Reasons for existence of Basis Risk…..

I suggest you ask questions around our exam, as only 13 days left, and our tutor too busy.

I copy some for you, enough for 5 marks.

The basis reflects the relationship between cash price and futures price. (In futures trading, the term “cash” refers to the underlying product). The basis is obtained by subtracting the futures price from the cash price. 

The basis can be a positive or negative number. A positive basis is said to be “over” as the cash price is higher than the futures price. A negative basis is said to be “under” as the cash price is lower than the futures price. 

Short term demand and supply situations are generally the main factors responsible for the change in the basis. If demand is strong and the available supply small, cash prices could rise relative to futures price, causing the basis to strengthen. On the other hand, if the demand is weak and a large supply is available, cash prices could fall relative to the futures price, causing the basis to weaken. 

However, although the basis can and does fluctuate, it is still generally less volatile than either the cash or futures price. 

Basis Risk 
Basis risk is the chance that the basis will have strengthened or weakened from the time the hedge is implemented to the time when the hedge is removed. Hedgers are exposed to basis risk and are said to have a position in the basis. 

What dazhong0703 copied is correct, but it is a little bit overcomplicated 🙂

The basic reason is simply that the spot rate and the futures price are two different things! Strictly a futures contract is like a forward rate – a rate quoted now to apply on a future date. The difference is that with futures, the future date is one of the four quarter days (a March future is a fixed rate for conversion on 31 March). Because there are only the 4 fixed dates, very few people use futures for actually converting money. The majority of people use them purely for gambling (or in the case of financial managers, for hedging against exchange rate risk).

Just as you would expect banks to change their forward rate quotes from day to day, so too the futures price changes. The only time the futures price will be equal to the spot rate will be on the last day of the future.

Probably what I have written sounds just as complicated – if it does then sorry 🙂

If the current futures price is higher than the current spot rate, then it will always be higher.
If the current futures price is lower than the current spot rate then it will always be lower.

So……you add or subtract the basis depending on which is currently the higher or the two.