Broadly, basis risk is the risk that the value of a futures contract or an over-the-counter hedge will not perfectly offset an underlying position. The sources of this risk can vary – relating to differences in timing or product that may only become meaningful under certain conditions. For example, credit default swaps (CDSs) are often used to hedge the changes in the credit quality of a bond. But CDS prices may not perfectly track changes in the price of the bond. Other examples abound: interest futures are often used to hedge interest rate swaps, while indexes are used to hedge single securities or baskets. In most cases, this kind of basis risk is taken deliberately, because the imperfect hedge is cheaper, more liquid or more convenient. In others, market participants may be blind to a basis that suddenly explodes, as was the case in 2015 when a pricing difference appeared in identical interest rate swaps, depending on where they were cleared – known as CCP basis.
BASIS RISK
