DP
Hedging & Basis Riskintermediate

Basis Risk

Basis risk is the uncertainty in the basis b2=S2−F2b_2 = S_2 - F_2 at the close date of a hedge. A short hedger receives an effective price of F1+b2F_1 + b_2, and a long hedger pays F1+b2F_1 + b_2. Because b2b_2 is unknown when the hedge is opened, the realised outcome differs from the intended lock by the basis change. Three drivers of basis risk are (1) closing the hedge before delivery, (2) using a futures contract on a different but correlated asset (cross hedge), and (3) timing mismatches between physical delivery and contract maturity.

Why it matters

Hedging does not delete risk, it swaps a big risk for a small one. A wheat farmer who sells wheat futures replaces the chance of a $50 per tonne price move with the chance of a $2 to $5 basis swing. Most of the variance is gone. The small residual exists because spot and futures rarely move in perfect lockstep, especially when the underlying is a slightly different grade, a different delivery location, or a different month.

Formulas

Effective price exposed to basis risk
Peff=F1+b2P_{\text{eff}} = F_1 + b_2
F1F_1 is known at hedge inception. The realised basis b2b_2 at the close date is the source of uncertainty in PeffP_{\text{eff}}.
Variance of hedged position under a 1:1 hedge
Var(Peff)=Var(b2)=σS2+σF2−2ρ σSσF\mathrm{Var}(P_{\text{eff}}) = \mathrm{Var}(b_2) = \sigma_S^2 + \sigma_F^2 - 2\rho\,\sigma_S\sigma_F
Variance of b2b_2 depends on the volatilities and correlation of spot and futures changes. Hedging effectiveness improves as ρ→1\rho \to 1.

Worked examples

Scenario

An Australian airline tries to hedge jet fuel exposure with WTI crude oil futures because no Australian jet fuel future is liquid. Jet fuel rises by US$10 per barrel, WTI futures rise by only US$8.

Solution

Basis weakens by −2-2 per barrel. The hedge offsets US$8 of the US$10 price rise, leaving a US$2 per barrel residual loss. The airline accepted US$2 of cross-hedge basis risk in exchange for the much larger reduction in outright fuel price risk.

Scenario

A wheat farmer in Western Australia hedges a March harvest using an ASX Eastern Wheat future that delivers in May because no March contract exists. Eastern Wheat trades at a small discount to Western Wheat, and the basis between the two regions can widen if there are differential local harvests.

Solution

The hedger faces three layers of basis risk. Grade basis comes from Eastern versus Western Wheat. Time basis comes from the March-versus-May delivery mismatch. Local supply basis comes from regional harvest conditions. None of these would arise if a Western Wheat March future existed and the farmer held to delivery.

Common mistakes

  • ✗Hedging eliminates all risk. A textbook hedge converts price risk into basis risk and the latter is typically a fraction of the former. Ederington (1979) showed empirically that variance reductions of 60 to 95 percent are common, not 100 percent.
  • ✗Basis risk only arises in cross hedges. Timing mismatches and early close-outs introduce basis risk even when the hedge instrument is on the exact same asset. Holding to delivery on a matching contract is the only way to drive basis risk close to zero.
  • ✗A bigger hedge ratio fixes basis risk. Increasing hh beyond the minimum-variance value h∗=ρ σS/σFh^* = \rho\,\sigma_S/\sigma_F actually raises variance because the marginal contract adds more futures noise than it offsets in spot exposure.

Revision bullets

  • •Risk that basis b2b_2 at close differs from forecast
  • •Sources are early close, cross hedge, and timing mismatch
  • •Smaller than price risk but never zero
  • •Effective price =F1+b2= F_1 + b_2
  • •Variance =σS2+σF2−2ρσSσF= \sigma_S^2 + \sigma_F^2 - 2\rho\sigma_S\sigma_F
  • •Minimised by matching asset and delivery date

Quick check

Basis risk is at its lowest when:

An airline hedges jet fuel with WTI crude futures. Jet fuel prices rise by US$5 per barrel and WTI futures rise by US$4 over the same period. Which statement is correct?

Connected topics

BasisCross HedgeTailing

In learning paths

Hedging & Risk PathExam Revision Path

Sources

  1. Hull (2022), §3.3
    Hull, John C. Options, Futures, and Other Derivatives. 11th ed. Pearson, 2022. ISBN 978-0-13-693997-9.
    Section 3.3 lists the three sources of basis risk and shows the effective-price expression that exposes the hedger to $b_2$.
  2. Ederington (1979)
    Ederington, Louis H. The Hedging Performance of the New Futures Markets. Journal of Finance, Vol. 34, No. 1, March 1979, pp. 157-170.
    Provides the variance-reduction framework that quantifies basis risk and shows that hedging eliminates 60 to 95 percent of outright price variance in early US futures markets.
  3. CME Group, Learn about Basis
    CME Group. Learn about Basis: Grains. CME Education Centre, accessed 2026.
    Practitioner reference on grain basis behaviour, useful for understanding regional and grade basis risks.
  4. Adams & Gerner (2012)
    Adams, Zeno and Mathias Gerner. Cross Hedging Jet-Fuel Price Exposure. Energy Economics, Vol. 34, No. 5, 2012, pp. 1301-1309.
    Empirical study showing that gasoil and Brent futures dominate WTI for short-horizon jet fuel hedging, illustrating cross-hedge basis risk in practice.
How to cite this page
Dr. Phil's Quant Lab. (2026). Basis Risk. Derivatives Atlas. https://phucnguyenvan.com/concept/basis-risk
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