Kevin Dhuyvetter
Extension Agricultural Economist
K-State Research and Extension
Presented at K-State Risk Management Workshops
Winter 2005
• Basis is the difference between two prices.
• In commodity marketing, basis is generally referred to the difference between a specific cash price and a specific futures price.
• Mathematically: Basis = Cash - Futures
• Nearby and Deferred
1

0
(+)
Over
Strong
Narrow
Under
Weak
Wide
(–)
Basis = Cash - Futures
… strong, narrow, weak, wide are all relative terms
• Generally, basis is more predictable than cash or futures prices due to:
·
Convergence
·
Futures and cash prices move together
(same fundamental conditions generally affect both markets)
·
Year-to-year stability
2

• Determine:
·
Location, date, quality, futures contract
• Daily vs. weekly (grain vs. livestock)
• Mathematically: Basis = Cash - Futures
• It is “easy” to calculate basis …
… but it is important to use the “right” price if we want the information to be useful.
3

Feeder cattle price indices
Seasonal Price Index for Steers, Dodge City, KS -- 1995-2004
104%
103%
102%
101%
100%
99%
98%
97%
96%
95%
5-6 cwt 6-7 cwt 7-8 cwt
94%
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Basis patterns will vary by calf weight
Weekly average feeder cattle prices
Weekly Feeder Cattle Prices
125
120
115
110
105
100
95
90
KS wt avg, 700-800
Cash index
Nearby futures
85
80
75
70
1/
5/
20
01
4/
5/
20
01
7/
5/
20
01
10
/5
/2
00
1
1/
5/
20
02
4/
5/
20
02
7/
5/
20
02
10
/5
/2
00
2
1/
5/
20
03
4/
5/
20
03
7/
5/
20
03
10
/5
/2
00
3
1/
5/
20
04
4/
5/
20
04
7/
5/
20
04
10
/5
/2
00
4
Prices appear to move together quite well
4

LRP versus hedging basis
Weekly Feeder Cattle Basis (700-800 lb steers)
12.00
10.00
8.00
6.00
4.00
2.00
Cash index
Nearby futures
0.00
-2.00
-4.00
-6.00
-8.00
Basis levels vary within a year and across years
-10.00
1/
5/
20
01
4/
5/
20
01
7/
5/
20
01
10
/5
/2
00
1
1/
5/
20
02
4/
5/
20
02
7/
5/
20
02
10
/5
/2
00
2
1/
5/
20
03
4/
5/
20
03
7/
5/
20
03
10
/5
/2
00
3
1/
5/
20
04
4/
5/
20
04
7/
5/
20
04
10
/5
/2
00
4
LRP versus hedging basis
Cash Index Basis less Nearby Futures Basis (700-800 lb steers)
6.00
4.00
2.00
0.00
-2.00
-4.00
-6.00
-8.00
-10.00
-12.00
-14.00
1/
5/
20
01
4/
5/
20
01
7/
5/
20
01
10
/5
/2
00
1
1/
5/
20
02
4/
5/
20
02
7/
5/
20
02
10
/5
/2
00
2
1/
5/
20
03
4/
5/
20
03
7/
5/
20
03
10
/5
/2
00
3
1/
5/
20
04
4/
5/
20
04
7/
5/
20
04
10
/5
/2
00
4
5

LRP versus hedging basis
Weekly Feeder Cattle Prices
140
135
130
125
120
115
110
105
KS wt avg, 500-600
FC cash index x 110%
Nearby futures
100
95
90
85
80
75
70
1/
5/
20
01
4/
5/
20
01
7/
5/
20
01
10
/5
/2
00
1
1/
5/
20
02
4/
5/
20
02
7/
5/
20
02
10
/5
/2
00
2
1/
5/
20
03
4/
5/
20
03
7/
5/
20
03
10
/5
/2
00
3
1/
5/
20
04
4/
5/
20
04
7/
5/
20
04
10
/5
/2
00
4
LRP versus hedging basis
Weekly Feeder Cattle Basis (500-600 lb steers)
35
30
25
20
15
10
5
Cash index
Nearby futures
0
-5
-10
-15
1/
5/
20
01
4/
5/
20
01
7/
5/
20
01
10
/5
/2
00
1
1/
5/
20
02
4/
5/
20
02
7/
5/
20
02
10
/5
/2
00
2
1/
5/
20
03
4/
5/
20
03
7/
5/
20
03
10
/5
/2
00
3
1/
5/
20
04
4/
5/
20
04
7/
5/
20
04
10
/5
/2
00
4
6

• Judge cash/contract bids
• Storage decisions
• Lifting hedges
• Projecting cash prices
• Picking marketing
• Evaluating hedging alternatives
Futures price
+ expected basis
Expected cash price*
* Simple and reasonably accurate procedure for formulating cash price forecast.
7

• Where does “expected” basis come from?
• Basis forecast = f (historical basis)
• Research has generally shown there is little benefit to complex fundamental models compared to historical averages.
• “Optimal” historical averages
·
Livestock, 3-yr or 4-yr average
LRP versus hedging basis…
1.00
0.00
-1.00
-2.00
-3.00
1
7.00
6.00
5.00
4.00
3.00
2.00
2002-04 Weekly Average LRP and Futures Basis, 700-800 Lb Steers
4
Cash Index, 700-800 Nearby Futures, 700-800
7
10 13 16 19 22 25 28 31 34 37 40 43 46 49 52
Week
8

