Basis Risk

Basis risk refers to the risk that arises when the price of a hedging instrument does not move perfectly in line with the price of the underlying asset it is intended to hedge. This discrepancy, known as the "basis," can lead to imperfect hedges, where the gains or losses on the hedging instrument do not completely offset the losses or gains on the underlying asset. Basis risk is common in futures contracts and other derivatives used for hedging purposes.

Example

A farmer uses corn futures to hedge against a drop in corn prices. If the futures price does not exactly match the spot price of corn when the contract expires, the farmer may face basis risk.