Basis risk
- Thread starter ajsa
- Start date
Hi asja,
We generally say there is a trade-off between the customized OTC forward which minimizes basis risk
(i.e., precisely because it can be customized to the counterparty's hedging needs) ...
and the liquidity of a futures contract (which, in order to trade on an exchange, requires standardized specifications). Tradeoff is: more liquidity (futures) versus less basis risk (forward)
If you hedge with a futures contract, you must "settle for" the standardized specs of the futures contract and it is unlikely these provide the perfect hedge ... this extends to several dimension (e.g., asset type) including the timing of delivery; e.g., the short probably can select timing within a window. The extreme example here is a cross-hedge; e.g., airlines that hedge jet fuel cost with heating oil futures. They would prefer "jet fuel futures" but none exist (trade on exchanges) so they settle for the liquidity of futures contract but incur the extra basis risk of hedging with an instrument (futures contract) that, while it likely correlates with the underlying, is niether the exact same thing nor quite the contract we would design "from scratch" if we wanted to minimize our basis risk.
David
We generally say there is a trade-off between the customized OTC forward which minimizes basis risk
(i.e., precisely because it can be customized to the counterparty's hedging needs) ...
and the liquidity of a futures contract (which, in order to trade on an exchange, requires standardized specifications). Tradeoff is: more liquidity (futures) versus less basis risk (forward)
If you hedge with a futures contract, you must "settle for" the standardized specs of the futures contract and it is unlikely these provide the perfect hedge ... this extends to several dimension (e.g., asset type) including the timing of delivery; e.g., the short probably can select timing within a window. The extreme example here is a cross-hedge; e.g., airlines that hedge jet fuel cost with heating oil futures. They would prefer "jet fuel futures" but none exist (trade on exchanges) so they settle for the liquidity of futures contract but incur the extra basis risk of hedging with an instrument (futures contract) that, while it likely correlates with the underlying, is niether the exact same thing nor quite the contract we would design "from scratch" if we wanted to minimize our basis risk.
David
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