Question

What is basis? How does basis link to hedging? How to forecast basis using last year’s basis, three-year moving average basis, and five-year moving average basis? How to use forecasted basis to forecast the net price received/paid by hedging?

Answer 1

Basis risk is a type of systematic risk that arises when perfect hedging is not possible. When there is a difference between hedge price and spot price of the hedged underlying at any given point of time, that difference is called ‘Basis’ and risk associated with it is called Basis Risk.

Example:

Suppose Tesla (TSLA) is quoting at a spot price of $355 while 1 month futures are quoting at $355.4. Now, on the date of expiry, the stock falls to $340 and futures price to $350. So the basis weakened from -0.4 to -10 giving a profit of $9.6.

Had the stock price gone up to $380 and the futures were $370, the basis would have weakened from -0.4 to 10 but it would have led to loss of $-10.4.

The basis of risk is classfied as strong basis or weak basis. At any point it strengthens when it gains in value and weakens when it loses value.

So, to sum up when there is imperfect hedging, basis risk arises.