Relative basis

What Is Relative Basis?

Relative basis refers to the price difference between the current spot price of an asset and the price of its corresponding futures contracts. This difference, often simply called the "basis," is a crucial concept within derivatives trading and represents a relative valuation between an underlying asset and its derivative. It highlights that financial markets frequently operate on comparative measurements rather than absolute values²³. The relative basis forms the foundation for various trading strategies, notably basis trading, where market participants aim to profit from the expected convergence or divergence of these two prices.

History and Origin

The concept of a price difference between a physical commodity and a contract for its future delivery has roots in ancient times, with rudimentary forms of derivatives existing in cultures like Mesopotamia to manage agricultural risk²². The formalization of these concepts, which underpin the relative basis, evolved significantly with the establishment of organized markets. The first modern organized futures market in North America, the Chicago Board of Trade (CBOT), was created in 1848, allowing for standardized contracts that facilitated clearer price discovery and the emergence of basis analysis²⁰, ²¹. The evolution of derivatives and the analytical tools used to assess their relative value, including the relative basis, accelerated with financial innovation from the 1970s onward, particularly with the introduction of financial derivatives on exchanges¹⁸, ¹⁹. The ongoing development of sophisticated financial models and increased computerization further refined the understanding and exploitation of relative basis in trading strategies¹⁷. A detailed historical account of derivative markets further illustrates this evolution.¹⁶

Key Takeaways

• Relative basis is the price spread between a physical asset's spot price and its corresponding futures contract price.
• It is a dynamic measure that reflects the cost of carrying the underlying asset until the futures contract's expiration.
• Traders utilize the relative basis to identify arbitrage opportunities and implement hedging strategies.
• The relative basis tends to converge to zero as the futures contract approaches its expiration date.
• Unexpected changes in the relative basis contribute to basis risk, a significant consideration for hedgers.

Formula and Calculation

The relative basis is calculated as the spot price of the underlying asset minus the futures price of the corresponding derivative. For certain instruments, particularly U.S. Treasury futures, a conversion factor is applied to the futures price to standardize different deliverable bonds.

The formula for relative basis is:

$\text{Relative Basis} = \text{Spot Price} - (\text{Futures Price} \times \text{Conversion Factor})$

Where:

• Spot Price: The current market price for immediate delivery of the underlying asset.
• Futures Price: The price of the futures contract for delivery on a specified future date.
• Conversion Factor (CF): A multiplier used in certain futures contracts (e.g., Treasury futures) to adjust the futures price for different deliverable securities, standardizing them to a hypothetical bond.

For example, in commodity markets or simpler financial futures where no conversion factor is explicitly defined (or it is 1), the formula simplifies to:

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

Interpreting the Relative Basis

Interpreting the relative basis involves understanding its magnitude and direction, which can provide insights into market expectations regarding supply, demand, and the cost of carry. A positive relative basis, known as contango, indicates that the futures price is lower than the spot price. This is common when there are costs associated with holding the physical asset, such as storage, insurance, and financing. Conversely, a negative relative basis, or backwardation, means the futures price is higher than the spot price, often signaling tight supply in the cash market or strong immediate demand.

The behavior of the relative basis is crucial for participants engaged in portfolio management and derivatives strategies. As a futures contract approaches its expiration, the relative basis for that contract tends to narrow and converge towards zero. This convergence occurs because, at expiration, the futures contract becomes equivalent to the spot asset, and their prices must align. Traders continuously monitor this convergence, as deviations can present profitable opportunities or indicate potential market inefficiencies. Understanding these dynamics is essential for effective risk management and strategic decision-making in derivatives markets.

Hypothetical Example

Consider a hypothetical scenario involving corn. A farmer expects to harvest corn in three months and wants to lock in a price.

• Current spot price of corn: $4.50 per bushel
• Price of a futures contract for delivery in three months: $4.65 per bushel (assuming no conversion factor)

The relative basis calculation would be:
Relative Basis = Spot Price - Futures Price
Relative Basis = $4.50 - $4.65 = -$0.15

In this example, the relative basis is -$0.15. This indicates that the futures price is higher than the current spot price, a state of backwardation. This might¹²³, ⁴⁵⁶⁷⁸⁹, ¹⁰¹¹, ¹²¹³