Basis Risk: A More General Definition

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1. Context

In this video from the FRM Part 1 curriculum, we take a generalized look at the concept and definition of basis risk.

AreaFinancial Markets and Products
ReadingUsing Futures for Hedging
ReferenceChapter 8, Using Futures for Hedging, GARP Official Books (Book 3, Financial Markets and Products).

2. Video

3. Transcript

When using futures for hedging, basis risk arises if the basis, defined the difference between the spot price and the futures price, moves in an adverse direction. Broadly speaking, basis risk arises if you have an imperfect hedge, where the profit and loss (P&L) from the hedge does not completely offset the P&L from the underlying position.

This can happen for two main reasons.

  • First, an asset mismatch may occur. For example, if you’re trying to hedge a single stock position using an equities index, a corporate bond using a CDS, or an interest rate swap using interest rate futures.
  • Second, this risk can arise due to a maturity mismatch. For instance, if your futures maturity goes well beyond your chosen horizon.

You might opt for an imperfect hedge if it is less costly, more liquid, or simply more convenient.

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