Apr 30

Basis risk: the mother of all risks? A 9 minute screencasts

by David Harper, CFA, FRM, CIPM

Basis risk attaches to all derivatives. Lately, examples abound:

Imperfect CDS protection on retained, unfunded super-senior CDO tranches
Airlines struggle to hedge the cost of jet fuel (cross-hedging plus basis risk = hard to do!)
Surely commodities like corn and wheat don't have basis risk? Thing again!

The basis is the difference between the spot and futures price. Here is the key idea (for FRM candidates, see Hull Chapter 3):

For a long hedge, it is not the strengthening/weakening of the basis, it is the unexpected strengthening that creates losses
For a short hedge, it is unexpected weakening that creates losses

Here is the screencast: