F1 ≡ futures price at time 1 (today)

F2 ≡ futures price at time 2

S2 ≡ Uncertain spot price at time 2

Long Hedge

You hedge the future purchase of an asset by entering into a long futures contract.

Exposed to basis risk if hedging period does not match maturity date of futures.

Effective Cost of Purchasing Asset using a Long Hedge

Effective Cost of Asset = Future Spot Price - Gain on Futures

Gain on Futures: F2 − F1

Future Spot Price: S2

Effective Cost of Asset: S2 − (F2 − F1)

Effective Cost of Asset: F1 + BASIS2

Basis at time 2: S2 − F2

Future basis is uncertain. Therefore, effective cost of asset hedged is uncertain.

Short Hedge

You hedge the future sale of an asset by entering into a short futures contract

Exposed to basis risk if hedging period does not match maturity date of futures

Effective Price Realized using a Short Hedge

Effective Price = Future Spot Price + Gain on Futures

Gain on Futures: F1 − F2

Future Spot Price: S2

Effective Price: S2 + (F1 − F2)

Effective Cost of Asset: F1 + BASIS2

Future basis is uncertain. Therefore, effective price of an asset short hedged is uncertain
Example

Hedging period 3 months

But, Futures contract expires in 4 months

We’re exposed to basis risk.

Suppose F1 = $105 and S1 = 100

Current BASIS: 100 − 105 = −5

Basis in 3 months is uncertain.

What is basis in 4 months?

Suppose: F2 = 110 and S2 = $102

Long Hedge

Gain: 110 − 105 = $5

Effective cost: 102 + (−5) = $97

Short Hedge

Gain: 105 − 110 = $ − 5

Realized (effective) price: = 102 + (−5) = $97

BASIS2: 102 − 110 = −8

Formula: F1 + BASIS2 = 105 − 8 = 97