The futures markets for livestock indicate the prices for cattle and hogs that are discovered through buying and selling at the exchange, representing the culmination of the forces of supply and demand.
Livestock cash prices and futures prices tend to move up and down together, which is what makes the concept of effective hedging possible. But those involved in the business of buying or selling cattle and hogs are aware that the cash price in their own local area, or what their supplier quotes, usually differs from the price that is quoted in the futures market.
This is because in local markets, the futures price for livestock is going to be adjusted for such variables as quality, location, and transportation, as well as supply and demand factors impacting that particular area.
This price difference is known as the basis, which is calculated as the cash price minus the futures price, and can be either positive or negative.
A negative basis is referred to as being under, meaning the cash price is lower than the futures price.
A positive basis is referred to as being over, meaning the cash price is higher than the futures price.
Basis is important because it can help a livestock or meat buyer or seller determine if they should use futures to manage the price risk of their eventual cash market purchase or sell, when to initiate or close out their futures position and who they should eventually sell their animals to, or who they should buy them from.
But most significantly, the basis is important because it affects the final outcome of a hedge, in terms of the ultimate price paid or received.
One issue in determining the livestock basis is identifying which cash market price should be used in the calculation. There are numerous livestock cash markets around the world, but you only need to be concerned with the local market that you regularly buy from or sell to. The futures price used to calculate the basis should be the futures price of the contract month that is closest to, but not before, the time period in which you plan to buy or sell the physical livestock product.
Suppose in September a producer plans to sell calves to a feedlot in February. He would be looking to establish a short position in the March Feeder Cattle futures contract. The March Feeder Cattle futures price is $152 per hundredweight, and the cash price in his local area in February is normally about two under the March futures price. With a basis of two under, the approximate selling price the cattle farmer is hoping to establish by hedging is $150 per hundredweight, which is the March futures price of $152 minus the basis.
One of the key considerations in understanding the basis is its potential to strengthen or weaken when cash prices increase or decrease relative to the futures prices. The more positive, or less negative, the basis becomes, the stronger it is. In contrast, the more negative, or less positive, the basis becomes, the weaker it is.
A strengthening basis will increase the selling price for a short hedger. In the previous example, suppose the basis in mid-February turned out to be one under rather than the expected two under. The net selling price, taking into account both futures and cash transactions, would be $151 per hundredweight, rather than $150. If the cash market price decreases relative to the futures price, the basis is said to have weakened. A basis that is weaker, or more negative, than expected decreases the selling price. Had the basis changed from two under to three under, the net selling price would be $149.
Basis has the exact opposite effect on long-term hedges: long hedgers benefit from a weakening basis.
Imagine that in March a meat packer is planning to purchase hogs in September for his packing operation, so he is looking to establish a long position in the October Lean Hog futures contract. Lean Hog futures are trading at $70 per hundredweight, and the local basis is typically five over the futures price. The hedge would result in an expected purchase price of $75: the $70 October futures price plus the five over expected basis.
But what if the basis strengthens, in this case, becomes more positive, and instead of the expected five over it is actually seven over in September? Then, the net purchase price increases to $77 per hundredweight ($70 + 7).
Conversely if the basis weakens, moving from five over to three over, the net purchase price drops to $73 per hundredweight ($70 + 3). Again, note that the long hedgers benefit from a weakening basis and short hedgers benefit from a strengthening basis.
As you can see, the behavior of the basis livestock markets can have a significant impact on the performance of a hedge. By hedging with futures, livestock buyers and sellers are essentially reducing their price risk by assuming basis risk. Luckily, basis risk is typically much lower than price risk, so hedgers are usually quite happy to make this tradeoff.
Planning is key and it is important that hedgers maintain historical basis records in order to make realistic basis expectations for the time they plan to buy or sell.