basis risk
The risk that the value of a hedge will not move perfectly in opposition to the asset being hedged, creating residual risk from the imperfect correlation.
Example
“The airline's jet fuel hedge had basis risk — crude oil futures didn't move exactly with jet fuel prices.”
Memory Tip
BASIS RISK = your hedge isn't perfect. The thing you're hedging and your hedge don't move identically.
Why It Matters
Understanding basis risk helps you recognize that even when you try to protect yourself financially through hedging strategies, you may still face losses from imperfect protection. This matters because it explains why insurance, protective investments, or other risk management tools do not always work exactly as intended, which affects your overall financial security.
Common Misconception
Many people believe that if they hedge a financial position, they have completely eliminated all risk from that investment. In reality, basis risk means there will almost always be some leftover exposure because the hedge and the original asset rarely move in perfect lockstep, leaving you with some unprotected downside.
In Practice
Suppose you own a wheat farm and sell wheat futures contracts to lock in a price of $5 per bushel for your harvest. If your local market price only drops to $4.80 per bushel while futures drop to $4.50, you will not fully recoup your losses from the futures gain because the local price did not fall as much as the futures price. This difference in price movements represents your basis risk in this hedging scenario.
Etymology
BASIS (the spread between spot and futures price) RISK. RISK from the imperfect BASIS (correlation) between hedged positions.
Common Misspellings
Protect your assets with the right insurance
Related Terms
More in risk management
Other risk management terms you should know
Need financial definitions?
Clear definitions for 2,500+ finance, insurance, and investing terms.