Basis Risk

I'm struggling to understand basis risk.

In the example on p.10 of chapter 23, a cost/benefit arises if the future price at time 1 (F1) is different from the underlying asset price at time 1 (S1). Assuming the asset being hedge is identical to the asset underlying the futures contract (i.e. no cross hedging risk), there are no cashflows and interest rates are fixed at zero (no time value of money), why would F1 not equal S1?

If anybody could clear this up, that would be great. Thanks.

 

Thanks for your reply. Sorry I've only just had a chance to really think about it.

I'm trying to get at what is it that creates the basis risk.

To clarify, is F the discounted future price in today's prices, or is F the actual price that the underlying asset will be bought/sold for at the future date?

If it's the latter, are you saying that providing interest rates aren't zero (or equal to the expected future income) then S <> F and therefore a basis cost/profit arises (=S-F)?

Or does the basis cost/profit only arise when the discount rate applied between t=1 and t=2 change as we move in time from t=0 to t=1 (ignoring expected future income), so that F0 and F1 are calculated using different assumptions?

 

Hi there

As I recall F_0 is the "strike price" of the future, i.e. the price that we agree to sell the asset for at time t=2.

There is no guarantee that S_1 = F_0. Recall that F_0 = S_0 exp(2r).

The cashflow that occurs at time 1 is the sale of the asset for +S. At time 2 we have the net effect of entering into the two futures, i.e. F_0 - F_1 = S_0 exp(2r) - S_1 exp(r).

That's my take on the basis risk. I don't work with derivatives and would love to know if I understand them correctly!

I hope this helps
Alastair

 

Thanks for this Alastair.

The basis by definition is S_t - F_t, not S_1 - F_0, as you imply.

To extend your example, the cash from the sale of S at t=1 would have accumulated to S_1 exp(r) at t=2, leaving you with F_0 = S_0 exp(2r). Where's the basis cost/profit there?