What Is ‘Basis Risk’ and How Does the Exercise Style Affect It?

Basis risk is the risk that the price of the hedging instrument (e.g. an option on a future) does not perfectly correlate with the price of the underlying asset being hedged. The exercise style does not directly cause basis risk, but the fixed expiration of European options allows hedgers to plan for the risk better.

Early exercise of an American option could unexpectedly alter the hedge ratio, complicating basis risk management.