What is Basis Risk?
Even when we hedge, there may still be an element of underlying risk that we simply cannot eliminate. This residual exposure is known as basis risk.
Basis risk exists because a perfect hedge - where the physical exposure exactly matches the hedging instrument in every respect - is extremely rare.
Basis risk can arise from several sources:
Timing differences
Location differences
Quality or specification differences
Volume differences
Let's take a look at volume basis risk:
Most futures contracts trade in fixed, round number sizes. 25MT contracts for Copper on the LME, 1,000 barrel contracts for WTI and Brent, or 5,000 bushels of wheat. Physical contracts rarely finalize at volumes that are perfectly divisible by these futures contract sizes. I have never seen a copper contract that was 1,000MT or exactly 40 lots of futures - more likely is 996.432MT.
When you hedge a physical contract, you are likely to be slightly over or under hedged on every single execution. In the above copper example, you would still hedge 40 lots (1,000 MT) so you would be overhedged by 3.568MT.
Let's say in that example you had bought physical and hence when you hedged you had sold futures. When you came to your physical sale, you would only be delivering 996.432MT but you would still be buying back 1000MT of copper futures. If the copper price increased between your physical purchase and sale - say from $12,000/mt to $13,000/mt, you would lose money on that 3.568MT overhedge:
Physical Purchase: 996.432 $12,000 = -$11,957,184
Physical Sale: 996.432 $13,000 = +$12,953,616
Futures Sale: 1,000 $12,000 = +$12,000,000
Futures Purchase: 1,000 13,000 = -$13,000,000
You are gaining $996,432 on your physical sale of 996.432MT. However, you are making a loss of $1,000,000 on your futures trades. This means that despite hedging the price exposure, you still incurred a loss of $3,568 due to the volume mismatch.
That loss equates to just $3.58/mt and had prices fallen instead of risen, the volume mismatch would have generated a gain.
In this example, the basis risk only equated to $3.58/mt, a small fraction of the $1,000/mt move in the outright copper price. The purpose of hedging is not to eliminate risk entirely but to reduce it to a level that is manageable and commercially acceptable.
A danger for traders is that these small over/under hedges continue to accumulate in the background and are never corrected or managed. To avoid this, traders maintain detailed hedge cards that compare physical exposures against futures hedges. These hedge cards help identify residual risks, volume mismatches, and other basis exposures before they become material problems.
Volume basis risk is usually relatively small and manageable. Timing, location, and quality differences can often create much larger basis exposures - we will look at each of these in upcoming posts.
