Positive basis

What Is Positive Basis?

Positive basis describes a market condition in derivatives trading where the price of a futures contract is higher than the current spot price of its underlying asset. It represents the spread between these two prices, specifically when the futures price exceeds the spot price. This concept is fundamental to understanding pricing relationships within derivatives markets, especially for commodity futures. When a positive basis exists, it suggests that market participants anticipate an increase in the price of the underlying asset by the contract's expiration date, or it reflects the cost of carry associated with holding the physical asset.

History and Origin

The concept of basis and its variations, like positive basis, is intrinsically linked to the evolution of futures markets. Early forms of forward contracts, which predated modern futures, emerged in ancient civilizations to manage price risks for agricultural goods. The formalization of these agreements into standardized futures contract trading began with the establishment of exchanges such as the Dojima Rice Exchange in Japan in the late 17th century and the Chicago Board of Trade (CBOT) in the mid-19th century in the United States.,⁶ The development of these markets provided a structured environment where the difference between immediate (spot) prices and future delivery prices became a measurable and tradable element. The dynamics of supply, demand, storage costs, and interest rates inherently led to situations where futures prices were often higher than spot prices, laying the groundwork for the observed phenomenon of positive basis.

Key Takeaways

• Positive basis occurs when the futures price of an asset is greater than its spot price.
• It is often observed in markets exhibiting contango, where deferred futures contracts trade at higher prices.
• The magnitude of the positive basis can reflect factors such as the cost of carry, storage costs, and prevailing interest rates.
• Traders and hedgers analyze positive basis to gauge market expectations and inform their hedging and arbitrage strategies.
• As a futures contract approaches its delivery month, the positive basis typically converges towards zero.

Formula and Calculation

The basis is calculated as the difference between the futures price and the spot price of an underlying asset. A positive basis occurs when this calculation yields a positive value:

$\text{Basis} = \text{Futures Price} - \text{Spot Price}$

Where:

• Futures Price = The price at which a futures contract is currently trading for a specific future delivery month.
• Spot Price = The current market price at which the underlying asset can be bought or sold for immediate delivery.

For example, if the futures price for a crude oil contract is $80 per barrel and the current spot price for crude oil is $78 per barrel, the basis would be:

$\text{Basis} = \$80 - \$78 = \$2$

In this instance, the basis is positive, indicating a positive basis of $2.

Interpreting the Positive Basis

A positive basis is a common occurrence, particularly in commodity markets, and often signals a market structure known as contango. In a contango market, futures prices for distant delivery months are higher than those for nearer months or the current spot price. This reflects the cost of carry, which includes expenses like storage, insurance, and financing costs (interest rates) incurred when holding a physical asset until the futures contract's expiration.

When a positive basis exists, it suggests that the market expects the underlying asset's price to increase over time, or at least anticipates that the costs of holding the physical asset will be covered by the premium in the futures price. Traders monitor changes in the positive basis closely, as a widening or narrowing basis can indicate shifts in supply and demand fundamentals, changes in interest rates, or alterations in market participants' expectations for future spot prices.

Hypothetical Example

Consider an investor analyzing corn futures. On a given day, the spot price of corn is $4.50 per bushel. The futures price for a corn futures contract set to expire in three months is $4.65 per bushel.

1. Identify the Spot Price: Current corn price = $4.50/bushel.
2. Identify the Futures Price: Three-month corn futures price = $4.65/bushel.
3. Calculate the Basis: Basis = Futures Price - Spot Price
   Basis = $4.65 - $4.50 = $0.15

In this scenario, the positive basis is $0.15 per bushel. This indicates that the market expects corn prices to be 15 cents higher in three months, or that the costs associated with storing and financing the corn for three months amount to $0.15 per bushel. For a farmer looking to hedge future production, this positive basis might offer a favorable opportunity to lock in a higher price for their crop.

Practical Applications

Positive basis is a crucial metric for various market participants, especially in commodity markets.

