CandleFocus Glossary Editor
Basis risk is a risk associated with hedging that occurs when the expected return on a hedged instrument does not completely match that of the unhedged instrument. When two instruments have a different return, basis risk may arise. Basis risk is the risk that the hedging instrument does not perfectly offset the potential losses from the unhedged instrument.
Basis risk arises when the hedging instrument and the unhedged instrument do not move in tandem. For example, if a hedger is attempting to hedge an equity position with a debt instrument that behaves differently than the equity instrument under a given set of conditions, then basis risk is present. If the hedger has not sufficiently taken into account the differences in the behavior of the two instruments, an adverse event could lead to losses that are not fully offset.
Basis risk can also come from decisions to buy or sell derivatives on different exchanges. For example, if a trader uses a futures contract based on the Standard & Poor's 500 index at the Chicago Mercantile Exchange while trading equities on the New York Stock Exchange, the two instruments are not perfectly correlated, creating some basis risk.
Basis risk can occur when assets that are supposed to be perfectly correlated have uncorrelated movements. This happens when assets move either more or less than each other when correlated instruments move in the same direction. For example, if an investor has two investments with perfectly positive correlation when the market moves up, but the two investments diverge when the market falls then basis risk is present.
Basis risk can also arise from the difference between cash and derivatives prices. If an investor buys a stock and hedges its value by buying an options or futures contract, there is still a risk if the futures or options price does not perfectly reflect the underlying stock price.
In order to reduce basis risk, hedgers can diversify the instruments they use in their hedging strategies to ensure that the returns on the hedged instrument will mirror the returns on the unhedged instrument. Hedgers can also switch to different exchange traded funds (ETFs) or separate asset classes when available to further diversify the risk they are exposed to. Additionally, hedgers should always be aware of the differences between the vehicles they are hedging with to avoid introducing an inadvertent basis risk into their portfolios.
Basis risk arises when the hedging instrument and the unhedged instrument do not move in tandem. For example, if a hedger is attempting to hedge an equity position with a debt instrument that behaves differently than the equity instrument under a given set of conditions, then basis risk is present. If the hedger has not sufficiently taken into account the differences in the behavior of the two instruments, an adverse event could lead to losses that are not fully offset.
Basis risk can also come from decisions to buy or sell derivatives on different exchanges. For example, if a trader uses a futures contract based on the Standard & Poor's 500 index at the Chicago Mercantile Exchange while trading equities on the New York Stock Exchange, the two instruments are not perfectly correlated, creating some basis risk.
Basis risk can occur when assets that are supposed to be perfectly correlated have uncorrelated movements. This happens when assets move either more or less than each other when correlated instruments move in the same direction. For example, if an investor has two investments with perfectly positive correlation when the market moves up, but the two investments diverge when the market falls then basis risk is present.
Basis risk can also arise from the difference between cash and derivatives prices. If an investor buys a stock and hedges its value by buying an options or futures contract, there is still a risk if the futures or options price does not perfectly reflect the underlying stock price.
In order to reduce basis risk, hedgers can diversify the instruments they use in their hedging strategies to ensure that the returns on the hedged instrument will mirror the returns on the unhedged instrument. Hedgers can also switch to different exchange traded funds (ETFs) or separate asset classes when available to further diversify the risk they are exposed to. Additionally, hedgers should always be aware of the differences between the vehicles they are hedging with to avoid introducing an inadvertent basis risk into their portfolios.