What is meant by basis risk when futures contracts are used for hedging?
Basis risk is the potential risk that arises from mismatches in a hedged position. Basis risk occurs when a hedge is imperfect, so that losses in an investment are not exactly offset by the hedge. Certain investments do not have good hedging instruments, making basis risk more of a concern than with others assets.
How do you hedge basis risk?
The simplest way to mitigate your exposure to basis risk is to enter into supply (in the case of a consumer) or marketing (in the case of a producer) agreements that reference a “primary” index (i.e. NYMEX natural gas furtures, ICE Brent crude oil, etc) or one of the numerous, liquid (actively traded) regional indices …
What is the basic principle of hedging?
The principle of hedging is quite basic, but one critical premise applies: hedging is based on the idea that prices of the physical commodity and the futures contracts generally move closely together.
How futures can be used for hedging?
A short hedge is one where a short position is taken on a futures contract. It is typically appropriate for a hedger to use when an asset is expected to be sold in the future. Alternatively, it can be used by a speculator who anticipates that the price of a contract will decrease.
How basis risk arises for hedging with US Treasury futures?
Whenever we cross-hedge, we are subject to basis risk. The basis is the difference between the futures price and the spot price. Basis risk arises when the futures price does not change one-for-one with the hedged-asset’s spot price.
Which of the following increases basis risk a large difference between the futures prices when the hedge is put in place and when it is closed out?
Which of the following increases basis risk? Basis is the difference between futures and spot at the time the hedge is closed out. This increases as the time between the date when the futures contract is put in place and the delivery month increases.
How Basis risk arises for hedging with US Treasury futures?
When can the futures price in commodities be less than the spot price?
Contango and backwardation are terms used to define the structure of the forward curve. When a market is in contango, the forward price of a futures contract is higher than the spot price. Conversely, when a market is in backwardation, the forward price of the futures contract is lower than the spot price.
What is hedging in risk management?
Hedging is a risk management strategy employed to offset losses in investments by taking an opposite position in a related asset. The reduction in risk provided by hedging also typically results in a reduction in potential profits. Hedging strategies typically involve derivatives, such as options and futures contracts.
What are the 3 common hedging strategies to reduce market risk?
There are a number of effective hedging strategies to reduce market risk, depending on the asset or portfolio of assets being hedged. Three popular ones are portfolio construction, options, and volatility indicators.
Do futures affect spot prices?
How Do Futures Prices Affect Spot Prices? It’s actually more the other way round: Spot prices influence futures prices. A futures contract price is commonly determined using the spot price of a commodity—as the starting point, at least.
How could a firm use futures contracts to reduce risk?
Both producers and end-users can use futures to protect themselves against adverse price movements. They offset their price risk by obtaining a futures contract on a futures exchange, hereby securing themselves of a pre-determined price for their product.