1

Understanding Basis

• Definition

• Influence factors

• Basics of basis

• Patterns and trends

2

Basis

Basis = Cash – Futures

• Futures reflect global S&D

• Basis reflects the local S&D

Cash = Futures + Basis

3

Basis basics

• Specific to time and place

• Typically use nearby futures

• Convergence

• Less variable than cash

• Relatively predictable

4

Basis Factors

• Relative storage capacity

• Transportation availability and cost

• Time to expiration

• Quality issues

7

Iowa Grain Price Reporthttp://www.ams.usda.gov/mnreports/nw_gr110.txt

NW_GR110 Fri. Jan. 8, 2010 IA Dept. of Ag-USDA Market News Interior Iowa Daily Grain Prices

Closing cash grain bids offered to producers as of 2:30 p.m. Dollars per bushel, delivered to Interior Iowa Country Elevators.

Iowa Regions #2 Yellow Corn #1 Yellow Soybeans

Range Avg Range Avg

Northwest 3.72 – 3.86 3.82 9.55 – 9.64 9.61

North Central 3.82 – 3.91 3.86 9.48 – 9.65 9.59

Northeast 3.82 – 3.99 3.89 9.48 – 9.74 9.60

Southwest 3.64 – 3.85 3.77 9.48 – 9.72 9.63

South Central 3.80 – 3.88 3.84 9.57 – 9.75 9.64

Southeast 3.53 – 3.93 3.82 9.54 – 9.72 9.65

Corn basis to STATE AVERAGE PRICE for the CBOT Mar. contract is -.39

Soybean basis to STATE AVERAGE PRICE for the CBOT Mar. contract is -.61

8

Iowa Grain Price Reporthttp://www.ams.usda.gov/mnreports/nw_gr110.txt

NW_GR110 Fri. Jan. 8, 2010 IA Dept. of Ag-USDA Market News Interior Iowa Daily Grain Prices

Closing cash grain bids offered to producers as of 2:30 p.m. Dollars per bushel, delivered to Interior Iowa Country Elevators.

March Futures Closing Price 4.23 10.22

Iowa Regions #2 Yellow Corn #1 Yellow Soybeans

Avg Basis? Avg Basis?

Northwest 3.82 9.61

North Central 3.86 9.59

Northeast 3.89 9.60

Southwest 3.77 9.63

South Central 3.84 9.64

Southeast 3.82 9.65

9

Iowa Live Cattle BasisThree Year Average and 70% Range

-8.00

-6.00

-4.00

-2.00

0.00

2.00

4.00

6.00Ja

n 1-

15

Feb

1-1

5

Mar

1-1

5

Apr

1-1

5

May

1-1

5

Jun

1-15

Jul 1

-15

Aug

1-1

5

Sep

1-1

5

Oct

1-1

5

Nov

1-1

5

Dec

1-1

5

Period

$/cw

t

More Negative 15% of Time Expected Basis More Positive 15% of Time

10

Iowa Live Cattle Basis by Year

-8.00

-6.00

-4.00

-2.00

0.00

2.00

4.00

6.00

1-Ja

n

1-F

eb

1-M

ar

1-A

pr

1-M

ay

1-Ju

n

1-Ju

l

1-A

ug

1-S

ep

1-O

ct

1-N

ov

1-D

ec

20052006200720082009

11

ISM Lean Hog Basis, 2007-2009

-12.00-10.00

-8.00-6.00-4.00-2.000.002.004.006.008.00

Jan-

1st

half

Feb- 1

st ha

lf

Mar

- 1st

half

Apr-1

st ha

lf

May

-1st

half

Jun-

1st

half

Jul-

1st h

alf

Aug- 1

st ha

lf

Sep- 1

st ha

lf

Oct- 1

st ha

lf

Nov- 1

st ha

lf

Dec- 1

st ha

lf

Average 15% lower 15% upper

12

Iowa S. MN Lean Hog Weekly Average Price and Basis ($/cwt Carcass)

$(20)

$-

$20

$40

$60

$80

$100S

ep-

01

Mar

-02

Se

p-02

Mar

-03

Se

p-03

Mar

-04

Se

p-04

Mar

-05

Se

p-05

Mar

-06

Se

p-06

Mar

-07

Se

p-07

Mar

-08

Se

p-08

Mar

-09

Se

p-09

ISM Avg Price ISM Basis

Price Basis

Avg 62.55 0.90

Stdev 11.09 3.61

Min 28.77 -10.57

Max 90.43 13.22

13

Specific to time and place

http://www.ams.usda.gov/mnreports/lsddgr.pdf

http://www.card.iastate.edu/ag_risk_tools/basis_maps/

www.BeefBasis.com

http://www.econ.iastate.edu/faculty/lawrence/Acrobat/CurrentLiveCattleBasis.pdf

http://www.econ.iastate.edu/faculty/lawrence/Acrobat/CurrentHogBasis.pdf

14

Grain Basis vs. Livestock Basis

• Grain is a storable commodity and the same grain can be used to satisfy several futures contract delivery months. So grain futures prices tend to be tied to one another.

