Reading #41, basis risk

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guhongying

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why does the notes say that, entering a contract with a maturity equal to the desired holding period could eliminate basis risk?
Basis depends upon the interest rate differential between the two economies, and at the maturity, the interest rate differential could change so that the basis is changed. How come the basis risk could be eliminated in this way?
Thanks
 
I think the overall idea was that whenever you had a hedge that didn’t fit your underlying exactly you end up with basis risk. So if you are trying to hedge the fact that you are going to sell oil in 2 years, a 1 year oil future would have basis risk because the price of the future would not move exactly the same as the price of your underlying.
 
So in your opinion, a TWO year oil future has no basis risk?
 
Actual oil price and oil futur contract; actual stock price and stock future; acutal interest rate and interest rate future; acutal whatever and whatever future don’t move in lock steps. Therefore, if you want do a 2 year hedge, during the life of the hedge, there is basis risk if hedge is to be lifted before the 2 year period.
Make sense?
 
guhongying Wrote:
——————————————————-
> Basis depends upon the interest rate differential
> between the two economies, and at the maturity,
> the interest rate differential could change so
> that the basis is changed. How come the basis risk
> could be eliminated in this way?
>
> Thanks
As contract moves toward to its “maturity”, the spot price will move closer and closer to its future price; if not, the arbtriager will make sure it happens.
 
What WS said. Under the arbitrage assumption you should have no basis risk.
 
Dear all,
What I know is that the “basis” is the difference between the futures price and spot prce but I don’t know what does “basic risk” means.
Does “basic risk” mean that the “basis” can not be kept constant ? Or the amount change in futures price does not equal to the amount change in spot price ? Or the % change in futures price does not equal to the % change in spot price ?
I remember that “basic risk” is mentioned in several readings but I do not understand what it means exactly ! Anybody can help ?
 
in my opinion, a TWO year oil future still no basis risk.
the basis risk simply getting closer to 0 when closing to the maturity if you want 2 years future to hedge 2 years oil price.
 
well, my understanding is that basis is the differnce between the spot price and the future price for a particular underlying and since you are heding the instrument right across, you are locking in that spread or in other words to say you are locking the future price of that underlying and hence eliminating the risk of having to buy the same at a higher price in future.
For eg. if you are hedging a forward oil contract for 1 year at a price of $41 and if the current oil price is $40, then eseentially by hedging you have fixed that $1 of basis and eliminated the risk for delievery after one year….
Other example you can take is with regards to cash bonds and CDS spreads. theoritically or lets say in normal market conditions, if the cash bond is trading at a spread of 200bps and 5-yr CDS at 150bps, ideally what you have is a negative basis of 50bps. (CDS-Cash 150-200bps). now since CDS is a leading indicator atlease relative to the bond value for the credit health of a particluar issuer, you base your trade on the thesis that since CDS has already tightened, bond is trading cheap and will come in eventually and hence buy the bond and take advantage of the negative basis. the only risk to this thesis is that if CDS widens due to some reason then you are toast.. CDS/Bond are compared here because these are the two ways to taking a long/short exposure to a particular issuer.
thoughts/Q’s/Make sense????
 
Hi, bdeora :
In your example of “hedging a forward (or futures) oil contract for 1 year at a price of $41 and if the current oil price is $40” the $1 of basis is well understood.
But, does the “basis risk” mean (in this case) that “the $1 (=41-40) of basis” will change before the expiration of the forward ? Conversly, Does that “no basis risk” mean “the $1 of basis” will be kept constant during the life of the forward (or futures) contract ? If so, the change of the basis shall be judged by the difference (the $1 in your example) of amount of forward (or futures) price ($41) and spot price ($40) ?
Or the change shall be judged by % change in futures prices ? The ratio (41/40 = 1.025) between the futures price ($41) and spot price ($40) shall be kept during the life of the forward (or futures) contract ? For example, when the forward (or futures) price changes to $45.1 and the spot price changes to $44, and the intial ratio of 1.025 is kept (45.1/44 =1.025)?
Your further advice will be much appreciated !
 
to all what i can think here is the broader thought..
the main purpose of hedging the basis risk is to lock in the costs for the future in today’s terms. hence in this case i have locked the price at $41..
whether the basis ($41-$40) will change over the period till the time the actual excercise date comes?.. yes it will change and will keep changing depending on the spot price and the future price, but since your intention/primary objective was to hedge which you have done, you are safe…
can you take advantage of the basis if its in your favor before the exercise date but after hedging? yes if you want to , so before expiry if you decide to take off your hedge by either taking a profit (bcoz you no longer believe you require the hedge since oil moved to $46 and you want to book $5 profit now and believe that it will come back to $40) or by taking a limited loss (bcoz your expectation is that the asset price will be much cheaper than what you hedged for like $35 from $41 hedge price). in those cases the basis risk is not fully hedged
thoughts/Q’s/Correction welcome
 
mwvt9 Wrote:
——————————————————-
> I think the overall idea was that whenever you had
> a hedge that didn’t fit your underlying exactly
> you end up with basis risk. So if you are trying
> to hedge the fact that you are going to sell oil
> in 2 years, a 1 year oil future would have basis
> risk because the price of the future would not
> move exactly the same as the price of your
> underlying.
Great explanation, mwvt. Just to rephrase:
If a position can be hedged perfectly (holding period exactly 2 years, futures contract expires exactly in 2 years), there is no hedging risk. If hedge is not perfect (either hedge oil with gasoline futures 2 year contract or oil contract with different expiration), you end up with basis risk.
 
Dear all :
I know that “no basis risk” means the relative value between the forward (or futures) price and the spot price shall be kept constant (they must move together perfectly).
And I know that if the forward (or futures) is not lifted until it’s expiry, there will be no basis risk because there is no change in their relative value.
What I don’t know is what is the “relative value” to be kept constant. Is it that the difference (amount of price) to be kept constant ? Or the ratio (Futures price / Spot price) to be kept constant ?
Anybody can advise ?
 
i dont have a clue but my best guess would be that since you want to minimize your financial liability in dollar terms it would be the price differntial and not the ratio
 
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