A hedge is supposed to gain exactly what the exposure loses. Basis risk is the gap when it does not. The basis is the difference between the price of the thing you hold and the price of the instrument you hedged with, and that difference moves on its own.
Where the gap comes from
A hedge and an exposure diverge along four axes: location, grade, timing, and quantity. The hedging instrument is standardized and liquid; the exposure is specific. The divergence between the prices of the underlying asset and the hedging instrument means complete protection is rarely guaranteed.
The split runs deeper between indemnity and index instruments. An indemnity contract pays your actual measured loss and carries little basis risk. An index or parametric instrument pays off a published number, so the payout can miss the actual loss in either direction: loss without payout, or payout without loss.
Cross-hedging jet fuel
There is no liquid jet-fuel futures market, so airlines hedge jet fuel with crude or refined-product futures. The proxy is not the same molecule. Over a two-year horizon, heating oil ran about 90% correlated with jet fuel and crude about 80%. The missing 10 to 20 points is basis risk, and it is not stable. The same study found heating oil works as a proxy out to roughly three months before the relationship decays, and that the crude-to-jet correlation was not constant across its sample.
Metallgesellschaft, 1993
A US subsidiary of Metallgesellschaft sold long-dated fixed-price oil contracts running up to ten years and hedged them with a stack of near-month futures, rolling each contract forward as it expired. The maturities did not match: a ten-year obligation hedged with one-month paper.
When oil flipped from backwardation to contango in late 1993, rolling forward turned from a small gain into a recurring cost, and the near-month long positions generated variation margin calls that the long-dated receivables could not fund. The board unwound the book at a loss near $1.3 billion. The underlying business case may have been sound over ten years. The timing basis broke it inside one, though whether the basis itself or the board’s decision to liquidate caused the loss is still disputed: Culp and Miller argued the hedge was coherent and the forced unwind, not the roll, destroyed the value.
Delivery-point basis
Even a same-commodity hedge carries location basis. US natural gas futures settle at the Henry Hub in Louisiana, but gas is consumed at a city-gate somewhere else. The basis is a traded geographical differential: the price gap between your delivery point and Henry Hub, and it widens when local supply and demand pull away from the national benchmark. Hedge the Hub and the local spread still floats.
Try it
Roughly an hour. Pull two daily price series from EIA’s free data API or its spot-price spreadsheets: US Gulf Coast jet fuel (or No. 2 heating oil) and WTI crude spot, both in dollars per gallon (convert WTI from per-barrel by dividing by 42). Compute the daily basis as jet minus a regression-fitted multiple of crude. Run a one-variable OLS of jet returns on crude returns; the slope is your minimum-variance hedge ratio and R-squared is the fraction of jet variance the hedge removes. The residual variance, (1 minus R-squared) times the variance of jet returns, is the basis risk a cross-hedge leaves on the table. Re-run on a 2008 or 2022 window and watch the residual jump when the crack spread blows out.
See also
Sources
- What is Basis Risk? Types, Causes, Examples - POEMS
- Hedging jet fuel price risk: The case of U.S. passenger airlines - PMC
- Case Study: Metallgesellschaft (MG) - Penn State EBF 301
- Managing basis risks in weather parametric insurance - The Geneva Papers
- Henry Hub natural gas basis in the US: to fix or not to fix - EECC