📚 PASS Research Analyst Certification Examination Difficulty: Beginner ℹ️ Info   ~5 min read
📌 Chapter 11.9 — Hedging in Commodities

During your review of a downstream steel manufacturer, you notice that management consistently hedges their iron ore requirements using global futures contracts. On paper, the firm appears perfectly insulated from price volatility, yet their quarterly cash flows continue to exhibit unexpected variance. As a researcher, you recognize that the correlation between the futures contract they trade and the actual physical grade of ore they consume is not perfectly synchronized. This discrepancy is the hallmark of basis risk, the fundamental disconnect between the asset being hedged and the hedging instrument itself.

Basis risk is defined as the difference between the spot price of the asset being hedged and the futures price of the contract used for that hedge. In a perfect world, these prices would move in lockstep, narrowing to zero as the contract approaches maturity. In reality, the physical commodity may differ in location, grade, or timing from the standardized exchange-traded contract.

When an Indian manufacturer imports high-grade coal but hedges using a standardized thermal coal contract on a foreign exchange, the price divergence creates a residual risk that no amount of hedging can fully eliminate.

For an analyst, ignoring basis risk leads to an overestimation of a company’s risk-mitigation capabilities. When you model future margins, you must account for the fact that the ’effective’ hedge is rarely 100% efficient. If the historical basis—the difference between the spot and futures prices—is volatile, the company’s operating cash flows will remain inherently unpredictable. During your valuation process, a firm with high basis risk warrants a higher risk premium in your Discounted Cash Flow (DCF) model because their ‘protection’ is structurally leaky.

Consider an Indian textile firm hedging cotton prices using a global contract. If local monsoon conditions disrupt domestic crop yields, the local price of cotton might spike while the global futures price remains stagnant due to an oversupply in other regions. The company faces a double whammy: they pay more for their raw material while their hedge fails to appreciate in tandem.

Assessing how management tracks and manages this basis risk is a key differentiator between a company that treats hedging as a core competency and one that merely performs it as a box-ticking exercise.1

Nuance

⚠️ Nuance
Candidates often mistake basis risk for simple price risk, assuming that as long as one is hedged, the ‘risk’ is eliminated. In professional practice, the trap lies in failing to distinguish between ‘price risk’ (the volatility of the underlying commodity) and ‘basis risk’ (the volatility of the price difference). An analyst must understand that hedging transforms one type of risk into another; it does not vanish into thin air.

Check Your Understanding

Practice Question 1

A firm in Maharashtra uses a liquid international copper futures contract to hedge its physical procurement of locally sourced copper scrap. Which of the following best describes the risk the firm faces if the local price of copper scrap and the international futures price diverge significantly due to supply chain constraints?

Practice Question 2

How should an analyst adjust their valuation model when a company exhibits high historical volatility in the basis between its physical inputs and its futures hedging instruments?

This is a companion read for Section 11.9 — Hedging in Commodities from PASS Research Analyst Certification Examination by Akhilesh Gururani, available on Amazon Kindle.

Copyright © 2026 Akhilesh Gururani. All rights reserved.

  1. Basis is calculated as: Spot Price of the Asset - Futures Price of the Hedging Instrument. A positive basis is termed ‘strengthening,’ while a negative basis is termed ‘weakening.’ ↩︎