The cash-futures basis

Figure 4: Cash-futures Basis

The difference between a commodity's or security's cash and futures prices is known as the "cash-futures basis," as illustrated in Figure 4. While futures trading can eliminate price level risk, it cannot eliminate the risk that the basis will change unfavorably and unpredictably during the lifetime of the hedge. The cash-futures basis is subject to many influences, including seasonal factors, weather conditions, temporary gluts or scarcities of commodities, and the availability of transport facilities. Other factors affecting the relationship between cash and futures prices are costs related to carrying commodities and securities, such as interest rates and warehouse fees. In certain financial markets, basis reflects the difference between long-term and short-term interest rates.

Basis risk is particularly prevalent in "cross hedging" one commodity with another one. For example, if the commodity to be hedged does not have an exact match in the futures market, the closest commodity may have to be substituted—e.g., an airline might use crude or heating oil futures to hedge jet fuel needs or a money manager may use the S&P 500 Index futures contract to hedge his portfolio of stocks. Prices of the two types of fuel or the two groups of securities may move closely for significant periods of time, but there is no guarantee that past price relationships will continue into the future. Care must be taken to evaluate properly the relationship between the commodity underlying the futures contract and the cash commodity being hedged.