How Does Basis Risk Affect the Effectiveness of a Futures Hedge?

Basis risk is the potential for loss that arises when the price of the asset being hedged (spot price) and the price of the hedging instrument (futures price) do not move perfectly in tandem. The basis is the difference between these two prices.

If the basis widens or narrows unexpectedly between the time the hedge is initiated and when it is lifted, the gain or loss on the futures contract may not exactly offset the loss or gain on the spot position. This imperfection reduces the hedge's effectiveness.