Sixty futures contracts are used to hedge an exposure to the...

Sixty futures contracts are used to hedge an exposure to the price of silver. Each futures contract is on 5,000 ounces of silver. At the time the hedge is closed out, the basis is $$\$ 0.20$$ per ounce. What is the effect of the basis on the hedger's financial position if (a) the trader is hedging the purchase of silver and (b) the trader is hedging the sale of silver?

Key Concepts

Futures Contracts

Futures contracts are standardized, exchange?traded agreements to buy or sell an asset at a predetermined price and date. They allow market participants to hedge against adverse price movements or to speculate on future price directions, with each contract representing a fixed quantity of the underlying asset.

Hedging Strategy

Hedging involves taking a position in a financial instrument to offset potential losses in an underlying asset. In commodity markets, a hedger may use futures contracts to protect against price fluctuations when planning either a future purchase or sale. The strategy differs depending on the exposure: hedging a purchase (long position in the physical market) typically involves taking a short position in futures, while hedging a sale (short position in the physical market) involves taking a long position in futures.

Basis

The basis is defined as the difference between the cash (spot) price of the commodity and the futures price. It is a crucial element in hedging because changes in the basis—the basis risk—can lead to discrepancies between the gains or losses in the futures position and the movements in the underlying cash market. The final basis at closing influences the overall effectiveness and final financial result of the hedge.

Impact of Basis on Hedge Performance

The effect of a positive basis at the time of closing the hedge depends on the nature of the hedged exposure. For a trader hedging a purchase (who is long the commodity and short futures), a positive basis means the spot price is higher relative to the futures price, thereby increasing the effective purchase cost despite gains on the short futures. Conversely, for a trader hedging a sale (who is holding the commodity and is long futures), a positive basis reduces the effective sale price because the gain in the futures market does not fully compensate for the relatively lower futures price compared to the spot price. The overall financial impact is scaled by the total quantity hedged.

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