What it means
A futures contract is an agreement to buy or sell something at a set price on a future date, and it rarely matches the exact grade, location or timing of the physical goods a business actually handles. The gap between the local cash price and the futures price is the basis, and the prices used to calculate it are the basis prices.
The basis exists because of transport, storage, quality differences and local supply and demand. It is usually far more stable than the outright price, which is what makes hedging useful: a hedge removes most of the price risk and leaves the smaller basis risk behind.
In practice, commercial buyers and sellers often quote in basis terms rather than absolute prices. A grain elevator may offer a farmer 25 cents under the nearby futures contract, which fixes the basis today and leaves the futures price to be set later.
In the options world, basis price means something different: it is the exercise price written into the contract. Reading the phrase without checking which market is being discussed is the most common source of confusion.
A third, narrower use appears in bond markets, where an instrument quoted on a yield basis has a basis price calculated from that yield. In every case the term points to the reference price from which something else is derived rather than to a market price in its own right.
In practice
Real-world examples.
Example
A flour miller buys wheat at an agreed basis of 20 cents over the nearby futures contract. The futures price then falls, so the miller's cash cost falls with it, and the only part of the price the miller negotiated directly was the basis.
Example
A diesel distributor hedges its inventory using a national benchmark futures contract. When a local refinery outage pushes regional prices well above the benchmark, the hedge covers the general price move but the widened basis produces an unexpected loss on the quarter.
Example
An options trader reviews a contract described as having a basis price of $45. Checking the documentation confirms that this is the strike price at which the shares may be bought, not a reference to any cash-versus-futures calculation.
Formula
Calculation
Basis = cash price - futures price, where both are the basis prices used in the comparison.
Suppose local cash corn is $4.20 per bushel while the nearby futures contract trades at $4.55 per bushel. The basis is $4.20 - $4.55 = -$0.35 per bushel, usually described as 35 cents under the futures price.
Now take a farmer with 50,000 bushels to sell who agrees a basis contract with an elevator at 30 cents under, and who later prices against futures at $4.55. The cash price received is $4.55 - $0.30 = $4.25 per bushel, and the total proceeds are 50,000 x $4.25 = $212,500. Had the basis widened to 45 cents under before the sale, the price would have been $4.55 - $0.45 = $4.10 and the proceeds 50,000 x $4.10 = $205,000, a difference of $7,500 caused by basis alone.Case study
Seen in the real world.
Hollow Creek Grain is an illustrative, fictional farming partnership that sells around 200,000 bushels of soyabeans a year. Having been caught by a price fall two seasons earlier, the partners now sell futures against the crop and believe they have removed their price risk.
In this fictional season, the futures hedge performs exactly as intended, but local cash prices weaken relative to futures because a nearby processing plant closes for maintenance at harvest. The basis moves from 15 cents under to 50 cents under, which costs the partnership 35 cents on 200,000 bushels, or $70,000, even though the outright price risk was hedged.
The illustrative change in practice is to manage the basis as a separate decision. Hollow Creek now fixes the basis with its buyer in the spring, when local demand is known and competition between buyers is stronger, and prices against futures separately later in the year.
Watch out
Common mistakes.
- Assuming a futures hedge removes all price risk, when it leaves basis risk between the local cash price and the contract price.
- Reading basis price as the strike price of an option when the discussion is actually about a cash-versus-futures comparison, or the reverse.
- Treating a negative basis as a problem in itself, when being under the futures price is entirely normal in many locations and seasons.
Questions
People also ask.
Does a negative basis mean the cash price is wrong?
No, it usually reflects transport, storage and quality differences between the local product and the contract specification.
Why fix the basis and the futures price separately?
Because they are driven by different forces, so a business can lock in each one at the moment its own market looks most favourable.
Is basis risk smaller than outright price risk?
Generally yes, which is the main reason hedging is worthwhile, but basis can still move enough to matter on large volumes.
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