is the spread between Futures Price and Spot Price, the spread can increase/decrease from the change in rf, FV of Costs, or FV of benefits.

You can eliminate basis risk entirely, in theory, if your hedging instrument has the same maturity as the holding period of the underyling asset. You expose yourself to basis risk if the maturity of the forward/futures contract does not match your holding timeframe.

And the underlying of your hedging instrument is identical to the asset you’re hedging. (Think cross-hedge, or Eurodollar futures).

Or if the hedging instrument’s price doesn’t move in perfect sync with the hedged asset’s price.

I thought basis = spot - future. That’s why you short basis when it’s positive. Can some one plz confirm/correct me