Basis Risk

Hedges are rarely perfect. The asset being hedged may differ from the asset underlying the hedging instrument in type, quality, location or timing. As a result, their prices may move differently, leaving some risk unhedged.

For example, an airline hedges its jet fuel costs using crude oil futures, because jet fuel futures are less liquid. If jet fuel prices rise more than crude oil prices, perhaps because of a refinery shortage, the gains on the crude oil futures will not fully cover the higher fuel costs.

Basis risk also arises when the timing of the hedge does not match the timing of the exposure, or when a company hedges a regional price with a contract based on a different region.

Basis risk can be reduced by choosing hedging instruments that closely match the exposure, but perfect matches are often unavailable or too expensive. It is a key consideration for commodity producers, airlines, utilities, banks and investors using derivatives to manage risk.