Can anyone explain the difference between basis risk and cross hedging risk? Every time I try to come up with an example of basis risk it seems to be due to cross hedging risk i.e. actual assets differing from those underlying the future. Thanks
Hi James, Cross-hedging risk is a particular type of basis risk. Basis risk = risk that the prices of the asset we want to hedge and the asset we are using to hedge it do not move in the same way. This could happen for 3 different reasons: 1) the asset we are using to hedge isn't a precise match. eg hedging a UK technology portfolio with FTSE 100 futures hedging the price of cherry tomatoes with standard tomato futures (this is cross-hedging risk) Even if the asset is a precise match, this doesn't mean we escape basis risk 2) We might need to close out early at a time when the basis is not in a favourable position to us 3) It might be unclear when we are going to sell our tomatoes or liquidate our technology portfolio John
