Basis Risk Between Futures and Spot

Basis risk is the risk that futures prices won't move in perfect lockstep with the asset being hedged. Understanding basis—the difference between spot and futures prices—is essential for effective hedging. While hedging eliminates outright price risk, it introduces basis risk, which must be monitored and managed.

Definition and Key Concepts

What Is Basis?

Basis is the difference between the local cash (spot) price and the futures price:

Basis = Spot Price - Futures Price

When spot exceeds futures: positive basis (backwardation) When futures exceeds spot: negative basis (contango)

Basis Convergence

As a futures contract approaches expiration, basis should converge to zero (or delivery costs). At expiration:

• Arbitrageurs ensure futures equal spot
• Delivery mechanism enforces convergence
• Basis risk diminishes for matching delivery timing

Components of Basis

Basis reflects several factors:

Types of Basis Risk

How It Works in Practice

Basis in Agricultural Markets

Corn hedging example:

A farmer in Iowa sells corn locally. The local elevator price differs from CBOT corn futures:

The -$0.30 basis reflects:

• Transportation to delivery point (Chicago)
• Local supply/demand balance
• Elevator margins

Hedge outcome depends on basis change:

In Exit A, the basis narrowed (strengthened), benefiting the short hedger. In Exit B, the basis widened (weakened), hurting the short hedger.

Energy Basis Example

Gulf Coast refiner hedging crude oil:

The refiner buys Mars crude (sour grade) delivered to Louisiana. They hedge with WTI futures (sweet crude, Cushing delivery).

Basis components:

• WTI-Mars quality spread (sweet-sour differential)
• Cushing-Gulf Coast location differential
• Transportation costs

Historical WTI-Mars spread:

• Average: WTI +$3.00/barrel (WTI premium)
• Range: +$1.00 to +$6.00

Hedge analysis:

Hedger P/L:

• Futures gain: +$5.00/barrel (short position)
• Cash cost reduction: -$3.50/barrel
• Net hedging result: +$5.00 - $3.50 = +$1.50/barrel

The +$1.50 windfall came from favorable basis movement, not from the hedge design. In reverse, basis could have moved against the hedger.

Worked Example

Managing Cross-Hedge Basis Risk

An airline hedges jet fuel purchases using heating oil futures (no liquid jet fuel futures exist).

Position:

• Jet fuel consumption: 1,000,000 gallons/month
• Hedge: Long heating oil futures (HO)

Jet fuel-heating oil relationship: Historical correlation: 0.95 Average spread: Jet fuel = HO + $0.15/gallon Spread range: +$0.05 to +$0.30

Hedge ratio adjustment:

Because jet fuel moves more than heating oil (beta > 1.0):

• Regression beta: 1.08
• Adjusted hedge: 1.08 × 1,000,000 = 1,080,000 gallons of HO futures

HO contract: 42,000 gallons Contracts needed: 1,080,000 ÷ 42,000 = 26 contracts

Scenario analysis over 3 months:

P/L breakdown (Month 3 settlement):

Analysis: The hedge locked in roughly $2.50 + $0.15 = $2.65/gallon equivalent. Actual cost was $2.48, so the hedge created an opportunity cost of $0.17/gallon. But if jet fuel had spiked to $3.00, the hedge would have saved significant money.

Cross-hedge effectiveness: The $65,000 loss represents basis risk—the jet fuel-heating oil spread moved slightly against the hedger. This is the cost of cross-hedging when no perfect hedge exists.

Risks, Limitations, and Tradeoffs

Basis Volatility Can Exceed Price Volatility

In some markets, basis is more volatile than outright prices:

• Regional supply disruptions
• Transportation bottlenecks
• Quality premiums during shortages

A "perfect" hedge on price may still produce significant P/L from basis swings.

Basis History May Not Predict Future

Historical basis relationships can shift due to:

• Infrastructure changes (new pipelines, storage)
• Regulatory changes (environmental specs)
• Supply source shifts (shale oil, imports)
• Demand pattern changes

Cross-Hedge Correlation Breakdown

Cross-hedges depend on stable correlations. During market stress:

• Correlations often break down
• Cross-hedge performance deteriorates
• Basis risk amplifies losses

Geographic Basis Traps

Location basis can move dramatically:

• Regional supply disruptions
• Logistics constraints
• Local demand spikes

A hedge in Cushing crude doesn't protect against basis blowout at a Midland, Texas delivery point.

Common Pitfalls

1. Ignoring basis in hedge design: Hedging notional exposure without considering local basis understates risk.

2. Assuming constant basis: Historical average basis doesn't account for basis volatility.

3. Mismatching hedge timing: Rolling futures that don't align with physical exposure timing creates roll-adjusted basis risk.

4. Over-relying on correlation: 0.95 correlation still leaves 5% unexplained variance—significant for large positions.

5. Not monitoring basis: Basis changes during the hedge period require attention and possible adjustment.

Checklist for Basis Risk Management

• Identify local cash market and relevant futures contract
• Calculate historical basis average and range
• Assess basis volatility relative to outright price volatility
• Determine if cross-hedge is needed (and correlation)
• Adjust hedge ratio for beta if cross-hedging
• Match futures expiration to physical timing
• Monitor basis during hedge holding period
• Set basis triggers for hedge adjustment
• Document basis assumptions in hedge rationale
• Review hedge effectiveness post-execution

Next Steps

To compare capital efficiency across hedge instruments, see Margin Efficiency vs. ETFs or Swaps.

For seasonal patterns affecting basis, review Seasonality Considerations in Futures Markets.