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  • Differential risk or basis risk

     
     
    When there is a lack of correlation between the movements of the futures price and the cash price, that is they move in opposite directions or one rises/falls more than the other, then hedging serves only to reduce risk rather than eliminate it altogether, and traders and exporters may therefore be exposed to differential risk or basis risk. If prices in the physical and futures markets have not moved in parallel, the trader makes either a residual capital gain or a loss, depending on the way the prices have spread or the basis has changed. For example, prime washed Guatemalan coffee beans for April shipment might be quoted at 3 cents (the differential) over the New York May future, in which case the basis would be expressed as 'three over'.

    Even if there is no change in the market as a whole, the trader who bought at three over may find they can only obtain one over when they sell the physicals, for example because of greater selling pressure from the origin in question. Their basis has changed and they lose 2 cents per pound: this is the differential risk that cannot be offset. The price risk is that the market falls as a whole: this can be offset or hedged. Of course hedging is not entirely risk free but it does reduce the potential losses that can result from sharp market fluctuations.

    The differential can also move in the other direction, of course, meaning that three over could become four over, thus adding another cent of profit. Either way, the differential or basis risk must always be considered separately from the primary risk management concern, the price risk.
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