Option valuation and hedging with basis risk

In the world of financial derivatives, "basis risk" is the risk that arises when the asset on which an option is written is not available for hedging - usually because there is no liquid market in it - and hedging must be done using some "closely related" asset. In this situation the market is incomplete and perfect hedging is, even in principle, impossible. In earlier work, the author proposed an approach to option valuation in incomplete markets based on utility theory. Here this approach is applied in a study of basis risk and how to minimize it.