What Is Booking the Basis?
Booking the basis is an arrangement made between a buyer and a seller using a forward sales agreement. Booking the basis effectively locks in the current basis, or the discrepancy between the futures contract price and the spot price of the underlying asset. It does not lock in the full price that must be paid at the end of the contract/agreement.
The full price is the basis added to (or subtracted from) the price of the goods, which will be determined at a later date. The price of goods may be selected at any time in the future, usually based on the market rates at that time. The basis will be added or subtracted from that price to determine the full price of the payment for the sales agreement.
This can be put into use by traders or firms who believe that the basis will expand or contract in the future and wish to hedge themselves against that risk.
- Booking the basis locks in the basis for a forward sales agreement but does not lock in the final total price of the agreement.
- To determine the final or total cost of the sales agreement, the basis is added (or subtracted) to the price of the goods in question, which is determined at a future date.
- The basis is typically calculated as the difference between the price of a futures contract and the spot price for that asset.
Understanding Booking the Basis
"Booking the basis" is used to calculate a portion of the price of a sales agreement. The price of goods will be set let later, but the basis is determined now. The basis and price of the goods will be added together at a later date to provide the full price of the sales agreement.
First, the two parties to a transaction agree upon the formula or basis for the deal. Then, at a later date, the final price is found by applying the previously agreed-upon basis to the current price of goods levels. The agreed-upon basis may be either positive or negative and is typically the difference between the spot price and the futures price in the market.
In effect, the two parties are only locking in the difference between a futures price and a spot price. They are agreeing to add (or subtract) this difference from the actual price of the goods. The price of the goods will be determined at a later date and is usually based on the prevailing rates in the market at that time.
Example of Booking the Basis
Imagine that a forward sales agreement for delivering cotton is inked in June, with the buyer and seller agreeing to a time horizon ending in November. Both parties also agree that a basis of $20 will be added to the price of cotton at some later date. They may agree to this level because the spot price for cotton is trading at $200 while the front-month futures contract is trading for $220.
Since the basis has booked, this means that the buyer, the seller, or both parties will have the option to declare at an earlier date than November what the price of goods will be. For example, one party may request to lock in a price of goods in August when the futures price of cotton is $210.
The total payment or cost of the sales agreement would be $230 = ($210 + $20), which results from adding the original basis to the agreed-upon price of goods.
By booking the basis, both sides have locked in a $20 basis.