Basis Risk: Measurement and Analysis of

Basis Fluctuations for Selected Livestock

Markets
Philip Garcia, Raymond M. Leuthold, and Mohamed E. Sarhan

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Unanticipated basis changes can reduce the ability of futures markets to transfer risk and
can affect income levels o f p r o d u c e r s and market participants. This study examines
short-term basis risk, defined as the variance o f the random c o m p o n e n t of the basis over
time, for several Midwest livestock markets. Basis risk is related to several factors
influencing the long-term pattern in the time series and u n e x p e c t e d changes in price.
Litfle evidence is found that basis risk changed as maturity approached or that risk
va¡ across markets except for the Interior Iowa hog market.

Key words: basis risk, livestock markets, variate difference.

Understanding the basis and the factors which such as livestock, change form over time, and
affect its behavior are fundamental to success- inventory demand is not in the character tradi-
fui commodity production and marketing deci- tionally associated with storable commodities.
sions, t Unanticipated basis movements re- This leaves open the degree of the tie between
duce the ability of the futures market to trans- today's cash price and today's price for de-
fer risk from hedgers to speculators and can ferred delivery. However, this does not make
result in lower income to hedgers. Commercial the understanding of the basis for livestock
firms and traders who buy in either the cash or products any less important as commercial
futures market and sell in the other market do firms, producers, and traders do take market
so in anticipation of a specific change in the positions with respect to the basis. Unantici-
basis. Unexpected changes in this basis create pated basis changes can affect their income
additional risk for the hedger associated with levels and risk management positions, so un-
this market position and make it less desirable derstanding basis risk and developing appro-
to hold. Empirical assessment of the magnitude priate marketing strategies become important.
and volatility of the basis and analysis of the One important area of livestock basis re-
factors influencing basis risk may permit the search that has emerged examines its variabil-
development of selected management prac- ity over time and space and assesses alterna-
tices designed to minimize basis risk impacts tive hedging strategies with respect to ex-
on market participants' decisions. pected returns and variance (risk). These stud-
Livestock basis relationships, in general, ies (Price et al., Bobst and Davis), while il-
have not received as much attention by re- luminating in many respects, implicitly as-
searchers as the cash-futures price relation- sume that all variation in the basis is random
ships for storable commodities. 2 This stems and therefore risky. A recent examination of
from the fact that nonstorable commodities, the variation in live-cattle basis suggests that
this may not be approp¡ (Leuthold). Using
The authors are, respectively, an associate professor, professor, variables which reflect current and expected
and assistant professor, Department of Agricultural Economics, supply, a rather large percentage of the vari-
University of Illinois at Urbana-Champaign. ation in monthly bases is explained. More
Review was coordinated by Richard T. Crowder, associate
editor. reasonably, basis fluctuations should be
Conceptually, the basis is defined as the difference between viewed in terms of a systematic component
cash and futures prices. The specific basis definition used in the and an unsystematic, or risky, component.
empirical portion of this paper is defined latez.
2 A complete review of livestock basis work through 1979 is
The primary objective of this paper is to
provided by Leuthold and Tomek. measure and analyze within-contract basis

