Query - Basis Risk

[Avishek]

Hi David!

Me back again. In your Fixed Income Video 1 at 36:56 Minutes, you have shown as to what happens when the Forward Price at time T1 falls getting the Basis at the same level at Time T0.

I got a conceptual query here. What is a Risk Manager's motive here? To simply try and hedge or to make profits. This is a kind of forcasting, isn't it? - To predict the Forward Price at Time T1? If so, then a Risk Manager should try and not short 1.67F but infact maybe 1.25F or likewise to get the Net near to 0. I am not sure if am able to explain properly. Just in case you are not able to catch my point, please let me know and I will make a better effort.

What I exactly mean is -> My motive should be to get the Net to 0 or higher on the positive side?

Sorry again if I confused you with my confused point of view.

Wishes, Avi

 

[David Harper CFA FRM]

Avi,

Not confusing, it is profound and thematic to the FRM. An important idea that took me years to grasp.

Basis risk can be found everywhere there is a hedge. We can (perhaps) assume the risk manager's motive is to deploy a perfect hedge: to eliminate the impact of a change in the spot price. A perfect hedge, if we produce oil, is to eliminate the impact of a change in the spot price of the oil and, to know today, that our revenues will be solely a function of quantity sold and a locked-in price. If we are supplied oil, as a airline, a perfect hedge would be that oil cost would only be a function of unknown quantity. But the airlines cannot achieve this idea: the refined jet fuel they actually pay for is not EXACTLY the same as the asset that underlies an oil futures contract.

The perfect hedge, without basis risk, is possible only if the asset being hedged is exactly the same as the asset that underlies the futures contract. It never really is, the futures asset is some imperfect proxy. Basis risk is that imperfection.

The point of the basis risk LO is very important - it says the risk manager may deploy a hedge but the hedge will fail to the extent there is UNEXPECTED strengthening/weakening of the basis. And it can move to benefit or penalty of the risk manager.

It is just like under the Stulz cash flows, there is a formula for the "optimal hedge" when there is price and quantity risk. It is instructive that the optimal hedge still produces variability (random fluctuation) in anything less than perfect (positive or negative) correlation. The hedger can only hedge so far.

Hope that helps...honestly, to ask the question as you did, indicates to me you are, as the Buddha says, well on the path - David