Dairy Futures and Options Tutorial

Basis: What is it and Why is it Important

Dairy producers sell their milk to a dairy processor and users of milk, such as a cheese plant, purchase their milk for use as an input in the cash market. For both producers and purchasers of milk, the futures market may be used to manage the risk of changing output (farm milk) price or input (milk) costs. In order to effectively use dairy futures and options for price risk management, both producers and users of milk need to know the historical relationship between the cash and futures markets. This relationship involves the concept of basis.

Basis Defined

Basis is the difference between a cash price at a specific location and the price of a particular futures contract for the same commodity. There are a number of ways of defining a basis even for the same commodity. The following are two basis examples:

Why is Basis Important?

A Unique Aspect of the Class III Futures Contract

One advantage of Class III futures contracts are that they are cash settle against the announced Class III. That is, the last day of trading for a particular Class III contract is on a Thursday, the day before the announced prices are released by USDA and which occurs on a Friday and is no later than the 5th of the month following production. A large proportion of the Grade A milk produced in the U.S. is priced under a federal milk marketing order. Most milk that isn't price under a federal order is priced under a state order like California, for example. Most basis risk is due to changes in premiums and discounts received. Even in California, there is a strong relationship between the Class III and California producer milk prices.

The role of basis risk when undertaking a hedging strategy can be seen in the Understanding Hedging section.

How is Basis Calculated?

Basis is calculated by a particular cash price minus a particular futures price As noted above, for farm milk, the mailbox price minus Class III futures price is one type of basis. As an example, if a producer's mailbox price is $15.90 and announced Class III price is $13.75, the basis is $2.15 . Remember that the Class III futures cash-settles to the announced Class III price.

How Can You Use Your Previous Price History to Calculate Your Basis?