Date of this Version
Farm and Ranch Management News (April 22, 2020).
A Fundamental Review on Basis
Basis is defined as the cash minus futures. Cash market reflects today's supply conditions and price. Futures market reflects upcoming supply and demand conditions. If it is anticipated that there will be a period of increasing supplies, futures prices will decline to reflect that information. Likewise, periods of time with expected decreasing supplies, future prices are expected to increase.
Since cash and futures prices can move simultaneously, basis will fluctuate through time. In periods where basis becomes more positive (i.e. basis is said to be strengthening/narrowing) it implies that cash prices are increasing more relative to futures. As basis becomes more negative (i.e. basis is said to be weakening/widening) it implies that cash prices are decreasing relative to futures. Basis can weaken or strengthen in periods of declining or rising futures and cash prices. Declining cash prices does not necessarily imply weakening basis. It is the relative relationship between cash and futures that determine basis.
Futures markets exist as an exchange or risk transfer between market participants. Cattle producers agree to deliver cattle to a given location, date, and specified price. Packers or meat wholesalers agree to purchase cattle under contract specifications. This contract for future delivery allows both parties to better predict output/input prices and thus profitability. The contract does not eliminate risk but rather allows the exchange of price risk for basis risk. Since basis is specific to a time a place, it must be predictable and reliable to allow the futures markets to be used as an effective risk management strategy.
The basis position provides some signal of the near future supply and demand conditions. If basis is negative the market is said to be a “normal market” implying no supply shortage. In order for producers to bring cattle to market, basis would need to increase. When basis is over, the market is said to be a “premium market” implying a supply shortage. Producers see the basis and have an incentive to deliver to the market thus decreasing basis.
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