Basis risk

Basis risk is the risk that the change in price of a hedge may not match the change in price of the asset it hedges. It may occur because of how a hedge is constructed, or because of the terms of the derivative contracts. A few examples should make the ways in which this happens clear:

  • A portfolio of UK listed shares is hedged by buying put options on the FTSE, but under-performs the index.
  • A company that needs to buy large amounts of petrol in the future enters into cash settled oil futures. A shortage of refining capacity causes the price of petrol rise faster than the price of crude oil on which the futures are based.
  • A farmer in a remote location uses futures to hedge the price of wheat he expects to produce, but rising transport costs cause the price he receives to fall, even though the price of wheat is unchanged if delivered to the location specified in the contract terms (traded futures contracts are standardised).
  • A delta hedge cannot be re-balanced fast enough to hedge a high gamma position.
  • A chain of restaurants (that expects bad weather to keep away customers) buys weather CFDs based on average temperatures across the entire country, but the cities they have the largest operations in have worse weather than the rest of the country.
  • The interest rate risk on a bond portfolio is hedged by a short position in a government bond that has a higher duration than the portfolio. This saves some money (a smaller short position is needed in a higher duration bond) but the hedge will be insufficient if the yield curve flattens.

In some cases the imperfection of the hedge is desired: in the case of the equities portfolio hedged with index derivatives, without the imperfect hedging there would be no chance of the portfolio out-performing the market.

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