What is basis risk?

Basis risk arises when traders open positions with a futures contract to hedge the risk of potential price movements in the asset held. Basis represents the difference between the price of the underlying assets and the futures price. It is calculated as follows:

Basis = price in cash – the price of futures contracts

The risk arises when futures prices and cash prices are not matched in accordance with the expectations or anticipation. Two situations may occur, the basis to be under or over. The basis is under when the futures price of reference assets is above the cash (spot) price of the asset. The basis is over when the cash price is above the futures price. The first situation is called contango and indicates that there is enough supply. The second situation is called backwardation and it shows that there is a lack of supply.

Basis risk meaning

Price basis risk arises due to differences in spot price and the price of the futures instruments. It can also happen when the prices don't move simultaneously during the maturity period of the futures. It should be noted that by entering into futures contract parties have an obligation to buy or sell the underlying assets. There are a couple of basic types of basis risk.

Location basis risk commonly occurs in commodities trading. It arises when the futures market delivery location is different from the location of the spot market.

Calendar basis risk refers to differences in the selling date for spot market assets and futures expiration date.

Product quality basis risk occurs when the characteristics of the reference assets are different from the characteristics of the underlying assets in the futures contract.

Basis risk can arise when a trader enters into a short position or takes a long position with the futures for the underlying assets.

Let's say that a trader plans to sell an ounce of gold in three months. The current spot (trading) price for an ounce of gold is $1,200, while the price of the September gold futures contract is $1,210. The basis, the difference between the current price and futures price, is $10. The trader is shorting one ounce of gold of its September gold futures at $1,210. If the gold price in September is $1,200, then the trader makes a profit of $10.