Basis risk: when the hedge misses

Two things that nearly always move together come apart exactly when it matters — and nobody carries the difference but you.

This lesson has had no expert review. It was written for this platform and against the evidence it cites; nobody has gone through it independently.

Learning objectives

You can identify basis risk where it is reported as a hedge.
You can distinguish the three most common sources of divergence.
You can describe a hedge so the remaining difference stays visible.

Check your prior knowledge

Answer these for yourself before reading on. Wherever you hesitate is where this lesson pays off.

What does it mean to hedge a position?
Why is a deposit receipt not the same as the deposit?
What happens to two related prices when many exit at once?

Core concept

Fact

Hedged means swapped, not removed

Hedging a position against a related but not identical instrument does not remove the risk, it replaces it: instead of the full move you now carry the difference between the two moves. That difference is the basis. It is normally small, and its smallness is why it routinely drops out of view.

Fact

Three sources of divergence

First, the object: a receipt on a locked position is not the position. Second, the venue: the same asset has two prices at two venues, and under stress they diverge. Third, the time: a hedge with a fixed term covers one period, the position another. Each source creates a basis of its own, and they add up.

Risk

The basis grows when it is inconvenient

The awkward property of this difference is its correlation with need: while nothing happens the two prices run closely together. When many want out at once, the less liquid leg diverges more — which is precisely the one meant to carry the hedge. So a basis measured in calm periods systematically understates the basis under stress.

Assessment

It disappears easily in the reporting

In a line reading “position hedged” the basis is invisible. Three figures make it visible: what exactly the position was hedged with, how far the two prices diverged historically, and how far they diverged in the worst period observed. The third is the only one usable for a decision — and the only one usually missing.

Definitions

Basis: The difference between the price of the position and the price of the instrument hedging it.
Hedge: An offsetting position intended to compensate losses on the main position.
More liquid leg: The side of a pair that trades more easily — and therefore diverges less under stress.

Model

What exactly the position was hedged with — instrument and venue
Which of the three sources create a basis: object, venue, time
The basis in the worst period observed
The consequence in money, at the current position size

What a hedge line should look like — Without the third line the hedge describes only the calm case.

Formulas

Residual risk after hedging

residual = move_position - move_hedge

move_position: Price change of the hedged position
move_hedge: Price change of the hedging instrument

Limit: The difference is only measurable in hindsight. Estimated from calm periods it regularly understates the stress case — which is exactly where it is needed. A basis computed from a year without stress is a number missing the case it exists for.

Worked example

Hedged, and a 3.4 % loss anyway

Position: receipt on a locked deposit, USD 10m
Hedge: offsetting position in the underlying asset
Move in the underlying: −12.0 %
Move in the receipt: −15.4 %

Residual = −15.4 % − (−12.0 %) = −3.4 %. The hedge absorbed twelve of the fifteen percentage points; the remaining 3.4 points are the basis, here arising from the receipt's waiting period.

USD 340,000 lost on a position the report carried as hedged.

Reading: The hedge worked — just not completely, and that was known beforehand: a receipt on something locked cannot track the locked thing during a rush for the exit. The report line should have read: “hedged except for the basis between receipt and underlying; in the worst period observed it was X %.”

Retrieval

Nothing more — that is what a hedge is for.The difference between the two moves, that is the basis.The full market risk, because hedges do not work in DeFi.

Because it was computed from too few data points.Because the less liquid leg diverges more precisely when many want out at once.Because prices cannot be measured in calm periods.

Exercise on real data

Check which guiding questions compare two related prices — and which look at only one.

Dimension 1: market →

Application

A report contains the line “position fully hedged”. Rewrite it so it can be decided on.

Related case studies

Institutional reading

Bank: Which positions do you carry as hedged without reporting the basis?
Insurance: Does a policy cover the basis, or only the failure of the hedging instrument?
Asset management: Which period does the basis in your risk report come from?

Metrics in this lesson

Sigma (APY volatility)

Key takeaways

A hedge swaps the risk for the basis — it does not remove it.
The basis arises from object, venue and time, and the three add up.
Measured in a calm period, it understates exactly the case it is needed for.