The Importance of Basis to Hedging Success

Distributing surplus commodities, St. Johns, A...

Distributing surplus commodities, St. Johns, Ariz. (LOC) (Photo credit: The Library of Congress)

The importance of basis has been greatly discussed by various academics and experts in the industry – however, I wanted to touch on this subject quickly for those who’ve never thought or read about it before.

In simple terms, basis is the difference between the price of a physical commodity at any specific location at the current point in time and the future price of that commodity for a certain delivery month. Unlike futures and options, basis is all about today.

As basis refers to the price of the commodity in a specific location, it does indeed reflect the local supply and demand. Therefore, basis for soft wheat in Lisbon, Portugal, will be clearly different to the basis for soft wheat in Rouen, France. Moreover, basis for wheat in the Krasnodar region of Russia will be different to basis for wheat in neighboring Rostov.

Basis also reflects logistics and transportation issues and availability in the local market place, as well as handling costs and profit margins, quality of the crop and currency movements.

It is essential to understand and calculate your basis prior to looking into hedging. Comparing historical levels of basis to current ones helps hedgers to make a decision of either being long or short basis from a hedging perspective. It also helps to decide on the best time to enter the market to give one a better chance to overcompensate as the hedge is closed out. Charting the basis historical versus current basis levels will definitely help to visualize the logic behind it.

I was attending a recent Gafta (Grain and Feed Trade Association) foundation course where I had a chance to talk with participants from the grains and oilseeds physical trade and to understand their concerns and issues. As always, the first question to be asked was "why would one hedge and what are the guarantees?"

Analyzing the volatility in the market based on Commodity Research Index (CRI) it is clear that we are in a period of high and continuous volatility (37% 2011 vs 20% in 2001-2006). Both the grains and oilseed industries could experience an increase in volatility this year - both Ukraine and Russia expressed their concerns over the size of the crop over the summer as the winter was cold but with a lack of snow, which could damage the crop.

The same is applicable to the rapeseed crops from Poland and parts of Eastern Europe. High volatility in the markets could mean only one thing to the end users - unpredictable profits or losses, inability to work on budget and lock in the margin. That pretty much answers the question of why to hedge and how derivative contracts could be used to offset the price volatility risk.

NYSE Liffe, along with our partners, often organizes seminars and webinars on the subjects described above, as well as more specific commodity derivatives courses. For more information, please visit our education pages on the website. We are also hosting a one day workshop on hedging strategies on 17 April 2012 in Kiev. Please contact me on epatimova@nyx.com if you are interested in attending.

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