Basis risk is the potential risk that arises from mismatches in a hedged position. Basis risk occurs when a hedge is imperfect, so that losses in an investment are not exactly offset by the hedge. Certain investments do not have good hedging instruments, making basis risk more of a concern than with others assets.
Basis risk is defined as the inherent risk a trader takes when hedging a position by taking a contrary position in a derivative of the asset, such as a futures contract. Basis risk is accepted in an attempt to hedge away price risk.
a) Price Basis Risk: This occurs when there is a difference between spot price and relative future price or they do not move in tandem during the start and end of trade. Example, gold futures price is not changing as much gold spot price.
Basis risk occurs when the expected value of a derivative instrument suddenly deviates from that of the underlying or hedged transaction. Basis risk may manifest when a derivative instrument references a price of an index that is similar but does not precisely match the underlying exposure.
Basis risk describes the impact of relative changes in interest rates for financial instruments that have similar tenors but are priced using different interest rate indices.
In other words, when a variation exists between the futures or hedge price and the spot or cash price of the hedged underlying asset at any given time, the variation is the basis, and the associated risk is the basis risk. Thus, the basis is the relationship between an underlying asset's futures and cash prices.
To manage basis risk, proper analysis of market trends is important. For example, typically, the basis is large during the harvest time (the discount on the local market compared to the futures market is large), and narrows afterwards.
Risk is the combination of the probability of an event and its consequence. In general, this can be explained as: Risk = Likelihood × Impact.
Types of Risks
Widely, risks can be classified into three types: Business Risk, Non-Business Risk, and Financial Risk. Business Risk: These types of risks are taken by business enterprises themselves in order to maximize shareholder value and profits.
Unsystematic Risk – Asset-specific or company-specific uncertainty. Political/Regulatory Risk – The impact of political decisions and changes in regulation. Financial Risk – The capital structure of a company (degree of financial leverage or debt burden)
Most commonly used risk classifications include strategic, financial, operational, people, regulatory and finance.
The definition of a risk assessment is a systematic process of identifying hazards and evaluating any associated risks within a workplace, then implementing reasonable control measures to remove or reduce them.
Operational risk is the risk of loss as a result of ineffective or failed internal processes, people, systems, or external events which can disrupt the flow of business operations.
The fundamental risk factors in financial markets are the market parameters which determine the price of the financial instruments being traded. They include foreign currency exchange rates and the price of commodities and stocks and, of course, interest rates.
The two major types of risk are systematic risk and unsystematic risk. Systematic risk impacts everything. It is the general, broad risk assumed when investing. Unsystematic risk is more specific to a company, industry, or sector.
Risks are normally classified as time (schedule), cost (budget), and scope but they could also include client transformation relationship risks, contractual risks, technological risks, scope and complexity risks, environmental (corporate) risks, personnel risks, and client acceptance risks.
These risk categories can each be broken down on each level into financial risks, strategic risks, performance risks, and external risks.
Determine the probable value of each of the assets to the probable threat actors (asset target value calculation). ○ Likelihood = threat ranking × asset attractiveness × remaining vulnerabilities. Calculate the risk of attack: Risk = consequences × likelihood.
The risk score is the result of your analysis, calculated by multiplying the Risk Impact Rating by Risk Probability. It's the quantifiable number that allows key personnel to quickly and confidently make decisions regarding risks.
While it's nearly impossible for most companies to completely eliminate their exposure to basis risk, there are numerous ways to mitigate it.
The basic methods for risk management—avoidance, retention, sharing, transferring, and loss prevention and reduction—can apply to all facets of an individual's life and can pay off in the long run.