LRP versus hedging basis…
2002-04 Weekly Average LRP and Futures Basis, 500-600 Lb Steers
25
20
15
10
5
0
-5
1 4
Cash Index, 500-600 Nearby Futures, 500-600
7
10 13 16 19 22 25 28 31 34 37 40 43 46 49 52
We ek
Put option strike (97.9%)
+ Expected basis
$96.00
3.50
− Premium 2.13
= Expected minimum selling price $97.37
Based on May FC futures of $98.02 on 2/11/05 and expected selling date of mid May
9

LRP coverage level (93.9%) $92.29
+ Expected basis
− Premium
4.00
1.21
= Expected minimum selling price $95.08
Based on LRP quotes on 2/11/05 and ending date of 5/13/05
(expected ending value = $98.31, 13 week endorsement)
10

• Average over several years (years may vary depending on commodity)
·
Average = expected value
• Measure variability (risk)
·
·
Historical range (highs and lows), standard deviation
Variability measure indication of risk
Weekly Dodge City Steer Prices
1995-2004
Purecount
Count
Average
Min
Max
Date (Wed)
09/01/2004
09/08/2004
09/15/2004
09/22/2004
09/29/2004
10/06/2004
10/13/2004
10/20/2004
10/27/2004
11/03/2004
11/10/2004
11/17/2004
11/24/2004
12/01/2004
12/08/2004
12/15/2004
12/22/2004
12/29/2004
2004
2004
2004
2004
2004
2004
2004
2004
2004
2004
2004
2004
Year
2004
2004
2004
2004
2004
2004
45
46
47
48
41
42
43
44
49
50
51
52
Week
35
36
37
38
39
40
522
522
79.70
50.8
118.37
Futures Contract
110.15
Sep
110.85
113.97
Sep
Sep
114.70
114.80
113.10
Sep
Sep
Oct
114.10
112.25
114.07
107.92
108.20
108.37
102.27
103.27
102.42
102.07
104.72
103.05
Oct
Oct
Oct
Nov
Nov
Nov
Jan
Jan
Jan
Jan
Jan
Jan
406
522
88.70
50.12
132.08
5-6 cw t
132.08
120.50
123.89
132.00
n/a n/a
127.14
124.99
122.82
119.14
118.48
115.56
n/a
115.25
121.10
116.67
n/a n/a
382
522
96.40
52.57
150
4-5 cw t
144.77
132.00
137.96
136.00
n/a
128.64
142.69
n/a
137.03
134.75
136.16
133.50
n/a n/a n/a
129.00
n/a n/a
488
522
79.86
49.89
121.75
7-8 cw t
113.17
114.77
113.71
117.27
n/a
117.42
114.52
115.88
114.46
111.50
109.51
110.29
n/a n/a
106.42
105.13
107.00
n/a
442
522
82.51
51.08
122.75
6-7 cw t
114.85
115.12
n/a
118.53
n/a
119.46
115.72
110.89
113.26
109.48
112.83
107.71
n/a
110.00
n/a
108.36
108.32
n/a
11

Dodge City 7-8 cwt feeder steer basis
10
8
6
4
2
-4
-6
0
-2
3-yr Avg, 10-yr Min/Max Basis for 7-8 cwt Feeder Steers
Max
Avg
Min
Contract / Weeks to Expiration
1995-2004
Dodge City 7-8 cwt feeder heifer basis
4
2
0
-2
-4
-10
-12
-6
-8
3-yr Avg, 10-yr Min/Max Basis for 7-8 cwt Feeder Heifers
Max
Avg
Min
Contract / Weeks to Expiration
1995-2004
12

Dodge City 5-6 cwt feeder steer basis
0
-10
-20
30
20
3-yr Avg, 10-yr Min/Max Basis for 5-6 cwt Feeder Steers
Max
Avg
Min
10
Contract / Weeks to Expiration
1995-2004
Dodge City 5-6 cwt feeder steer basis
20
15
10
-10
-15
5
0
-5
3-yr Avg, 10-yr Min/Max Basis for 5-6 cwt Feeder Heifers
Max
Avg
Min
Contract / Weeks to Expiration
1995-2004
13

Absolute forecast error = 3-yr average - actual
4
3
2
1
0
6
Mean Absolute Basis Forecast Error, Feeder Steers -- 1995-2004
5-6 cwt 6-7 cwt 7-8 cwt
5
Contract / Weeks to Expiration
Easier to predict heavier weight steers
Absolute forecast error = 3-yr average - actual
4
3
2
1
0
6
Mean Absolute Basis Forecast Error, Feeder Heifers -- 1995-2004
5-6 cwt 6-7 cwt 7-8 cwt
5
Contract / Weeks to Expiration
Easier to predict heavier weight heifers (easier to predict heifers than steers)
14

• Basis is generally more predictable than prices.
• Very important when thinking about basis to make sure relevant/correct prices are used.
• Ignoring missing data in a multiple year average may lead to inappropriate averages.
• Basis is typically forecasted using historical basis information.
Kevin C. Dhuyvetter
785-532-3527 kcd@ksu.edu
15