Hedging - The Basis
The basis tends to be more stable than either the cash or futures price. It also tends to differ from one exchange to another. Among conditions factoring into the basis are:
- Current supply and demand locally,
- Market expectations of changes in supply and demand,
- Availability of substitutes,
- Handling costs (that is, middlemen's profit margins),
- Storage availability and its associated costs, and
- Transportation bottlenecks or disruptions.
The basis varies seasonally, but these swing fairly predictable year-over-year patterns.
Determining the basis
The basis is determined by subtracting the futures price from cash price, but that raises the question, "Which futures price?" The general rule is to not use a contract's price during its delivery month. In a perfect market, as we described, the basis would always be at or approaching zero, if the basis were figured that way. A calculation that compares prices for September cash corn with September futures corn in September won't really measure anything except distortions from logistical hiccups. The transaction would be for naught. Instead, the basis would be calculated in September by subtracting the December futures price (there is no market for October or November corn) from the September cash price.
The basis tends to be negative for most agricultural commodities, or "under" the futures price, due to the cost of carry. Conversely, a positive basis is said to be "over" the future price. If the basis is more negative or less positive than usual, it is considered "weaker" than the historical norm. If it is less negative or more positive, then, it is said to be "stronger."
Say that September cash corn is trading at 228 cents/bushel and December futures corn is trading at 248 cents/bushel. In market parlance: "The basis is 20 under December."
The basis indicates current local demand. A strong basis means the market wants the grain sooner rather than later. A weak basis suggests that the market doesn't want grain now, although demand may grow over a matter of months.
Strong basis trends toward a less negative and more positive number. Cash prices increase relative to futures prices. This works to the seller's benefit. He or she would sell at the cash price, benefitting from the aforementioned increased local demand.
Weak basis trends toward a less positive and more negative number. Cash prices decrease relative to futures prices. This works to the buyer's benefit. He or she would enter into a futures contract, benefitting from anticipated future demand.
The basis is a localized phenomenon. It could be under and weakening in a Midwestern farm community, but over and strengthening in Chicago or New York.
All this helps the producers of the commodities – those likely to be short-the-basis, to decide how to sell. As the basis strengthens, the producer's incentive is to sell for cash. As the basis weakens, the producer's incentive is to enter into a futures contract.