Series 3: 1.4.2. Basis And Basis Risk

1.4.2.  Basis and Basis Risk

Hedgers in commodities markets—whether sellers or buyers—fear price volatility. Without a forward or futures market, they would have no choice but to speculate on commodities prices. Instead, the futures market enables buyers and sellers to speculate on something far less volatile: basis. Basis is a critically important concept for understanding hedging in the futures market.

Basis is a measure of the relationship between the cash price and the corresponding futures prices of a commodity at any given time. More specifically, it is the difference between the current local cash price and the current futures price for any given commodity and any specific contract month. The equation looks like this, where “t” equals time.