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Hedging with Futures and Basis Risk

A futures hedge rarely offsets the underlying exposure exactly, because the futures contract and the thing being hedged are never perfectly identical in location, grade, or timing — the leftover mismatch is basis risk, and it's what remains after the obvious risk is gone.

commoditieshedgingbasis-riskfuturesrisk-management

Prerequisites: Commodity Futures Basics, The Spot-Futures Basis in Commodities

An airline wants to hedge next quarter's jet fuel bill. There's no liquid jet fuel futures market, so it hedges with heating oil futures instead — a similar but different product. A wheat farmer in Kansas hedges with a futures contract that settles based on delivery in Chicago. In both cases the hedge removes most of the price risk, but not all of it, because the futures contract and the actual exposure are never exactly the same thing. What's left over after the obvious price risk is hedged away is basis risk — and in commodity hedging, it's rarely small enough to ignore.

Basis risk is the risk that the futures price and the price of what you're actually hedging don't move in lockstep, because they differ in location, grade, or delivery timing. A futures hedge that looks "fully hedged" on paper (equal and opposite notional) can still leave real, sometimes large, residual risk once the basis itself moves unexpectedly.

Where the mismatch comes from

The value of a hedged position at expiry depends on how much the basis — spot minus futures — has changed between putting the hedge on and taking it off, not on the price level itself:

Δ(hedged position)≈(S2−S1)−(F2−F1)=b2−b1\Delta(\text{hedged position}) \approx (S_2 - S_1) - (F_2 - F_1) = b_2 - b_1

In words: if the spot exposure and the futures move by exactly the same amount, the hedge is perfect and the basis change is zero. Any difference between how much spot moved and how much futures moved shows up directly as basis risk — profit or loss on the hedge that has nothing to do with getting the overall market direction right or wrong.

spot futures the gap between the lines is what remains after hedging
Spot and futures track each other loosely, not exactly — the wobble between them is the risk a hedge doesn't remove.

Worked example

The airline needs 1 million gallons of jet fuel and sells (goes long, to hedge a purchase) heating oil futures as a proxy, at $2.60/gallon. When it buys the actual jet fuel three months later, jet fuel spot has risen to $2.95/gallon while heating oil futures have only risen to $2.85/gallon — the two didn't move by identical amounts because they're genuinely different products with different supply and demand. The futures gain of $0.25/gallon partially offsets the $0.35/gallon rise in the airline's actual cost, leaving $0.10/gallon of basis risk unhedged — on 1 million gallons, a $100,000 shortfall the hedge was never able to close, purely because heating oil and jet fuel are correlated but not identical.

What this means in practice

Hedgers manage basis risk by choosing the futures contract with the highest historical correlation to their actual exposure, sizing the hedge with a regression-based hedge ratio rather than assuming one-to-one, and accepting that some residual risk is the price of using a liquid, standardized contract instead of a bespoke (and probably illiquid or nonexistent) one.

"Hedged" does not mean "riskless." A hedge that removes 90% of the price risk still leaves the other 10% live, and basis risk tends to widen exactly when markets are most stressed — the moments a hedge is supposed to matter most.

Related concepts

Practice in interviews

Probability →Mental Math →

Further reading

  • Hull, Options, Futures, and Other Derivatives (ch. 3)
  • Kolb & Overdahl, Futures, Options, and Swaps (ch. 4)
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