How Does “Basis Risk” Relate to Cash-Settled Derivatives?

Basis risk is the risk that the price of the derivative contract does not perfectly track the price of the underlying asset or index, which is the "basis." In cash-settled derivatives, if the settlement price (the index) deviates significantly from the trader's exit price, the hedging effectiveness is reduced. This risk is inherent because the derivative is priced off a benchmark, not the specific spot price a trader might transact at.