Effect of increase or decrease in basis on a short and long hed

ashishsinha
Good Student
Posts: 12
Joined: Mon Jul 01, 2013 5:45 pm

Effect of increase/decrease in basis on a short and long hed

Postby ashishsinha » Fri Nov 22, 2013 3:32 pm

In sentence 2 para 3 page 47 of FMP book (Garp core reading) it says that if the basis strengths (i.e., increases) unexpectedly, the hedger's position improves(in a short hedge); if the basis weakens (i.e.,decreases) unexpectedly, the hedger's position worsens.For a long hedge, if the basis strengthens unexpectedly, the hedger's position worsens; if the basis weakens unexpectedly, the hedger's position improves.

I think the reverse should be true.If sb is short his position will worsen if the basis increases (i.e., difference between Spot and Future price goes up),b'coz without hedge he could have sold his stuff at a higher price than he can with hedge.Hedge will in fact offset the profit made by him on a/c of higher spot price. Same will happen with the other 3 cases i.e., in a short hedge when the basis weakens and in a long hedge when the basis strengthens and weakens.

Please tell me whether i am right or wrong.

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shreyas
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Joined: Thu Jul 19, 2012 6:49 pm

Effect of increase/decrease in basis on a short and long hed

Postby shreyas » Wed Nov 27, 2013 1:29 pm

The paragraph discussed is correct in all aspects and to make it more meaningful it discusses about a hedger's position and the rewards he will receive based on the basis risk he faces. So your statement regarding the without hedge position cannot be considered in this scenario, since this is a totally a different situation.

If you look at the example in the core reading where the basis (b2) is $0.1. Had the basis been 0 which means the futures priced at $2 then the profit on short position would be only $0.2 instead of $0.3, which is nothing but weakening of the basis.


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