Series 3: 1.4.2.3. Understanding Basis

1.4.2.3. Understanding Basis

We have defined basis as the difference between the cash and futures price of a commodity. We have also said that hedgers in the futures market are not buying and selling commodities, but they are buying and selling basis. Let’s see how this works.

Example: Ralph is a corn farmer with his harvest expected five months from now in September. He calls his local grain elevator and learns that it is bidding $2.52 for corn and the September futures price is $2.74. Basis is -$0.22. Ralph wishes to hedge against falling corn prices. He decides that now is a good time to sell a futures contract. He places a short hedge on September corn.

By early August, the cash price of corn has dropped to $2.40, and September corn is selling at $2.60. Basis has strengthened (become less negative) to -$0.20. Ralph decides to sell his corn now and offset his futures contract by buying September corn. By selling the corn at $2.40, he has lost $0.12 in terms of the price he could have gotten last April ($2.52 – $2.40). But by buying September corn at $2.60 that he had previously sold at $2.74, he gains $0.14 on the futures contract. Had he not hedged his corn, he would have lost $0.12 per bushel. Instead, Ralph has gained $0.02.

Notice that $0.02 per bushel is precisely the difference between the basis for September corn in August (-$0.20) and the basis that prevailed in April (-$0.22). When determining gains and losses for hedgers in the futures market, it is only necessary to look at differences in basis.