How Does Basis Risk Affect the Effectiveness of a Hedge Using Cash-Settled Futures?
Basis risk is the risk that the price of the futures contract and the price of the underlying asset (spot price) do not move perfectly in tandem. Basis is defined as the spot price minus the futures price.
If the basis changes unexpectedly between the time the hedge is placed and when it is lifted, the gain or loss on the futures position will not exactly offset the loss or gain on the spot position. This imperfection reduces the hedge's effectiveness.
