Basis Risk
The residual risk that remains when a hedge does not perfectly offset the underlying exposure due to price differences between related instruments.
What is Basis Risk?
Basis risk arises when the instrument used to hedge an exposure does not move in perfect lockstep with the underlying exposure being hedged. The "basis" is the difference between the spot price of the asset being hedged and the price of the hedging instrument (typically a futures contract or swap). Even when prices are closely correlated, timing differences, product specification differences, or contract roll costs mean the hedge is imperfect. For example, a jet fuel buyer hedging with crude oil futures faces basis risk because jet fuel and crude oil prices, while correlated, diverge during refinery disruptions. Basis risk is generally accepted as a manageable cost of hedging because it is much smaller than the unhedged price risk.
Example
A cattle rancher wants to lock in a selling price for a herd of cattle ready for market in 60 days. The rancher sells live cattle futures on the CME. However, the futures contract specifies a slightly different grade of cattle and delivery location than the rancher's actual herd. When the hedger closes the futures and sells the physical cattle, the futures gain/loss does not exactly offset the physical price movement. The difference — the basis — is the rancher's residual risk after hedging.