Glossary
Basis Risk
Basis risk is the risk that a hedge does not move exactly in line with the exposure it is meant to protect, leaving a residual gain or loss. It arises when the hedge references a different index, asset, location, timing or trigger than the underlying risk.
Formula
Example
A company has a $10,000,000 floating rate loan priced at Index A plus 3.00% and hedges it with a swap that pays Index B. If Index A rises 1.00% but Index B rises only 0.75%, annual interest increases by $100,000 while the hedge offsets $75,000. The remaining $25,000 of unhedged cost is basis risk, which persists for as long as the two indexes diverge.
How it is used in underwriting
Basis risk appears across underwriting. In lending, borrowers and lenders may hedge loans with derivatives tied to a different benchmark, tenor or reset date than the loan, and the mismatch affects coverage ratios. Banks face basis risk when assets and liabilities reprice off different indexes. In insurance, parametric and index-based covers pay based on a measured trigger, such as wind speed or an industry loss index, rather than the policyholder's actual loss, so payouts may be larger or smaller than the real damage. Commodity producers hedging with futures on a different grade or delivery location face similar mismatches.
Underwriters should identify the source of basis, estimate how far the hedge and exposure have diverged historically, and stress that divergence. A hedge with low cost and high liquidity may carry more basis risk than a customized one, and the tradeoff should be explicit. Basis risk is often ignored because the hedge appears to match the exposure on paper. For lenders relying on a borrower's hedge to support DSCR, the question is whether the hedge actually covers the loan's index, term and notional amount through maturity, including any amortization and extensions.
Frequently asked questions
What causes basis risk?
Basis risk is caused by differences between a hedge and the underlying exposure, such as different reference indexes, assets of different quality or location, mismatched timing or reset dates, or index-based triggers that do not track actual losses. Any of these can cause the hedge to gain or lose a different amount than the exposure.
How does basis risk affect parametric insurance?
Parametric insurance pays when a measured event, such as earthquake magnitude or rainfall, crosses a threshold, rather than on actual loss. A policyholder may suffer damage without a payout if the trigger is not met, or receive a payout larger than the loss. That gap between trigger and real loss is basis risk.
Can basis risk be eliminated?
Basis risk can be reduced but rarely eliminated. Using hedges that reference the same index, tenor and notional as the exposure minimizes it, but customized hedges cost more and may be less liquid. Most hedgers accept some basis risk in exchange for lower cost and simpler execution, and monitor it over time.
Related terms
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