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"Cash Basis" - How it Works

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"Cash Basis" - How it Works

Post by fxjedi on Tue Sep 16, 2008 6:15 pm

The cash market is also called the “prompt” market, the “physical” market or the “spot” market.

All futures markets are based upon some type of underlying cash or physical market. A futures market must be tied to some type of physical market, in order to keep the futures market price fairly valued and actively traded. For example, in the corn futures there is the “cash” corn that farmers harvest and deliver to their local elevators. In the crude oil futures, there is the physical crude oil that is refined into various industrial forms, such as gasoline. In gold, there is the world “spot” market and London cash fixings. The same situation applies to other raw commodities futures. All have some type of an underlying cash market.

U.S. Treasury Bond futures also have a cash market, which is the actual debt sold at auction by the U.S. Treasury Department, via bonds, notes and bills. Stock index futures also have a cash market, which are the actual individual stocks that are bought and sold on stock exchanges.
Many cash market products are actually deliverable at designated locations to offset an existing position in the futures market. Grain futures are one example of a deliverable commodity against existing futures market positions. There are some futures markets that are cash-settled only, such as feeder cattle futures and the stock indexes.

Cash Market “Basis”

Cash basis is defined as the cash price of the commodity minus the futures price of the commodity. Basis can be positive or negative depending on the factors that determine basis. These factors include local supply and demand for the raw commodity, supply and demand for transportation, variations in the commodity’s quality and the futures contract specifications, and the availability of substitutes for the commodity. Generally, transportation expenses makes up the largest portion of cash basis.

Changes in cash basis are not as volatile as changes in cash market or futures prices. Changes in basis tend to follow seasonal patterns. At harvest, grain supplies are generally more plentiful, resulting in a higher demand for transportation services and an increased cost to move grain (weaker basis). Post-harvest improvement in basis often occurs because of increased availability of transportation services at a better price, and improvements in local supply and demand conditions.

Country grain elevators base the price they will pay farmers for their grain on the price of grain futures at the Chicago Board of Trade. For example, a grain elevator in central Nebraska will likely have a wider basis than will a grain elevator located on the Mississippi River in Dubuque, Iowa. Reason: Shipping costs to get grain from the elevator in central Nebraska to the Gulf of Mexico are more than the shipping costs of the elevator located in Dubuque, Iowa, shipping to the Gulf of Mexico.

For example, the cash soybean price quote from a grain elevator in Nebraska might be “28 cents under the May futures contract.” Whereas the cash soybean quote from a Dubuque elevator might be “8 cents under the May futures contract.” And at the Gulf of Mexico, cash soybeans could be quoted at “30 cents over the May contract.” See how the basis “narrows” as the cash grain gets closer to its final shipping destination. The cash basis at the Gulf of Mexico includes the transportation costs of getting the grain to that major shipping destination.

Changes in cash basis levels are closely watched by futures traders. Commercials go to great lengths to keep history and study various cash basis levels for the markets in which they are involved. It is a laborious process. Changes in cash basis levels signal changes in demand coming from the end-users and changes in supply coming from the producers of the raw commodity.

fxjedi

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