Confused about basis risk

[Arka Bose]

Hello all,

Till now I know that the profit/loss/pay off in a futures contract is the Spot at maturity less The Forward Contracted price.

Now, Even if the underlying assets to be hedged are different, why would Futures price at maturity matter (and thus basis matter) as Future is a contracted price and i have to pay that amount only, so the pay off remains the same.

Please help, I am terribly confused about this

 

[QuantMan2318]

"From your underlying assets to be hedged are different", I assume that the asset you want to hedge is not the same as the asset for which the future is available. So we resort to cross hedging. The problem with this strategy is that there are two sides to it,
First let us look at the Asset to be hedged and the Future itself, futures contracts can be closed by an opposite position at any time and further even if you are trying to keep it till maturity, you have to close the futures by taking an opposite position. Assume you are buying 1000 gallons of Furnace Oil for running a Furnace and you want to hedge it, you hedge it by taking a Long position in 10 Future contracts of 6 months for 100 gallons each, the current Spot price is $50/Gallon and the Futures price is $52 per gallon; you have to buy it at 3 months from now ( remember futures unlike forwards will mostly never match with with your time horizon and is mostly never held to maturity ).
3 months from now say the Futures price is $51 per gallon and the Spot price is $49/gallon

So your cash outflow on the futures market will be -Long+Short ( -52+51 ) $1 per gallon loss and corresponding cash outflow in spot market will be $49/ gallon, so you have locked a price of $50 and saved from the uncertainty of buying the Furnace oil spot. Now your ultimate savings or even expenditure on your hedge depends on the Futures price at maturity as well, the Treasurer is Short the Basis here, so when the Spot at maturity falls more than the Futures price at maturity, you would have profited from your hedge. Try Spot price at $47/gallon, your profit on the Spot is ( 50-47); while in the hedge is ( -52+51)
Same thing for increase in Futures and Spot; If the Futures price at maturity was $55, you make a profit in Futures market offset by having to buy the oil at higher spot prices ( $52 and hence loss of $2)

When you hedge it using a different futures, say Gasoline futures rather than Furnace oil futures, the basis risk of the spot position of commodity to be hedged and the underlying new commodity comes into play as well as the underlying and the futures on that underlying