Basis risk

The risk that a hedge and the exposure it protects do not move together, usually because the hedge is on a related but different asset, date or place. It is what remains once the hedge is on.

Where you will meet it

Basis risk appears in 6 learning outcomes on the CFA syllabus. A few of them:

• Set out what derivatives offer users and the risks they carry
  CFA Level I · Derivatives

  “The risks follow from the same features: the implicit leverage means small margin supports large exposure, basis risk means an imperfect hedge can move against the position it was meant to protect, and opacity in bilateral markets hides the build-up of exposure.”

• Contrast the vehicles through which an investor can gain index-based equity exposure
  CFA Level III · Portfolio Management Pathway

  “Derivatives-based approaches use index futures, total return swaps or options: they are capital-efficient and quick to put in place, but futures must be rolled, carry basis risk and margin calls, and swaps add counterparty risk.”

• Show how interest rate futures, forwards and swaps can reshape the risk and return of a portfolio
  CFA Level III · Derivatives and Risk Management

  “Traps: the sign, since shortening means selling futures or paying fixed, and basis risk from non-parallel curve shifts.”

• Weigh derivatives against physical (cash market) trades as ways to set or change asset class and risk exposures, in terms of costs and benefits
  CFA Level III · Portfolio Management Pathway

  “Their drawbacks are roll costs and basis risk when the derivative does not track the exposure precisely, margin and collateral calls that create liquidity needs, counterparty risk on OTC contracts, and hidden leverage.”

Practise it

• Today's practice question One question, with every wrong option explained.
• Free Level I diagnostic test Twelve questions that show which topics to start with.
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All terms beginning with B · Glossary