Understanding Basis Risk

by | Sep 25, 2014

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Understanding basis risk gives valuable insights into how fund managers seek to manage the exposure of their investments, says Nick Samouilhan, multi asset manager at Aviva Investors 


 

 

deflationWhat is Basis Risk?

This is an expression that describes the mismatch between one type of asset, exposure to which is being managed, or hedged, and the asset bought in order to achieve this goal. The extent to which the two assets do not mirror each other is the “basis risk”.

Sometimes there is no basis risk at all. Thus a fund manager may be holding all the shares in the equity Index and can limit his exposure by buying a futures contract to sell the equity index. For the relatively small cost involved, the exposure has been hedged.

Much the same is true of a broad range of blue-chip equity indices in the US, Europe and elsewhere. But many types of exposure cannot be hedged in this straightforward way.

One example is exposure to smaller UK companies. Yes, there is a futures contract in these shares, but it is very illiquid. That means a manager would probably choose a UK larger-companies futures contract, which is very liquid but is also an imperfect fit when managing exposure to smaller companies.

 

How is Basis Risk Worked Out?

Basis risk can be measured as the extent to which the hedge assets do not perform in the same way as the original assets. This is known as “correlation”.

Suppose a fund manager has a position in Chinese equities. There isn’t really a futures contract available in Chinese equities, so they are going to have to look for a substitute – and that means, inevitably, taking on some basis risk.

Let us suppose the fund manager buys a futures contract in large-cap UK companies. The correlation there is about 60 per cent, meaning basis risk is 40 per cent.

 

No Such Thing as a Free Lunch

Here is another example. After the 2007-2008 financial crisis, a lot of investors wanted to know how they could guard against that sort of shock event in future. One way, of course, is simply to buy a “put” contract on the stock market. But the trouble here is that, if you assume that markets tend to rise over time, you end up leaking money.

So a different solution was hit upon – to hedge against market volatility, either up or down. Contracts were sold that were tied to the Volatility Index (VIX), which measures volatility in the Standard & Poor’s 500. VIX futures are much cheaper to buy than “puts”, but the fund manager would be taking on quite significant basis risk.

That is because the correlation between volatility and market losses is far from being one-to-one. It is possible to lose money without markets being especially volatile.

Major investment banks will put together “mirror” hedge positions in which there is no basis risk, for the simple reason that they have taken the risk on their own books. Whatever the client wants hedging – whether North London property or more exotic investments – will be hedged.

But the catch is that the price is high and only the wealthiest investors can afford to pay it. For the great majority of investors, basis risk is a fact of financial life

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