Basis risks of hedging using futures

joeyk · October 17th, 2008, 4:28 am

Hi,If I wrote an option on an equity index and I delta-hedge using futures, but the changes in the futures prices are very different from the changes in the spot prices day over day (ie. delta of spot vs. futures is not close to 1) which gives me basis risks.1) How does this impact the daily P&L? Does it make the P&L more volatile? How would one quantify this?2) How can this be reduced? (assuming that you cannot hold all the stocks in the index and you cannot enter into a back-to-back deal)

daveangel · October 17th, 2008, 8:50 am

which market is this ? Its quite hard to see futures fv drift too far away from spot market. Also, when you say basis what do you mean. Do you mean the difference between your Theoretical values versus settlement prices on exchange ? Or are you valuing you options book using the spot and then hedging with futures that are MTM ? If doign the latter I would suggest that you use the implied spot fromt he futures to value your options.