What is 'Basis Grade'

Basis grade is the minimum accepted standard that a deliverable commodity must meet to be used as the actual asset of a futures contract. This is also known as par grade or contract grade.

BREAKING DOWN 'Basis Grade'

Basis grade is important for futures investors for maintaining uniformity, since a given commodity such as oil may vary drastically in quality. For example, the basis grade of crude futures contracts is set according to certain levels of hydrogen and sulfur in crude oil.

A grading certificate issued by qualified inspectors or an approved grading panel may be used to evaluate and document the grade of a particular commodity. Other official documentation that confirms the products meet the required specifications may also suffice.   

As the name implies, as basis grade establishes a baseline from which other variations of the same product or material can be compared to make an assessment of quality of determine their acceptability. Anything that fails to meet this level established by the basis grade would be rejected as unacceptable. Of course, since this is just the minimum standard that would be tolerated, ideally the commodity would exceed the criteria determined by this grade. Higher quality products that far exceed the basis grade could command a higher value and possibly justify a better exchange rate.

Basis grades and differentials

Deviations to any significant degree from the level established by the basis grade would result in differentials. This would be any adjustment that must be made based on the quality of the actual commodity when compared to the characteristics of minimum acceptable quality as established by the basis grade. If the assessed commodity is determined to be of better quality and thus rates above the basis grade, it could command a premium rate. On the other hand, products or materials that fail to at least meet the standards set by the basis grade may incur a reduction in value, if they are deemed acceptable at all.

Differentials may also come into play if there is an adjustment to the specified location of the commodities involved in a futures contract. Some futures contracts allow for differentials, while others do not. If they are allowed, the contacts would typically allow the short position to make these adjustments. These differentials, when allowed, and all other terms related to quality and premiums or penalties would be spelled out by the contract, and are usually established in fixed terms on most exchanges.

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