The basis or historical difference in the cash and futures price should be used to adjust or localize the futures price. The most accurate basis information is that which can be recorded by beef producers when their cattle are sold. The cash price is for the cattle and what the futures price is on the same day. In hedging with a futures contract, the basis should be used to localize the futures price. This is accomplished by subtracting or adding the basis to or from the futures price.
BASIS
The Key to Successful Forward Pricing
The term basis is used in different ways to define prices in relation to something else. It may be in relation to location or the futures price. In this discussion, basis is defined as the cash price minus the nearby futures price. If the feeder cattle futures price is $350 per hundredweight and the cash price for feeder cattle is $345 per hundredweight, the basis is -$5.00 ($345 minus $350 =- $5.00).
Other uses of the term basis need to be understood to avoid possible confusion. Contract basis is the fixed discount or premium that a buyer is willing to offer in setting the price for cattle to be delivered at a specific time in the future. Another use of the term might be to quote a price such as fed cattle are $350 per hundredweight basis Dodge City. This simply means the quoted price is for the Dodge City areas. It has nothing to do with forward pricing, futures or options.
Why Basis Is Important
The basis or historical difference in the cash and futures price should be used to adjust or localize the futures price. The historical data are usually available from the Extension marketing specialist. The most accurate basis information is that which can be recorded by beef producers when their cattle are sold. Simply note what the cash price is for the cattle and what the futures price is on the same day. If a producer has some record of prices received in the past, the state Extension marketing specialist can usually supply the futures prices for those dates.
In hedging with a futures contract, the basis should be used to localize the futures price. This is accomplished by subtracting or adding the basis to or from the futures price. Similarly, the basis is subtracted from or added to the strike price of an option in order to know what floor or minimum selling price is being set by using the option. Once a futures position is taken in the market, the producer should follow the basis as the time of cattle sale approaches. Usually the cash and futures prices come together during the contract month, but it does not always happen. It is to the seller’s advantage for the basis to become less negative or more positive at time of sale. This will allow the net price to be equal to or higher than projected, using the futures and basis estimate before initiating the hedge.
Example 1: Hedging 1 load (50,000 lbs.) of 725 lbs. steers in October for sale in March.
March feeder cattle futures
$ 350.00
Estimated basis
– 0.33
Expected hedged price in March
$ 349.67
(from page 18)
Date
Cash
Futures
Basis
October
Expected hedged price in March
$349.67
Sell March futures
$350.00
-$0.33
March
Sell cattle
$344.67
Buy March futures
$345.00
-$0.33
Futures profit
$ 5.00
Net price on cattle
Sell cattle
$344.67
Futures profit
+ 5.00
Net price
$349.67
Widening Basis
Date
Cash
Futures
Basis
October
Expected hedged price in March
$349.67
Sell March futures
$350.00
-$0.33
March
Sell cattle
$341.67
Buy March futures
$345.00
-$3.33
Futures profit
$ 5.00
Net price on cattle
Sell cattle
$341.67
Futures profit
+ 5.00
Net price
$346.67
Narrowing Basis
Date
Cash
Futures
Basis
October
Expected hedged price in March
$349.67
Sell March futures
$350.00
-$0.33
March
Sell cattle
$346.67
Buy March futures
$345.00
-$1.67
Futures profit $ 5.00
Net price on cattle
Sell cattle
$346.67
Futures profit
+ 5.00
Net price
$351.67
Example 2: Use of a Put Option in October to set a floor price on feeder steers that will be sold as a load in March, weighing 725 lbs.
Buy March Put Option
$ 350.00
Estimated basis
– 0.33
Premium
– 2.00
Expected hedged price in April
$ 347.67
(from page 18)
Cattle Prices Increase
Date
Cash
Option
Basis
October
Expected hedged price in March
$347.67 Buy March $350.00 $2.00 Put Option
-0.33
March
Put Option expires worthless
-0.33
Sell cattle
$359.67 (March Futures$360)
Option loss $ 2.00
(cost of option)
Net price on cattle
Sell cattle
$359.67
Option loss
– 2.00
Net price
$357.67
Cattle Prices Decrease
Date
Cash
Futures
Basis
October
Expected hedged price in March
$347.67
Buy March $350.00 Sell March $345
$2.00
-0.33
March
Sell cattle
$344.67
Put Option (March Futures $345.00)
$5.00
-0.33
Option profit
$ 3.00
Net price on cattle
Sell cattle
$344.67
Option profit
+ 3.00
Net price
$347.67
Use of basis to localize the option strike price provides a more accurate estimate of the floor price or protection.
