Basis Risk
Basis risk is the risk that the difference between the spot price and the futures price will be different than what is expected.
What is Basis Risk?
In Hedging, most of the financial positions are hedged using forwards and futures, in which the basic assumption is that the expected spot price in the future will become the actual spot price in the future. However, it doesn’t happen all the time, and this risk of getting the difference between spot prices and futures prices is referred to as Basis Risk.
Basis Risk = Spot Price – Future Price
Example
Let’s take an example of a futures contract of copper. If the contract spot price of the contract is USD 25 and the Future Price is USD 24.5, then it would be USD 0.5
Why is it significant?
It is essential because it plays a vital role in hedging the instruments well. Analysts need to ensure that the tool used for Hedging is closely linked to the hedged instrument to minimise it.
This page was last updated:
Owais Siddiqui
Expert Tutor at Learnsignal
Qualified professional with years of experience in teaching and helping students achieve their accounting qualifications.
View all posts by Owais Siddiqui