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