Basic Risk

Basis risk refers to the situation where a futures contract is used to hedge an open position in the physical market. That is, if an investor owns a portfolio of Australian shares, they might choose to protect the value of their assets by shorting the futures market. I

If the futures market moves in an exact opposite direction to the physical (XJO), then the investor has protected the value of their portfolio. In this situation there is no 'basis risk', however generally the futures market and the physical will not move in an exact opposite direction, and this difference in correlation is referred to as 'basis risk'.

Imperfect Correlation

In short, any imperfect correlation between two investment hedging strategies has the potential to provide the trader with either excessive gains or losses. In practical terms, if a trader is hedging a trade and the hedge does not move in the exact reflection of the underlying instrument, a risk is evident. This is 'basis risk'. i.e. SPI (read futures) does not exactly equal XJO.

Readers might be wondering as to why the physical (XJO) and futures (SPI) don't move in an exact opposite direction. One of the main reasons is that at is core, the futures contract is very similar to the physical, but not exact. As a case example, an investor wants to potect their portfolio of Australian shares. This investor might choose the SPI200 as the futures contract to hedge their portfolio. The most obvious problem is that the investor's portfolio would have to hold the top 200 shares in the exact same weight as the XJO for the futures contract to accurately represent their portfolio.

Furthermore, even owning shares that exactly reflects the futures contract will fail to eliminate basis risk. The futures contract would still not provide a 100% perfect hedge against the physical. The reason for this is that the market makers and speculators dominate the markets. Their short-term directional drive will sway the futures contract away from an exact image of the physical. As such, 'basis risk' is something that cannot be diversified away.

• The futures and physical will never be 100% in correlation.This imperfection is called basis risk.
• Basis risk is something that cannot be diversified away.

Example

The charts below contain the intra day price movements of the XJO and the SPI 200. Notice that while they do generally move in a similar fashion, the movement isn't 100%. The futures chart (lower chart) is a lot more volatile than the physical.

The XJO

The SPI 200