Basis risk

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Basis risk in finance is the risk associated with imperfect hedging due to the variables or characteristics that affect the difference between the futures contract and the underlying "cash" position.^[1] It arises because of the difference between the price of the asset to be hedged and the price of the asset serving as the hedge before expiration, namely b = S - F. Barring idiosyncratic influence by the other aspects to be enumerated just below, by the time of expiration this simple difference will be eliminated by arbitrage. The other aspects that give rise to basis risk include:

1. Quality (grade) arising when the hedge in place has a different grade which is not perfectly correlated with the basis;
2. Timing arising due to mismatch between the expiration date of the hedge asset and the actual selling date of the underlying asset;
3. Location (leading to Transportation Costs) arising due to the difference in the location of the asset being hedged and the asset serving as the hedge, and which typically includes a premium to cover the risk these transportation costs may rise, causing a negative impact on the hedger.