Dairy Futures and Options Tutorial

Long Hedge Example with Changing Basis Relationships

If you are a user of milk you will want to use the following example to familiarize yourself with the role of basis in determining your final input cost. Similar to the above short hedge example we examine the impact of changing basis on your hedging results.

In the 1^st example we provide you with the opportunity to see the impacts on a long hedge under a Constant Basis assumption (e.g., there is no basis risk).

Under the 2^nd assumption we assume a Weakening Basis (e.g., the basis decreases from what you expected when you initiated your hedging strategy).

The 3^rd scenario pertains to a situation where the Basis Strengthen (e.g., the basis increases from what you expected when you initiated your hedge).

Under these last two scenarios we assume the basis experiences an unanticipated change of $0.25.

Assuming a Constant Basis

Futures Transaction Price		Basis	Result
- Buy		+	= Expected Input Cost
+ Sell		+	= Unhedged Input Cost
= Diff			= Gain

Short Hedge Results
Unhedged Input Cost	- Futures Market Gain	= Hedged Input Cost

Basis Weakens (Decreases)

Futures Transaction Price		Basis	Result
- Buy		+	= Expected Input Cost
+ Sell		+	= Unhedged Input Cost
= Diff			= Gain

Short Hedge Results
Unhedged Input Cost	- Futures Market Gain	= Hedged Input Cost

Basis Strengthens (Increases)

Futures Transaction Price		Basis	Result
- Buy		+	= Expected Input Cost
+ Sell		+	= Unhedged Input Cost
= Diff			= Gain

Short Hedge Results
Unhedged Input Cost	- Futures Market Gain	= Hedged Input Cost

© 2007 Brian W. Gould, Agricultural and Applied Economics, University of Wisconsin Madison