Explain what is meant by basis

Explain what is meant by basis risk whenfutures contracts are used for hedging. Next, make a comparativeanalysis between basis risk in futures contracts and creditrisk in forward contracts. Last, compare theliquidity issue in futures and forwardcontracts.


Basis risk whenfuture contracts are used:

Basis risk is a risk that arises as a result of hedger’suncertainty as a result of difference between spot price &futures price at the time of expiration of the hedge.

Basis risk infutures contract & credit risk in forwardcontracts:

Basis risk is the risk that is inbuilt in the futures market.Hedge positions are generally not perfect because of this risk. Thecommon emphasis is that basic risk eliminates all kind of risks.Brosen in 1995 finds that in case of fluctuations in basis risk, itcan make forwards the cheapest in some times & futures to becheapest in other time periods.

Hence the benefit of hedging can be made utilized when there isproper understanding of the market position.

Credit risk in forwards:

Credit risk is a risk that arises when the counterparty owinggreater money is unable to make the payment at the time ofexpiration r declares bankruptcy prior to expiration.

The market value of a forward contract is a measure of netamount that one party owes the other. The party owing the lessermoney faces the credit risk any time; this is because the marketposition can change any time making positive as negative. The otherparty will also face the risk at a later date.

Counter parties usually mark forward contracts to the marketwith one party paying the other the current market value. Thecontract is then repriced to the current market price or rate.Marking to market is the concept that helps one party from becominghighly debited to the other without paying up.

Liquidity issuesin futures & forwards:

Generally speaking, it is easy to buy & sell futures in theexchanges. But it is difficult to find counterparty over thecontract to trade on forwards that are non standard. The volume oftransactions on an exchange is higher than OTC derivatives as aresult of which future contracts tend to be more liquid.

The forward contracts are illiquid & future contracts areliquid. This is because it is difficult to find a buyer for theforward contracts. The other fact is that future contracts are ofstandardized nature meaning it has a specified amount to be bought& sold on a specified date or at a specified price. Thisstandardization helps the futures to be easily traded & ensureliquidity.

Flexibility on the other hand leads to less trading of contractsin the market making it illiquid. Hence forwards are illiquid &futures are said to be liquid.

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