Options, Futures, and Other Derivatives, 10th Edition

3.3 BASIS RISK

The hedges in the examples considered so far have been almost too good to be true. The hedger was able to identify the precise date in the future when an asset would be bought or sold. The hedger was then able to use futures contracts to remove almost all the risk arising from the price of the asset on that date. In practice, hedging is often not quite as straightforward as this. Some of the reasons are as follows:

1. The asset whose price is to be hedged may not be exactly the same as the asset underlying the futures contract.

2. There may be uncertainty as to the exact date when the asset will be bought or sold.

3. The hedge may require the futures contract to be closed out before its delivery month.

These problems give rise to what ...