BASIS RISK Meaning and
Definition
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Basis risk refers to a type of market risk associated with imperfect hedging or the potential for the value of a financial instrument to deviate from the value of its underlying asset or benchmark. It is the risk that arises from a mismatch or discrepancy between the cash market position, such as a commodity or a security, and the corresponding hedging position taken in the derivatives market.
In simple terms, basis risk can occur when there is a difference in the price movements of two related assets. For example, an investor may seek to hedge the price risk of a stock by using stock index futures. However, due to various factors such as market volatility or timing variations, the prices of the stock and the futures may not always move in perfect sync. This divergence in price movements leads to basis risk.
Basis risk is particularly relevant in hedging strategies, where the objective is to minimize or eliminate exposure to price fluctuations. If the basis risk is high, the hedge may not be as effective in protecting the investor from adverse price movements, potentially resulting in financial losses.
Financial institutions and traders are often exposed to basis risk when dealing with derivatives, such as futures contracts, options, or swaps. Managing basis risk requires careful monitoring, analysis, and adjustment of hedging positions to ensure the effectiveness of the hedge.
Overall, basis risk is a type of financial risk arising from imperfect hedging, which can result in the deviation between the value of a financial instrument and its underlying asset or benchmark.
Etymology of BASIS RISK
The term "basis risk" is derived from the noun "basis" and the noun "risk".
The word "basis" originally comes from the Latin word "bas-is", meaning "foundation" or "support". In finance and economics, "basis" refers to the difference between the spot or cash price of a commodity and the price of a derivative contract based on that commodity. It is essentially the price difference between the underlying asset and its related derivative.
The word "risk" has its origins in the Middle English word "riske", which comes from the Old French word "risque". It was originally used in the context of the possibility of harm or danger. In finance, "risk" generally refers to the potential for loss or uncertainty associated with an investment or financial instrument.
