What Is Basis Risk?
Basis risk is the financial 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.
Understanding Basis Risk
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 the Treasury bill and the bond will not fluctuate identically.
To quantify the amount of the basis risk, an investor simply needs to take the current market price of the asset being hedged and subtract the futures price of the contract. For example, if the price of oil is $55 per barrel and the future contract being used to hedge this position is priced at $54.98, the basis is $0.02. When large quantities of shares or contracts are involved in a trade, the total dollar amount, in gains or losses, from basis risk can have a significant impact.
Key Takeaways
- Basis risk is the potential risk that arises from mismatches in a hedged position.
- Basis risk occurs when a hedge is imperfect, so that losses in an investment are not exactly offset by the hedge.
- Certain investments do not have good hedging instruments, making basis risk more of a concern than with others assets.
Other Forms of Basis Risk
Another form of basis risk is known as locational basis risk. This is seen in the commodities markets when a contract does not have the same delivery point as the commodity's seller needs. For example, a natural gas producer in Louisiana has locational basis risk if it decides to hedge its price risk with contracts deliverable in Colorado. If the Louisiana contracts are trading at $3.50 per one million British Thermal Units (MMBtu) and the Colorado contracts are trading at $3.65/MMBtu, the locational basis risk is $0.15/MMBtu.
Product or quality basis risk arises when a contract of one product or quality is used to hedge another product or quality. An often-used example of this is jet fuel being hedged with crude oil or low sulfur diesel fuel because these contracts are far more liquid than derivatives on jet fuel itself. Companies making these trades are generally well aware of the product basis risk but willingly accept the risk instead of not hedging at all.
Calendar basis risk arises when a company or investor hedges a position with a contract that does not expire on the same date as the position being hedged. For example, RBOB gasoline futures on the New York Mercantile Exchange (NYMEX) expire on the last calendar day of the month prior to delivery. Thus, a contract deliverable in May expires on April 30. Though this discrepancy may only be for a short period of time, basis risk still exists.
FAQs
Basis = Spot price of hedged asset - Futures price of contract. Basis risk is not to be confused with another type of risk known as price risk.
What is the formula for basis risk? ›
Basis = Spot price of hedged asset - Futures price of contract. Basis risk is not to be confused with another type of risk known as price risk.
What is the basic formula for risk? ›
Risk is the combination of the probability of an event and its consequence. In general, this can be explained as: Risk = Likelihood × Impact. In particular, IT risk is the business risk associated with the use, ownership, operation, involvement, influence and adoption of IT within an enterprise.
What are the different types of basis risk? ›
There are four types of basis risk — location, price, calendar, and product quality. This risk in insurance is the possibility that a person buys an insurance policy, but the amount that the insurer pays them in the case of a claim does not equal the total cost of the claim event.
How is basis risk measured? ›
To quantify the amount of the basis risk, an investor simply needs to take the current market price of the asset being hedged and subtract the futures price of the contract.
What is the formula to calculate basis? ›
At a very basic level, basis is the cost of your business. The calculation of basis consists of your financial contributions into the company plus ordinary income and losses minus distributions (like dividends and other payouts).
How do you calculate your risk? ›
Determine risk by conducting a risk versus reward calculation. A risk calculation is a great place to start as you determine whether a risk is worth it. Risk is calculated by dividing the net profit that you estimate would result from the decision by the maximum price that could occur if the risk doesn't pan out.
What is the formula for calculating risk ratio? ›
Risk Ratios or Relative Risk (RR)
The formula for RR equals (risk of an event in one group)/(risk of an event in a second group). It is an indication of the strength of the association between the 2 risks. Its interpretation is intuitive.
What is the value at risk formula and example? ›
Here are three commonly used formulas for VaR calculation: Historical VaR: VaR = -1 x (percentile loss) x (portfolio value) Parametric VaR: VaR = -1 x (Z-score) x (standard deviation of returns) x (portfolio value) Monte Carlo VaR: VaR = -1 x (percentile loss) x (portfolio value)
How is risk mathematically calculated? ›
Risk Calculation: Probability x Impact + Time.
To manage basis risk, proper analysis of market trends is important. For example, typically, the basis is large during the harvest time (the discount on the local market compared to the futures market is large), and narrows afterwards.
What are the four types of basis? ›
There are four nucleotides, or bases, in DNA: adenine (A), cytosine (C), guanine (G), and thymine (T).
What are the 3 main types of risk? ›
There are three different types of risk:
- Systematic Risk.
- Unsystematic Risk.
- Regulatory Risk.
You may also rephrase as "risk = failure probability x damage related to the failure". So, if you are risk averse, you may prefer A over B. This formula is also used (with a further term related to the possibility to detect the disruption, or failure as it is called) in the Failure modes and effects analysis (FMEA).
How do you calculate risk adjusted basis? ›
Sharpe Ratio = (Return - Risk Free Rate) / Volatility
You had to withstand twice as much volatility — the degree of variation in the price of a security over time — to achieve the same portfolio return for Investment B vs. Investment A, meaning Investment A was a better performer on a risk-adjusted basis.
What is the basis of risk analysis? ›
To carry out a Risk Analysis, you must first identify the possible threats that you face, then estimate their likely impacts if they were to happen, and finally estimate the likelihood that these threats will materialize.
What is the rate basis risk? ›
Basis is the difference between the futures and spot prices and, for the purposes of recommending a hedging strategy, it is often assumed to diminish at a constant rate. Basis risk arises when the price of a futures contract does not have a predictable relationship with the spot price of the instrument being hedged.
What is the formula for risk in probability? ›
You can use risk scoring to rank and prioritize the risks based on their relative importance and urgency. You can use a simple formula, such as risk score = probability x impact, or a more complex formula, such as risk score = probability x impact x detectability, to calculate the risk score of each risk.
What is the formula for calculating risk in trading? ›
To calculate the risk/return ratio (also known as the risk-reward ratio), you need to divide the amount you stand to lose if your investment does not perform as expected (the risk) by the amount you stand to gain if it does (the reward).
