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Futures Basis Risk
Basis Risk - Definition
Basis Risk in futures trading is risk caused by the difference between spot price and futures price.
Basis Risk - Introduction
Basis risk, also known as Spread Risk, is risk inherent in futures trading due to the difference in price between the underlying asset and futures contracts. Yes, futures price and spot price is only the same the moment a futures contract expires. Anytime before expiration, futures prices will fluctuate in relation to changes in the price of the underlying asset based on supply and demand. This difference and price fluctuation creates "Basis Risk", which is the risk that futures price will not follow the movements of spot price perfectly.
This tutorial shall explore in depth what Basis Risk is and how basis risk affects your futures trading.
What Is "Basis"?
Basis is the simply the difference between the price of a futures contract and the spot price of the underlying asset itself. As futures contracts of different expiration months have different prices, the basis of all futures contracts on the same underlying asset will be different. The formula for calculating basis is simply:
Basis = Futures Price - Spot PriceBasis is always changing due to the changing price of the underlying asset and futures prices and the reason for basis change is different for each different market. Read the full tutorial on Basis. Ultimately, basis will become zero upon expiration of a futures contract as futures price converges fully with spot price.
What Is "Basis Risk"?
Since basis is changing all the time, basis becomes a source of risk for people who hedge using futures contracts, as well as futures arbitrageurs seeking to make an arbitrage profit on the basis. In fact, the larger the basis, the larger the basis risk as there is more room for imperfect correlation between the spot price and futures price.
How Basis Risk Affects Hedging
For hedgers, using futures contracts to hedge against positions in the underlying asset, basis risk is the risk that the price of the hedge (futures contract) not moving in the exact opposite amount as the price of the underlying asset. This is of course due to the ever changing basis, which is the difference between futures and spot price. Since the basis is always changing, the hedge may actually move more or less than the price of the underlying asset, creating an imperfect hedge. As such, the bigger the change in the basis, the bigger the basis risk for futures traders hedging using futures contracts.
In the example above, as futures price will always converge with spot price by expiration, the price of AAPL's Aug2011 futures contracts will drop gradually if AAPL remains at $391.82, resulting in an overall profit on the position of the basis amount of $0.71. This kind of futures price movement is known as a "Contango". However, if you are hedging a short AAPL position by going long the same futures contract, the position will result in an overall loss as the futures price converge downwards towards the stock price. Yes, basis risk introduces a new element of profit or loss to your position which may not be the intention of your hedge, which is why it is a form of "risk".
How Basis Risk Affects Futures Arbitrage
All forms of futures arbitrage involving the underlying asset and futures contracts are exposed to Basis Risk as it is the basis value that is being arbitraged. Anytime before the arbitrage value is realised, basis will change which can lead to temporary unrealised losses to an arbitrage position. This isn't a problem when the arbitrageur plays according to plan and hold the position until arbitrage profit is realized. However, it becomes a problem for arbitrageurs who may need to liquid such positions due to problems such as short term liquidity needs. Such arbitrageurs may be forced to liquidate such a position at a loss just when the basis has moved against their favor.
How Basis Risk Affects Outright Futures Trading
Basis risk affects outright futures trading, which is directly going long or short a futures contract in a speculative position, in two ways. One, basis results in imperfect tracking of the spot price which introduces an element of uncertainty regarding profitability of a position even if the spot price plays out exactly as predicted. In fact, there are even times when futures price actually decreases due to narrowing of the basis even though spot price increases as expected. Two, narrowing of the basis over time when spot price remains stagnant results in contango or backwardation which will introduce unexpected profit or loss to the position. Indeed, any uncertainties created by the movement of basis are basis risks.
Other Forms of Basis Risk
The above mentioned forms of basis risk are the most common and direct ones involving futures contracts of the same underlying asset. There are more complex forms of basis risks involving similar futures contracts at different locations, known as "Locational Basis Risk", positions hedged with futures contracts of similar but different products, known as "Product Basis Risk" as well as products hedged with futures contracts that delivers on different dates, known as "Calendar Basis Risk". These are basis risks that need to be understood for sophisticated hedging in the energy and commodities market. Such basis risks are typically hedged with what is known as "Basis Swaps" as well as with forward contracts.