Option pricing and hedging problems cause basis risk

Option pricing and hedging cause problems when a futures contract is written on the underlying asset for the underlying asset. Using the optimal strategy is likely to generate meaningful welfare gains.

Because of the presence of higher liquidity and lower frictions, sellers of equity derivatives routinely hedge index options or basket options by trading equity index futures as substitutes for trading in cash and interest rate futures in the underlying portfolios. These are typically used in dynamic hedging/replicating strategies for options on bonds and other fixed income derivatives.

If changes in the price of the futures and cash contracts were perfectly correlated, no further risk would be