What Is a Basis Price?
A basis price is a price quoted for a security investment regarding its yield to maturity. A basis price is generally quoted for fixed-income securities, such as bonds.
A bond will have a pre-determined annual rate of return. This annual rate is the amount that the bondholder may expect to accrue in interest each year. Assuming that this interest is continually reinvested and that the bondholder does not sell the bond prematurely, the bond will eventually yield to maturity and earn the bondholder the full basis price.
Understanding Basis Price
The basis price lets potential investors know how much they can expect to earn on their investment, should they choose to purchase a given bond or security. This information is helpful because if a bond can be definitively said to earn 9 percent per year, an investor will immediately know if that rate is better than another investment which promises only 6 percent per year. If the price has a basis on the investment's current or future value, the investor would have to calculate the rate of return to compare it with another type of investment.
Basis Price in Commodity Futures
Basis price is also a term used commonly in trading commodity futures. Futures are speculative investments because no one can be 100% certain of what tomorrow will bring. Commodities include things like agricultural products, oil, and metals. These products trade as “futures,” based on the products’ anticipated future prices. The future price basis is on the commodity’s past price, as well as expectations of future market conditions. Also, anticipated instability is considered.
Because they are primarily speculative investment products, futures markets can be volatile. They take into account global market trends and conditions, but they cannot account for the particulars of smaller, individual markets. Thus, they cannot always predict future prices with high accuracy. It may be helpful to look at past prices, but they do not reflect future changes to the market. Market unpredictable can come from political situations, natural disasters, or other unforeseen events that affect the economy. Therefore, they are not very useful to someone who is trying to determine when to buy or sell futures.
To create a more stable base from which to buy and sell futures, investors established an equation that determines a basis price. The basis price for a commodity is equal to the local trading price for that commodity minus the futures price for it at a given time.
For example, if oil is currently trading locally at $100 per barrel, but has a futures price of $95 per barrel in December, the basis price for oil right now would be said to be $5 over December. That’s because the difference between the current local price and the price in December future is $5.