What is Timing Basis Risk?

Yesterday we looked at volume basis risk - where the physical quantity does not perfectly match the hedge quantity.

Today let's look at timing basis risk.

Timing basis risk occurs when the physical exposure and the hedge are priced, settled, or fixed against different dates. Unless you are handling this type of risk personally, you may not even recognize it as a risk. From a high level you have bought physical and sold futures so you are hedged right?

Let's look at a simple example:

A trader purchases 1,000MT of physical copper, priced on the LME official cash settlement of June 1st and sells 40 lots of copper futures as a hedge against the outright price. The trader manages their futures positions on the 3rd Wednesday and so their hedge is to sell 40 lots prompt the 3rd Wednesday of June.

Because of the forward curve (as discussed in last week's posts) the hedge price may be different to the physical purchase price. They have hedged the outright price risk but were still exposed to the difference in price between the cash settlement and the 3rd Wednesday.

Let's say the physical contract price settled at $13,000/mt. If on June 1st the market is in contango, the 3rd Wednesday hedge price will be slightly higher. And vice versa if there is a backwardation, the hedge price will be lower than the physical. The trader is exposed to the difference in these prices.

To take it one step further, let's say that they don't sell that metal until July. Their short futures position sits on the 3rd Wednesday of June so they now have a timing exposure between June and July.

Since they are short futures they will need to borrow that position. If the market is in a contango they will gain money from the borrow. But if the market is in a backwardation this trade will cost them money. This exact cost or gain was unknown at the time of executing the initial hedge and remains so until the spread trade is executed.

Even after dealing with the initial timing risk between the cash settlement and the June 3rd Wednesday, the trader was still exposed to the relationship between the June and July prices.

This is why traders run detailed spread cards as well as outright hedge cards. They monitor prompt dates, carry trades, and spread exposures to ensure that timing risks do not go unnoticed.

Timing basis risk can become far more significant than volume basis risk, particularly during periods of tight supply when time-spreads can move dramatically. In many commodity markets, some of the largest gains and losses come not from outright price moves but from changes in spreads, prompt dates, and carry trades.