Basis risk
Also written Basis risk (three sources) · Hedging mismatch risk · Residual hedge risk
The risk left over after hedging, because the exposure and the contract used to hedge it do not move identically — in size, in expiry date, or in what they are written on.
In plain language
A perfect hedge would move rupee for rupee against the exposure. Exchange-traded contracts cannot do that, because they are standardised — fixed lot size, fixed expiry, fixed underlying — and a real exposure is not.
Whatever the hedge fails to cancel is basis risk. It is the price of using a liquid, guaranteed, cheap instrument instead of a bespoke one.
The name comes from basis, the spot-minus-futures measure that tracks the gap; basis risk is the risk that the gap moves against you while the hedge is on.
How it works
The workbook identifies three distinct sources, and questions usually turn on which one is operating.
1. Amount. Contracts come in lots of Rs 2,00,000 face value. An exposure of Rs 9,00,000 needs 9,00,000 ÷ 2,00,000 = 4.5 contracts, and half a contract does not exist. Four leaves you under-hedged; five leaves you over-hedged, which is a fresh speculative position in the opposite direction.
2. Maturity. GOI bond derivatives expire on the last Thursday of the contract month. If the exposure matures on any other day, the hedge comes off before or after the risk does.
3. Underlying. The workbook's own examples: hedging a two-year GOI bond with 91-day T-bill futures; hedging a corporate bond portfolio with single GOI bond futures; hedging a floating-rate housing loan with an ETIRD contract whose reference rate has little correlation with it. Prices that are not the same price do not move by the same amount.
A fourth strand runs through all of them: current ETIRD contracts are cash settled, so there is a mismatch between when and at what price the contract is cancelled and when and at what price the underlying is actually traded.
On the sign convention — NISM defines basis as spot minus futures. When the futures price sits above spot, the basis is negative.
The formula
Basis = Spot price − Futures price (negative when futures trade above spot)
Contracts required = Exposure ÷ 2,00,000 (rounded: under-hedge or over-hedge)
The basis converges to zero at expiry, which is why a hedge held to the last Thursday behaves better than one lifted midway.
A worked example
The workbook's exposure: Rs 9,00,000 of face value to hedge, against a lot size of Rs 2,00,000. That is 4.5 contracts, and you must choose.
Suppose the bond then falls from Rs 100.00 to Rs 98.36 — the 1.64-point move from the workbook's own October 2021 illustration.
The cash position loses the same either way:
Rs 9,00,000 face × (100.00 − 98.36)/100 = Rs 14,760 lost
Hedged with 4 lots (under-hedged by Rs 1,00,000):
Futures gain = 1.64 × 4 × 2,000 = Rs 13,120
Net = 13,120 − 14,760 = −Rs 1,640
Hedged with 5 lots (over-hedged by Rs 1,00,000):
Futures gain = 1.64 × 5 × 2,000 = Rs 16,400
Net = 16,400 − 14,760 = +Rs 1,640
The residual is Rs 1,640 either way — exactly 1.64% of the Rs 1,00,000 that is unmatched. Under-hedging leaves you short of cover; over-hedging leaves you long a naked Rs 1 lakh short position, and it will cost Rs 1,640 rather than earn it if the bond rises instead.
Neither outcome is a mistake. Both are basis risk, and the only choice available is which side of it to sit on.
Why NISM asks about it
Chapter 5, section 5.7 (Limitation of Interest Rate Derivatives for Hedgers) states the maturity and underlying mismatches; Chapter 10, section 10.7.3 (Risks faced by investors trading in Exchange Traded Interest Rate Derivatives markets) gives the full three-source definition with the 4.5-contract arithmetic, alongside market, liquidity, leverage and execution risk. Chapter 10's risk disclosure list names "basis risk vis-à-vis spot prices/rates" as a required disclosure.
Questions ask you to identify the source of an imperfect hedge in a described scenario, to name under-hedging versus over-hedging, and to list what a Risk Disclosure Document must cover.
Common exam traps
- Basis risk is not basis. Basis is a measured number, spot minus futures; basis risk is the risk that it changes while you are hedged.
- NISM defines basis as spot − futures. So a futures price above spot gives a negative basis. Reversing the subtraction flips every sign in the answer.
- Over-hedging is not the safe option. Rounding up creates a naked position in the opposite direction — a new speculative exposure, not extra protection.