Copyright 1984 American Agricultural Economics Association

500 November 1984
risk for selected livestock markets. Basis risk
is defined here as the variance of the random,
unsystematic, component of the basis over
time. Presumably, the systematic component
of basis variation can be identified and used by
producers and market participants in their
marketing strategies. In this context, basis risk
increases when the unsystematic component
of the time series increases, that is, when the
unsystematic variance widens (Ishii).
Knowledge of this basis risk based on day-
to-day variation within contracts is important
because the producer has the option of making
cash sales over a period of several weeks.
Abrupt changes in the basis can influence the
final value of hedged commodities purchased
and sold. Awareness of this basis behavior
also permits assessment of a number of differ-
ent and important questions. Does basis risk
vary across markets? Are basis risk levels
higher as contracts approach maturity, or does
the increased market information and activity
near maturity influence both futures and cash
prices in a similar manner? Are levels of
short-run risk in livestock basis behavior re-
lated to general perturbations in the economy
and long-run factors influencing the livestock
sector? Finally, do differences exist in the pat-
tern of random behavior between cattle and
hog bases?
The paper is organized as follows: first, the-
oretical considerations are presented concern-
ing basis behavior; second, methodology and
data are detailed; third, results of the variate
difference and the regression analysis used to
assess the factors that influence basis risk are
examined; and finally, a summary of findings
and implications are presented.
The Theoretical Model
For nonstorable commodities, the basis is not
a market determined value as in the case of
grains. Instead, it is the difference between
two rather independent series. The futures
price for nonstorable commodities can be in-
terpreted as reflecting the expected cash price
a t a particular time in the future, given current
information. That is, it is determined by the
interaction of expected supply and demand.
The cash price is a result of current supply and
demand conditions. The difference between
the two series, the basis, reflects the expected
relative movement in cash prices and, hence,
is a function of expected shifts in supply and
demand.
The basis may change a s a result of (a) the
Amer. J. Agr. Econ.
passage of time--as the maturity of the fhtures
contract nears, the cash and futures prices
should approach each other; and (b) new in-
formation about expected supply and demand
conditions becoming available. The impact of
new information on the magnitude of the basis
is unclear. With new information, the basis
can either expand or contract in response to
the nature of the information.
The risk associated with short-term (daily)
basis behavior results from factors related to
the flow of new information and its impact on
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futures and cash prices. The arrival of new
information influencing price tends to occur
rather randomly. Its frequency and impact on
current and expected supply and demand is
uncertain and often unpredictable.
In addition, rather similar information may
influence the basis behavior differently at var-
ious points in the contract life, resulting in
varying levels of risk throughout the contract.
In early periods of the contract, new informa-
tion about expected supply and demand tends
to influence the futures more than current cash
pfice. Also, in these periods, forecasts of sub-
sequent supply and demand, based on new
information, may be subject to large error.
This forecast error may result in unwarranted
movement in futures prices and, hence, in-
creased risk. As maturity nears, cash and fu-
tutes are more closely tied. Changes in infor-
mation may affect both cash and futures in a
similar manner. Further, as maturity nears,
market participants presumably are able to
forecast more accurately subsequent demand
and supply conditions. F o r a given level of
information, this may result in more accurate
forecasts of the expected cash price and less
basis risk.
These considerations indicate that the risk
in basis behavior may vary over the contract
life as new information becomes available and
as it impacts on futures and the general level of
cash prices. In addition, short-term basis be-
havior at different markets may be influenced
considerably by shifts in local supply and de-
mand conditions. Hence, changes in market
information about local supply and demand
conditions may result in different levels of
short-term basis risk at various markets.
Methodology and Data
Basis, as with any series of time-ordered ob-
servations, may be viewed from a time-series
perspective. Consider the time series of ob-
servations on basis as
Garcia, Leuthold, and Sarhan
/3t = St + et,
where/3 is basis, S is systematic component, e
is stochastic component, and t is the unit or
period of observation.
Conceptually, the basis demonstrates a sys-
tematic component with the cash price ap-
proaching the futures as the contract matures.
