Basis risk

Definition

Basis risk in plain English

When you use a futures contract to protect yourself against a price swing (a 'hedge'), you're betting that the thing you own and the futures contract will move together. Basis risk is the danger that they DON'T move perfectly in step, so your protection turns out to be leaky. Imagine you're worried about the price of jet fuel but the only futures contract available is for crude oil — they usually track each other, but if their gap unexpectedly widens, your hedge under- or over-shoots and you're left partly exposed. In short, it's the risk that the basis (the spot-minus-futures gap) shifts while your hedge is on.

Related Principles of Finance terms

• Agency bond
• American option
• Arbitrage pricing theory (APT)
• Asset-backed security (ABS)
• Bid-ask spread
• Bookrunner
• Carhart four-factor model
• Clientele effect
• Collateralized debt obligation (CDO)
• Common-size analysis