What Is Adjusted Future Basis?
Adjusted future basis refers to the difference between the current spot price of an underlying asset and the price of its corresponding futures contracts, after accounting for factors such as the carry cost, interest rates, and any dividends or yields. This concept is fundamental to derivatives and hedging strategies within financial markets. While the traditional "basis" is simply the spot price minus the futures price, the adjusted future basis provides a more nuanced view by incorporating the theoretical fair value of the futures contract, considering the time value of money and costs associated with holding the asset until the futures expiration. Understanding the adjusted future basis is crucial for participants in futures markets seeking to execute effective investment strategy and manage risk.
History and Origin
The concept of basis is as old as futures trading itself, evolving from the need to manage price risk in agricultural commodities. Early forms of forward contracts emerged to provide certainty for farmers and merchants. The standardization of these contracts, leading to modern futures markets, began in the mid-19th century. The Chicago Board of Trade (CBOT), established in 1848, was instrumental in this development, formalizing "to-arrive" contracts and later, in 1864, listing the first standardized exchange-traded futures contracts.5, As markets grew in complexity, and financial futures emerged in the latter half of the 20th century, the simple basis began to be refined. The inclusion of elements like interest rates for financial assets and storage costs for physical commodities became essential for accurate price discovery and effective arbitrage. The notion of an "adjusted" future basis implicitly developed as traders and academics sought to explain deviations from theoretical fair value, particularly as financial engineering became more sophisticated.
Key Takeaways
- Refined Basis Measurement: Adjusted future basis extends the basic spot-minus-futures calculation by integrating the theoretical cost of carrying the underlying asset.
- Arbitrage Opportunities: Deviations in adjusted future basis from zero can signal potential arbitrage opportunities or hedging inefficiencies.
- Risk Management Tool: For hedgers, understanding how the adjusted future basis behaves is vital for assessing the effectiveness of their hedging strategies and managing basis risk.
- Market Efficiency Indicator: A consistent non-zero adjusted future basis might suggest market inefficiencies or structural characteristics that prevent perfect convergence.
- Broader Application: While often discussed with commodities, the concept of adjusted future basis is equally relevant for financial futures, such as those on stock indexes or bonds.
Formula and Calculation
The adjusted future basis refines the basic formula for basis. The unadjusted basis is simply:
For the adjusted future basis, the calculation incorporates the theoretical futures price, which reflects the spot price plus the net carry cost (financing costs minus any income generated by the asset, such as dividends or storage benefits, over the life of the contract).
The theoretical futures price ($F_0$) for a storable commodity or a financial asset without dividends can be expressed as:
Where:
- (S_0) = Current spot price of the underlying asset
- (r) = Risk-free interest rates (annualized)
- (T) = Time to expiration of the futures contract (in years)
- (CC) = Storage costs (for commodities) or financing costs (for financial assets) net of any income (like dividends from a stock index). For simplicity in financial futures, (CC) often collapses into the interest rate differential.
Therefore, the Adjusted Future Basis can be conceptualized as:
Or, equivalently, the difference between the theoretical futures price and the actual market futures price:
A positive adjusted future basis suggests the actual futures price is lower than its theoretical value, potentially indicating an undervaluation of the futures contract relative to the spot market and carry costs. Conversely, a negative adjusted future basis implies the futures contract is trading above its theoretical value.
Interpreting the Adjusted Future Basis
Interpreting the adjusted future basis involves understanding whether the futures contract is priced "correctly" relative to its underlying asset, considering the costs and benefits of holding that asset until the futures expiration. A zero adjusted future basis would imply perfect market efficiency where the futures contracts exactly reflect the spot price plus all associated costs of carry.
In practice, the adjusted future basis rarely sits at exactly zero due to various market frictions like transaction costs, liquidity differences, and information asymmetry. A positive adjusted future basis means the spot price is higher than the futures price, adjusted for carry. This situation, known as backwardation, typically occurs in commodity markets when there is high current demand for the physical commodity. A negative adjusted future basis, or contango, indicates the futures price is higher than the spot price plus carry, which is more common in markets with significant storage costs or for financial assets where the future value of money pushes futures prices higher. Traders and risk management professionals monitor the adjusted future basis to identify mispricings that could be exploited through arbitrage strategies or to gauge the cost-effectiveness of their hedging activities.
Hypothetical Example
Consider an oil refiner planning to purchase 10,000 barrels of crude oil in three months. The current spot price of crude oil is $80 per barrel. A futures contract for delivery in three months is currently trading at $82 per barrel. Let's assume the risk-free interest rates for three months are 0.5% (or 2% annualized), and the storage cost for crude oil over three months is $0.50 per barrel.
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Calculate Theoretical Futures Price:
- Cost of financing (for 3 months): $80 \times 0.005 = $0.40
- Storage cost (for 3 months): $0.50
- Total theoretical carry cost: $0.40 + $0.50 = $0.90
- Theoretical Futures Price = Spot Price + Total Theoretical Carry Cost = $80 + $0.90 = $80.90
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Calculate Adjusted Future Basis:
- Adjusted Future Basis = Theoretical Futures Price - Actual Futures Price
- Adjusted Future Basis = $80.90 - $82.00 = -$1.10
In this hypothetical example, the adjusted future basis is -$1.10. This negative value indicates that the actual three-month futures contracts for crude oil are trading $1.10 higher than their theoretical fair value, after accounting for financing and storage costs. An arbitrage opportunity might exist for those who can simultaneously buy the spot commodity, store it, finance it, and sell the futures contract, provided the transaction costs are less than $1.10 per barrel.
