How the Basis Is Determined

This section sets the one convention the entire chapter depends on and shows what pushes the number around. Get the subtraction and its sign right here, because every later conclusion is built on it.

The Definition: Cash Minus Futures

The basis is the local cash (spot) price (the price for the physical commodity available right now) minus the futures price for the same commodity.

• Because it is a difference, the basis can be positive or negative.
• A positive basis means cash is above futures. This is quoted as being "over" (cash is over futures).
• A negative basis means cash is below futures. This is quoted as being "under" (cash is under futures). A cash price 10 cents below the futures price is "10 under."
• Cash minus futures is the fixed order used all through this chapter. Reverse it and every strengthening or weakening conclusion flips, so always put cash first.

Think of it this way: the futures price is one national benchmark that everybody sees. The basis is your local price tag written as a distance from that benchmark. "10 under" just means your local corn is trading 10 cents below the futures screen.

Exam Tip: Gotchas

• Basis is cash minus futures, not futures minus cash. A negative result is quoted "under," a positive result "over." Flip the subtraction and you invert every later conclusion about who a basis move helps.
• A negative basis is normal, not broken. Cash sitting below futures ("under") is the everyday case for many storable commodities carried toward a future delivery. The sign tells you where cash sits, not whether something is wrong.

What Drives the Basis

The futures price is a single benchmark number, so anything specific to a location or a moment shows up in the basis rather than in the futures quote.

• Local supply and demand: a regional surplus pushes the local cash price down relative to futures (a weaker, more negative basis); a local shortage pulls cash up (a stronger basis).
• Carrying charges: the cost of holding the physical commodity over time, made up of storage, insurance, and interest on the money tied up in inventory.
• Transportation: moving the commodity from where it sits to an approved delivery location costs money, and that cost shifts the local basis (covered in the section on the commodity actually delivered or purchased).
• Deliverable-grade differences: cash of a better or worse grade than the one the contract is written on trades above or below futures accordingly (also covered in that later section; the futures contract unit introduces the basis grade and its premiums and discounts).
• Time to expiration: the further a futures contract is from delivery, the more carrying charges are embedded in it relative to nearby cash, so a distant contract typically shows a wider basis than a nearby one.

Convergence Toward Delivery

The basis is not a fixed number you can set and forget. It drifts toward zero as the contract nears its delivery (spot) month.

• As a futures contract approaches expiration and enters the delivery month, the cash price and the futures price are driven together, and the basis narrows toward zero.
• At the delivery point on the last day, cash and futures are essentially equal, because a holder could deliver the physical directly against the contract. This coming-together is called convergence (also described as a "narrowing of the basis").
• The basis is not constant. It moves every day with local conditions and trends toward zero as delivery nears.

Think of it this way: cash and futures are two runners headed for the same finish line at delivery. Early in the race they can be far apart, but as they approach the line, the option to deliver physical against the contract pulls them side by side. The gap (the basis) shrinks toward zero.

Exam Tip: Gotchas

• The basis narrows toward zero into delivery, it does not widen. A question that treats the basis as a constant, or has it widening into the delivery month, has convergence backwards.
• A hedge does not remove all risk, it swaps price risk for basis risk. What remains after a hedge is placed is basis risk (uncertainty in how the basis will move), which is far smaller than the full outright price risk of an unhedged cash position.