, and that this variation in the basis may undermine the efficiency of a hedging technique used to reduce a trader’s risk of losing money. The
What does the term “base risk” mean?
The potential risk that results from mismatches in a hedged position is known as basis risk. When a hedge is imperfect, losses in an investment are not exactly covered by the hedge. This is known as basis risk. Because some investments lack adequate hedging devices, basis risk is a greater worry than with other assets.
What is the definition of basis in futures contracts?
The price difference between the futures price and the cash price of the commodity is known as basis in the futures market. The basis is an important concept for traders and portfolio managers, as the connection between cash and futures prices affects the cost of hedge contracts. Because there are variances between relative and spot prices until the shortest contract expires, the basis may not always be accurate.
Aside from the changes caused by the difference in time between the expiration of a spot commodity and a futures contract, delivery location, product quality, and items might also differ. In general, investors use the foundation to calculate revenue and profitability of cash deliveries or goods, as well as to look for arbitrage opportunities.
What are your strategies for dealing with basis risk?
We spend a lot of time examining and evaluating basis relationships and the danger that comes with them, as readers of our site are well aware. While it’s practically impossible for most businesses to totally eliminate their foundation risk exposure, there are a number of techniques to reduce it.
The most straightforward way to reduce your exposure to basis risk is to enter into supply (for consumers) or marketing (for producers) agreements that reference a “primary” index (i.e. NYMEX natural gas futures, ICE Brent crude oil, etc.) or one of the numerous, liquid (actively traded) regional indices (i.e. Platts’ Rotterdam 3.5 percent Fuel Oil, Platts Singapore jet kerosene, etc.).
A North American natural gas producer, for example, could sign into a marketing contract that references the NYMEX natural gas futures contract, plus or minus a premium, to reduce their exposure to basis risk.
On the consumer side, Platts’ Singapore jet kerosene could be referenced in a supply deal with an Asian airline, for example.
If you don’t have access to transparent index supply or marketing agreements, another option is to hedge with a combination of a futures contract, or swap, that references one of the primary indices AND a basis swap that references the difference between one of the primary indices and a regional index.
For example, a Colorado-based natural gas producer could use a combination of a NYMEX natural gas future contract (or a swap that references the futures contract) and a Rockies basis swap that references the basis (price difference) between the Platts’ Rocky Mountain index and the NYMEX natural gas futures contract to hedge their exposure to natural gas prices in Colorado.
Similarly, an airline wishing to limit its basis exposure to jet fuel prices in the Northeast US could use a combination of a NYMEX heating oil swap and a basis swap that references the basis between Platts’ New York jet fuel index and NYMEX heating oil to hedge their basis risk.
While the preceding three methods of managing basis risk are very widespread, one method that we don’t see used nearly enough is option hedging.
Consider the scenario of an African airline, for example.
Due to the lack of liquid derivative markets for jet fuel or crude oil in Africa, African airlines must rely on liquid indices from other regions, such as Rotterdam or Singapore jet fuel or Brent crude oil.
Obviously, this isn’t ideal, but it’s certainly preferable to not hedging at all.
When a corporation is forced to hedge with an instrument that does not represent the spot price in their local or regional market, such as African airlines, basis risk increases.
However, as we will see momentarily, there are hedging options that can significantly lower a company’s basis risk exposure.
Returning to the African airline, let’s say that the airline has concluded that ICE Brent crude oil is the liquid indicator with the highest correlation to its own jet fuel prices.
Assume that the airline is considering hedging their jet fuel risk for the next 12 months using fixed price swaps or call options on ICE Brent crude oil.
Finally, assume that the airline is considering a $105/BBL swap or a call option with a $105/BBL strike price.
Despite the basis, both the $105 swap and $105 call option perform well when both Brent and the airline’s actual fuel expenses rise, as shown in the figure above.
The swap, on the other hand, exposes the airline to much more basis risk than the call option when both Brent and the airline’s fuel expenses are dropping, as they are beginning in month five of the chart.
This is because a swap puts the airline “at risk” if prices fall below $95, whereas a call option does not.
It’s also worth noting that if the price of Brent falls while the cost of aircraft fuel rises, as it did in month seven, the basis exposure grows.
While the expense of hedging with options cannot be denied, the story of the African airline demonstrates how hedging using options, rather than fixed price instruments, can assist airlines manage their basis risk exposure.
In a future piece, we’ll expand on this notion with more instances, as well as how hedging using costless collars frequently introduces “hidden” basis risk, which all too often leads to unanticipated hedging losses.
This is the first in a series of posts on using options to hedge energy basis risk. The following link will take you to the second installment of the series:
What is the danger of commodity basis?
The farmer trades price risk for basis risk when he uses a hedging technique like the one described. The danger that the difference between the cash and futures prices diverges from one another is known as basis risk. As a result, the farmer still faces risk with his produce, albeit not price risk, but rather basis risk. By selling futures, the farmer has created a short hedge. The hedge puts the farmer in a situation where he is now long the base.
In futures, how do you figure out the basis?
The difference between the cash price and the nearest (nearest to expiration) futures contract is commonly used to compute basis. In June, for example, the wheat basis would be computed by subtracting the current cash price from the price of the July futures contract.
How can you protect against basis risk?
A bear spread, which comprises of selling a futures contract with a near-expiration and purchasing a futures contract with a later expiration, would be used to hedge against the risk of a lower basis.
How do you figure out the basis?
For mutual funds, the average cost approach is most typically used to determine cost basis. The average cost technique divides the cost of all the shares you’ve purchased by the number of shares you own to arrive at your basis. If you bought 10 shares of XYZ for $100 each and then bought 10 more for $120 each, your cost basis would be the entire cost ($2,200) divided by the total number of shares (20 shares), or $110 per share, using the example above.
When hedging with US Treasury futures, how does basis risk arise?
We are exposed to basis risk if we cross-hedge. The gap between the futures and spot prices called the basis. When the futures price does not fluctuate in lockstep with the spot price of the hedged asset, basis risk occurs.