Basis Risk

Published Aug 16, 2023

Definition of Basis Risk

Basis risk is the risk that the actual return on an investment will differ from the expected return due to changes in the relationship between two assets or markets. That means it describes the uncertainty of the return on an investment due to changes in the relationship between two assets or markets.

Example

To illustrate this, let’s look at a simple example. Imagine an investor who wants to invest in the stock market. To do so, he buys a futures contract on the S&P 500 index. The investor expects the S&P 500 to increase in value over the next few months. However, due to changes in the relationship between the stock market and the futures market, the actual return on the investment may differ from the expected return. This is what we call basis risk.

Why Basis Risk Matters

Basis risk is an important concept for investors because it can have a significant impact on their returns. That means investors need to be aware of the potential risks associated with their investments and take steps to mitigate them. They can diversify their investments across different asset classes or use hedging strategies to reduce their exposure to basis risk. By doing so, they can reduce their risk and maximize their returns.