what exactly is basis and basis risk?

CFA Level III Derivatives
#1

came across the term a few times in different sections. there is cost basis, basis in futures, basis risk.

just what exactly do they mean?

thanks!

#2

basis = difference between the spot and the futures prices. (futures price - Spot price)

basis risk = risk that the basis will move adversely.

Cost basis = what you originally paid for an investment.

#3

well-said cpk123

#4

We should get you to write the textbooks, seriously.

#5

I agree, some of the fixed income and derivative topics are by far the worst I have read in my CFA curriculum. (CFA l2 Quants was another)!!

Lets get CPK, SMagician2000 to write books :slight_smile: mighty less stressful to study then :slight_smile:

#6

cpk is a legend

#7

Is someone able to give an (easy) example of basis risk ie. the risk that the difference between futures and spot prices moves adversely?

#8

The way I think about it is if a hedge worked wonderfully then the spot price would converge perfectly to the futures price at expiration. But what if other factors (macro shocks perhaps) got in the way of the spot converging to your orignally locked in futures price ? Your hedge is imperfect.

#9

Futures Price = Spot Price * (1 + rf) ^ T + FV of Costs - FV of Benefits.

Costs can be storage costs

Benefits can be convenience benefits

Assuming basis risk is the spread between Futures Price and Spot Price, the spread can increase/decrease from the change in rf, FV of Costs, or FV of benefits.

#10

You can eliminate basis risk entirely, in theory, if your hedging instrument has the same maturity as the holding period of the underyling asset. You expose yourself to basis risk if the maturity of the forward/futures contract does not match your holding timeframe.

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#11

And the underlying of your hedging instrument is identical to the asset you’re hedging. (Think cross-hedge, or Eurodollar futures).

Or if the hedging instrument’s price doesn’t move in perfect sync with the hedged asset’s price.

#12

I thought basis = spot - future. That’s why you short basis when it’s positive. Can some one plz confirm/correct me

#13

Hey Magician, can you elaborate on this a little? Why is basis risk eliminated if holding until maturity?

Let’s say I sell corn forward 5 years at $2 and today the price is $1. I do that to hedge my current investment in corn of $1. If I hold to maturity (5 years) and the spot at maturity is $4 then the forward price converged to $4, how is basis risk eliminated? I’m still locked in for selling at $2 what is now worth $4… My futures price differs from the spot price in the end.

#14

Following up on this, so it looks like my net cost stays the same since the forward matches the spot at maturity when I settle or roll so that the value of what I get actually ends up netting out to $2, which is what I wanted from the start. Was trying to do this conceptually but I think a little arithmetic got me there. Does that make sense?

#15

Perhaps you misunderstand what “basis” means.

It’s the difference between the spot price today and the forward price today.

Suppose that you enter into a forward contract to buy GOOG in 6 months. The spot price is, say, USD 166.60 per share, and the (annual, effective) 6-month risk-free rate is 5.42%, so the forward price is:

USD\ 166.60\left(1.0542\right)^{1/2} = USD\ 171.06

and the basis is USD 4.46 (= USD 171.06 − USD 166.60).

Suppose that on 1 November (6 months less one day from today), the spot price of GOOG is USD 181.15 per share, and the (annual, effective) 1-day risk-free rate is 5.30%. Then the forward price is:

USD\ 181.15\left(1.0530\right)^{1/360} = USD\ 181.18

and the basis is USD 0.03 (= USD 181.18 − USD 181.15).

This has nothing to do with the price of USD 171.06 that you locked in almost 6 months earlier.

1 Like
#16

Thank you!

#17

My pleasure.