Are you a newbie in the sector of the investment industry? Do you want to know some of the crucial investment-related risks? Are you looking for a complete guide on what is hedge and basis risk?
You are not in the right place. Here I will give you detailed information about the hedge and what is basis risk. Here you will get all the necessary pieces of information that you need in order to make your investment-related knowledge more apt.
First, we will get the knowledge about what hedge is, and then we will move deeper into the basis risk along with the basic meaning.
What Is Hedge?
In simple words, you can consider a hedge as an investment, which is made with the intention of eliminating or at least reducing the risk of adverse price movements in a particular asset.
Generally, a hedge includes taking an offsetting, or in another way, opposite position in a related security. So, in shorts here are the crucial points of the hedge.
- Hedging is a strategy in order to limit risks in financial assets.
- Famous hedging techniques often include going for offsetting positions in derivatives which also correspond to an already existing position.
- Via other means, such as diversification, other kinds of hedges also can be constructed. Investing both in the counter-cyclical and cyclical stocks is an example you can take.
How Does A Hedge Work?
We all know about insurance policies; hedging is more or less a bit similar in function to taking out an insurance policy. In case you own a house in a flood area, you would like to protect it from flooding in order to hedge it.
In other words, you will go for flood insurance. Here, you can not prevent flooding, so what you can do is plan ahead of time to reduce the dangers that a flood can cause. This particular example is for that.
In hedging, there is a risk-reward tradeoff inherent. Apart from reducing the potential risk, it also takes aways potential gains. Hedging is not at all free. If we take the example of the previous flood insurance policy, you need to make the monthly payments.
And if the flood never happens, the policyholder will not get any payout. Still, people prefer to take that foreseeable, circumscribed loss in place of suddenly losing their roof over their heads.
In the same way, hedging works in the world of investment. Money managers and investors use these hedging practices to reduce control and controlling their exposures to risks. In the investment world, for appropriately hedging, one has to use various instruments in a specific strategic fashion in order to lower the risk of adverse price movements in the market.
If you are thinking, what is the best way to do this? Well, the answer is making another investment in a controlled and targeted way. In the space of investment, the hedging solution is more complex and, at the same time, an imperfect science.
A perfect hedge is capable of eliminating all risks in a portfolio or position. The hedge is correlated 100% inversely with the vulnerable assets. So, I hope you have already got that it is more of an ideal concept than an actual reality on the ground.
And still, the hypothetical perfect hedge is not without a cost. Here comes the basis risk, which refers to the specific risk that a hedge and an asset will never move in the opposite directions. Here, the ‘basis’ meaning is a discrepancy.
Hedging Through Diversification
When you use derivatives in order to hedge an investment, it enables precise risk calculation. On the other hand, it also requires a measure of sophistication along with quite a bit of capital often. However, order to hedge derivatives is not the only way.
In order to reduce certain risks, we also can consider strategically diverse a portfolio as a hedge. Let’s take an example, and you might invest in a company that deals with luxury goods with rising margins.
You must be worried that a recession can wipe out the market, especially for visible consumption. The only way to combat that will be buying tobacco stocks or utilities. These tend to weather recessions and also pay hefty dividends.
In case jobs are plentiful and the wages are also high, the market of luxury goods may thrive. But at the same time, there will be few investors who will be attracted to those counter striking stocks that are boring enough.
To more exciting places, it may fall as capital flows. Here, also, it has its own risks. And that is, no one can guarantee that the hedge and obviously the luxury goods stock will move in the opposite directions. Due to any catastrophic event, they both can drop.
And these events can happen due to some unrelated reasons or a financial crisis. For example, we can take the event of Mexico’s suspension of mining production, which happened due to covid 19. It also drove up the price of silver.
Moderate price declines in the index space are quite common. Apart from this, they are also highly unpredictable. Investors, who are focusing on this area, can be more concerned with all those moderate declines rather than the ones, which are more severe.
If the case is this, a common hedging strategy is a bear put spread. In this spread type, the index inverter generally purchases a put with a higher strike price. After that, the investor sells a put that has a lower strike price but with the same expiration date.
On the basis of the behavior of the index, the investor seems to have a specific degree of price protection. And this protection is equal to the difference between the two strike prices. Though it seems like a moderate amount of protection, it is often enough to cover a brief downturn in the specific index.
Risks Of Hedging
From the earlier discussion, we can think of hedging as a technique, which is utilized to reduce risks. But at the same time, we also need to keep in mind that almost all hedging practices will always contain their own downside.
