bottom up and top down approach
07 Sep 2008
Apr
25
Basis risk in futures - learning objective "in the news"
by David Harper, CFA, FRM, CIPM
- 2008 FRM AIM: "Define the various sources of basis risk and explain how basis risks arise when hedging using futures"
Basis risk attaches to all derivatives
In regard to a futures contract, basis = spot price (S) - futures price (F). A negative basis reflects contango (a more typical scenario where there is cost of carry); a positive basis, backwardation. (note: normal backwardation and normal contango are different, they relate to expected future spot prices and are theoretical not observed!)
- When the spot price increases by more than the futures price, the basis increases and this is said to be a “strengthening of the basis” (and when unexpected, this strengthening is favorable for a short hedge and unfavorable for a long hedge).
- When the futures price increases by more than the spot price, the basis declines and this is said to be a “weakening of the basis” (and when unexpected, this weakening is favorable for a long hedge and unfavorable for a short hedge).
About the FRM, I've maintained that basis risk is thematic: anywhere there is a derivative, basis risk attaches. That's because no hedge is perfect; the only perfect hedge, I think, is to short the asset itself (asset = asset, but derivative does *not equal = underlying). Lately, subprime structured finance has provided an illustration: banks that retained super senior tranches often hedged this unfunded tranche with credit default swaps (CDS). Even aside from counterparty risk (that's different), basis risk refers to the imperfect protection provided by the CDS.
...Even to commodity futures
The New York Times covers a fascinating development in the futures market for corn, soybean and wheat. Here and here. It has always been a truism, easily shown with a no arbitrage approach, that the future/forward price must converge with the spot (cash) price of a commodity. Or, more accurately, should converge to a zone. Not so true lately! Although with some variation, for these markets, converged has been failing (since early 2006) as futures prices have been higher than spot prices, at delivery.
Scott Irwin has a great explanation at Econbrowser as he shares his ongoing research.
Comments
Be the first to leave a comment!
Leave a Comment