Basis risk

This term is usually coined to help people know of the risk that may arise when the change in the price of a hedge may not match the cost or the value of the asset that is being hedged. This phrase of basis risk is thus a term that is used in hedge funds. This difference maybe a result of imperfect hedging strategies, (using futures) that are followed while determining the cost of the asset. Hedging is a strategy that uses futures. The basis risk may be either due to a difference in the expiration dates of the futures contract and the actual date of sale of the underlying asset; or due to a mismatch between the value of the underlying and the price of the hedge and they thus do not converge or match, resulting in a loss.

Thus basis risk is basically a name that is given to the risk that you may have to bear, when you resort to offset the investments by way of a hedging strategy and the result is not favourable due to a difference between the prices of the underlying asset and the hedge fund. However, this difference may not always be negative and you may also end up with unexpected gains. However, it is this uncertainty that makes this strategy of hedging attain this name. The instruments that are used to help you hedge or protect your funds against future risk in price fluctuation are similar to the underlying asset. For instance, you may opt to hedge the underlying asset of a Treasury bill with a bond. However, there is still a risk that you are exposed to: i.e. the fluctuations in the hedging instrument and the underlying asset may not be identical. This causes the scope for losses on the eve of expiration date to be broadened even farther. This implies that the spot price of the underlying asset and the futures price does not end up converging on the expiration date. This difference, if it does arise, may or may not be in your favor, i.e. you may end up incurring losses or gaining unexpectedly. To be able to understand this, it is imperative to know what a hedge fund is: this is an instrument to help you offset or significantly reduce the risk that you are exposed to, related to future price changes of the asset. In such a case, you would opt for a futures contract. The asset may be of any kind: stock / shares or other securities, such as Treasury Bills, bonds etc.