Trader Resources : Hedging in the Futures Markets : Important Concepts in Hedging
One of the most important concepts in hedging is the basis. The basis is the difference between the cash market price and the futures price of a certain commodity at the same point in time. When selecting a futures contract, the futures contract for month closest, to but beyond, the estimated month of product delivery is usually chosen. Thus, the basis is calculated as such:

Basis = Cash Price – Futures Price

The basis value will change over time and is affected by many factors, including:

• Time – cost of storage, expectations.
• Space – Availability of storage, cost of transportation.
• Quality – Differences from contract specifications.
• Availability and price of substitutes.

When hedging, general price level risk is eliminated, and the only risk left to manage is basis risk. There are repeatable patterns in the relationship between cash market price and futures price. Consequently, evaluating historical patterns in this relationship can give indications on what the Expected Basis will be. Developing an expected basis for when you will sell or buy your cash commodity is essential to better understanding the potential for marketing alternatives to satisfy management objectives. The more we understand about basis patterns, the better we will be at managing risk to meet our organization objectives.

Once an expected basis has been derived, it can be used to calculate the value another important concept in hedging: the target price. The target price is the net price you expect to receive or pay for products you will sell or buy when hedging in the Futures Market. It is calculated as follows:

Target Price = Futures Price + Expected Basis

For example, if you believe that that on October 1 the expected basis for your corn crop relative to the November corn futures contract will be -$0.25 and the price of the corn futures contract is $2.95, then your target price would be:

Target Price = $2.95 - 0.25 = $2.70

Evaluating the success of a hedge can be done using another important hedging concept, the net price. Net price can be calculated in a number of ways, including:

• The cash price in at the beginning of the hedge, plus any gains or losses accrued in both in the cash and futures markets over the course of the hedge.
• The cash value of the product at the end of the hedging period plus any gains or losses in futures market.
• The cash value of the product at the beginning of the hedge, plus the change in basis.

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