What is Basis Risk?

A basis risk is the potential risk associated with utilizing a hedging strategy as a means of earning a return. Specifically, this type of risk has to do with carefully managing the investments in the hedging activity so that the prices of the offsetting elements do not move in opposite directions. This form of imperfect hedging increases the possibility of experiencing an unanticipated amount of return, depending on the nature of the movement and the types of trades involved in the hedge, but it also can lead to a significantly higher loss.

One of the classic examples of basis risk involves the action of hedging Treasury bill futures with a bond issue. Ideally, the fluctuation between the prices of the two assets would remain somewhat consistent with one another for the life of the bond issue. Should the value of the futures move in a direction that is opposed to the movement of the bond, the basis risk increases, since the chances that the investor will lose money increases.

There are several reasons why a basis risk may develop. If the maturity date of the bond and the expiration date of the futures are not aligned properly, the risk will increase. At the same time, if there is some drastic change that impacts the underlying price of the derivative, and the price of the asset that is being hedged is not affected, this creates a price gap that could result in a loss for the investor. Not all situations that start with or later develop an increased amount of basis risk will lead to losses for the investor. There is at least some potential for the imperfect hedging to result in gains that the investor did not originally envision. Still, some investors would consider the possibility of increasing the return with the use of mismatched assets in a hedge strategy to be outweighed by the likely chance of failure and loss.

While hedging is an investment strategy that does work very well in many instances, it is important that the prices of the assets used to offset one another do move in the same direction. For this reason, investors should take time to investigate the past performance of both assets, as well as plot their projected movement based on all known factors. Doing so will help to minimize the level of basis risk associated with the approach, and thus improve the chances of receiving the type of return that the investor wants to derive from the transactions.