Basis Risk
Definition
In general, basis risk is the risk that the price or rate of one instrument or position might not move exactly in line with the price or rate of another instrument or position which is being used to hedge it.
How is it used?
A trader’s position is often hedged with a related but different instrument. For example, when a trader sells a FRA to a customer and is not willing to leave this position open, he could simply close his position by buying an identical FRA from another bank. However, he might very well instead hedge the position by selling futures contracts. The advantage would be that, in developed markets, futures markets are generally very liquid and the bid/offer spread is very fine. The disadvantage would be that ...
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