how would you define "basis risk"

CFA Level III
#1

for a 3 point question

#2

unexpected change between future and spot prices?

#3

change in future price that is not explained by change in spot prices.

change in future price: 1 point

not explained by: 1 point

change in spot: 1 point

maybe I will add:

can be caused by interest rate differential

:smiley:

#4

thought it was more like “risk that futures and spot prices do not move in sync as predicted by IRP. anytime a positiion and the product it is hedged with do not have the same maturities, basis risk increases”

#5

IRP has nothing to do with basis risk

#6

Basis risk is the risk that the change in the futures price does not match the change in the underlying spot price. You eliminate it by holding the future to expiration, where it is guaranteed to converge to the spot price (excepting transaction costs).

If you have to exit your position before expiry, you expose yourself basis risk.

#7

you wanna bet?

#8

yes, I am very sure IRP and PPP has nothing related to currency basis risk, if you don’t agree, pls provide the reference to support your opinion

also nothing to do with …

#9

The problem with being "very sure’ is youre usually wrong.

2011 PM mock number 14.

…“futures and spot differ by a basis and this basis is created by the interest rate differential between the two currencies”

F=S(1+D)/(1+F)

Page 301 book 5 Im goign to paraphrase…forward or swap futures exchange rates are based on the interest rate differential, otherwise known as the basis.

^ That basic formula above? the (1+D)/(1+F) is the basis, which is also interest rate parity.

But thanks for making me look it up…got that sh*t down now…

#10

I think you need to check the text book again, that is basis, not basis risk, I’m usually right

first f is not equal to (1+D)/(1+F), this depends direct quote/indirect quote

secondary your basis definition is wrong, it says basis is created by…

thirdly, I will tell after Sunday 19:00 …

#11

Basis risk is the risk of change in the parity relationship…so yeah (1+D)/(1+F) is the basis, but that parity relationship changing is the risk. Its right there in the book man directly under the heading “Basis Risk”.

#12

My interpretation(And from experience):

The way to look at this is, specific to currencies, at any given point in time a currency’s forward curve exhibits a relationship between it’s interest rates(usually around IRP) based on market participant’s exectations, however the market’s expectation of that can change daily, which is called shifting of the curve in the trade.

This woud expose you of basis for currencies. So when you trade currencies at any point, you actually lock in the spot rate and the expected interest rate differencial at that specific point in time. As time passes before expiration, the interest rate relationship changes and that is your basis risk.

#13

Basis risk is the risk that the basis will change in an unexpected way. So you enter a futures contract with an expectation of what will happen to the basis. But by doing so, you expose yourself to the risk that the basis will not change as expected.

So what is basis? Basis is just the interest rate differential between domestic and foreign. That interest rate differential comes from the relationships defined in interest rate parity.