Basis risk

CFA Level III Derivatives
#1

Kindly explain

#2

When the price movements in the asset being hedged are not perfectly correlated with the price movements in the cross-hedge or macro-hedge instrument and when the correlation is not constant…

#3

simply stated, the risk of the spot (your underlying) not moving at the same rate of change as your hedging instrument.

For example, if you’re long an equity index and hedge with a future’s conract expiring in T=3 months, by the time 3 months passes the performance for the future’s contract may not fully reflect the change in the equity contract.

This difference is basis risk.