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Basis risk

Hi David,

I feel like I know what the answer to this question is but I have to ask it. As you have mentioned, basis can be futures-spot or spot-futures. Doesn't this ambiguity lead to some confusion about the strengthening or weakening of the basis and how it affects a long hedger or a short hedger?

Is there some way to think about this so that the different meanings of these terms can be ignored or at least some way that is consistent with both definitions of basis?

Thanks in advance for any advice.

Mike
 

David Harper CFA FRM

David Harper CFA FRM
Staff member
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Hi Mike,

That's exactly right: Hull's "rules" about UNEXPECTED strengthening/weakening of basis only strictly apply under his given definition (B = S - F). I don't see any way to simplify this. (Take a look at this thread with Hend, where even the concept of short hedge can be confusing http://www.bionicturtle.com/forum/viewthread/5182/).

I think the essential point in Hull is that it is UNEXPECTED changes in (S-F) or (F-S) that interfere with the hedge, a subclass of which is a lack of expected convergence between spot and forward.

The rest, I think, is best left to situational assessment: I think hard "rules" risk running into the same interpretation problem illustrated in my link above; i.e., in that case, step back and thinking just beats the rule. The issue, in my opinion, is that you can have a fine rule, but a seemingly minor assumptional change can render it obsolete and, we'd have been much better off to stay a bit flexible to the concept or principle than too attached to the specific rule.

David
 
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