Perspective

Hedger
BASIS
• The difference between spot price and futures price is called Basis.

• Basis= Spot Price - Futures Price

Reliance Spot and Futures Prices

Futures and Spot Price

620

600

580
Futures_Price
560
STOCKPRICE
540

520

500
T 28 27 24 23 22 21 20 17 16 15 14 13 10 9 8 7 6 2 1
Time to Maturity
Behavior of Basis
• When the futures price is at expiration, the futures price of reliance
and spot price of reliance must be same.

• That is the basis must be zero.

• This behavior of basis over time is called convergence

When basis is constant you get perfect hedge

Hedge 1; Long in spot and sell in futures  

  Spot Price Futures Price Basis
 before maturity 10 15 -5
 before Maturity 20 25 -5
Profit/Loss 10 -10  

Hedge 2; Short in spot and buy in futures  

  Spot Price Futures Price Basis
 Some time Bef. Mat 10 15 -5
 Before Maturity 20 25 -5
Profit/Loss -10 10  
Basis Risk

Basis risk arises because basis does not remain constant

• We know that Basis at maturity is always equal to ZERO.

• At the time of purchase of futures contract the basis is either negative or positive

• You have either positive or negative basis at start and if you hold the contract until maturity basis
will become zero

• Implies Basis rarely will be constant during the holding period of the contract.
Basis Risk

Nature Of
hedge   Basis At the start

    Positive Negative
BUY (Futures)
and Hold until
maturity   Favorable Adverse
SELL (Futures)
Hold Until
Maturity   Adverse Favorable
When Basis is negative at start
Hedge 1; Long in spot and sell in futures
Futures
  Spot Price Price Basis Total P/L
 before mat. 10 15 -5  
 At maturity 20 20 0  
Profit/Loss 10 -5   5
 
Hedge 2; Short in spot and buy in futures  
Futures
  Spot Price Price Basis  
 Before Mat. 10 15 -5  
 At Maturity 20 20 0  
Profit/Loss -10 5   -5
When Basis is Positive at start
Hedge 1; Long in spot and sell in futures
Futures
  Spot Price Price Basis Total P/L
  20 15 5  
 At maturity 20 20 0  
Profit/Loss 0 -5   -5
 
Hedge 2; Short in spot and buy in futures  
Futures
  Spot Price Price Basis  
  20 15 5  
 At maturity 20 20 0  
Profit/Loss 0 5   5
Basis Risk

Nature Of
hedge   Basis At the start

    Positive Negative

       

BUY (Futures)   Favorable Adverse

SELL (Futures)   Adverse Favorable

Perspective

Arbitrageur
How are Futures Prices Determined
• How to determine Futures Prices.
• How are Futures prices related to Spot Price.
Models of Future Prices
• Model No 1
• Cost of Carry Model

• According to this model futures price depend on the cash price of a

commodity and the cost of storing the underlying good from the
present to the delivery date of the futures contract.
Cost of Carry Model
• The cost of carry model in perfect markets.

• The cost of carry or carrying charge is the total cost to carry a good forward in time.

• For example, wheat on hand in June can be carried forward to, or stored until,
December
• Carrying charges fall into four basic categories.
• Storage Costs
• Insurance Costs
• Transportation Costs
• Financing Costs
Cost of Carry Model
• The carrying charge reflects only the charges involved in carrying a commodity
from one time or one place to another.

• The carrying charges do not include the value of commodity itself.

• So, if gold costs $400 per ounce and the financing rate is 1 percent per month,

• the financing charge for carrying the gold forward is $ 4 per month (1%X$400)
What Should be Futures Price?
• Let us assume that
• futures price > Spot + Cost to Carry
Cash and Carry gold – Arbitrage Transactions

• Prices for the analysis:

• Spot price of gold $400
• Future price of Gold ?
• Interest Rate 10%

• Let Future price = $450

• T=0
• Borrow $ 400 for one year at 10% +$400
• Buy one ounce of gold in the spot market -$400
• Sell a futures contract for $450 for delivery
of one ounce in one year $0
• T=1
• Remove the gold from storage $0
• Deliver the ounce of gold against the futures contract $450
• Repay loan, including interest -$440

