Basis Risk Explainer
Basis risk arises when the value of a hedge and the value of the exposure do not move in equal and opposite amounts. In commodity futures, basis is commonly defined as the local cash price minus the related futures price, and that difference can widen or narrow unexpectedly.
A producer may hedge one grade or location with a contract based on another. Timing, quantity, quality, currency, index composition, delivery rules, and local transportation can all create mismatch. A cross hedge introduces additional correlation risk because the instruments are not identical.
Futures and spot prices normally converge for the deliverable specification near expiration, but the hedger may close before then or hold a non-deliverable local exposure. The realized selling or buying price therefore depends on both the futures result and the final local basis.
Hedge effectiveness should be measured across scenarios and over the intended horizon. A derivative loss can be acceptable when offset by a gain in the business exposure, while a profitable hedge can coincide with a worse total outcome. Documentation must define the actual risk being reduced.
Their price changes can diverge even when the broad market view is correct.
The remaining difference is basis risk.
Location, quality, timing, quantity, and index composition matter.
Cross hedges add correlation uncertainty.
A derivative loss may accompany an offsetting commercial gain.
Hedge success is not the standalone trade result.
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