What is Basis Risk?

   When we hedge any stock, commodity, currency or interest rates we use the derivatives such as forwards, futures, options or swap. Hedging helps us to cover our open risk of losses. While using futures or options we generally square off our position in the market and book the profit or loss on the derivatives market. This is adjusted against our risk in the underlying asset. For instance, if we have a receivable of $1m and we book a futures contract to sell $ at 75 per 1 INR. Suppose the spot rate on the date of receipt is $74 and futures is at $73. Therefore on the settlement date we will get INR 74m (1000000*74) and we will also book a profit of INR 20,000 {1m*(75-73)%}. This extra 20,000 has covered the risk in underlying asset where we had a fear that $ will strengthen.

 

Similarly in interest rate hedging the depositor has a fear that the interest rate will fall and wants to hedge at a rate so that his future cash surplus can be invested at higher interest rate. For Futures and options we have a contract size and expiry as per available in the market and we will have to book number of contracts depending on our underlying asset. Whereas in certain scenarios there might not be a perfect hedge that will be available in terms or contract size or contract expiry. Basis risk pertains to the contract expiry where we have futures or options in expiry in say March 2021 but our receivable is on 31st January 2021. In this case we will have to estimate our future rate for 31st January 2021 using the march futures or options. This can be done using the basis points. Basis points is the gap between the Spot and future rate which is supposed to be zero (0) on expiry. I.e. on 31st March 2021 the Spot rate = Future rate.

 

Now if today we determine the future rate for 31st January 2021, there are still 2 months to expiry.

The future rate on 31st Jan 2021 will be estimated using the basis points for march expiry that will

diminish at a constant rate till expiry. There is an uncertainty factor involved here that is the actual

futures rate on 31st January 2021 may differ from the once determined by us using the basis

points. This uncertainty factor is defined as the Basis Risk.

 

Lets take an example to understand this better.

 

Today is 1st Nov 2020, and we have a receivable of $50m on 31st Jan 2021 to be deposited for 6

months time.The exporter will be has fear of interest rates falling by 0.02% The spot rate is

99.7725.

Contract details ( Source - CME Group)

Contract size - $2500

Dec 2020 expiry - 99.755

March 2021 Expiry - 99.79

The depositor will buy march 2021 interest rate futures at 99.79 (100-99.79 = 0.21%)

No of contract = 50m/2500*6/3 = 40,000 contracts

Calculation of basis

Spot = 99.7725

Future = 99.79

Basis = -0.0175

Basis per month = -0.0175/5 = -0.0035 per month

Unexpired period = 2 months

Basis for 2 months = -0.007

Spot rate expected = 0.2275 - 0.02 = 0.2075% = 99.7925

Estimated future = 99.7925 + 0.007 = 99.7995 I.e. 0.2005%

Once we receive the dollar payment we shall deposit the money

On 30th June 2020

Interest inflow = (50m*0.2075%*6/12) = 51,875

Profit on squaring off future = (2500*40000*(99.7995-99.79)%*3/12) = 2,375

Total Inflow = 54,250

 

Now if the future so estimated does not turn out to be the actual futures even if the actual spot

rate it same. If futures is 99.75 instead then there will be a loss in futures. This will be the basis

risk for us.

In this case the net inflow will be follows

Interest inflow ( same as above ) = 51,875

Loss in futures = (2500*40000*(99.7825-99.79)%*3/12) = -1,875

Total inflow = 50,000

Thus we can say that even if the expected interest rate turns out to be same still there can be

change in thein the inflow or outflow due to the basis risk as we work on estimates in futures market.