What is Basis risk?
Basis risk is a type of risk in finance. It can happen when you use one thing to protect yourself against losing money on something else, but the two things don’t match up perfectly.
What causes basis risk
Trying to reduce other risks
Many times, basis risk happens because people are trying to get rid of other risks, like the risk that prices will go in a bad direction (directional risk) or the risk that prices will bounce around a lot (volatility risk).
Using derivatives
One common way basis risk shows up is when you use a derivative contract to protect yourself. A derivative is a special agreement based on an asset. But the derivative doesn’t always perfectly track the asset.
For example, say you own a lot of oil. The price might go down, so you want to protect yourself. You could buy a derivative called an oil futures contract. This is an agreement to sell your oil at a set price in the future.
But the futures contract price might not match the actual oil price perfectly. The difference between the two prices is the basis. And the risk that they won’t match is the basis risk.
Using a second asset
Another way you can get basis risk is by using a second asset to protect the first one. Like, imagine you own stock in ExxonMobil, an oil company. You might buy stock in another company, like a solar panel maker, to balance it out.
The idea is that if oil prices drop and hurt ExxonMobil, the solar company might do better. But the two stocks won’t always move exactly opposite of each other. The difference in how they move is the basis risk.
Why it matters
Leftover risk
So when you try to protect yourself from some risks, you often end up with this leftover basis risk instead. It’s like a trade-off. You get rid of the big scary risk but take on a smaller, sneakier one.
Harder to measure
The tricky thing about basis risk is that it’s harder to measure and predict than the other kinds of risk. With directional risk, you can usually tell which way prices will go, even if you don’t know how far. And with volatility risk, you have an idea of how much prices will bounce around.
But with basis risk, you don’t know when or how the difference between the two things will change. It depends on a lot of complex market forces. So it can catch you by surprise.
Real world examples
Let’s look at a few more cases where basis risk pops up in the real world.
Mortgages and mortgage-backed securities
Banks give out mortgages, which are loans to buy houses. They get paid back over a long time, usually 30 years. But banks don’t like to wait that long. So they often sell the mortgages to other investors.
They do this by packaging a bunch of mortgages together into a bond called a mortgage-backed security or MBS. The investors who buy the MBS get a share of the mortgage payments.
The bank might keep some mortgages and sell others. The ones they keep are on their books at the original value. But the price of the MBS might not match that, because it can go up or down based on market demand. That difference is a basis risk for the bank.
Libor and interest rate swaps
A lot of loans, like some mortgages and student loans, have adjustable interest rates. The rates are tied to an index called Libor. When Libor goes up, these loans get more expensive.
Some companies borrow money at a floating rate tied to Libor. If Libor goes up a lot, they will owe a lot more interest. To protect against this, they can do an interest rate swap.
In the swap, they agree to pay a fixed rate and receive a floating rate tied to Libor. This cancels out their risk from rising rates. But the fixed rate might not perfectly match their floating rate. The difference is the basis risk.
S&P 500 index and futures
The S&P 500 is a stock index that tracks 500 big U.S. companies. People can invest in the S&P 500 in a few ways. Two common ones are:
- Buying an ETF (exchange-traded fund) that holds all the stocks in the index
- Buying S&P 500 futures contracts
The ETF price should match the actual S&P 500 index value pretty closely. But the futures price can be a little different. It depends on things like interest rates and how far in the future the contract is. The difference between the futures price and the index is the basis.
If you’re using futures to hedge your S&P 500 ETF investment, you have basis risk. The futures might not perfectly protect you.
