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FRM-1 Study Notes

Hedging in a practical world (Basis Risk)

  • Not always does the futures contract date be the same as the date the asset is to be bought or sold.
  • What if the farmer didn’t know when his corn produce would be ready for sale?
  • What if he doesn’t get a long contract that will close his position just one day before the closing of his short contract?
  • What if there is no contract for the type/grade of corn the farmer is selling?

This is basis risk

  • Basis = spot price of asset – futures price contract
    • Basis = 0 when spot price = futures price
    • b1 = S1 - F1 and b2 = S2 - F2
    • Farmer pay off when he sells his corn: S2 + F1 - F2 or F1 + b2
    • In a typical transaction, F1 is known but  b2 is not known at time
      t1 → b2 is the basis

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