• Total Cash Flow +$10

Cash and Carry gold – Arbitrage Transactions

Cash and Carry Gold: Long in spot and Short in futures

  Spot Price Futures Price Basis

Time 0 400 450 -50

Time 1 10000 10000 0

Profit/Loss 9600 -9550 50

Cost of Borrowing =   40

    Net Profit 10
Cash and Carry Arbitrage
• Rule 1: If Future Price > Spot + Cost to carry then traders could carry
out cash and carry arbitrage

• Hence :
• Futures price must be less than or equal to the spot price of the commodity
plus the carrying charges necessary to carry the spot commodity forward to
delivery. ( To avoid arbitrage)
What should be Futures Price?
• Let us Assume that
• Futures Price < Spot + Cost to Carry
Reverse Cash and Carry gold –
Arbitrage Transactions
• Prices for the analysis:
• Spot price of gold $400
• Future price of Gold ?
• Interest Rate 10% p.a

• Let Future price = $430

• T=0
• Sell one ounce of gold +$400
• Lend $ 400 for one year at 10% -$400
• Buy one ounce of gold futures contract for $430 for delivery
of one ounce in one year $0
• T=1

• Collect proceeds from the loan ($400 X1.1) $440

• Accept delivery on the futures contract -$430
• Use gold from futures delivery to repay short sale $0

• Total Cash Flow +$10

 Reverse Cash and Carry Arbitrage
• Rule 2 : If future price < Spot Price + Cost of Carry then traders could
carry out reverse cash and carry arbitrage

• Hence :
• Futures price must be greater than or equal to the spot price of the
commodity plus the cost of carrying the good to the future delivery date. (To
avoid arbitrage)
No Arbitrage future price in Perfect Markets
• Combining Rule one and Two.
• We have
Only when

• Futures price = Spot Price + Cost of Carrying

• Then Arbitrage is Not possible

Cost of Carry Model
Assuming Perfect markets and no arbitrage conditions

FP = spot price + cost to carry

Cost of Carry Model

• If futures price follow cost of carry model then basis is negative.

• FP = Spot + cost of carry.

• Since Futures price is always more than spot price: Basis is always negative.

• Given FP = Spot price (SP) + Cost to carry (X)

• Basis = Spot price – Futures price

= Spot price – (spot price + x)
= -x
Contango Market
• When futures price is higher than cash price then the market is said to
be in “Contango” or “Normal”.
Or
when Basis is negative then Market is said to be in “Contango”.
Or
When the market follows Full cost of carry model then it is called
“Contango” Market.
Can the Basis be Positive?
Convenience Yield
• When an asset has convenience yield then full cost of carry model does not hold.

• Convenience Yield is a return on holding an Asset

• Anybody who has use of an asset for consumption can derive “Convenience Yield”.
• Ex: Food processor might Derive a convenience yield by holding on to commodity.

• When Futures price is below cash price or spot price then you need to do reverse cash and carry arbitrage to
exploit it.

• But because (say soya beans) has convenience yield there will be no one willing to lend. Hence short selling
of beans will not be possible.
Backwardation
• When basis is positive then the market is said to be in backwardation or
“Inverted”.

• Expectation Model
• The price of the Futures contract is the expected Future Spot Price.
• Normal Backwardation Hypothesis
• If hedgers are net short and speculator are net long- then future price must underestimate
the future spot price (speculators demand premium for risk)
• Contango – If hedgers are net long and speculators are net short then future price must
overestimate the spot price.
Role of Speculators and Expectation Model
• If the Futures price were $15 , exceeding the expected Futures spot
price of $10. Then speculators would sell futures at $ 15 and on
maturity they would buy back the futures at $10 and make a profit.

• In effect speculators would make sure that Futures price is equal to

expected Future Spot Price.
Who would trade in Futures?
Futures trading will be of interest to those who wish to:

1) Transfer Price Risk - Hedging

2) Invest- Speculating

3) Arbitrage

4) Leverage