In addition, if seasonal patterns exist in the
cash price, this may be reflected in seasonal
patterns in basis fluctuations. Empirically, the
important question is how to isolate the com-
ponents of the time se¡ Several approaches
exist for separating the variance of a time
series into the systematic and unsystematic
portions (Tomek). These include an autore-
gressive model, seasonal dummy variables in a
regression model, and the variate difference
approach, each differing in its specification of
the systematic component. One method that is
rather flexible in terms of dealing with short
time periods and the nature of the systematic
component is the variate difference approach
(Tintner).
The variate difference approach is similar to
fitting a polynomial of a given degree to a time
series. The systematic portion is the mathe-
matical expectation of the series and is as-
sumed to have a more or less smooth shape.
This smooth part of the time series can be
approximated by polynomials of the variable
time. Finite differencing removes or elimi-
nates the smooth portion of the series. The
same is not true for the unsystematic portion
of the series. The random element cannot be
reduced by finite differencing because it is not
ordered in time. Hence, application of succes-
sive finite differencing to the original basis
series reduces the smooth element or the
mathematical expectation without signifi-
cantly affecting the random element. Once
the systematic component has been elimi-
nated, then it is possible to assess the mag-
nitude and the patterns of factors influencing
basis risk.
The definition of risk employed here is simi-
lar to the mean squared error (MSE) approach
frequently used in the literature (Berck, Just,
Hurt and Garcia). The MSE approach defines
risk as deviations from the expectations of the
subjective probability distribution. Expecta-
tions are generated based on assumptions
concerning the nature of this subjective prob-
ability distribution. In practice, the expected
value often is derived as the predicted value of
an econometric representation of the investi-
gated variable (Berck) or based on some other
Basis Risk 501
assumption as to how the expectation is gen-
erated, e.g., a moving average of past values
(Peck). As discussed above, the variate differ-
ence approach assumes the mathematical ex-
pectation can be approximated by polynomials
of the variable time. Differencing eliminates
the expectation from the time series and
leaves the random element, the deviations
from the expectations, i.e., the risk. 3
A focus of this paper is the daily basis risk
for hogs and cattle in several markets. In order
to examine this question, cash and futures
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price information for similar grade and quality
animals was used to calculate daily basis for
live hogs and cattle for five markets (Sioux
City, Omaha, Interior Iowa, East St. Louis
and PeorŸ These daily bases were calculated
beginning nine months from maturity for the
December and June contracts for the period
1970 to 1979. A midpoint of the daily high and
low cash prices reported was subtracted from
the closing December or June futures price for
the corresponding day. In several instances,
especially in two cattle markets, no price data
were reported on specific days because of in-
sufficient activity to test the market. This was
especially the case for East St. Louis and
Peoria in the later years. Because this in-
volved such a large number of days, these two
markets were not considered in the cattle
analysis. When no cash price was recorded in
any one of the other markets, observations for
that day were dropped. Finally, to permit
analysis of short-term fluctuations in the basis
but still provide sufficient observations to iso-
late the systematic component of the time
series, the nine-month time series of daily
basis was subdivided into three-month pe-
riods. 4 The number of observations in each
time period differed depending on the number
of days with no market activity. In general,
hog markets were the most active, providing up
to sixty-five observations in a quarter. Cattle
markets tended to be less active and thus per-
mitted fewer observations per time period.
3 Clearly, the magnitude of the deviations will vary depending
upon the accuracy of the specification of the expectations mecha-
nism. In an analysis of time-se¡ data, Tomek found that the
variate difference approach provided smaller squared errors of the
residuals than estimated autoregressive or seasonally adjusted
trend models. In part, this is a function of the difficulty of specify-
ing time-series models. Ir suggests that a statistical method such as
variate differencing, which does not require a priori specification
of the model, may be a useful technique for identifying risk in a
time-series framework.
4 Periods shorter than three months were examined for cattle
contracts. In general, most of the variance for monthly time pe-
riods was unsystematic. Presumably, within such a short time
frame and with a limited number of observations, it is difficult to
identify any systematic components of the basis series.
 502 November 1984 Amer. J. Agr. Econ.

