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Mismatch in Basis & Basis Risk

Basis Risk is the risk of unexpected change in relationship between futures & Spot prices. Hedging replaces price risk with Basis risk. 1. Quantitative mismatch: Over-hedged position: Quantity of futures position > quantity of spot position Under-hedged position: Spot price position > futures position


2. Commodity Mismatch: Proxy Hedging: Mismatch of the underlying commodity itself. Ex: hedging copper by electric cable manufacturer for copper based electric cable.

3. Delivery Date Mismatch: Spot price & future price do not converge on expiry.


4. Strengthening & Weakening of Basis: Basis Risk in long hedge
Spot Market November February Change Spot price of wheat 11,900 Buy wheat at spot of 12,200 300 loss Futures Market Buy March Wheat Futures at 12000 Sell March wheat futures at 12,250 250 gain -100 -50 50 (strengthened) Basis


Basis Risk in Short Hedge:
Spot Market November Spot price of wheat 11,900 Buy wheat at spot of 12,200 300 loss Futures Market Buy March Wheat Futures at 12000 Sell March wheat futures at 12,350 350 gain -100 Basis

February

-150

Change

50 (weakened)


Spot Market November Spot price of wheat 11,800 Sell wheat at spot of 11,500 300 loss Futures Market Sell April Wheat Futures at 12000 Buy April wheat futures at 11,650 350 gain -200 Basis March -150

Change

50 (strengthened)


Spot Market November March Change Spot price of wheat 11,800 Sell wheat at spot of 11,500 300 loss Futures Market Sell April Wheat Futures at 12000 Buy April wheat futures at 11,750 250 gain -200 -250 50 (weakened) Basis

Additional payments such as margin calls can be an risk.

Optimal Hedge Ratio

It tell how many contracts are needed to create an hedge. HR = (size of future position)/(size of exposure) Optimal ratio is 1 Proportion of risk to be hedged: h = x S/ F


Ex: company requires 10,000 tonnes wheat in three month. S = 0.040, F = 0.055, correlation is 0.9. Optimal Hedge ratio (h) = 0.9 x (0.040/0.050) = 0.9 x 0.8 = 0.72 No. of contracts the company should buy = 0.72 x 10,000/10 = 720 contracts

Rolling Hedge

Hedge horizon lies beyond the latest date of the futures contracts traded Ex. Jeweller converts gold into jewellery & sell after 1 year. Assuming only contacts of 4 months are liquid
Time (in months) 0 4 8 12 Action Short Futures Contract 1 Close out Futures Contract 1 Short Futures Contract 2 Close out Futures Contract 2 Short Futures Contract 3 Close out Futures Contract 3