Basis risk in finance

Finance

"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...

 is the risk

Risk

Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...

 associated with imperfect hedging

Hedge (finance)

A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment.A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of...

 using future

Futures contract

In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...

s. It could arise because of the difference between the asset whose price is to be hedged and the asset underlying the derivative

Derivative (finance)

A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...

, or because of a mismatch between the expiration date of the futures

Futures contract

In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...

 and the actual selling date of the asset.

Under these conditions, the spot price

Spot price

The spot price or spot rate of a commodity, a security or a currency is the price that is quoted for immediate settlement . Spot settlement is normally one or two business days from trade date...

 of the asset, and the futures price, do not converge on the expiration date of the future. The amount by which the two quantities differ measures the value of the basis risk. That is,

Basis = Spot price of hedged asset - Futures price of contract

Example Of Basis Risk
Treasury bill future being hedged by two year Bond, there lies the risk of not fluctuating as desired.

See also

• Risk
  Risk
  Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...
  
  
• Uncertainty
  Uncertainty
  Uncertainty is a term used in subtly different ways in a number of fields, including physics, philosophy, statistics, economics, finance, insurance, psychology, sociology, engineering, and information science...
  
  
• Financial risk management
  Financial risk management
  Financial risk management is the practice of creating economic value in a firm by using financial instruments to manage exposure to risk, particularly credit risk and market risk. Other types include Foreign exchange, Shape, Volatility, Sector, Liquidity, Inflation risks, etc...
  
  
• List of finance topics