When investors want to reduce their risk, they use a strategy called "hedging." However, there is still a risk because those assets could change in price. This risk goes by the term "basis risk," which refers to the chance that there may be an unpredicted mismatch between the price set on the futures contract and the actual cash price at the designated time.
When hedging, investors will often use a futures contract. Basis risk is the risk that the price set in the contract will differ from the price at the time it comes due.
Understanding Hedging Basics
A hedge is the buying or selling of an asset or the initiation of a financial contract to eliminate the risk associated with an investment. A typical example of a hedge involves the use of a futures contract. Such contracts are binding agreements to buy or sell something at a set price on a specific future date. If, for example, you are holding gold bought at $1,000 per ounce, you can enter into a futures contract to sell your holdings for $1,020 in exactly a month. With this binding contract in place, you are immune to losses resulting from declines in the price of gold.
Why Investors Hedge
To minimize or eliminate the risk associated with holding volatile assets, investors often hedge their positions. There is always a chance, however, that the hedge will fail to work as intended and will not eliminate the potential loss. Basis finance risk is one of various ways this can happen when you trade in the futures basis markets.
Basis Risk Definition
Basis risk arises when the instrument used to hedge your exposure fails to act as predicted and most frequently occurs when using futures contracts. Since a hedge involves two financial instruments, basis risk refers to the possibility that the second asset or financial contract, which is referred to as the basis, will fail to exhibit the expected behavior in response to the adverse movements in the price of the original investment.
In some instances, basis finance risk may result in the hedge providing less protection than you had expected. In extreme cases, the hedge can do more harm than good and you may lose more money as a result of the hedge than you would have without it.
An Example Involving Gold
Traders face a basis finance risk if they use long-dated futures contracts to hedge short-term holdings. Assume you have gold, which you desire to sell in a month. But for some reason, you have assumed a seller position in a futures basis contract that locks in a price for six months from now. Normally, your losses from present price declines in gold should be offset by this arrangement.
When gold gets cheaper today, the sales price you locked in a while ago when prices were higher will look like a good bargain. You can transfer, at a profit, this privilege of being able to sell gold at a high price and use this profit to offset your loss from holding gold whose market price fell.
Another Relevant Example
Say you’re holding 100 ounces of gold, bought at $1,000 an ounce, and must sell this in a month. If you enter a futures contract to sell 100 ounces of gold in exactly one month, you are not exposed to basis risk. If, however, you sign an agreement to sell it in six months, you are exposed to basis risk. If gold prices drop by $10 per ounce, your gold will be worth $1,000 less.
Your historical analysis may have shown that when the cash price of gold drops by $10, the privilege of having locked in a future sale price will also be worth $10 more per ounce. If this present situation proves to be an exception, your transfer of futures basis sales rights will fail to cover your loss from holding gold.
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