Basis Risk in Commodities Hedging
The concept of basis risk in the commodities markets is similar to basis risk in financial products. It occurs when spot price and the futures price do not converge when the futures contract expires. This happens in two situations. In the first case the risk associated with a commodity price exposure cannot be entirely hedged using any of the commodity futures contracts trading in the market due to a quantity mismatch. The second case is when cross-hedging needs to be resorted to when there are no available future contracts trading on the market for the commodity in question. Cross-hedging happens when either the maturity, quantity or the quality of hedge cannot be matched with the price exposure to that needs to be hedged.
Basis is defined by the following equation:
Basis=Cash Price (S)- Futures Price (F)
On the day when the position is bought into the books the basis is unknown.
The day when the hedge is lifted is normally unknown and is a random variable unless the day is the same as the futures contact delivery day and the underlying instrument of the futures contract is the same as the commodity being hedged.
There is always basis risk in the case of cross-hedging.
The most common reason why it is not possible to hedge all the price risk in a commodity cash position is that it is not always possible to find futures contracts based on the underlying that trade in the market. In this situation the objective is normally to hedge away as much of the exposure as possible by trading contracts on related assets. This is most common reason why basis risk arises and two examples when this happens in the market are cited below.
- There is no futures contract for jet fuel so in the market oil and gasoline futures are used for hedging exposure to jet fuel prices. The types of organizations that have a requirement for this are airlines. There is of course not a strong correlation between the prices of oil and gasoline futures, alone or in combinations and the market price of jet fuel. So although it is possible to hedge most of the price risk there will always be some remaining exposure.
- Most of the crude oil futures contracts being traded in the market are based on the West Texas intermediate crude and for oil that is produced in a different region or of a different grade the hedge using these futures will always be imperfect.