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Hedging in a practical world (Basis Risk)

  • Not always does the futures contract date be the same as the date the asset is to be bought or sold.
  • What if HP didn’t know when his hens would be ready for sale ?
  • What if he doesn’t get a long contract that will close his position just one day before the closing of his short contract?
  • What if there is no contract for the type of hens HP is selling?

This is basis risk

  • Basis = spot price of asset – futures price contract
  • Basis = 0 when spot price = futures price
  • b1 = S1 - F1 and b2 = S2 - F2
  • HP pay off when he sells his hens: S2 + F1 - F2 or F1 + b2
  • In a typical transaction, F1 is known but b2 is not known at time
  • t1->  b2 is the basis



Imagine a stack-and-roll hedge of monthly commodity deliveries that you continue for the next five years. Assume the hedge ratio is adjusted to take into effect the mistiming of cash flows but is not adjusted for the basis risk of the hedge. In which of the following situations is your calendar basis risk likely to be greatest? (FRM 2008 Sample Paper)

  1. Stack and roll in the front month in oil futures
  2. Stack and roll in the 12-month contract in natural gas futures
  3. Stack and roll in the 3-year contract in gold futures
  4. All four situations will have the same basis risk

The oil term structure is highly volatile at the short end, making a front-month stack-and roll hedge heavily exposed to basis fluctuations. In natural gas, much of the movement occurs at the front end, as well, so the 12-month contract won’t move as much. In gold, the term structure rarely moves much at all and won’t begin to compare with oil and gas.

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