Basis Risk - hull notes page 36

[puneet_]

Hi, I am little confused in below table on page 36 of Hull Notes. specially around red color part. if spot is 2.00 in sept -13, why would future price difference from spot assuming future expiry is also in sept. isn't it like corn is selling in market at spot at 2.00 and future is at 1.95 then buy future at 1.95 that will expire immediately and sell it at 2.00.

I am terribly confused on thinking of why future price would be different from spot if future is expiring immediately. can you please help me to understand future expiry date in below example?

thanks in advance.

 

[QuantMan2318]

Hi @puneet,

Can you tell me why is that you are assuming that the contract expires in September? I don't have the complete question.

I thought that the Basis Risk deals with cases where the need for Hedge close out arises prior to Contract expiration. Of course, if the Asset to be Hedged is not the same as the Asset for which the Futures are available, then there may be cases where the Spot price at maturity doesn't converge to the Futures price on the same date (but thats Cross Hedging, however that can be related to the case above)

So, if you think that Hedge is closed in September which happens to be the end of the Hedge duration, then, it is perfectly plausible that the Future Price of the contract ( which can be any Futures beyond September )at that date is different from the Spot price then. Also, if its a case of Cross Hedging as above, then if the Contract Expires in September, it is likely that the Futures price may not equal the Spot Price at that date.

 

[David Harper CFA FRM]

Hi @puneet_ In addition to what @QuantMan2318 wrote (and I agree with it) I want to add: even if the contract expires in the same month (September), it is unlikely to be the same day. As Hull says, in general a contract maturity is chosen with a delivery month that is later than the desired hedge expiration; for example, if the company plans to purchase Copper in September (the underlying exposure), then a likely choice for the hedging futures contract is one that matures in October.

However, even if we assume the contract expires in the same month, two comments:

1. You are correct, and I do not want to dissuade you from, about the fact that, due to arbitrage, there is no doubt that the pricing model ("theoretically" as they say) assumes a perfect convergence of spot price and futures price at expiration.
   
2. At the same time, the example still means to illustrate a possible market reality, there is still some basis risk even at maturity. More realistically, there is a so-called "zone of convergence." Here is an old but favorite article (using corn) http://econbrowser.com/archives/2008/04/commodity_arbit and here is another http://www.choicesmagazine.org/magazine/article.php?article=26

 

[puneet_]

Thanks both for response.

So main point that i understand is - there is some difference between underlying and hedge that would most probably the reason of basis risk or in other words, it will make spot and future price difference. but if day, quality etc everything is same then spot and future should have same price, so possibility of basis risk is extremely low.

cross hedging would also mean some difference between underlying and hedge in my mind.

thanks again.