Futures Pricing: The Basis

Study Notes:

Now that we’ve touched on and explored some of the different types of risks in the futures, and broader financial markets, let’s now discuss why the price of a futures contract differs from the price you might pay now.

The current market settles on a ‘spot’ basis, which is typically for immediate delivery, where ‘Immediate’ could mean two days. Or, for example, in a supermarket, you would likely find that the cash price would equate to what you pay for, say, corn at the cash register, and while shoppers can generally buy corn throughout the year, the crop might be harvested just once annually.

It’s the role of the futures market to draw-in all known information about next year’s crop, and figure out what the forward or future’s price is.

And this is where producers, hedgers and speculators get together on a near-24-hour basis to assimilate the latest information and reflect it through what is called price discovery.

This is important information to global financial and physical market participants, as futures allow them to see the current price of a product not yet produced.

• The difference between the cash or spot price and the forward or futures price is known as ‘the basis’.

If we take a look at the prevailing market price for the current corn contract, for instance, and compare it with, say, the price of a futures contract that expires in a year, we can note the difference between these prices as the basis.

Changes in the basis deliver their own message to producers. Should forward prices reflect too much supply of a specific commodity at a future date in time, a farmer, for example, might decide to switch to a less abundant crop.

In our next video, we’ll discuss futures prices a bit further, providing some insights into concepts known as contango and backwardation.