7/31/2019 Basis & Basis Risk
1/10
7/31/2019 Basis & Basis Risk
2/10
Basis Risk is the risk of unexpected change in relationship
between futures & Spot prices.
Hedging replaces price risk with Basis risk.
1. Quantitative mismatch:
Over-hedged position:
Quantity of futures position > quantity of spot position
Under-hedged position:
Spot price position > futures position
Mismatch in Basis & Basis Risk
7/31/2019 Basis & Basis Risk
3/10
2. Commodity Mismatch: Proxy Hedging:
Mismatch of the underlying commodity itself.
Ex: hedging copper by electric cable manufacturerfor copper based electric cable.
3. Delivery Date Mismatch:
Spot price & future price do not converge on expiry.
7/31/2019 Basis & Basis Risk
4/10
4. Strengthening & Weakening of Basis:
Basis Risk in long hedge
Spot Market Futures Market Basis
November Spot price of wheat11,900
Buy March WheatFutures at 12000
-100
February Buy wheat at spot of12,200
Sell March wheatfutures at 12,250
-50
Change 300 loss 250 gain 50(strengthened)
7/31/2019 Basis & Basis Risk
5/10
Basis Risk in Short Hedge:
Spot Market Futures Market Basis
November Spot price ofwheat 11,900
Buy MarchWheat Futuresat 12000
-100
February Buy wheat atspot of 12,200
Sell Marchwheat futures at12,350
-150
Change 300 loss 350 gain 50 (weakened)
7/31/2019 Basis & Basis Risk
6/10
Spot Market Futures Market Basis
November Spot price of wheat
11,800
Sell April Wheat
Futures at 12000
-200
March Sell wheat at spot of11,500
Buy April wheatfutures at 11,650
-150
Change 300 loss 350 gain 50(strengthened)
7/31/2019 Basis & Basis Risk
7/10
Spot Market Futures Market Basis
November Spot price of wheat11,800
Sell April WheatFutures at 12000
-200
March Sell wheat at spot of11,500
Buy April wheatfutures at 11,750
-250
Change 300 loss 250 gain 50 (weakened)
Additional payments such as margin calls can be an risk.
7/31/2019 Basis & Basis Risk
8/10
It tell how many contracts are needed to create anhedge.
HR = (size of future position)/(size of exposure)Optimal ratio is 1
Proportion of risk to be hedged:
h = x S/ F
Optimal Hedge Ratio
7/31/2019 Basis & Basis Risk
9/10
Ex: company requires 10,000 tonnes wheat in threemonth.
S = 0.040, F = 0.055, correlation is 0.9.Optimal Hedge ratio (h)
= 0.9 x (0.040/0.050)
= 0.9 x 0.8 = 0.72
No. of contracts the company should buy
= 0.72 x 10,000/10 = 720 contracts
7/31/2019 Basis & Basis Risk
10/10
Hedge horizon lies beyond the latest date of thefutures contracts traded
Ex. Jeweller converts gold into jewellery & sell after 1year. Assuming only contacts of 4 months are liquid
Rolling Hedge
Time (in months) Action
0 Short Futures Contract 14 Close out Futures Contract 1
Short Futures Contract 2
8 Close out Futures Contract 2Short Futures Contract 3
12 Close out Futures Contract 3