What is Basis Risk?
In Hedging, most of the financial positions are hedged using forwards and futures, in which the basic assumption is that the expected spot price in the future will become the actual spot price in the future. However, it doesn't happen all the time, and this risk of getting the difference between spot prices and futures prices is referred to as Basis Risk.
Basis Risk = Spot Price – Future Price
Example of Basis Risk:
Let's take an example of a futures contract of copper. If the contract spot price of the contract is USD 25 and the Future Price is USD 24.5, the Basis risk would be USD 0.5
Why is Basis Risk significant?
Basis Risk is essential because it plays a vital role in hedging the instruments well. Analysts need to ensure that the tool used for Hedging is closely linked to the hedged instrument to minimize the basis risk.