What Is Basis Risk in a Hedging Strategy?

Basis risk is the risk that the price of the asset being hedged (the spot asset) and the price of the derivative used to hedge it (the futures or forward contract) will not move perfectly in tandem. The 'basis' is the difference between the two prices.

If the basis widens or narrows unexpectedly, the hedge will not perfectly offset the risk, leading to a loss on the combined position. This risk is inherent when the derivative does not exactly match the underlying exposure.