What Is Basis?
Basis, within the context of futures trading, refers to the price difference between the current cash price (also known as the spot price) of an underlying asset and the price of its corresponding futures contract. This concept is fundamental to derivatives trading and is a key component of understanding price relationships in commodity and financial markets. Basis is a critical consideration in hedging strategies and arbitrage opportunities.
History and Origin
The concept of basis is intrinsically linked to the development of futures markets, which emerged from the need to manage price risk in agricultural commodities. Early forms of forward contracts, agreements to buy or sell a commodity at a future date for a predetermined price, existed for centuries. The modern futures market, however, began to take shape in the mid-19th century in the United States, particularly with the formation of the Chicago Board of Trade (CBOT) in 184816, 17, 18.
Initially, the CBOT facilitated cash trading and forward contracts, but as agricultural production grew, the need for standardized agreements became apparent14, 15. This led to the introduction of standardized futures contracts in 1865, which allowed for centralized clearing and trading13. As these markets matured, participants began to closely observe the relationship between the immediate cash price of a commodity and its future delivery price, giving rise to the formal understanding and application of basis. The Commodity Futures Trading Commission (CFTC), established in 1974, plays a crucial role in regulating these markets and defining terms like basis within the U.S. financial system11, 12.
Key Takeaways
- Basis is the difference between an asset's spot price and its futures contract price.
- It is a dynamic value influenced by supply, demand, carrying costs, and other market factors.
- Understanding basis is crucial for participants in futures markets, especially for hedging and speculative strategies.
- A strong basis implies the cash price is high relative to the futures price, while a weak basis indicates the opposite.
- Basis tends to converge to zero as a futures contract approaches its expiration date.
Formula and Calculation
The formula for basis is straightforward:
Where:
- Cash Price (Spot Price): The current market price for immediate delivery of an asset.
- Futures Price: The price at which a futures contract trades for delivery at a specific future date.
For example, if the cash price of corn is $4.00 per bushel and the nearest corn futures contract is trading at $4.25 per bushel, the basis would be:
( $4.00 - $4.25 = -$0.25 ) or -$0.25 per bushel. This is a negative basis. The basis is typically calculated in relation to the futures contract next to expire10.
Interpreting the Basis
Interpreting the basis provides valuable insights into market dynamics and expectations for future prices. A positive basis, where the cash price is higher than the futures price, is known as backwardation. This typically occurs when there is high immediate demand for the underlying asset, or a perceived shortage, making the spot price more valuable than future delivery prices.
Conversely, a negative basis, where the cash price is lower than the futures price, is known as contango. Contango is more common in markets with significant carrying costs, such as storage and interest rates, as it reflects the cost of holding the asset until the futures delivery date9. As the futures contract approaches its expiration date, the basis tends to narrow, eventually converging to zero at expiration. This phenomenon is known as convergence8.
Hypothetical Example
Consider a soybean farmer who expects to harvest their crop in three months. The current cash price for soybeans is $12.00 per bushel, and a futures contract for delivery in three months is trading at $12.30 per bushel.
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Calculate the current basis:
Basis = Cash Price - Futures Price
Basis = $12.00 - $12.30 = -$0.30 per bushel.This represents a contango market, where the futures price is higher than the cash price, reflecting the costs of storage and financing for three months.
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Hedging decision:
The farmer is concerned that soybean prices might fall by harvest time. To lock in a price, the farmer could sell soybean futures contracts. If, at harvest, the cash price drops to $11.50 and the futures price for the expiring contract drops to $11.50, the basis would have converged to zero.The farmer would sell their physical soybeans at $11.50 per bushel but profit from their short futures position, effectively offsetting the lower cash price and securing a price closer to their initial expectation, less any basis fluctuation. This demonstrates how futures contracts can be used in risk management.
Practical Applications
Basis is a crucial concept with numerous practical applications across financial markets, particularly in commodity markets and derivatives trading. Producers and consumers use basis to make informed decisions about when to buy or sell physical commodities and when to take positions in the futures market.