• Livestock is not storable so livestock futures prices for alternative delivery months tend to move independently.

• Because grain is a storable commodity, the grain basis is tied closely to grain storage costs and interest costs. Livestock are not storable so there are no storage costs built into the basis.

15

Grain Basis vs. Livestock Basis

• An inverse basis in grain futures (cash above futures) is unusual and indicates there is something amiss in the grain industry (lack of transportation, for example). An inverse basis in grains will usually last only for a short period.

• An inverse basis in livestock futures is not unusual for distant delivery contracts and can exist for extended periods of time. Only during the nearby futures contract delivery periods do we expect livestock futures to be above cash price.

16

Basis Summary

• Difference between cash and futures

• Reflects local conditions

• More predictable than futures

• Essential to effective hedging

17

Introduction to Hedging

• Definition

• Types

• Mechanics

18

Hedging definition

• Hedging is buying or selling futures contracts as protection against the risk of loss due to changing prices in the cash markets.

• Holding equal and opposite positions in the cash and futures markets

• The substitution of a futures contract for a later cash-market transaction

19

Market participants

• Hedgers are willing to make or take physical delivery because they are producers or users of commodity. • Use futures to protect against a price movement• Cash and futures prices are highly correlated• Hold counterbalancing positions in the two markets

to manage the risk of price movement

20

Short Hedgers

• Producers with a commodity to sell in the cash market at some point in the future• Are hurt by a price decline

• Short hedgers1 Sell the futures contract initially2 Buy the futures contract (offset) when they sell

the physical commodity

21

Long Hedgers

• Processors or feeders that plan to buy a commodity in the future• Are hurt by a price increase

• Long hedgers1 Buy the futures initially2 Sell the futures contract (offset) when they buy

the physical commodity

22

Preharvest short hedge example

• A farmer will have 50,000 bushels of corn to sell after harvest

• The farmer is long the cash market

• Damaged by a price decline

35

The Storage Hedge

• Store grain at harvest for sale a later date

• Protect against adverse price change

• Help earn a carrying charge• Storage, interest

37

The Storage HedgeTime Cash July Fut BasisNov 1 $3.40 $3.85 $0.45Action store sell July 1 $3.70 $3.00 $0.30Action sell buyGain/loss +$0.30 -$0.15 +$0.15Net gain from storage hedge is +$0.15 and is equal to the change in basis

38

Short hedge for middleman

• It is March. A grain elevator has storage available and is thinking about buying corn to store until July.

• Estimated storage cost is $0.10/bu

• Current spot (cash) price is $3.40/bu

• July corn futures are at $3.70

• Expected July basis is -$.15/bu

39

Short hedge for middleman

• Compare expected price to current price• Expected July hedge price• $3.70-.15-.01= $3.54• Less storage cost -.10• Net price in July $3.44• Current spot price $3.40• Profit potential per bushel $.04

• What is the risk?

40

Short hedge for middleman

• What if prices rise by July?• $4.20-.15-.01= $4.04• Less storage cost -.10• Net price in July $3.94• Current spot price $3.40• Cash profit per bushel $.54• Futures G/L (3.70-4.20) -.50• Net profit $.04

41

Short hedge for middleman

• What if prices fall by July?• $3.20-.15-.01= $3.04• Less storage cost -.10• Net price in July $2.94• Current spot price $3.40• Cash profit per bushel -$.46• Futures G/L (3.70-3.20) +.50• Net profit $.04

42

Short hedge for middleman

• What if the basis changes from expected?• $3.20-.25-.01= $2.94• Less storage cost -.10• Net price in July $2.84• Current spot price $3.40• Cash profit per bushel -$.56• Futures G/L (3.70-3.20) +.50• Net profit -$.06

• Basis changed $.10 and net profit changed $.10

43

Hedging Summary

• “Counterbalancing investment” “equal and opposite” position in cash and futures

• Used to manage price risk

• Basis estimation is essential

• Allows for forward contracting