strengthening of the basis

[atandon]

Hi David,

This will be a very silly question but I need to ask to get a clear picture. This is to understand "Basis Risk on page - 110 (2012.T3.Products.pdf).

Statement -
"The basis converges to zero over time, as the spot price converges toward the future price. When the spot price increases by more than the futures price, the basis increases and this is said to be a “strengthening of the basis” (and when unexpected, this strengthening is favorable for a short hedge and unfavorable for a long hedge)."

If I try to interpret it, let's c - I am long on a spot commodity and short on a future contract. Now we say at the time of expiry, future price and spot price may or may not converge due to factor we have already listed in study notes. So if the 'strenghening of the basis' happens, we say it's favourable to short hedge (i.e. - long spot and short future contract - the position I have taken). So I am gaining on my spot commodity since price increased and losing on my future contract(bec I am selling for less than mrkt value)...pls clarify?

Regards,
atandon

 

[David Harper CFA FRM]

Hi atandon,

Your interpretation looks good, except Hull's point is about the unexpected basis strengthening (beyond any convergence/strengthening anticipated by the hedge). You don't even require the convergence. As you say, if you start with a "short hedge" = long spot + short futures contract = S - F. Hull's point is that, initially, you can put on a perfect hedge against any predicted future basis: S(t) - F(t), convergence or not. You short whatever number of futures are required to zero your profit/loss when the future basis reaches your predicted S(t) - F(t).

Hull's point that it is the unexpected basis strengthening (weakening) that creates a profit (loss) despite your hedge. Your hedge will guarantee zero profit/gain in the case of future S(t) and F(t), but an unexpected basis strengthening--i.e., an increase in [S(t) - F(t)] above the expected level, including zero in the case of convergence--is caused by either an unexpected increase in S(t) and/or an unexpected decrease in F(t), the former (as you say) profits your spot position, the latter profits your future position. If you forum search on "strengthening of the basis" there are several discussions, I realize this is always difficult and I will try to improve the T3 video segment in this year's video. Thanks,

 

[atandon]

Wow...thanks. But that was useful.