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How to understand basis risk
As we all know, investment is bound to have certain risks, and there are many risks in the investment field, such as basis risk, so how to understand basis risk?

How to understand basis risk?

Basis risk refers to the risk caused by unsynchronized price fluctuations between hedging instruments and hedged commodities. Basis refers to the difference between the spot price of a commodity and the price of derivatives. Basis will be affected by industry, economic environment and even investor sentiment. The basis is sometimes large, sometimes small, sometimes positive and sometimes negative. Base price = spot price-derivative price. Financial derivatives generally have a mechanism of convergence with the price of basic assets, some of which are physical delivery and some are cash settlement. Before the expiration date, there will be inconsistency between the spot price and the derivative price. This has caused the basis difference.

How is the basis risk generated?

I. Holding cost

Under the assumption that the risk-free interest rate remains unchanged, the forward price is equal to the futures contract price on the maturity date. Theoretically, the futures price is equal to the spot price plus the holding cost. This measures the difference between futures market and spot market under different delivery month and time factors. Holding costs include storage costs, insurance costs and capital costs. Storage cost refers to the actual cost of storing goods. Insurance cost is the cost of insuring the stored goods. The cost of capital refers to the cost of capital lost by holding goods and occupying funds. These factors will inevitably affect futures, and the price-driven basis will be weakened or enhanced, resulting in basis risk. At the same time, in the same market, the difference of futures prices in different delivery months reflects the difference of their holding costs. The longer the delivery period of the contract, the greater the holding cost. The shorter the time from the contract delivery date, the smaller the holding cost.

Second, the relationship between market supply and demand.

In market economy theory, market supply and demand determine prices. The futures market is developed on the basis of the spot market. Therefore, market supply and demand factors must be one of the same factors that affect futures prices and spot prices. For example, when the supply exceeds demand in the spot market, the spot price will fall. At the same time, an effective futures market will reflect the supply and demand information on the price, and the futures price will also drop accordingly. However, the declines in the two markets are not necessarily the same, so the basis will change. Moreover, because different investors have different expectations and operational strategies for the future price level. The price fluctuation range of futures and spot markets is often different, and the basis fluctuation is naturally uncertain.

Third, seasonal factors.

For the agricultural futures market, seasonal factors are also important factors affecting the change of basis. The periodicity of agricultural production makes agricultural products have strong seasonality, and the seasonal change of agricultural product prices will inevitably lead to the change of basis. The fluctuation of basis is the comprehensive result of the fluctuation of spot market and futures market. In addition to the above factors, the country's economic operation, industrial policy, futures. The structure of market participants, the system of futures market itself and the psychological factors of traders will also cause the change of basis.