An empirical test of the effect of basis risk on cash market positions

Abstract

Traditional theory holds that hedgers use futures markets to reduce the amount of price risk they bear. In doing so, they trade price risk for basis risk, that is, unexpected movements in the difference between the spot and futures prices. Theoretical work has shown that the presence of basis risk reduces the position in the cash market as well as the relative use of futures as a hedging instrument. This paper empirically measures the effect of basis risk on the cash market position, using data on the storage of corn. Results show that basis risk statistically and economically significantly reduces the level of storage. The implications of basis risk on cash market positions extend beyond commodity storage to any hedging situation, including the use of currency futures to insure against exchange rate risk.