A hedge offsets the loss on the hedged item with the gain or loss on a commodity or index used as the hedge. If the two do not move together, part of the loss is left uncancelled. In commodity futures, the term refers to the risk that the basis, the difference between the spot price of the physical commodity and the futures price, widens or narrows unexpectedly between the time the hedge is placed and the time it is lifted1. The same term is used where an index does not track the actual loss or holding from the start, as in weather, freight, property, and longevity2345.

Consider a hypothetical example in which a farmer uses a weather derivative to prepare for a loss of 10 million yen from a cool summer, with the payout capped at 8 million yen. Even if the loss reaches 10 million yen, the payout stops at 8 million yen, so 2 million yen remains. Even in a year with no loss, the farmer can still receive a payout if the index meets the contract condition. A paper describes this as a payout being made without actual damage once the condition is met6. The gap that remains does not always work against the hedger.

Matching the contract terms does not remove the gap entirely. The sources cite vessel specifications and routes for FFAs, the uniqueness of each property and the frequency of index publication for property, and the difference between a fund's pensioners and the index population for longevity swaps345.

Notes

  1. CFTC, "CFTC Glossary", entries "Basis" and "Basis Risk" ("unexpected widening or narrowing of the basis between the time a hedge position is established and the time that it is lifted"). ↩

  2. Ministry of the Environment (Japan), "保険会社（株式会社損害保険ジャパン）へのヒアリング結果要旨" (Summary of hearing with an insurer (Sompo Japan), in Japanese), page 1 ("補償金と実際の損害額とにギャップが生じるリスク（ベーシスリスク）", the risk of a gap between the payout and the actual loss (basis risk)). ↩

  3. Adland and Alizadeh, "Explaining price differences between physical and derivative freight contracts" (2018), page 3 (introduction; lists differing vessel specifications and trading patterns). ↩ ↩2

  4. Real Estate Derivatives Study Group, "不動産デリバティブ研究会報告書" (Report of the Real Estate Derivatives Study Group, in Japanese; June 2007), footnote 30 ("原資産価格とデリバティブ価格が乖離するリスク", the risk that the underlying price and the derivative price diverge; caused by differing observation and publication frequencies and by the individuality of properties). ↩ ↩2

  5. Society of Actuaries, "Managing Longevity Risk: A Solution to Consider" (February 2023), "How a Longevity Swap Works" (index-based longevity swaps carry a greater degree of basis risk due to differences between the actual and index populations). ↩ ↩2

  6. 横内絢子, "農業経営における天候リスクマネジメント技術導入手法" (Introducing weather risk management techniques in agricultural management), 農業情報研究 vol. 16, no. 4 (2007), page 228 ("ヘッジ不完全", insufficient hedge, and "オーバーヘッジ", over-hedge) (in Japanese). ↩