Cross‐Hedging: Basis Risk and Choice of the Optimal Hedging Vehicle

Abstract The basis between a futures contract and its underlying instrument is an important measure of the cost of using the futures contract to hedge. In a cross‐hedge, the relative size of the basis of alternative hedging vehicles often plays a decisive role in the selection of the optimal hedging vehicle. After adjusting hedge ratios for basis risk, a genuine risk‐cost trade‐off is seen in hedging 90‐day certificates of deposit with either the Treasury bill contract or the Eurodollar contract. The Eurodollar contract was not uniformly superior as generally believed.