How Does the Concept of “Basis Risk” Relate to Using Cash-Settled Futures for Hedging?

Basis risk is the risk that the price of the asset being hedged (the spot price) will not move perfectly in tandem with the price of the futures contract used for the hedge. Since cash-settled futures settle against a specific index or benchmark, basis risk arises if the hedger's specific underlying asset price diverges from that benchmark.

This imperfect correlation means the hedge may not fully offset the spot market loss or gain, leading to residual risk.