First, hedging is imperfect and also does not guarantee any future success. It also does not ensure that any loss will be reduced. So, as an investor, you need to think of hedging considering both its pros and, of course, reduce control cons.
Hedging And The Everyday Investor
For almost every investor, in their financial activities, hedging will not come into action. At any point, there are some investors who are unlikely to trade a derivative contract. Some investors with a long-term strategy just like saving for retirement generally ignore the day-to-day fluctuations of any given security. This is one of the many reasons.
Here, short-term fluctuations are not seen as critical as the overall market investment is also likely to grow. For those investors, who normally fall into the buy-and-hold category, there might seem to be little or almost no reason for learning about hedging at all.
Still, large companies, along with investment funds, have a tendency to engage in hedging practices and that too on a regular basis. These investors also may follow or even actively be involved with all these larger financial entities.
Due to these two facts, it is always useful to have an understanding of hedging so that it will be better to comprehend and track the actions of all these larger players.
What Is Basis Risk?
The risk a trader, who is inherent takes at the time of hedging a position defines basis risk. And that is too by opting for a contrary position in a specific derivative of asset, like a futures contract. In an attempt to hedge away the price risk, basis risk is accepted.
As I have mentioned earlier, a hedging strategy is the one where the trader goes for a second market position and that too for minimizing the risk exposure in the initial market position. This strategy can include taking a future position in contradiction to the market position of one in the underlying asset.
For example, a trader may sell futures short in order to offset a long hedge purchase position in the specific underlying asset. The main motive behind this very strategy is that in the underlying asset position, a part of any potential loss will be offset by the particular profit, especially in the hedging with futures position.
Basis risk can affect the eventual losses or profits realized significantly, where large investments are surely involved. Even the slightest change in the basis is capable of making a difference between suffering a loss and banging a profit.
Here, between the cash and futures prices, there is an inherently imperfect correlation. It means both for excess losses and excess gains; there is potential. This very specific risk, which is related to a future hedging strategy, is very well a basic risk.
Components Of Basis Risk
In investments, risk can not be eliminated. However, we can at least reduce the risk. So, when a trader is entering into the futures contract for hedging against the possible price fluctuations, the investor is partly evolving the inherent price risk into another risk form.
This is known as basis risk. We can consider basis risk, a market, or systematic risk. The risk, which is arising from the markets’ inherent uncertainty is systematic risk. On the other hand, the risk that is associated with a specific investment is undoubtedly a non-systematic or unsystematic risk.
The high risk of a general economic depression is an example of systematic risk. At the same time, the risk that Apple might lose market share to a competitor is unsystematic risk. During the time the futures position is started and closed out, the spread among the short price and future s price may narrow or widen.
Types Of Basis Risks
Different types of basis risk include the following.
1. Price Basis Risk
When the prices of a particular asset and its futures contract do not shift in tandem with each other, this risk occurs.
2. Location Basis Risk
Suppose the underlying asset is located somewhere and is different from the location where the futures contract is traded. This is the scenario when this risk arises.
3. Basis Calendar Risk
The specific selling date of the spot market position may differ from the very expiry date of a futures market contract.
4. Product Quality Basis Risk
In case the quality or properties of the asset differ from the asset, which is represented by the futures contract, the product quality basis risk rises.
Frequently Asked Question (FAQs)
So, now I hope you get an overall idea about the hedge and also basis risk. Being an investor, I have been asked some questions. So, now as I am covering the topic basis risk, it will be better if I answer those questions which are related to this topic.
1. What Is The Basis For Trade?
In the whole space of futures trading, the trading strategies, which are built around the difference between the spot price and the futures contract’s price of a commodity, the basis for trade is. In futures trading, this difference is the basis. This is all about basis trading.
2. How To Get Rid Of Basis Risk?
The simplest way of reducing your exposure to basis risk is by entering into either supply or marketing agreements. You also need to make sure that the previous things are referring to a primary index or any one of the numerous liquid regional indices.
3. What Is The Basis Risk In Interest Rate Risk?
The risk of two benchmark rates, for example, Libor and BRB changing, which are related to one another, is the external reference basis risk. And here also a bank is exposed in case the bank has assets that are linked to one and liabilities to the other.
4. How Is Basis Risk Calculated?
As an investor, you need to take the current market price of the specific asset that is being hedged and, from it, subtract the futures price of the contract. Now, you will be able to quantify the amount of the basic risk.
So, this is all you need to know about basis risk and, of course, hedge. In 2021, it is really important to know all the minor details of the investment space. If you still have doubts, let me know in the comment box, or you also can directly write to me. I will try my best to come up with a reliable solution.