• Hedging: Producers and consumers use futures contracts to manage price risk. For a farmer, a positive basis means they can sell a futures contract at a price higher than the current spot price, potentially securing a favorable selling price for their future crop. This helps mitigate the risk of declining spot prices by the time their product is ready for market. Conversely, a buyer of a commodity might use a positive basis to estimate the cost of future inventory, taking into account the premium paid for future delivery.
• Arbitrage: Arbitrageurs seek to profit from price discrepancies. If the positive basis deviates significantly from the theoretical cost of carry, an arbitrage opportunity might arise. For example, if the futures price is excessively high relative to the spot price plus carrying costs, an arbitrageur could buy the physical asset, simultaneously sell a futures contract, and deliver the physical asset upon contract expiration, locking in a risk-free profit.
• Market Analysis: The direction and magnitude of the basis provide insights into market conditions. A strengthening positive basis can indicate increasing demand expectations or rising carrying costs, while a weakening positive basis could suggest the opposite. Reports from financial news outlets frequently reference basis trends in agricultural commodities, reflecting their importance to market participants.⁵,⁴

Limitations and Criticisms

While positive basis provides valuable information, it is subject to several limitations and inherent risks, primarily basis risk.

• Basis Risk: This is the primary concern when dealing with positive basis, particularly in hedging strategies. Basis risk is the risk that the basis will change unexpectedly between the time a hedge is put on and when it is lifted. Even if a positive basis exists when a position is initiated, there is no guarantee that it will remain at a predictable level or converge perfectly to zero by the expiration date. Unforeseen events—such as sudden changes in supply or demand, storage capacity issues, or changes in interest rates—can cause the basis to fluctuate unpredictably, leading to an imperfect hedge.,, T³h²i¹s can result in profits or losses that were not anticipated when the hedge was established.
• Liquidity: In less liquid markets or for contracts with very distant delivery months, the positive basis might be less reflective of true economic fundamentals and more susceptible to large price swings due to limited trading activity.
• Market Imperfections: The theoretical relationship between spot and futures prices (often explained by the cost of carry model) assumes perfect markets with no transaction costs, unlimited arbitrage opportunities, and easy access to financing. In reality, these imperfections can cause the positive basis to deviate from its theoretical fair value, making its interpretation more complex.

Positive Basis vs. Negative Basis

The primary distinction between positive basis and negative basis lies in the relationship between the futures price and the spot price of an asset.

While a positive basis indicates that it costs money to hold the physical asset over time (cost of carry), a negative basis, or backwardation, suggests that immediate possession of the asset is more valuable than future possession. This often occurs when there is a current shortage or high demand for the physical commodity, making it expensive to obtain immediately.

FAQs

What causes a positive basis?

A positive basis is primarily caused by the cost of carry, which includes expenses like storage costs, insurance, and the financing costs (interest rates) incurred when holding a physical asset until the futures contract's expiration date. It can also reflect market expectations of higher spot prices in the future.

How does positive basis affect hedgers?

For hedgers, a positive basis can be beneficial. A producer selling a futures contract to hedge future production might lock in a price higher than the current spot price. Conversely, a consumer buying a futures contract might face a higher cost for future delivery compared to immediate purchase. The effectiveness of the hedge depends on how the basis changes over time, introducing basis risk.

Does positive basis always imply a rising market?

Not necessarily. While a positive basis can reflect expectations of rising spot prices, it predominantly reflects the cost of carry. Even in a flat or slowly declining market, if storage and financing costs are significant, a positive basis (contango) can persist. However, a widening positive basis often suggests increased bullish sentiment or higher carrying costs.

How does positive basis converge at expiration?

As a futures contract approaches its expiration date, the futures price and the spot price of the underlying asset tend to converge. On the precise expiration day, the futures price must equal the spot price, effectively making the basis zero. This convergence is due to the opportunity for physical delivery or cash settlement at the spot price, eliminating any sustained arbitrage opportunities.