Glossary term
Basis Risk
Subject: Risk Management, Financial Risk (Credit, Market, Liquidity)
Basis risk is the chance that a hedge does not move in step with the exposure it is meant to offset, leaving a loss even though the hedge was put in place.
Explanation
A hedge works by taking a position that should gain when the exposure loses. The match is rarely exact. The hedging instrument may be linked to a different benchmark, a slightly different asset, another maturity or another delivery date than the exposure, so the gap, or basis, between the two can widen or narrow. A company hedging jet fuel with crude oil futures, or a lender funding with one reference rate and lending against another, faces this. Basis can also arise from timing, location or currency differences. Firms measure it by looking at how closely past prices have moved together and by setting hedge ratios, and for accounting purposes they test hedge effectiveness. It is usually smaller than the unhedged risk, but it can be large in stress. Treasurers therefore expect a hedge to leave a residual gap and size it when choosing the instrument.
Example
A food manufacturer buys flour but hedges with wheat futures, because no flour contract exists. Over a season wheat prices rise 10% while flour prices rise only 6%. The futures gain is larger than the extra cost of flour, so the result differs from what the hedge was meant to deliver. That gap is the basis effect, here in the firm's favour; it could as easily have gone the other way.
Not to be confused with
- Market Risk
- Market risk is the broad loss from price moves. Basis risk is the narrower mismatch between a hedge and the thing it hedges.