FRM: Basis risk is the mother of all derivatives risk

[@randymi9334]

16 year old video has the most coherent explaination of basis. Thanks!

[@harshchahal75]

I am preparing for Advanced derivatives strategies. This 13 year old video helped me understand the Basis risk. Thank you.

[@Schewingum]

In the example Mr Harper is trying to provide a more realistic scenario. In most cases people will take out a futures contracts expiring after the date of the required hedge because there simply are no contracts expiring on that particular day, which means that the contract position would have to be closed out and the profit would then be based on the forward price at that particular time and not the spot price. Forward contracts on the other hand can be customised to expire on an exact date.

[@Unused50]

The hedger is gonna close out his position and reverse it with a sale at the new futures price, as is the common practice usually because the hedging horizon might be shorter.

[@mdyearidsirajchowdhury6080]

You clear my 2 months of confusion. Really thank you for uploading this.

[@bionicturtle]

Our pleasure! please note this video is almost ten years old (yikes!) but we've started a new FRM series that is going in sequence. Thanks again,

[@Farts_and_more]

@@bionicturtle make that 15 years old (mega yikes!)

[@Shpira]

I agree with Kostil. If you are a hedger i.e. you actually use the copper (or even if you don't). You are getting a delivery at future time which can then be sold at spot. SO you really should be comparing futures today and spot price at delivery date to see whether you are making a profit or taking a loss.

[@himanshurawat5596]

same doubt here

[@Unused50]

This is not a customised contract like forward. In futures you have to deal in standardized contracts, so most hedgers here are interested in taking/giving delivery in cash/ spot market rather than at the contract location. So when the time to buy really comes, it happens at the spot, and you close out your position with the exchange.

[@andyv123]

I found this slightly confusing. I thought the forward price have to converge to the spot price at maturity otherwise there could be an arbitrage opportunity.

[@brickstunram9391]

When you speak of the Loss and Profit, what are you comparing it to ? Because it's a cost that's going to be there regardless you know ?

[@brickstunram9391]

Nvm "relative when I go into the hedge" so may 2008 spot

[@KaozuoYu]

So I buy a one year future in May 08, then buy one unit spot copper in next day?

[@victorsardon3521]

You're buying one unit spot copper next year. And you're hedging this with the one year long future. You have to take into account both the spot and futures transactions. Both of these make up the net cost in the cash market--see where he calculated Total cost. All cash baby because we're not taking delivery on the futures--we're closing out the futures with a cash settlement and taking delivery in the spot market.

[@bionicturtle]

@easye2233 i think you are generally and certainly theoretically correct. The issues are just practical. First, the hedger may not be able to achieve perfect TIMING of underlying versus contract delivery. Second, there may be frictional costs; e.g., delivery location, transport that may have slight variations to different participants. So, in practice, they speak of "zone of convergence" .... FWIW, several commodities have violated this no-arbitrage; e.g., wheat markedly in 2009

[@Kvmurali32]

Thanks for the clear explanation. I have a question though. Wouldn't the futures contract always settle against the spot price (as long as the futures is on the same specific underlying commodity)?

[@rheinxromer]

I got the same question.

[@milenao4455]

I dont think we are assuming that we allow future to expire in May 09 - we are going to close it at a profit or loss, and then buy the underlying commodity in the spot market - I believe these are the assumptions. Most future contracts don't entail delivery.

[@Kostil90]

Q: I'm confused now. I thought, the gain/loss of a future contract arises from the difference between the future price (set at the beginning of the contract, meaning it's constant) and the spot sprice of the underlying at maturity. But here it's the difference between future prices of 2 different contracts. Why? I thought the gain/loss in this case should be 0 (3.80 - 3.80, at the beginning of the video). Unless spot price means price of hedge vehicle... Please explain.

