Basis is defined as the difference between a cash price offered for a commodity at a specific location and a futures contract price for that commodity:
Basis = (Local Price – Futures Price)
This difference occurs because futures markets, which capture global conditions and expectations, do not fully reflect the conditions in any particular local market. These
discrepancies may be due to local variability in a commodity's quality level, local demand and supply, and transportation modes, among numerous other factors. If none of these
factors affected prices in a local market, then the basis would be zero, because the local price would be the same as the futures price.
Predicting Local Prices: The Usefulness of Basis
If someone asked you to predict the price of wheat in your local market three months from today, what would be your response? One reasonable strategy might be to
determine the local price last year or take an average of several previous years. However, you would be using only information about what already occurred, without incorporating expectations of
what will occur in three months. A second approach could be to look at the price of a futures contract expiring three months from today and assume that to be the most likely price. However, although
the futures price accounts for local, regional, national, and international expectations about future wheat prices, directly using futures prices to characterize local market conditions and prices
will almost always lead to errors. Both approaches, therefore, are likely to contain inaccuracies.
The solution: using the combination of basis (historical information) and futures prices (rational expectations). Historically, basis tends to be more stable than either
the local or futures prices alone. This is because the volatility in prices caused by market fundamentals tends to affect both local and futures prices in the same direction. That is, when futures
prices rise, local prices generally also increase. Similarly, decreases in local prices are associated with lower futures prices. Therefore, the difference between the local and futures prices,
basis, is not likely to change by the same magnitude as prices themselves.
The stability of basis over time makes it useful for predicting local cash prices for a given commodity and point in time.