basis risk

[liordp]

Hi David
i cant understand why strength of the basis is good for short seller ?
if i enterd into short position i have a commitment to sell in the future at fix price so i cant enjoy the fact
that the spot is rising cause my price is already fix
tnx

 

[David Harper CFA FRM]

Hi convexity:

per Hull, basis(0) = Spot(0)- Futures(0)

Where "short hedge" refers to commodity seller who protects spot price declines by shorting forward

So please note the "short hedge" refers to two transactions:
1. Commodity Seller plans to sell at future spot (St), plus
2. Seller short futures contract

so, UNANTICIPATED strengthening is where S-F is greater than expected. If we assume futures are constant, then strengthening must be due to higher spot. Note the commodity seller does profit from increase in spot because he/she sells at future spot.

(but note the unanticipated strengthening can still be due to an unanticipated LOSS on the futures contract. If enter short at F0 but F1 is higher than expected---e.g., maybe doesn't converge to spot--the strengthening could be driven by losses on the forward contract)

note that Hull stresses it's about the unanticipated change in spot or futures contact; i.e., if the hedger enters the hedge and correctly predicts the future basis, then he/she can hedge perfectly....

Hope that helps, David