What is the meaning of Basis Risk?
Basis Risk stands for the risk which arises due to the difference in hedge/futures/relative price and the cash/spot price of the underlying hedge at any particular time. The difference is referred to as ‘Basis’ and the risk linked with it is known as Basis Risk. The variation or differences arise when there is a change in location, quality, date or time.
The price risk of the acquired underlying trade in one market can be eliminated by taking a counter or an equal position in the relative or derivative market for attaining a perfect hedge. This generally occurs when an underlying and relative price is not matched properly.
It is one of the most critical risks for every person involved in hedging and trading. It occurs when there is no convergence of spot prices and relative prices on the offset trade date because of an imperfect hedging strategy. Basis risk can be positive or negative depending on the offsetting amount of the cash price of the hedged underlying and price of the relative hedged underlying. Various types of Basis Risk are:
- Price Basis Risk
- Location Basis Risk
- Calendar Basis Risk