Futures : Understanding basis risk


BASIS.

By creating a long or short hedge using futures, if you thought your cash position is safe, you are wrong. As we saw in the previous post’s examples, hedging eliminates price risk. But it opens up a second risk called ‘Basis risk’. To understand that, first you should understand the term ‘Basis’.

The difference between spot price and futures price at any point of time is called ‘Basis’.

BACK TO EXAMPLES.

Let’s go back to the HDFC’s example from our previous post. The basis at the beginning was Rs 5 per share. (How’s that? Cash price- futures price, Rs 500 – Rs 505).

In situation 1, the stock price moves up to Rs 525 and the futures were at Rs 530. Hence, the basis works out to Rs 5. In situation2, the stock price crashed to Rs 475 and the futures were at Rs 480. Again, the basis remains unchanged at Rs 5. The effect – in either situation, the loss was offset by the profit made.

Take note:

  • Basis at the beginning and at the end were same, i.e. Rs 5.
  • When the basis doesn’t change there’s no risk. The hedger neither makes a profit no incurs a loss.
  • The end result is, either way– the loss/profit in cash market is exactly offset by profits/loss in futures.

Now, our second example – in the case of ICICI, the basis at the beginning was Rs 10 per share.

In situation 1, When the stock fell to Rs 670, the futures were at Rs 673. So, the basis works out Rs 3 ( cash price Rs 670- futures price Rs 673)  In situation 2, when stock price went up to Rs 730, the futures were at Rs 733; hence, the basis at that time is also Rs 3.The effect was that – you made a profit of Rs 7 at the end in either situation.

In contrast to the first example,  note that:

  • Basis at the beginning and at the end were not the same. (at the beginning it was Rs 10, at the end it was Rs 3)
  • When the basis changed (favorably this time), the hedger made a profit.
  • The end result is that since the basis changed favorably, in either situation, the hedger makes money.

Hope you understood what basis is. Basis is a crucial factor in futures. It’s a source of risk for hedgers who use futures to safeguard their position. From the above examples we also come to the conclusion that when the basis doesn’t change, the hedge is perfect (as in the case of HDFC); but when the basis changes over time, it could turn favorable or unfavorable to the hedger (as in the case of ICICI).

BASIS RISK

Basis risk is described by many as the ‘mother of all risks’. It occurs when futures and cash prices fail to move in tandem. Depending on this relation between basis at the beginning and basis at the end, certain unavoidable risk scenarios may arise as explained below.

IF YOU’RE A SHORT HEDGER

Senario1. Cash Price Decreases  Faster than the Futures Price.

When cash prices drop faster than the futures price, you incur a loss which is equal to the difference between cash price at beginning (C0) – cash price at the end (C1) and  futures price at the beginning (F0) –  futures price at the end (F1).

  • Weak basis ; unavoidable loss = {( C0-C1) – (F0-F1)} + brokerage

Scenario 2. Cash Price Increases Faster than the Futures Price

When cash price increases faster than the futures price, you get a windfall gain which is equal to the difference between cash price at beginning (C0) – cash price at the end (C1) and  futures price at the beginning (F0) -  futures price at the end (F1).

  • Weak basis ; windfall gain = {( C0-C1) – (F0-F1)} less  brokerage

Scenario 3. Futures Price Decreases Faster than the Cash Price.

When futures prices drop faster than the cash price, you get a windfall gain.

  • Strong basis ; windfall gain  = { (F0-F1) – (C0-C1)} less brokerage

Scenario 4 Futures Price Increases Faster than the Cash Price.

When futures prices increases faster than the cash price, you incur a loss

  • Weak basis ; unavoidable loss  = { (F0-F1) – (C0-C1)} + brokerage

Scenario 5. Futures Price Decreases /Increases in tandem with the Cash Price.

  • No change in basis; perfect hedge.
  • Your expense for protection = brokerage paid.

Scenario 6. Cash price and futures price stays the same.

  • No change in basis; no hedge.
  • Your profit is C1-F1 less brokerage.

IF YOU’RE A LONG HEDGER

Scenario 7. Cash Price Increases Faster than the Futures Price

When cash price increases faster than the futures price, you incur a loss which is equal to the difference between cash price at beginning (C0) – cash price at the end (C1) and  futures price at the beginning (F0) -  futures price at the end (F1).

  • Strong basis ; unavoidable loss  = {( C0-C1) – (F0-F1)} +   brokerage

Scenario 8. Futures Price Increases Faster than the Cash Price

When futures price increases faster than cash price, you get a windfall gain which is equal to the difference between futures price at the beginning (F0) -  futures price at the end (F1) and cash price at beginning (C0) – cash price at the end (C1) and

  • Weak basis; windfall gain = { (F0-F1) – (C0-C1)} less  brokerage

Scenario 9 Cash Price Decreases Faster than the Futures Price

When cash price decreases faster than the futures price, you gain which is equal to the difference between cash price at beginning (C0) – cash price at the end (C1) and  futures price at the beginning (F0) -  futures price at the end (F1).

  • Weak basis ; windfall gain   = {( C0-C1) – (F0-F1)} less  brokerage

Scenario 10. Futures Price Decreases Faster than the Cash Price.

When futures price decreases faster than the cash price,  you incur a loss which is equal to the difference between cash price at beginning (C0) – cash price at the end (C1) and  futures price at the beginning (F0) -  futures price at the end (F1).

  • Strong basis; unavoidable loss = {( F0-F1) – (C0-C1)} +  brokerage

Scenario 11. Futures Price Increases / decreases in tandem with the Cash Price

  • No change in basis; perfect hedge.
  • Your expense for protection = brokerage paid.

Scenario 12. Cash price and futures price stays the same.

  • No change in basis; no hedge.
  • Your profit is F1-C1 less brokerage.

CONCLUSION: If you’ve hedged your position at any time, you’re definite to face any of the 12 scenarios mentioned above. There’s nothing you could do about it. The only way that you can reduce basis risk is to improve your hedging skills and make right moves to the maximum extent possible. You cannot eliminate this risk altogether.

You may like these posts:

  1. Futures: Understanding the basic terms
  2. Futures: Risk levels of participants.
  3. Futures: Understanding ‘Open interest’.

2 Responses to “Futures : Understanding basis risk”

Ricky

May 20, 2012 at 4:21 pm

What’s up man!! This article seems to be somewhat difficult to understand for beginners. Anyways, thank you, I’ll be coming during market hours to check for hot stuff on your site.

Hitesh

May 20, 2012 at 5:01 pm

Thanks victor for making us aware about the risks in futures basis. I often hedge stocks but was not aware about this topic.. Thank you.

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