Basis risk is a technical term in finance, in particular in derivatives trading. It is the risk associated with having a position in one asset, and hedging it with a position in another, very similar asset. I will attempt to explain this risk, and why it is so devious, using an example.

Imagine I work at an airline, where I am responsible for buying fuel. For consistent ticket prices, we don't like our costs to fluctuate a lot. One of our main costs is fuel, so making sure we have the same fuel price for quite some time is a good thing for us. Assuming I know how much fuel I will need in the future, the most obvious thing would be to buy the fuel in advance I can do this by buying (going long) a number of futures contract in jet fuel. What this future does is essentially allowing me to buy the jet fuel at a price negotiated now. In practice, however, I may not be able do this for two related reasons

  1. The futures contract I need for my hedge might not be exchange tradeable. Of course, I might call a refinery directly and have a tailor-made deal, called an over the counter for exactly the amount of fuel I need, but in that case, I would need to call all the refineries to make sure I get the best deal. The contract details might also differ, making a comparison even harder. More subtly, this deal exposes both me and the refinery to counterparty risk; the whole deal falls through if either of us goes bankrupt.
  2. It might be tradeable, but there might be so few trading parties that market efficiency is not guaranteed. This also is likely to drive up costs for me.

So, I don't want to buy a jet fuel contract. How else can I hedge my risk? Well, the price of jet fuel is chiefly determined by the price of crude oil. If crude prices fall, jet fuel prices will fall, and if they rise, jet fuel prices will rise. So, what I might do is compute the correlation between the price of jet fuel and crude, and then decide whether my hedge is good. The residual risk, which is the extent to which the prices do not correlate, is called the basis risk

For a good hedge, my basis risk should be small. If, for instance, I save 3% on the crude hedge, and my expected basis risk is around 3% as well, I will either win or break even-a good deal! Even if my edge (my expected profit) is smaller, say 2% savings with 5% risk, I may still want to use the crude oil hedge, as my expectation value is positive, especially if I can do this trade often, averaging out the variations and risk, and keeping the edge.

So far, so good. There is, however, a different type of risk I have introduced that I have conveniently ignored. This is the risk that my correlation changes, in other words, that something "external" happens that changes the price relation between jet fuel and crude oil systematically. It's important to note here that this is not necessarily a symmetric risk. In other words, there might be many reasons why the price of jet fuel could a lot rise with respect to the price of crude, but there may be few reasons why the opposite might happen. For this example, I can think of the following things:

  1. My correlation is very high now. It could go up only a little, but it could go down a lot. So, my risk can only be reduced a little, but it might up massively. This is not good, and essentially means that even though a hedge seems very good now, it could rapidly worsen. In principle, this could be in both directions: crude might go up a lot with respect to jet fuel, or vice versa.
  2. Worse, presently, I might lose a lot more than I might win. For instance, jet fuel may only cost a little bit more than crude oil. I only win when jet fuel becomes cheaper with respect to crude oil; hence, there is limited upside. It's not logical that jet fuel, a more complex product, would ever be systematically cheaper than crude. However, if for some reason, the cost of producing jet fuel would go up (tougher environmental rules, a hurricane demolishing a refinery, sudden demand spike in jet fuel, etc.), I might lose a potentially unlimited amount of money, and, much worse, my job.

Basis risk is particularly problematic because of the latter types of losses, which are difficult to predict, and can be massive. Hence, when assessing the risk of a hedge that is not basis free, it is important to consider whether the correlation you assumed might go away, and, perhaps even more importantly, whether it is more likely to cost you money or make you money, and how much.

Summarizing, basis risk is the risk you introduce by hedging your your exposure in one commodity or instrument with an exposure in another, related, commodity or instrument. This introduces two different types of risk: the "normal" price fluctuations between two related instruments, and the (small) chance that an extreme event happens that completely destroys the relation and gives you a massive exposure.

  1. I got the idea from Traders, Guns & Money, Satayajit Das, Prentice-Hall, 2006, ISBN 0-273-70474-5

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