01 Jan 2001, Energy Risk glossary , Energy Risk
Basis risk is the risk that the value of a futures contract (or an over-the-counter (OTC) hedge) will not move in line with that of the underlying exposure. Alternatively, it is the risk that the cash futures spread will widen or narrow between the times at which a hedge position is implemented and liquidated.
There are various types of basis risk. For example, a heating-oil wholesaler selling its product in Baltimore will be exposed to basis risk if it hedges using New York Harbor heating oil futures contracts listed by Nymex. This is a ‘locational’ basis risk.
Other forms of basis risk include ‘product’ basis, arising from mismatches in type or quality of hedge and underlying (for example, hedging jet fuel with heating oil); and ‘time’ or ‘calendar’ basis (for example, hedging an exposure to physical prices in December with a January futures contract).