Basis risk is very important in commodity trading. It means the risk that the difference between the spot price (current market price) and futures price of a commodity changes in an unexpected way. Traders use futures contracts to protect themselves from price changes. But because the spot and futures prices don’t always move together, this difference called basis can cause unexpected gains or losses.
What is Basis in Commodity Trading?
Basis is the difference between the spot price and futures price of a commodity. For example, if the spot price of wheat is ₹2000 per quintal and futures price is ₹2050, then basis is -₹50. This difference changes every day due to many reasons. Knowing the basis helps traders understand how futures prices relate to real market prices.
Why Does Basis Risk Happen?
Basis risk happens because futures and spot prices do not always move in the same way. Factors like storage costs, transportation, supply and demand changes, interest rates, and seasons can change this difference. For example, if the demand for oil futures increases due to a global event but the physical oil supply stays the same, futures and spot prices may move differently.
How Does Basis Risk Affect Hedging?
Hedging is done by producers or buyers to fix a price and avoid loss from price changes. But if basis risk happens, the hedge may not work well. For example, a farmer selling wheat futures before harvest may still lose money if the spot price falls but futures price doesn’t fall as expected. This makes basis risk a key challenge in hedging.
Can Basis Risk Cause Losses?
Yes, basis risk can cause losses even when futures contracts are used to protect against price changes. Because futures and spot prices may not move exactly opposite, a trader can still face loss. So, understanding basis risk is very important before making trading or hedging decisions.
How to Measure Basis Risk?
Traders study historical data of spot and futures prices to measure basis risk. They use tools like correlation and standard deviation to see how much the basis changes. This helps them decide how much to hedge and plan their trades better to avoid surprises.
Examples of Basis Risk in Commodities
One example is a wheat farmer who sells futures contracts before harvest. If the spot price falls due to bad weather but futures prices stay the same, the farmer will face losses because the hedge didn't protect fully. Another example is oil traders facing different movements in spot and futures prices due to global events.
Ways to Reduce Basis Risk
You can reduce basis risk by:
- Choosing futures contracts close to your actual commodity.
- Timing your hedge close to delivery or sale.
- Shortening the hedging period.
- Regularly tracking basis changes and adjusting trades.
Is Basis Risk Only a Hedger's Problem?
No, basis risk affects both hedgers and speculators. Hedgers use futures to avoid losses, and speculators try to make profits from price moves. Both need to understand basis risk because it can affect profits and losses.
Why Indian Traders Must Know Basis Risk?
India's commodity markets are growing fast. Factors like local supply, weather, and global changes affect spot and futures prices differently. Indian traders who understand basis risk can protect themselves better and trade smartly. Ignoring it may cause losses.
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