What is the Basis Grade
The basis grade is the minimum accepted standard that a deliverable commodity must meet for use as the actual asset of a futures contract. This grading is also known as par grade or contract grade.
Basis grade is vital for trading in futures and to maintain uniformity within the market.
BREAKING DOWN Basis Grade
As the name implies, the basis grade establishes a baseline from which other variations of the same product or material compare. Products failing to meet this established basis grade, are unacceptable and have the risk of rejection. Since basis grade is the minimum tolerable accepted standard, ideally the exchanged commodity would exceed the criteria. Products of a higher quality which exceed the basis grade command a higher value and justify better exchange terms.
Commodities such as oil and grains may vary drastically in quality. For example, the setting of the basis grade for a crude futures contracts is according to the specific levels of hydrogen and sulfur contained in the oil.
A grading certificate issued by a qualified inspector or an approved grading panel will evaluate and document the grade of a particular commodity. Other official documentation that confirms the products meet the required specifications may also suffice.
Differentials and Basis Grades
Significant deviations from the basis level grade would result in differentials. A differential is the value or degree of adjustment to the category of deliverables, or to their location, as permitted by a futures contract. Differentials include any modifications to the futures contract.
Futures contracts have standardization concerning the quality and quantity of a given commodity. Because of this, the futures price is representative of a typical range of conditions of the given commodity, and therefore is an average price. If the assessed merchandise is determined to be of better quality and rates above the basis grade, it could command a premium rate. Conversely, products which fail to meet at least the standards set by the basis grade may be unacceptable.
Some futures contracts allow for differentials, while others do not. If permitted, the contacts would typically allow the short position to take the differential. The terms of the contract identify differentials, basis grade, and other conditions related to quality, premiums, or penalties and are fixed conditions on most exchanges.