Question

Explain what is meant by basis risk when futures contracts are used for hedging. Next, make a comparative analysis between basis risk in futures contracts and credit risk in forward contracts. Last, compare the liquidity issue in futures and forward contracts.

Answer 1

Basis risk when future contracts are used:

Basis risk is a risk that arises as a result of hedger’s uncertainty as a result of difference between spot price & futures price at the time of expiration of the hedge.

Basis risk in futures contract & credit risk in forward contracts:

Basis risk is the risk that is inbuilt in the futures market. Hedge positions are generally not perfect because of this risk. The common emphasis is that basic risk eliminates all kind of risks. Brosen in 1995 finds that in case of fluctuations in basis risk, it can make forwards the cheapest in some times & futures to be cheapest in other time periods.

Hence the benefit of hedging can be made utilized when there is proper understanding of the market position.

Credit risk in forwards:

Credit risk is a risk that arises when the counterparty owing greater money is unable to make the payment at the time of expiration r declares bankruptcy prior to expiration.

The market value of a forward contract is a measure of net amount that one party owes the other. The party owing the lesser money faces the credit risk any time; this is because the market position can change any time making positive as negative. The other party will also face the risk at a later date.

Counter parties usually mark forward contracts to the market with one party paying the other the current market value. The contract is then repriced to the current market price or rate. Marking to market is the concept that helps one party from becoming highly debited to the other without paying up.

Liquidity issues in futures & forwards:

Generally speaking, it is easy to buy & sell futures in the exchanges. But it is difficult to find counterparty over the contract to trade on forwards that are non standard. The volume of transactions on an exchange is higher than OTC derivatives as a result of which future contracts tend to be more liquid.

The forward contracts are illiquid & future contracts are liquid. This is because it is difficult to find a buyer for the forward contracts. The other fact is that future contracts are of standardized nature meaning it has a specified amount to be bought & sold on a specified date or at a specified price. This standardization helps the futures to be easily traded & ensure liquidity.

Flexibility on the other hand leads to less trading of contracts in the market making it illiquid. Hence forwards are illiquid & futures are said to be liquid.