What Is Basis Risk and Why Is It Important

Basis risk refers to the potential mismatch between the value of an asset or liability and the financial instrument used to hedge or manage its risk. This divergence can result in unexpected gains or losses, even when a hedging strategy is in place. Basis risk is particularly relevant for investors, traders and companies that use derivatives or other hedging techniques to mitigate financial exposure. It also can help you to make more informed decisions about your investment or risk management strategies. You may also want to talk to a financial advisor to help you with your investments as well.

What Is Basis Risk and How Does It Work?

Basis risk occurs when the price of an asset and the financial instrument used to hedge it do not move perfectly in tandem. The difference between the two is referred to as the “basis.” This risk is most commonly associated with futures contracts, where the underlying asset’s price may deviate from the futures contract’s price.

Basis risk can arise in various markets, including commodities, interest rates and foreign exchange. It underscores the complexity of hedging strategies and the need for careful monitoring. Basis risk can also be dynamic, meaning it may change over time as market conditions evolve. Monitoring the basis and adjusting the hedge accordingly is essential to managing this risk effectively.

Examples of Basis Risk

Suppose a farmer expects to sell corn in three months and uses a corn futures contract to lock in a favorable price. If the spot price of corn and the futures price diverge due to unforeseen factors like weather or market sentiment, the farmer may experience basis risk. Even though the hedge was designed to mitigate price fluctuations, the mismatch can lead to unexpected financial outcomes.

Let’s look at another example involving the energy market. A utility company might hedge its exposure to natural gas prices using futures contracts. If the spot price of natural gas deviates from the futures price, the company faces basis risk.

The following example, however, might be most appropriate to the average investor. Imagine you own shares in a technology index fund and want to hedge against potential market downturns. You purchase a futures contract on the broader market index. While the index and the technology fund may generally move in the same direction, the magnitude of their movements may differ. If the technology sector underperforms the broader market, the hedge may not fully offset losses, resulting in basis risk.

Different Types of Basis Risk

What Is Basis Risk and Why Is It Important?

As you can probably tell from the examples above, there are various types of basis risk. The following are some of the more common ones you may encounter.

Commodity basis risk: Commodity basis risk arises when there’s a mismatch between the spot price of a physical commodity and the price of the futures contract used to hedge it. For example, an oil producer might hedge with a crude oil futures contract. If regional supply disruptions cause the spot price to deviate from the futures price, the producer faces basis risk.

Interest rate basis risk: Interest rate basis risk occurs when the interest rates of two related financial instruments do not move in sync. For instance, a bank might hedge its exposure to variable-rate loans using an interest rate swap. If the benchmark rate for the loan differs from the rate used in the swap, the hedge may be less effective, resulting in basis risk.

Currency basis risk: Currency basis risk arises when there’s a discrepancy between the spot exchange rate and the forward rate used in a currency hedge. A multinational corporation hedging foreign earnings might encounter this risk if market conditions or central bank policies cause the rates to diverge unexpectedly.

Geographic basis risk: Geographic, or location, basis risk occurs when the price of an asset varies across different regions. For example, natural gas prices in the U.S. may differ from those in Europe due to transportation costs or supply constraints. A company exporting natural gas may face basis risk if its hedging contracts are tied to a different geographic market.

The Importance of Basis Risk

Knowing what basis risk is and how it affects your investments can help you better manage your risk. It highlights the limitations of hedging strategies and the potential for unexpected financial outcomes. For businesses, basis risk can impact cash flow and profitability, especially in industries like agriculture, energy and finance. For individual investors, basis risk can affect the performance of hedged portfolios, altering the risk-reward balance.

Managing basis risk involves carefully selecting hedging instruments, monitoring market conditions and periodically re-evaluating strategies. For example, a company hedging its exposure to oil prices might use region-specific futures contracts or diversify its hedging instruments to minimize basis risk. Similarly, investors can reduce basis risk by aligning their hedging instruments closely with the underlying assets.

Addressing basis risk is not just about mitigating losses; it’s also about optimizing the effectiveness of risk management strategies.

Bottom Line

Basis risk is an inherent aspect of hedging and risk management strategies, reflecting the imperfect relationship between an asset and its hedge. While it cannot always be eliminated, understanding and managing basis risk can help reduce its impact on your financial outcomes. Whether you’re a business managing operational risks or an investor protecting your portfolio, a financial advisor can offer expert guidance to navigate the complexities of basis risk and refine your strategy.

Tips for Managing Investment Risk

A financial advisor can help you manage your entire investment portfolio, taking into account the right risk profile that can help you reach your long-term investing goals. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goal, get started now.
You can determine what the right risk profile for you might be by using an asset allocation calculator so that you can choose the right investments for your portfolio.