1. What is Basis Risk?

Basis Risk is the financial risk that traders assume when they hedge a position by holding an opposing position in a derivative, like a futures contract. It arises from the imperfect correlation between the price movements of the hedged asset and the futures contract.

2. How Does the Calculator Work?

The calculator uses the Basis Risk formula:

Where:

• Future Price of Contract — The agreed-upon price at which a specific commodity, financial instrument, etc will be bought or sold on a future date
• Spot Price of Hedged Asset — The current market price at which the underlying asset can be bought or sold for immediate delivery

Explanation: The basis represents the difference between the futures price and the spot price of the underlying asset being hedged.

3. Importance of Basis Risk Calculation

Details: Calculating basis risk is crucial for effective hedging strategies. It helps traders and investors understand the potential mismatch between their hedge position and the actual exposure, allowing for better risk management and more accurate hedging decisions.

4. Using the Calculator

Tips: Enter the future price of contract and spot price of hedged asset in the same currency units. Both values must be non-negative numbers.

5. Frequently Asked Questions (FAQ)

Q1: What causes basis risk?
A: Basis risk arises from factors such as differences in timing, location, quality, or other characteristics between the hedged asset and the futures contract.

Q2: Can basis risk be completely eliminated?
A: While basis risk can be minimized through careful hedging strategies, it cannot be completely eliminated due to the inherent differences between spot and futures markets.

Q3: How does basis risk affect hedging effectiveness?
A: Higher basis risk reduces hedging effectiveness, as the hedge may not perfectly offset the price movements of the underlying asset.

Q4: What is a positive vs negative basis?
A: Positive basis occurs when futures price exceeds spot price (contango), while negative basis occurs when spot price exceeds futures price (backwardation).

Q5: How often should basis risk be monitored?
A: Basis risk should be monitored regularly, especially around contract expiration dates and during periods of market volatility.