Basis Risk

Basis risk is the risk that a hedge does not perform exactly as intended because the price of the hedging instrument and the price of the exposure it protects do not move together. It arises whenever the two differ in grade, location, maturity or benchmark. The gap between the two prices, called the basis, can widen or narrow unpredictably, leaving the hedger with an unexpected gain or loss.

Basis risk is the main risk that remains after hedging with derivatives. A perfect hedge removes price risk entirely, but perfect hedges are rare because standardised futures contracts come in a few grades, places and dates, while real businesses buy and sell specific goods at specific times. Basis risk is distinct from counterparty risk, the risk that the other side of the hedge fails to pay, and from cross-currency basis, a funding spread in currency markets.

Imagine you want protection against rising bread prices, but the only contract on offer tracks the price of wheat. Usually bread and wheat move together, so if bread gets dearer, the wheat contract should pay you enough to cover it. But bread also depends on wages, energy and the baker's margin. If bread rises while wheat stays flat, your contract pays nothing and you bear the cost anyway.

That mismatch is basis risk. The closer the thing you hedge with resembles the thing you are worried about, the smaller the risk; the looser the resemblance, the more your protection becomes a guess. A hedger is effectively swapping one large, obvious risk for a smaller, subtler one, and the trade only pays off if that smaller risk is understood.

In commodity markets the basis is conventionally defined as:

• $S$ is the spot or cash price of the asset being hedged, at the hedger's location and grade.
• $F$ is the price of the futures contract used as the hedge.

For example, a grain elevator buys corn from farmers at 4.10 dollars a bushel when the nearby futures contract is at 4.40, a basis of $4.10 - 4.40 = -0.30$. It sells futures to protect the value of its stock. Two months later the cash price has fallen to 3.80 and futures to 4.00, so the basis is $3.80 - 4.00 = -0.20$. The elevator loses 0.30 on its corn and gains 0.40 on futures, a net gain of 0.10 a bushel, equal to the change in the basis. Had the basis weakened instead of strengthening, the hedge would have left a loss. As a futures contract nears expiry, its price normally converges toward the spot price of the deliverable asset, but that convergence does not apply to an asset that differs from the contract.

• Product or quality. Airlines hedge jet fuel with crude oil or heating oil futures because jet fuel contracts are thin, and the refining spread between them can move sharply.
• Location. A natural gas producer selling at a regional hub hedges with contracts priced at a different delivery point, and pipeline constraints can open wide price gaps.
• Timing. A hedge may expire before or after the exposure, forcing the hedger to roll positions or close early at an unfavourable basis.
• Index or benchmark. Loans and an interest rate swap referencing different rates, as during the move from LIBOR to SOFR that was completed for most US dollar LIBOR settings after 30 June 2023, can drift apart.
• Index-based protection. Payouts on a weather derivative or parametric insurance follow a measured index, which may not match the buyer's actual loss.

Basis risk explains why hedged firms still report surprising results. A company may be fully hedged on volume yet lose money because local prices diverged from the benchmark, or face daily variation margin calls on its futures while the offsetting gain on the physical asset only arrives on sale. In crypto, traders running a spot-versus-perpetual futures basis trade face a related problem when the funding rate turns against them or prices on one venue break away from the rest.

Firms manage basis risk by choosing the closest available contract, using a hedge ratio estimated from the historical relationship between the two prices, mixing several contracts, or buying a bespoke OTC contract tied to their exact grade and location at a higher cost. Basis that sits within expected ranges is often treated as an acceptable cost of hedging.

Under hedge accounting rules in US GAAP and IFRS 9, the part of a hedge that does not offset the hedged item, called ineffectiveness, is recognised in profit or loss, so basis risk shows up directly in earnings. Bank capital rules under Basel III also recognise basis risk in interest rate positions, requiring banks to measure the impact of benchmark rates moving by different amounts.

• Commodity Futures Trading Commission
• CME Group