For example, a grain elevator operator might use basis to determine the optimal time to purchase grain from farmers and sell futures contracts to lock in a profit margin, taking into account transportation costs and storage costs7. Basis trading, a strategy that seeks to profit from changes in the basis, is also common among speculators and hedgers. This involves simultaneously taking opposite positions in the cash and futures markets.
Furthermore, central banks and financial institutions, such as the Federal Reserve Bank of San Francisco, often analyze movements in financial derivatives to gauge market expectations for future interest rates and economic conditions4, 5, 6. The Federal Reserve also monitors broader financial market indicators and their relationship to various asset classes, including commodities, which can be seen as an inflation hedge under certain circumstances2, 3.
Limitations and Criticisms
While basis is a valuable tool, it does have limitations and criticisms. The accuracy of basis as a predictor of future spot prices can be affected by unforeseen market events, changes in supply and demand fundamentals, or external shocks. For instance, disruptions to transportation, unexpected weather patterns, or shifts in global trade policies can cause the basis to behave unpredictably, leading to basis risk.
Moreover, for less liquid commodities or financial instruments, the basis might be more volatile and less reliable due to wider bid-ask spreads and fewer participants. Some critics argue that while futures markets offer price discovery, reliance solely on basis for decision-making without considering other market factors can be problematic. The 2010 "flash crash," for example, highlighted how complex algorithmic trading, heavily reliant on market relationships and rapid execution, can lead to extreme and sudden price movements, even in widely traded instruments like E-Mini S&P 500 futures1. This demonstrates that even with well-understood concepts like basis, the interplay of advanced trading technologies and market structure can introduce new forms of risk.
Basis vs. Cost Basis
Basis, as discussed in the context of futures trading, is often confused with "cost basis." However, these two terms are distinctly different. Basis refers to the price differential between the cash price of an asset and its futures contract price, primarily used in the realm of derivatives and commodity trading to understand current market relationships and inform hedging or speculative strategies.
On the other hand, cost basis is an accounting term used in taxation and investment performance tracking. It represents the original value of an asset for tax purposes, typically the purchase price plus any commissions or fees. When an investment is sold, the cost basis is subtracted from the selling price to determine the capital gain or loss. Therefore, while both terms involve "basis," their application and meaning are entirely separate, with one pertaining to price relationships in active markets and the other to the historical cost of an asset for accounting and tax purposes. Investors should understand the difference to accurately assess their investment returns and tax obligations.
FAQs
What causes basis to change?
Basis changes due to a variety of factors, including shifts in supply and demand for the physical commodity, changes in carrying costs (such as storage and interest rates), transportation costs, and market expectations about future supply and demand. Local market conditions can also significantly impact basis relative to a national or global futures price.
Is a positive or negative basis better?
Neither a positive nor a negative basis is inherently "better"; their significance depends on a market participant's position and objectives. For a producer looking to sell a commodity, a strong (more positive or less negative) basis is generally favorable as it means the local cash price is relatively high compared to the futures price. For a buyer, a weak (more negative or less positive) basis might be preferred.
What is "strengthening" or "weakening" basis?
A "strengthening basis" means the cash price is increasing relative to the futures price, or the futures price is decreasing relative to the cash price. This leads to the basis becoming more positive or less negative. A "weakening basis" means the opposite: the cash price is decreasing relative to the futures price, or the futures price is increasing relative to the cash price, making the basis more negative or less positive. These movements impact profitability for hedgers and provide opportunities for speculators.
How does basis relate to arbitrage?
Basis is central to arbitrage strategies. If the basis deviates significantly from its historical or expected levels, it can create an opportunity for arbitrageurs to profit by simultaneously buying the undervalued side and selling the overvalued side (cash vs. futures), aiming to capture the convergence of prices.
How does basis relate to the concept of fair value?
Basis helps determine the fair value of a futures contract in relation to its underlying asset. In an efficient market, the futures price should reflect the current cash price plus the cost of carrying the asset until the futures delivery date. Deviations from this "cost of carry" model can indicate mispricing, which basis helps to identify.
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