Is Basis Risk the same as Contango and Backwardation? Thanks!
basis risk is the risk asscociated to the term structure of the futures which is the contango/backwardation
No.
Basis risk is the risk that the forward/futures price deviates from the spot price; it occurs during the term of a forward/futures contract and gives rise to the annoying valuation problems you had to solve at Level II.
Contango and backwardation refer to forward/futures prices at differing maturities: if the longer-maturity prices are higher than the shorter-maturity prices the market is in contango; if the longer-maturity prices are lower than the shorter-maturity prices the market is in backwardation.
Finally, we have normal contango and normal backwardation; those compare forward/futures prices to today’s spot price.
but they are related… large contango or large backwardation will be in line with a larger basis risk… if you take the term structure of the VIX future for example, the contango is insane, and your basis risk is also insane.
thanks guys, the discussion does help clarify things for me… my understanding is that basis risk is the phenomenon of forward prices not being = to spot prices, and basis risk comes from contango and backwardation of the forward price curve.
I think you’re looking at it the wrong way…
" Basis risk is the general problem of the futures or forward contract not representing exactly what is being hedged."
Examples from the text:
“The price of the commodity underlying the futures contract may move differently than the price of the commodity you are hedging. For example, because of transportation cost and time, the price of natural gas in California may differ from that in Louisiana, which is the location underlying the principal natural gas futures contract”
“Another example of basis risk occurs when hedgers decide to hedge distant obliga- tions with near-term futures.”
Re-read CFAI Reading 33, Pg. 185-186. It explains it pretty well.