What defines basis risk?

Basis risk is defined as the risk that the difference between the spot price of an asset and the futures price (the basis) will change in an unpredictable way. This type of risk emerges when there is an imperfect correlation between the price movements of the asset being hedged and the hedging instrument used, such as futures contracts.

For instance, when an investor uses futures to hedge against price changes in a commodity, if the price of the commodity and the price of the futures contract don't move in sync, it creates basis risk. Such discrepancy can result from various factors influencing each market differently, including local supply and demand conditions, storage costs, and transportation issues.

This means that even if a hedge appears to be in place, fluctuations in the basis can lead to unexpected gains or losses, highlighting the importance of understanding this risk for effective risk management strategies.