Dairy Futures and Options Tutorial

Short Hedge Example with Changing Basis Relationships

Now we extend the previous hedging example by allowing you to establish hedging strategies under alternative basis scenarios. In this first set of examples we provide you with the opportunity to see the impacts on a short hedge of basis changes.

Under the Constant Basis scenario, we assume you know your basis with certainty (e.g., there is no basis risk).

The Basis Weakens scenario implies that the basis decreases from what you expected when you initiated your hedging strategy.

The Basis Strengthens scenario pertains to the situation where the basis increases from what you expected when you initiated your hedging strategy.

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
+ Sell Contract		+	= Expected Output Price
- Buy Contract		+	= Unhedged Output Price
= Diff			= Gain

Short Hedge Results
Unhedged output Price	+ Futures Market Gain	= Hedged Output Price

Basis Weakens (Decreases)

Futures Transaction Price		Basis	Result
Sell Contract		+	= Expected Output Price
Buy Contract		+	= Unhedged Output Price
= Diff			= Gain

Short Hedge Results
Unhedged output Price	+ Futures Market Gain	= Hedged Output Price

Basis Strengthens (Increases)

Futures Transaction Price		Basis	Result
Sell Contract		+	= Expected Output Price
Buy Contract		+	= Unhedged Output Price
= Diff			= Gain

Short Hedge Results
Unhedged output Price	+ Futures Market Gain	= Hedged Output Price

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