- The duration-based hedge ratio does not eliminate basis risk, and it underhedges for large yield moves because the price-yield relationship is convex, not linear.
- Cash settlement is a source of basis risk in its own right. The contract is cancelled at the settlement price; the bond is traded at whatever the market gives you, at a different moment.
- The clearing corporation's guarantee does nothing about this. A CCP removes counterparty credit risk. Basis risk is market risk and survives the guarantee untouched.
- Correlation is not the same as identity: 91-day T-bill futures and a two-year GOI bond both respond to rates, and still do not move together.
Where this is taught
- Series IV · Chapter 5: Strategies using Interest Rate Derivativesintroduced here
- Series XVI · Chapter 5: Uses of Commodity Derivativesintroduced here
- Series I · Chapter 10: Codes of Conduct and Investor Protection Measuresintroduced here
- Series V-D · Chapter 10: Risk, Return and Performance of Fundsintroduced here
- Series IV · Chapter 10: Code of Conduct and Investor Protection Measures
- Series V-D · Chapter 22: Strategies using Interest Rate Derivatives
Related terms
- HedgingTaking a derivative position that moves opposite to an exposure you already have, so gains on one offset losses on the other and the future rate is locked in at a known level.
- BasisThe difference between the spot price and the futures price of an asset — positive when spot exceeds futures, negative when futures exceeds spot, and zero at expiry.
- Cheapest-to-deliverThe bond in the deliverable basket that costs a futures seller least to deliver — and, because the seller chooses, the bond whose cash price the futures contract actually tracks.
- ConvexityThe curvature of the price-yield relationship — the correction duration misses, because duration is a straight line and the true relationship bends.
- Duration-based hedge ratioThe number of interest rate futures that drives a bond portfolio's duration to zero — portfolio modified duration times market value, divided by futures modified duration times futures price over par.
- HedgerA participant who already carries interest rate risk from a real business exposure and uses derivatives to remove it, rather than to take a view on the market.
- Imperfect hedgeA hedge that cannot fully offset an exposure because the contract is standardised — fixed lot sizes, a fixed expiry date and cash settlement leave a remainder the hedger keeps.
- Interest Rate FuturesA standardised exchange-traded contract to buy or sell a notional government security, or an interest rate itself, at a price agreed today for settlement on a future date.
- UnderhedgingHolding fewer futures than the exposure needs — the specific failure of a duration-based hedge in a large yield move, because duration draws a straight line through a curved relationship.
- Corporate Bond Index FuturesCash-settled futures on an index of corporate debt rated AA+ and above, permitted by SEBI in January 2023 to give the corporate bond market a hedge of its own.
- ArbitragerA participant who locks a profit by entering opposite transactions in two markets at once — carrying no exposure and taking no view, and in the process pulling the two prices back together.
- State Development LoanA dated security issued by a State Government or Union Territory. States borrow in the G-Sec market solely through dated securities; only the Centre also issues Treasury Bills.
- Risk transferThe economic function by which commodity price risk moves off the hedger, who does not want it, onto the speculator, who is willing to carry it for a return.
- Strengthening basisA change in basis (spot minus futures) towards a more positive or less negative number — spot rising relative to futures — which benefits a short hedger.
- Weakening basisA change in basis (spot minus futures) towards a less positive or more negative number — futures rising relative to spot — which benefits a long hedger.
- Retrospective effectiveness testingThe mandatory check, at each reporting date, that a designated hedge actually was highly effective — its results falling within 80 to 125 per cent — as a condition of continuing hedge accounting.
- Spread riskThe risk that a floating rate security loses value because its spread over the benchmark moves adversely, even though the benchmark yield itself has not changed.
- Expiry dateThe last trading day of a currency futures or options contract — for monthly contracts, two working days before the month's last business day; for weekly, every Friday — with trading stopping at 12.30 pm.
- Calendar spread tradingTaking opposite positions in two maturities of the same currency futures (or options) contract to trade the change in the spread between them, rather than the direction of the currency.
- Effective priceThe rate a hedger actually ends up with: the price realised or paid in the spot market, adjusted by the payoff on the hedge — added for a receiver, subtracted for a payer.
- Partial hedgeCovering only a fraction of an exposure with derivatives, leaving the rest open — so the effective rate is a weighted average of the hedged rate and the spot rate.
- Cross hedgeHedging an exposure with futures on a different but closely associated asset, because no futures contract exists on the asset itself — for example, hedging a stock portfolio with index futures.