How Hedgers Utilize Basis
The basis affects both short and long hedgers. Basis risk – that cash and futures prices may change by different amounts – is a concern to hedgers, as fluctuations in basis make for a less than complete hedge.
The Short Hedge
It is July and the cash price for corn is 170 cents/bushel. A farmer wants to be sure to get the best price for her corn. She could sell it for cash, or she could enter into a futures contract to deliver it for 200 cents/bushel in September. The choice would seem apparent. But she knows from historical data that, between September and December, the basis has always strengthened and that, ultimately, the basis this time of year is generally 40 under December. With this year's price levels, that suggests a December futures price of 210 cents/bushel, and she would write a contract to lock in that price.
Short hedgers are long the basis as they are long the actuals. This means that they own or will own a commodity that they hedge by shorting futures. If basis strengthens (the gap between the futures and cash price decreases), the hedger's effective selling price is greater than the cash price that he or she is looking to protect.
In a short hedge, the hedger sells a futures contract to protect against falling prices. Assuming that prices decline, the short hedger makes money on the futures sale which compensates for losses on the actuals. If prices increase, the futures position loses, but the cash position gains.
The Long Hedge
This type of hedge either protects a future cash purchase or short (unowned) position in the underlying commodity. An example of the latter would be a promise to sell goods yet to be purchased by a middleman or produced by a manufacturer. The long hedger purchases futures, as he or she does not have the underlying good that she will have eventually to deliver at what she hopes is a profit. A long hedger is short the basis and wants weakening basis. A decrease in the spot price relative to the futures price advantages the long hedger as it decreases the net cost of assets purchased, which is the cash price on the day that the hedge is put on, less the degree to which basis weakened.
A flour miller will need wheat to produce flour. He purchases wheat futures. A rise in wheat prices increases the cost of his input and reduces his profit. However, the profit on the long futures position offsets the increased cost of wheat. The long position locks in the cost of wheat that he will need to buy in order to produce and sell flour, which he has already agreed to do.
Futures price + expected basis = expected buying price
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