Question

What is basis risk? What is cross-hedging? Please explain your answers.

Answer 1

Basis risk is defined as the difference between the spot price minus the future price of the underlying instrument.

Basis risk arises about the uncertainty of the future price when hedge is closed out.

Basis = Spot - forward price

Cross hedging reference to hedging using futures of two different assets but with similar price moments or same correlation of returns.

Foe example - you are a jeweller and you need raw gold at a particular point in time in future, so in order to hedge the same he buys gold futures but the same amount of gold futures aren't available so he buys platinum futures which have the same price moment.

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