Explain the Concept of “Basis Risk” in Hedging with Futures Contracts

Basis risk is the risk that the price of the asset being hedged and the price of the futures contract used for the hedge will not move in perfect lockstep. The "basis" is the difference between the spot price of the asset and the futures price.

Basis risk arises because the basis may change unexpectedly between the time the hedge is placed and when it is lifted. This imperfect correlation can lead to the hedge not fully offsetting the loss in the underlying position, resulting in residual risk.