Futures contracts are an essential tool used by traders and investors across the world. They are agreements that allow parties to buy or sell an asset at a predetermined price and time in the future. Futures contracts help to mitigate the risks associated with price fluctuations in commodities, stocks, and currencies.
However, even with futures contracts, there is still a risk that needs to be considered – basis risk. Basis risk occurs when there is a disparity between the price of a futures contract and the actual spot price of the underlying asset at the time of delivery.
This disparity can arise due to several factors, including changes in supply and demand, transportation costs, and weather conditions. When the basis between the futures contract and spot price widens, traders and investors can incur losses, which can be significant.
To understand basis risk, let`s take an example. Suppose that a farmer wants to sell a ton of wheat in six months` time. The farmer decides to sell a futures contract that agrees to sell the wheat at a price of $300 per ton in six months. However, at the time of delivery, the spot price of wheat has fallen to $280 per ton. In this scenario, the farmer will incur a loss of $20 per ton due to an increase in the basis.
Basis risk can be reduced by monitoring the market and identifying factors that could affect the basis. This could include analyzing the transportation costs, supply and demand, or weather patterns that could impact the underlying asset. By doing so, traders and investors can make informed decisions and manage their exposure to basis risk effectively.
In summary, basis risk is an important consideration for traders and investors using futures contracts to manage their exposure to price fluctuations in commodities, securities, or currencies. Understanding and mitigating this risk can help traders and investors limit their losses and maximize their profits.