Basis Risk: A Gap Between Two Investments

What Is Basis Risk and Its Different Types?

Basis risks are regarded as potential risks, which arise from mismatches developed in a hedged position. Hedging is regarded as a practice of obtaining a position in a market to offset. This helps in balancing the risks that are adopted by the assumption of a position in contrast to investment or market. Basis risks take place when the hedge is imperfect, in such a way that the losses occurring in investment are not exactly offset by the hedge.

There are some investments that do not have the proper tools for hedging. This increases the chances of basis risks within those investment points or sectors.

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There are different types of Basis Risks and they are discussed briefly below:

• Price basis risks: the price basis risks are the ones that occur when the price of the assets and the futures contract regarding the same do not move in cycle with one another.
• Location basis risks: this type of basis risk occurs when the location of the underlying assets is not in the same location or place of trading for future contracts.
• Calendar basis risks: the spot market position of the selling data on the calendar may differ from the expiry date of the market contract for the future market.
• Product quality basis risks: this risk arises when the quality of the assets or the properties which are in terms are different from the assets which are represented in future contracts.

The following formula shall help in summing up the basis risks: Basis = Futures price of contract − Spot price of the hedged asset.

Example of Basis Risks includes the following:

Over-the-counter (OTC) derivatives can assist in the minimization of the Basis Risks with the help of perfect hedge creation. This is mainly because the Over-the-counter (OTC) derivatives can help in fulfilling the exact need of the hedger.

How Can You Eliminate Basis Risk?

Risks are a common aspect of all the sectors. However, management and analysis of the risks can help in the mitigation or elimination of the risks. In other sectors, like information and communication technology, or other industries like oil and gas, medical, and healthcare, the risks can be managed with the help of proper risk management planning can help in the mitigation of the issues. However, in the case of finances, risks are high and proper techniques and tools are essential for mitigation or elimination of the risks.

One of the best and most effective ways in which risks can be mitigated within an organization is by the means of entering into a supply or marketing agreement, which helps with a primary index. The supply agreement is mainly for the consumers whereas, the marketing agreement is for the producers.

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How Do You Hedge the Risk Gap?

There are numerous techniques that can be used by investors, especially for hedging the gap between the risks. As mentioned before, for dealing with the risks involving investment or monetary transactions, tools and techniques which are in use are different. Investors can purchase various put options for hedging the risk gaps. Apart from that, they can make use of the inverse exchange-traded funds (ETFs) or short-sell highly correlated security, especially when they are in hold of a long-term position.  This can help in hedging gaps or risks.

The swing traders can mitigate or hedge the gap risks by reducing trade or closing the open positions before the company announces its earnings and reports. higher risk-reward ratios can be used by the investors for offsetting gap risks.

Risks can never be completely removed from the investments however, mitigation or reduction of the same is possible. Hence, when a trader enters a futures contract system for hedging against some of the fluctuations in the price, the inherent risks of price are partly changed to some other type of risks, which is again known as basis risks. This mitigation is essential. Gap analysis helps in identifying the underlying risks. A gap occurs in the investment market when the opening price of the next day is higher than the highest price of the previous day.

The only ways in which these risks can be mitigated are by the means of diversity in the marketing process, tweaking, and hedging of the portfolio.  

Why Is Basis Risk Important?

Basis risk is regarded as one of the most important types of risks in the market and investment sectors. These risks should be taken into consideration by all the traders and hedgers while trading. This type of risk occurs due to ‘non-convergence of spot price and relative price on the offset date of trade’ or due to wrong or imperfect hedging processes or strategies. Basis risks are regarded as potential risks, which arise from mismatches developed in a hedged position. Hedging is regarded as a practice of obtaining a position in a market to offset. This helps in balancing the risks that are adopted by the assumption of a position in contrast to investment or market. Basis risks take place when the hedge is imperfect, in such a way that the losses occurring in investment are not exactly offset by the hedge.

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What Factors Give Rise to Basis Risk?

The main factor giving rise to basis risk is imperfect hedging. The lack of hedging tools or instruments leads to this issue or concern to a larger extent. The other aspects which give rise to Basis Risks include the following:

Quality: this arises when the hedge which is placed has a grade that differs and is not quite correlated with the basis.

Timings: This risk occurs due to the lack of matching between the date of expiry of the huge assets and the actual date on which the underlying asset is selling.