Chapter 4 of 8

Hedging and basis risk

Study how an offsetting contract can reduce one exposure while introducing mismatch, timing and funding risks.

3 min read · Original educational chapter

In this chapter

Begin with an existing exposure
Matching is rarely perfect
Economic protection can create funding pressure
Decision lab: A hedge is defined against a business exposure
Worked example
Common mistakes
Check your understanding

Begin with an existing exposure #

A hedge is intended to offset a risk already present in an asset, liability or future commercial transaction. Selling futures against an asset whose value falls when prices fall can reduce one source of uncertainty. A business needing to buy an input later faces the opposite concern.

The hedge should identify the quantity, date, price reference and cash-flow problem being addressed. A position taken without an underlying exposure is not automatically a hedge merely because it uses a contract commonly used by hedgers.

Matching is rarely perfect #

A hedge can mismatch the underlying asset, location, quality, currency, maturity or sensitivity. The remaining difference is basis risk. An equity index future, for example, need not move identically with a particular portfolio. An estimated hedge ratio depends on data and assumptions.

Contract granularity also matters. If a business needs 230 units and each contract represents 100, two contracts leave 30 units unhedged while three overhedge by 70. Choosing either has consequences; the nearest whole number is not a universally correct answer.

Economic protection can create funding pressure #

An offsetting future can gain when the business exposure loses value, but its settlement cash flows may arrive on different dates from the commercial cash flows. A hedge that looks stable in final value can still require interim liquidity.

Hedging also gives up favorable movements in the risk being offset. Evaluate the goal as reducing specified uncertainty rather than maximizing a speculative return. Operational capacity to fund, roll and settle the hedge is part of its design.

Decision lab: A hedge is defined against a business exposure #

A commercial exposure with a different grade, location, timing or quantity than the futures contract retains basis risk. Matching the number of contracts without defining the underlying liability can overhedge instead of reduce uncertainty.

Specify the actual quantity, cash-flow date and price benchmark before choosing hedge units. Calculate two scenarios with the same futures move but different commercial-price moves. Separate the combined economic result from the interim cash requirement on the derivative leg.

Hypothetical worked example

A hedge offsets a move but not every mismatch

A fictional business expects to sell 200 units of a commodity later. It sells two futures contracts of 100 units at 500. If the matching cash price and future both fall to 470, sale proceeds decline ₹6,000 while the futures gain is ₹6,000 before costs.

If the actual local cash price falls to 460 but the future settles at 470, the cash decline is ₹8,000 and the hedge gain remains ₹6,000. The residual ₹2,000 loss illustrates basis risk.

No actual contract or hedge ratio is recommended. The example isolates why an offsetting direction is not the same as an exact match.

Common mistakes

Calling an unrelated speculative position a hedge.
Ignoring the cash dates of margin and commercial settlement.

Check your understanding

What is basis risk in a hedge?

Make this chapter useful

Can you defend the reasoning?

Before moving on, answer the self-check in your own words and write why each alternative fails. Use the worked example to test that explanation. Then apply it in the module research task; keep the assumptions and the evidence that could change your answer.

Sources and further reading

Further-reading references from the curriculum source list. Contract sizes, expiry calendars, settlement references, margin parameters and tax treatment can change; verify the current operative documents for the actual product. Worked figures are illustrative, not current quotes.

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General financial education. No securities recommendation, assured outcome or personal advice. Read the risk disclosures.