Feeder Cattle Basis
It is very important for producers of feeder cattle and calves to track their own basis data. The data contained in these tables are based on Medium and Large Frame No. 1 steer and heifer averages from Tennessee auction markets where 80 percent or more of the cattle sell as singles. Prices for uniform loads of 50,000 pounds may sell for $4 to $5 per hundredweight more than the average of auction cattle. Historical basis have been calculated for load lots of steers and heifers using price data from selected video and graded sale locations and are presented on page 18. Also, if the producer is selling or buying mixed No. 1 and No. 2 cattle, the basis needs to be adjusted to account for the lower cash prices for the lower grading cattle. The estimates in these tables are a starting point, but the beef producer’s own data is more reliable. Some record of cash prices received or paid is needed, as well as the futures prices on the day of sale. These are available from UT Extension, Department of Agricultural and Resource Economics.
Use of Basis in a Long Hedge
A long hedge involves the use of an initial buying of a feeder cattle contract or call option to protect against higher feeder cattle prices. An individual planning to buy stocker calves might do this or an individual or feedlot planning to acquire cattle in the future.
The futures price or call option strike price would need to be adjusted by the basis to know the approximate purchase price (in the case of futures) or ceiling price (in the case of options) being set.
Example 3: To lock in a purchase price in October for 400-500 lbs. steers to be purchased in April.
April feeder cattle futures
$ 350.00
Estimated basis
+ 53.03
Expected hedged price in April
$ 403.03
(from page 10)
If Futures Increase
Date
Cash
Futures
Basis
October
Expected hedged price in April
$403.03 Buy April futures
$350.00
+$53.03
April
Buy cattle
$408.03 Sell April futures
$345.00
+$53.03
Futures profit
$ 5.00
Actual cost of cattle
Buy cattle
$408.03
Futures profit
– 5.00
Actual cost
$403.03
If Futures Decrease
Date
Cash
Futures
Basis
October
Expected hedged price in April
$403.03 Buy April futures
$350.00
+$53.03
April
Buy cattle
$398.03 Sell April futures
$345.00
+$53.03
Futures loss
$ 5.00
Actual cost of cattle
Buy cattle
$398.03
Futures profit
+ 5.00
Actual cost
$403.03
Example 4: Use of a Call Option in October to set a ceiling price on a planned purchase of 450 lbs. steers in April using a $355 strike price and a premium cost of $2/hundredweight.
Feeder cattle basis estimates are also used in forward cash contracts with a cattle buyer to buy feeder cattle. Buyers will look at the futures price when the cattle will be delivered and adjust that price using historical basis information. They may also deduct an additional amount for costs associated with their use of the futures market, which protects them should the cattle market decline.
In the fed cattle business, most packers offer cattle feeders the opportunity to price cattle in advance of delivery using either a fixed price or basis contract. The fixed price contract is typically even with $2 per hundredweight under the futures price for the particular month of delivery. The futures price is usually the same as the cattle delivery month or the month following the month of delivery. The futures price is discounted by the basis. That basis is taken from the historical basis adjusted for the particular set of cattle being contracted. A set of desirable cattle likely to grade a high percent Choice of Yield grade 1, 2 or 3 would have a smaller discount to the futures or perhaps no discount at all. A less desirable set of cattle would have a larger (more negative) basis and consequently a lower contract price. A review of historical basis would help the cattle feeder to know whether the basis being offered was reasonable. If they believed it was too wide (negative), they could hedge the cattle directly on the futures market and hope to have a smaller basis.
Basis contracts offered by packers result in a commitment for the packer to buy the cattle at a certain basis. That basis would again reflect the historical basis and that particular set of cattle (quality). The seller would then have a period of time to set the price. That price would depend on the futures price for the month specified in the contract. Again, the seller could use historical basis data to decide if the basis offered by the packer is reasonable. Some forward price contracts and basis contracts have specifications requiring that the cattle grade a certain percentage Choice with limits on the yield grade and carcass weights.
