1.4.2.3. Understanding Basis
We have defined basis as the difference between the cash and futures price of a commodity. We have also said that hedgers in the futures market are not buying and selling commodities, but they are buying and selling basis. Let’s see how this works.
Example: Ralph is a corn farmer with his harvest expected five months from now in September. He calls his local grain elevator and learns that it is bidding $2.52 for corn and the September futures price is $2.74. Basis is -$0.22. Ralph wishes to hedge against falling corn prices. From his knowledge of the local market, he also suspects that the basis is abnormally weak and will become less negative. If the basis was at its normal level for this time of year, the futures price would be lower. He decides that now is a good time to sell a futures contract. He places a short hedge on September corn.
By early August, the cash price of corn has dropped to $2.40, and September corn is selling at $2.60. Basis has strengthened (become less negative) to -$0.20. Ralph decides to sell his corn now and offset his futures contract by buying September corn. By selling the corn at $2.40, he has lost $0.12 in terms of the price he could have gotten last April ($2.52 – $2.40). But by b