The concept of basis risk
Basis risk refers to the risk caused by the unsynchronized price fluctuation between the hedging instrument and the hedged commodity. Basis is the difference between spot transaction price and exchange futures price, and its amount is not fixed.
The fluctuation of basis brings inevitable risks to hedgers and directly affects the hedging effect, especially when using alternative varieties for hedging.
Causes of basis risk
1. Changes in the basic level and future convergence of futures prices and spot prices during hedging transactions. Due to arbitrage factors, futures prices are generally close to the spot price on the delivery date, that is, the basis is about zero.
Therefore, the level of basis, the trend of basis change and the time of hedging liquidation determine the risk and profit and loss of hedging.
2. Changes in factors affecting the cost of holding. Theoretically, the futures price is equal to the spot price plus the holding cost, which mainly includes storage cost, insurance cost, capital cost and loss. If the holding cost changes, the basis will also change, thus affecting the profit and loss of the hedging portfolio.
3. The hedged risk assets do not match the underlying assets of the hedged futures contract.
There was no soybean oil futures contract in China before 2006. Because of the high correlation between soybean price and soybean oil price fluctuation, soybean oil producers or consumers use domestic soybean futures contracts to hedge soybean oil prices, which is called cross hedging.
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The basis risk of cross hedging is relatively high, because the basis consists of two parts, one part comes from the difference between the futures price and the spot price of the hedged assets, and the other part comes from the difference between the spot price of the hedged assets and the spot price of the hedged assets.
Because the hedged risk assets are different from the underlying assets of the hedged futures contract, the basic factors affecting the price change are also different, resulting in a relatively high basis risk of cross hedging.
4. Random disturbance of futures price and spot price.
Due to the above four reasons, during the holding period of the hedging portfolio, the basis continues to expand or shrink, which makes the hedging portfolio generate profits and losses.
Under normal market conditions, because the factors affecting the spot price of assets are the same as the futures price, the fluctuation range of the hedging basis is relatively small and stable in a fixed fluctuation range, and the profit or loss of the hedging portfolio generated within this fluctuation range is small, so it will not have much impact on the effectiveness of hedging.
However, in some special cases, there will be abnormal situations that are not conducive to hedging in the market, which will lead to the continuous expansion or contraction of the basis of hedging, resulting in increasing losses of hedging portfolio. If the stop loss is not stopped in time, it will cause huge losses to the hedger.
In terms of probability, the abnormal basis biased towards the normal basis level is a small probability event, but if the risk of this small probability event is not handled properly, hedging will cause huge losses.
Basis risk type
1. exposurerisk, that is, the risk caused by so-called cross hedging (that is, futures contracts based on one interest rate offset the exposure risk of spot market financial instruments based on another interest rate).
2.periodbasis, that is, the risk caused by the inconsistency between the term of financial instruments in the spot market and the term of hedging instruments.
3. Convergence basis, which is the risk caused by the inconsistency between the futures market price and the spot market price.