The Empirical Analysis by several factors related to long-term basis

movements and unexpected changes in prices.
Variate Difference Analysis Specifically, two variables are included to
represent the impact of long-term p¡ fluctua-
The first step in the analysis involves isolating tions on the unsystematic basis component: a
the unsystematic, or random, component of livestock cycle indicator and the consumer
the daily basis. The random component Ÿ as- price index (CPI). The livestock cycle variable
sumed to be isolated, from a probability is cow (sow) slaughter as a proportion of the
standpoint, when the differences between the total cattle (hog) slaughter. This variable is
variances for successive finite differences are hypothesized to have a negative sign since low
less than three times the standard error (Tint- (high) ratios are associated with relatively high
ner, Powers). Table 1 provides the number of (low) prices for that quarter, and generally

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time series examined per contract and a per- more price and possibly basis variability oc-
centage breakdown of the order of differenc- curs at higher prices than at lower prices. The
ing needed to isolate the unsystematic compo- general trend in prices and economic condi-
nent per contract. The specific number of time tions is represented by the CPI. A rise in the
series per contract Ÿ a product of the number CPI is hypothesized to have led to larger basŸ
of quarters prior to maturity, number of years, variability and a larger unsystematic basis
and markets analyzed. The daily basis was component, s
analyzed for each contract for the three quar- Based on previous research, two additional
ters immediately prior to maturity. Basis rela- variables are included in the regression analy-
tionships were examined for nine June hogs sis. Tomek, in analyzing changes in the unsys-
and cattle contracts and ten December hogs tematic component of several futures price
and cattle contracts. Five markets were ana- series, relied on the coefficient of variation
lyzed for hogs and three markets for cattle. (the standard error adjusted by the mean) and
The results, in general, indicate that higher found it to be an important variable. A s a
orders of differencing were required to isolate result, the mean basis level is included asJan
the unsystematic component of the hog rela- exogenous variable. Also, because of the ter-
tive to cattle basis. For example, only 37% of mination of meat price controls, Tomek iden-
the December hog basis se¡ were reduced tified the thirty-third to the thirty-ninth weeks
to their unsystematic component noise by tak- of 1973 as a period of unusual and unexpected
Ÿ first differences, while 63% of the De- price change. A dummy variable is included to
cember cattle time series were reduced to their isolate this effect on the December contracts.
unsystematic component by taking first differ- The hypothesized model is
ences.
R V~jt = f(C, CPI, BL, MI,
Regression Analysis M2, M3, M4, P3, P2, DV73),

s The estimated relationships are in temas of the nominal level of

Theoretical considerations indicate that basis
risk for nonstorable commodities may vary
over the life of the contract and across mar-
kets. In addition, the variance of the random
component is hypothesized to be influenced
basis risk. ThŸ approach is used because decision makers tend not
to think in terms of deflated price and basis nor deflated price and
basis risk. The relevant factor is the actual magnitude of the risk
component for alternative market periods, locations, and market
positions. This, then, can be compared to returns from these
alternative positions.

Table 1. Order Differencing Required to Stabilize Residual Variances

Order of Differencing Number

of Time
Contract 1s t 2nd 3rd 4th 5th Series

(Percent of the time series within a contract

stabilizing at various levels of differencing)
Hogs-June contracts 1971-79 32 36 19 7 135
Hogs-December contracts 1970-79 37 39 14 6 150
Cattle-June contracts 1971-79 44 44 12 81
Cattle-December contracts 1970-79 63 26 11 90
Garcia, Leuthold, and Sarhan Basis Risk 503

where RV is residual variance; C is cycle, the Table 2. Regression Results of Factors

proportion of cow (sow) slaughter to total cat- Influencing Residual Variances
tle (hog) slaughter, quarterly; CPI, consumer
price index, 1967 = 100; BL, average basis Cattle Hogs
level, quarterly; MI, Interior Iowa; M2, Sioux Variables D e c e m b e r June December June
City; M3, Omaha; M4, East St. Louis; P3,
third quarter prior to contract maturity; P2, Constant -.35 -.44 .10 .33
second quarter prior to contract maturity; ( - 1.73) a (-2.33) (.52) (1.19)
DV73, dummy variable for the thirty-third to c - .008 - .004 - .02 - .07
(-.96) (-.52) (-.72) ( - 1.88)
thirty-ninth weeks of 1973; i, markets (i = 1,
9. . , 5); j, periods (j = 1, 2, 3); and t, con- CPI .005
(6.01)
.005
(5.25)
.002
(5.25)
.002
(3.04)
tracts (t = 1970, . . . , 1979)9

