What is Basis Risk?
Basis risk, in the context of financial derivatives trading, refers to the risk arising from the difference between the price of the underlying asset and the price of the derivative. Basis is an indicator that measures this difference.
Basis risk occurs due to the imperfect correlation or changes in market conditions between the underlying asset and the derivative. This may lead to a widening or narrowing of the difference between their prices at the expiry of the derivative contract, posing risks to investors or market participants.
Basis risk is an important consideration for investors and market participants, as it can impact the value of derivatives and investment returns. Methods to manage basis risk include effective risk management strategies, research and analysis of market conditions and relevant factors, as well as proper position management and hedging strategies.
Types of Basis Risk
The types of basis risk vary across different financial markets and products. Below are some common types of basis risk:
- Commodity Basis Risk: In commodity markets, commodity basis risk refers to the risk arising from the difference between the spot price of a commodity and the price of related futures contracts. If there is a difference between the spot price and the futures price of the underlying commodity, investors may receive returns different from the actual spot market when the futures contract expires.
- Interest Rate Basis Risk: In interest rate markets, interest rate basis risk refers to the risk arising from the difference between the price of interest rate derivatives and the related benchmark interest rate. Differences between the underlying interest rate and the price of the interest rate derivatives may result in investors not achieving the expected interest rate hedging effect upon the derivative's expiry.
- Currency Basis Risk: In foreign exchange markets, currency basis risk refers to the risk arising from the difference between the price of foreign exchange derivatives and the related currency exchange rate. Differences between the price of foreign exchange derivatives and the actual exchange rate may result in investors not achieving the expected foreign exchange risk hedging effect upon the derivative's expiry.
- Time Basis Risk: Time basis risk refers to the risk arising from changes in the difference between the price of the derivative and the price of the underlying asset over time. This difference may be caused by a mismatch between the settlement time of the futures contract and the delivery time of the underlying asset or differences between options contracts with different expiry dates. Time basis risk may lead to investors not achieving the expected price hedging effect at the derivative's expiry.
Characteristics of Basis Risk
As an important concept related to risk in financial derivatives trading, basis risk has the following characteristics:
- Variance: Basis risk refers to the difference between the price of the underlying asset and the derivative, which can be either temporary or long-term.
- Imperfect Correlation: Basis risk arises due to the imperfect correlation between the underlying asset and the derivative.
- Unpredictability: Basis risk is often difficult to accurately predict and quantify. Changes in market conditions and relevant factors are hard to forecast, making the difference between the price of the underlying asset and the derivative hard to determine.
- Individual Differences: The size and direction of basis risk may vary for different investors and market participants. Different investment strategies, position management, and hedging strategies may lead to different exposures to basis risk.
- Potential Impact: The existence of basis risk may affect the returns and risks of an investment portfolio. If basis risk is unfavorable to the investor, it may result in the price of derivatives not aligning with the actual performance of the underlying asset.
Causes of Basis Risk
The primary causes of basis risk are the imperfect correlation between the underlying asset and the derivative, or changes in market conditions. Here are some common causes of basis risk:
- Supply and Demand Relationships: Basis risk may arise from changes in the supply and demand relationships between the underlying asset and the derivative. If there are changes in supply and demand, leading to an expansion or contraction of the difference between the price of the underlying asset and the derivative, basis risk will occur.
- Changes in Market Expectations: Basis risk may arise from changes in market expectations. Different expectations of market participants regarding future market conditions and price trends may lead to differences between the price of the underlying asset and the derivative.
- Market Liquidity Issues: Basis risk may arise from market liquidity issues. Insufficient market liquidity may cause price differences between the markets of the underlying asset and the derivative.
- Market Policy and Intervention: Market policies and government interventions can also lead to basis risk. Changes in policies, market regulation and restrictions, monetary policy interventions, and other factors can impact the prices of the underlying asset and the derivative, thereby causing basis risk.
- Trading Rules and Contract Terms: Basis risk may arise from differences in trading rules and contract terms. Different exchanges and contracts have varying regulations on delivery methods, delivery times, delivery locations, etc., which can lead to basis risk between the prices of the underlying asset and the derivative.
How to Manage Basis Risk?
Since basis risk cannot be completely eliminated, investors or market participants can refer to the following common methods and strategies to manage basis risk reasonably and effectively:
- Diversified Investment Portfolio: By diversifying investments across different underlying assets and derivatives, the basis risk between any specific underlying asset and derivative can be reduced.
- Using Hedging Strategies: Hedging strategies are a common method for managing basis risk. By simultaneously holding the underlying asset and corresponding derivatives, hedging strategies can help manage basis risk.
- Understanding Market Fundamentals: A deep understanding of the market fundamentals and supply-demand relationships of both the underlying asset and derivatives can help investors better assess the changes in basis risk.
- Market Analysis and Model Building: Using market analysis and building appropriate models can help investors better understand and quantify basis risk.
- Monitoring and Adjusting: Regularly monitoring the changes in the basis between the prices of the underlying asset and derivatives, and adjusting investment portfolios and hedging strategies according to market conditions.