Basis risk

The risk that offsetting investments in a hedging strategy will not experience price changes in entirely opposite directions from each other. This imperfect correlation between the two investments creates the potential for excess gains or losses in a hedging strategy, thus adding risk to the position.

Investopedia Says:
Offsetting vehicles are generally similar in structure to the investments being hedged, but they are still different enough to cause concern. For example, in the attempt to hedge against a two-year bond with the purchase of Treasury bill futures, there is a risk that the Treasury bill and the bond will not fluctuate identically.

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In Asset-Liability Management the risk that changes in interest rates will cause interest-bearing deposit liabilities to reprice at a different rate than interest-bearing assets, creating an asset liability Mismatch. For example, a 1% rise in 30-day money market rates may produce a 0.5% increase in the yield on bank loans and a full 1% rise in rates paid on corresponding deposit accounts. Basis risk also means the risk that prices on financial instruments in the cash market will react differently to changes in rates than prices on futures market contracts.

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Basis risk in finance is the risk associated with imperfect hedging using futures. It could arise because of the difference between the asset whose price is to be hedged and the asset underlying the derivative, or because of a mismatch between the expiration date of the futures and the actual selling date of the asset.

Under these conditions, the spot price of the asset, and the futures price, do not converge on the expiration date of the future. The amount by which the two quantities differ measures the value of the basis risk. That is,

Basis = Spot price of hedged asset - Futures price of contract

Example Of Basis Risk Treasury bill future being hedged by two year Bond, there lies the risk of not fluctuating as desired.

See also

• Risk
• Uncertainty
• Financial risk management
• List of finance topics

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