What Is Basis Risk? What Are the Sources of Basis

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The Answer is Basis risk is the degree to which fluctuations in the basis are unpredictable,given perfect foresight about the path the price takes in the future.Since the basis is simply the difference between the futures (or forward)price and the spot price,basis risk is also the degree to which the futures (or forward)price is unpredictable,given perfect foresight about the path the spot price will take.Basis risk may arise because investors are irrational,or face market frictions that prevent them from arbitraging a mispriced futures or forward contract.Basis risk may also arise because changes in interest rates are unpredictable.While this eliminates the ability to arbitrage any deviation from the futures-spot pricing relation,the effect on the pricing relation and on hedge ratios has to be negligible.Finally,basis risk may arise because of variability in convenience yields that is not determined by changes in the spot price of the commodity.Convenience yield risk of this type is unhedgeable,and eliminates not only the ability to perfectly hedge long-term obligations with short-term forwards,but also the ability to arbitrage deviations from the forward spot pricing relation.It is largely this unhedgeable convenience yield risk that the analyst needs to be concerned about when estimating hedge ratios.

What Is Basis Risk? What Are the Sources of Basis

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