Your firm operates an oil refinery and is therefore naturally short on crude oil. You buy offsetting oil market futures to hedge your natural position. Shortly thereafter, local pipelines were damaged in a recent earthquake, leaving you with the highest local crude oil prices in decades. Simultaneously, unexpectedly high recent production from Mexico, Brazil, and the Baltic Sea has driven down the global price of crude and your financial hedge has lost you millions. You have fallen victim to what kind of risk?

Question

Quizplus · Accepted Answer

The hedging strategy involves offsetting the natural position by buying futures contracts, which aims to mitigate basis risk - the risk that price changes in the spot market do not match the price changes of the futures contracts. However, in this situation, the local crude oil prices increased due to the earthquake, causing the basis risk to materialize, and the financial hedge to lose value. This situation is characteristic of basis risk.

Your Firm Operates an Oil Refinery and Is Therefore Naturally