What is Basis Risk associated with futures contracts?

Basis risk is a significant concept when dealing with futures contracts and arises from the discrepancy between the price movement of the underlying asset and the price movement of the futures contract used for hedging. In this context, basis risk is defined as the risk that the position being hedged does not move in the same way as the underlying instrument.

When a trader or investor uses futures contracts to hedge a particular asset, they assume that the futures price will move in tandem with the price of the asset being hedged. However, various factors—such as changes in supply and demand, market sentiment, or the time to expiration of the futures contract—can cause the futures prices and the spot prices of the underlying asset to diverge. This disconnection can lead to ineffective hedging, where the financial outcome does not align with the expectations based on the hedging strategy.

Given this understanding, the correct answer explains a core aspect of risk management in futures trading, highlighting the importance of accurately assessing and mitigating basis risk to ensure that hedging strategies are effective.