Practical Applications
The adjusted future basis plays a critical role across various facets of financial markets and corporate finance. Its primary application lies in hedging strategies, where businesses and investors use futures contracts to mitigate price risk. For instance, a farmer might use agricultural futures to lock in a price for their crop, while a pension fund might use bond futures to manage its exposure to interest rates. The adjusted future basis helps these entities assess the effectiveness and cost of their hedges, indicating how closely the futures price reflects the underlying spot market plus carrying costs.
Beyond hedging, the adjusted future basis is central to arbitrage trading, where sophisticated investors seek to profit from temporary misalignments between spot and futures prices. These "basis trades," particularly prevalent in Treasury markets, involve simultaneously taking opposite positions in the cash market and the futures market to capture small, risk-adjusted profits from price convergence.4 The Commodity Futures Trading Commission (CFTC) regulates these markets to ensure fair and transparent trading, providing guidelines and oversight for participants in futures and options.3 Understanding the adjusted future basis also informs speculation, as traders analyze its movements to forecast future price trends or identify over/undervalued contracts.
Limitations and Criticisms
While the adjusted future basis provides a valuable framework for understanding futures pricing, it has inherent limitations. One significant challenge is accurately calculating the true carry cost, especially for commodities that involve complex storage, insurance, or spoilage considerations. For financial assets, variations in borrowing rates or unexpected changes in dividend payments can also distort the theoretical calculation.
Perhaps the most critical limitation is basis risk itself. Despite attempts to "adjust" the basis for theoretical factors, the actual relationship between spot and futures prices can diverge due to unforeseen market volatility, supply-demand imbalances, or unique market events. This non-convergence of the basis at contract maturity, or unexpected fluctuations leading up to it, can undermine even well-constructed hedging strategies.2 For example, differences in the quality or location of the physical asset versus the standardized futures contract, or timing mismatches between the hedge's expiration and the actual sale date of the underlying, contribute to basis risk. These factors mean that even with a precisely calculated adjusted future basis, a perfect hedge is often unattainable, potentially leading to unexpected gains or losses for participants.
Adjusted Future Basis vs. Basis Risk
Adjusted future basis and basis risk are related but distinct concepts in derivatives markets.
The Adjusted Future Basis is a calculation or measurement. It represents the difference between the spot price of an underlying asset and its futures contracts price, after accounting for theoretical factors like carry cost, interest rates, and other income streams (like dividends). It attempts to present the "fair" theoretical difference between the two prices. A perfectly efficient market with no frictions would theoretically have an adjusted future basis of zero.
Basis Risk, on the other hand, is the inherent uncertainty that the basis—whether unadjusted or adjusted—will change unexpectedly. It is the risk that the spot price and the futures price will not move in perfect tandem, or that they will not converge as expected at the futures contract's expiration. Thi1s divergence can be caused by various factors, including differences in the exact specifications of the underlying asset compared to the futures contract (quality, location), unforeseen supply and demand shifts, or liquidity issues. Basis risk can lead to hedging being imperfect, resulting in unexpected gains or losses even when a hedging strategy is in place. Thus, the adjusted future basis helps quantify the expected relationship, while basis risk quantifies the potential for unexpected deviations from that expected relationship.
FAQs
Why is it called "adjusted" future basis?
It is called "adjusted" because it goes beyond the simple difference between the spot price and the futures price. It incorporates additional financial elements, primarily the carry cost, which accounts for the cost of financing the underlying asset until the futures expiration, minus any income generated by holding it.
How does adjusted future basis relate to fair value?
The adjusted future basis helps assess if a futures contracts is trading at its theoretical fair value. If the adjusted future basis is close to zero, it suggests the futures price is aligned with the spot price plus the cost of carry. Significant deviations might indicate the futures contract is over- or undervalued relative to its theoretical price, potentially signaling arbitrage opportunities.
Is a positive or negative adjusted future basis better?
Neither a positive nor a negative adjusted future basis is inherently "better"; their interpretation depends on the context and the market participant's position. A positive adjusted future basis (where the spot price is higher than the futures price plus carry) is often called backwardation and can occur in commodity markets due to immediate demand. A negative adjusted future basis (where the futures price is higher than the spot price plus carry) is known as contango and is common when there are storage costs or for financial markets where time value of money is significant. For hedging, the stability and predictability of the adjusted future basis are generally more important than its absolute sign.
Can adjusted future basis predict market direction?
While analysis of adjusted future basis can provide insights into the relative pricing of spot and futures contracts, it is not a direct predictor of overall market direction. It primarily indicates the relationship between current and future prices, accounting for carrying costs. Extreme or persistent deviations might highlight supply-demand imbalances or market volatility, but forecasting price trends requires a broader analysis of fundamental and technical factors.