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BL .005 .02 .006 .01
Dummy variables were included to ascer- (.45) ( 1.40) (.90) (2.31)
tain if basis risk varŸ from one time period to M I -.09 -.07 -.18 -.16
another or across markets. All five markets (-1.30) (-.94) (-3.85) (-2.87)
were used for the hog analysis with Peoria as M2 - .03 - .003 - .03 .009
the base market. Three markets were included ( - .47) (-.04) ( - .36) (. 16)
in the cattle equations with Omaha as the M3 - .03 - .02
(-.64) ( - .38)
base. The data were aggregated into three
quarter-year tŸ periods prior to the maturity M4 - .05
( - 1.05)
- .02
(-.41)
month, and the nearest quarter was selected as P3 .03 -.13 -.09 .18
the base. (.32) (-1.53) (-2.17) (2.82)
The results of the regressions using ordinary P2 .03 - . 11 - .05 .07
least squares are presented in table 2. The (.33) ( - 1.53) ( - .92) (1.45)
residual variance of the basis does not vary DV73 .28 1.06
significantly across markets except for Interior (1.62) (12.78)
Iowa hogs where the unsystematic variability R2 .34 .38 .62 .21
is smaller. This may result from the way prices Note: The mean of the dependent va¡ its va¡ and the
are collected and averaged among many small mean basis level, respectively, are as follows: December cattle,
markets in Iowa. Also, the random component .369, .104, .044; June catre, .324, .097, 1.938; December hogs,
.320, .072, -.727; June hogs, .333, .048, 1.060.
of the basis vades significantly from period to a Numbers in p a r e n t h e s e s are t-ratios.
period only for hogs in the most distant quar-
ter. In general, the period dummy variables
are more important for hogs than for cattle, are advised to take into account where prices
possibly reflecting some seasonality to the hog are in terms of level and long-term behavior
basis. Nevertheless, the evidence is not strong patterns. That is, more basis risk occurs when
that basis risk for livestock changes m u c h a s cash prices and the CPI are high, and less risk
the contract approaches maturity. occurs when the value of these variables are
The signs of the other coefficients are gen- low. Attention to these circumstances should
eraUy as expected. Consumer price index is help these traders with basis positions in re-
positively related to the residual variance and ducing risk.
significant in each regression. Basis level is
also positive but significant only in the case of
June hogs. Similarly, cycle is negative each Summary and Conclusions
time but has a relatively high t-ratio only for
June hogs. The June 1973 dummy variable is This study examines the unsystematic, or ran-
positive in each regression but significant only dom, fluctuations of the hog and cattle basis
for hogs. Hence, variables representing long- over time in several Midwest markets. The
term price levels and unexpected changes in variate difference method is employed to
prices can be important in explaining the un- quantify the unsystematic component of
systematic basis variation. short-term within-contract basis movements.
The R2s show that the proportion of the Evidence suggests the existence of significant
variation explained by the model varies con- va¡ in the unsystematic basis compo-
siderably across contracts and commodities. nent. Analysis of the residual variances indi-
The results suggest that producers and traders cates that this measure of risk is related to
who hedge, and hence have basis positions, several factors influencing the long-term pat-
504 November 1984
terns in these time series and unexpected
changes in price.
Analysis of market and intracontract
movements of the residual variance provides
several interesting results. Except for the
Interior Iowa hog market, little difference
could be found in the basis risk at different
market locations. Evidence of lower levels of
risk in basis behavior as contract maturity ap-
proaches, which would indicate that increased
market information and market activity near
maturity influence both futures and cash
prices in a similar manner, is not strong nor
overwhelming. Results of the analysis suggest
that producers and market participants who
hedge would be well advised to ascertain
where prices are in terms of level and their
long-term patterns. This information could
permit identification of periods of high
within-contract basis risk and lead to appro-
priate marketing strategies.
[Received March 1983; final revision
received May 1984.]
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