[@sidds5039]

kind of late, but if it helps anyone else... the assumption here is that you never want to see the futures contract to expiration. futures prices are a bit more chaotic during delivery month, and you usually don't want to risk the actual delivery specified in the futures contract, because that could be expensive or inconvenient for you, and you might have a different supplier you'd rather buy from with the spot price. the asset from the futures contract might not also be the exact same as the asset you are trying to buy/sell... so instead, you close out the futures contract you got. yes, you are right, the price on the futures contract won't change. however, if I try to sell a futures contract today that I bought a year ago, well I am not going to be able to sell it for the price specified in the futures contract (most likely). I will have to make either a profit or loss from selling that futures contract, but the actual price on that futures contract will be the exact same.

[@OrangeBossa]

I was confused, if in May 08, the cooper futures price is $3.8, and turns out that in May 09 the spot price is also $3.8, there should be no gain or loss right? Doesn't matter if you hedge. In the second scenario, futures price is 3.8, and spot is 4.2, isn't there going to be a gain of $4.2? Thanks!

[@sarahr.2501]

Thank you for the video. Question: I'm looking at 6:09 where the futures gain/loss is determined by the difference in futures prices... Maybe I'm confused but I thought futures gain or losses are determined by difference in futures rate and spot rate? Or is that only for FRA's? Thanks

[@qiannizhang4521]

When we start to learn future, we assume a very perfect situation where investors close out their position on the delivery date/ on the delivery month. For example, if you take a long position on the future whose "delivery month" is in two months, then it is as if on the delivery date, you purchase the underlying asset from the counterparty at the agreed price, which is the F1 (future price specified today), and sell the asset in the market and get S2 (the spot price). Then the profit is the difference between spot and future price. In reality, investors usually close out their position prior to delivery month. Also,there is a marking to market / daily settlement system. I do not know how to explain this very clearly (have a look at the marking to market, then you will understand what I say in the following part). For example, if you take a long position, and the future price increases, then your margin account balance increases. If you take a long position, and the future price decreases, your margin account balance decreases. And the computation is done everyday. When you close out your position, your profit is determined basically by the difference between the future price at the day you close out your position and the future price initially specified on the contract. When you close out exactly on the delivery month/ delivery date, the future price is just the spot price provided that the asset hedged and the asset underlying the future contract is the same.

[@ritikasarswat2506]

​@@qiannizhang4521 Thank you for the explanation. I too had same doubt but its clear now.

[@adityaaryansonkar]

Yup 13 years Ago and still useful

[@britishenglishaccent141]

Brilliant explanation

[@sajidhasan8385]

Really nice explanation

[@bionicturtle]

Thank you for watching!

[@tecwynlim2087]

isn't the market in contango because the futures is < spot?

[@mattmarkham4734]

I think you have it switched, futures > spot mean the market is in contango: i.investopedia.com/inv/articles/site/CT-Contango2.gif

[@amashmlk7543]

Can someone recommend me a comprehensive book for derivatives.but for beginners plz

[@chidieze5586]

You may need do another video, because you made a fundamental error here that will keep most people confused. First of all you don't talk about basis risk if you will be holding a contract till maturity. Because the futures price entered at Time zero is going to eventually be the price the trade will take place, the only benefits to the hedger is if the spot price at maturity is trading above or below the futures price. Basis risk only occurs when one is trading in futures by closing out before maturity.

[@bionicturtle]

this video is >12 years old, it has been updated in the P1.T3 playlist

[@feverpitch82]

Why would the copper market be in backwardation? I thought backwardation only occurred in things like STIR and bond markets where there is a net benefit to carry?

[@victorsardon3521]

Must take into account technical factors such as change in demand which has a considerable effect on the spot price, which then has a considerable effect on the futures price.

[@feverpitch82]

@@victorsardon3521 I asked this question 11 years ago. I became an Investment Banker in this time, realised nearly everyone is full of shit and miserable and quit in 2023.

[@hitendramehra5439]

completely confused after watching this video. Had a little bit of understanding earlier .. but now it's all gone.

[@jiyoungyun7494]

this is such an amazing video

[@bionicturtle]

Thank you for watching!! :)

[@movzx0fh]

Apparently the most chaotic and nonsensical speech on basis risk .. :-(

[@BLOODINTHECUP]

Thanks!

[@cyberborgman2000]

thanks!