Managing Basis Risk – Problem or Opportunity?

When the Lord gave us Hedging as the answer to the industrialist’s prayer to save him from risk, there was no promise made that we would be saved from thinking, or making market judgements. Commercial prices and their hedge instruments almost always leave some daylight between them, called basis risk. It’s a common challenge for most hedgers and caused by a derivative price that does not move in lock step with the price of the physical exposure being hedged. Not all risks are created equal however. Challenges to some can be opportunities to others and this risk, in our experience, presents such a contradiction for players in the physical world like processors and traders. If your business is wrestling with what to do about basis risk here are seven considerations that you should bear in mind:

1. Financial contracts used for hedging are homogeneous and regulated whereas commercial transactions are spontaneous and diverse. The physical world is complicated by diverse locations, different qualities and changing schedules. Imperfect correlation in both prices and timing inevitably results – just be grateful your risk is reduced from 100% to 1% by the ability to hedge the underlying volatility.

2. A simple example of basis risk is when a US aluminum ingot maker buys scrap at 2-4 cents under LME and sells ingot at 4-6 cents over LME. If he hedges his transactions his basis spread is 6-10 cents, a 4 cent risk. The variance in this spread, the risk, can often eliminate, or double the profit from conversion.

3. You must understand the economic causes of basis variance. If the commercial and hedge products are technically the same, as with LME and COMEX metals, what is the delivery cost difference (the arbitrage) between exchange warehouse and commercial delivery point? What are the market factors that govern the price spread between the date of the spot or forward commercial price and the closest hedge settlement date? Where commercial products and exchange contracts are different, for example crude oil and jet fuel, what are the conversion costs? Government regulations and transportation or storage blockages can also be factors.

4. Charts of basis spreads over time are always helpful but remember, in variable markets the past is not necessarily the key to the present – the tombstones of those chart followers who thought the spread between Brent and WTI crude would never exceed $1.50 per barrel bear witness to this.

5. For a fully hedged trader or processor, buying at a low basis spread and selling at a high basis spread – provided you hedge both – is a consistent low risk supplement to the bottom line – so long as no black swan event intervenes to blow out or invert the basis spread.

6. Furthermore, basis trading often enhances deals for your non-hedging counterparts – when exchange prices shoot up you can offer your supplier a better price and hedge at a better price still. Likewise, in reverse, when you sell to a customer. Good for both of you.

7. Remember commercial products and hedging exchanges have differences other than price points – in particular, cash flow requirements better known as margin calls. It is no good locking in maximum basis spreads from your hedges if you don’t keep track of and recognize the costs of your cash flow obligations.

If this sounds complicated, as well as potentially profitable, it is. One thing is for sure though. No matter what your intention, to effectively manage basis risk you need thorough understanding, well-considered policies, sound controls and internal visibility – and, if you need help in setting it all up, you know where to come.

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