Basis Change

[YCHEN7458]

Hi there, I have a question regarding basis change concept at BT P1.T3. reading (page 9):
* When the spot price increases by more than the future price, the basis increases, ... for a short(long) hedge position, it is favorable (unfavorable) to the hedger, as the price received (paid) for the asset will be higher.

But doesn't the long hedger sign a contract at the very beginning to set up a predetermined price (known as the futures price)? Therefore, when the spot price increases larger than the futures price, the long hedger does not need to pay that much to buy the asset. For example, if the spot price is $3 and the futures price is $1.5, then according to the contract, the hedger could only pay $1.5 to eventually buy the asset?

Thanks for the help !!

 

[gsarm1987]

@YCHEN7458 basis risk implies under/over hedging. underhedging exposes us to the uncovered risk and overhedging is inefficient. in context of a short hedge (aka shorting the future), if futures price increases, he is in a loss with respect to that hedge. remember the future has not been assigned yet (still time to expire), so in that mean time, short hedge will feel upset that they took the decision too early and could have waited a bit more to lock in at higher future price. your example with reference to spot $3 and future $1.5 would have been considered if the position was closed/rolled or assigned but we are looking at the "meantime".

 

[YCHEN7458]

Hi @gsarm1987, thank you so much (again) for the clear explanation.
However, according to the text, "When the spot price increases by more than the futures price.." I assume the futures price in this case still increases but just less than the increase of the spot price. Then, according to what you've mentioned, "if futures price increases, he (short position) is in a loss with respect to that hedge", I wonder, how can a short hedge position is favorable to the hedge in this case considering the futures price increases (but less than the speed of increase in the spot price)? Thanks!

 

[gsarm1987]

@YCHEN7458 full hedge with futures cut out upside gains and any downside loss. They just lock you to one place. If you are long or short only the future and no asset to hedge then comes the topic of gain/loss on rollover or assigning of the future. Say you buy a future 100$ if spot falls to 90 means you will will bought at 100 so have a loss. Buying or selling a future implies we commit to buy /sell the spot at a given date in future.

 

[YCHEN7458]

Hi @gsarm1987 , thanks for the reply again. I wrote an example and could you please let me know if my understanding is correct, Thanks!

Let says we purchase an asset at the spot price right now is 141.5 and the futures price for the short position is 141.25 (the net exposure is +0.5). Let says the market is bull and the price of the asset rises up to 150.5, and the futures price is 150 (the spot price increases by more than the futures price). The gain in the value of an asset is (150.5-141.5) and the loss from the short futures position is (150 -141.25) sum up as +0.25; on the other hand, for a long hedger: let’s assume the futures price for the long position is also 141.25, later be 150, the spot prices are 141.5 now and 150.5 later. The gain from the long futures position is (150-141.25) but he will suffer the loss from the asset (150.5-141.5) because he could purchase it at the beginning, and the loss from the asset is larger than gain from the long futures position, therefore, the long hedger is in the unfavourite position.

 

[gsarm1987]

Hi @gsarm1987 , thanks for the reply again. I wrote an example and could you please let me know if my understanding is correct, Thanks!

Let says we purchase an asset at the spot price right now is 141.5 and the futures price for the short position is 141.25 (the net exposure is +0.5). Let says the market is bull and the price of the asset rises up to 150.5, and the futures price is 150 (the spot price increases by more than the futures price). The gain in the value of an asset is (150.5-141.5) and the loss from the short futures position is (150 -141.25) sum up as +0.25; on the other hand, for a long hedger: let’s assume the futures price for the long position is also 141.25, later be 150, the spot prices are 141.5 now and 150.5 later. The gain from the long futures position is (150-141.25) but he will suffer the loss from the asset (150.5-141.5) because he could purchase it at the beginning, and the loss from the asset is larger than gain from the long futures position, therefore, the long hedger is in the unfavourite position.

@YCHEN7458 spot on!