To be concrete, let's assume that today is April and you are planting your corn crop which you will harvest and sell in November in your local market. You have decided to forward price some of fall production. In April, you observe that the December corn futures price is $2.80 so you can lock-in that price by selling the December corn futures contract through a futures broker.

Once the contract is sold, you will be required to deposit margin funds with your futures broker to assure that you will adhere to the terms of the contract. If the price were to increase, your futures account would begin to lose money so you may need to send more money to cover the losses. Conversely, if the price falls, money will be added to your account.

The combination of your futures position and your sale of corn in the cash market will yield a net-price. This price takes into account any profits or losses on the futures position as well as the cash price received for corn. Let's now consider what happens in November to see what happens to your net-price for corn under different price scenarios.

Lower Prices in November
In November let's say the December corn futures price has fallen to $2.35. At this point in time, you offset the futures contract by simply buying back the December futures contract for a price of $2.35. Because you had originally sold the contract for $2.80 and you bought it back for a lower price of $2.35, you will earn a profit of $0.45 (less broker commission).

This profit of $0.45 can be applied to the price you sell corn for in your local market. Let's say that your local price for corn is $2.45 so your net-price is $2.90 ($2.45+$0.45).

Net-Price from Selling a December Corn Futures Contract at $2.80.
	Lower Prices in November	Higher Prices in November
December Futures	$2.35	$3.10
Profit on Futures	+$0.45	-$0.30
Cash Corn Price	$2.45	$3.20
Net Corn Price (cash price+futures profit)	$2.90	$2.90

Higher Prices in November
What if instead of falling, the December corn futures price had been higher at harvest? Suppose that the December corn futures price is $3.10. You buy back your December contract at that price and have a loss of $0.30, which you would have already paid through any margin calls. At the same time, however, the price for corn in your local market will be higher because of the higher futures price. Let?s say your local price for corn at harvest is $3.20. Your net-price for corn is $2.90, which is simply your cash price of $3.20 less the loss on the futures contract of $0.30.

Net-Price is the Same
In either case, no matter whether the market moved higher or lower than what was contracted at $2.80, your net-price is still the same: $2.90. This occurs because the corn basis was always the same. The basis, which is the difference between the cash price and futures price, was $0.10 no matter whether prices were higher or lower. In the real world, the basis may vary somewhat but it is usually easier to predict than price levels. Therefore, you can be reasonably confident of getting a specific price for your grain once you establish a price level using a futures contract.


B. Grain Basis

Understanding your local basis can be useful for making wise marketing decisions. The basis measures the difference between your local cash price and the futures price:

Basis = Local Cash Price - Futures Price.

For example, if on a given day the cash price for corn in your market is $2.40 and the December futures price is $2.30, then your basis at that time is +10 cents. Some will refer to this basis as 10 cents over, implying that the local cash price is 10 cents higher than the futures. Similarly, if the basis is -5 cents, it is referred to as 5 cents under implying that your local cash price is 5 cents below the futures.

The cash price and the futures prices generally move together in the short run implying that the basis does not change significantly. However, over a longer period (say more than one month), the basis can change, usually reflecting local supply and demand conditions.

One of the most important aspects of grain basis is that it has a tendency to be lowest at harvest time in the fall and highest at some point in the spring or summer. An increasing basis over the season is a consequence of the market paying for the cost of storing the grain locally or the cost of bringing in supplies from outside markets.

Estimating Your Local Basis
If you do not already have historical basis information for your local market, you should attempt to get some. Two good sources are your local Cooperative Extension office or the feed/grain companies that your purchase from. Both should maintain this type of information.

Once you have information on historical basis for your market, you can begin to make pricing decisions. For example, suppose you have decided to store wheat after harvest and you anticipate selling it in October. To know what price you could establish using futures, you would need to know what your local basis tends to be in October. If normally your local basis is +15 cents and the December futures is trading for $3.45, then your forecast for your local cash price for October is:

October Cash Price = October Basis + December Futures Price
= $0.15 + $3.45 = $3.60.

Now, this does not imply that the October cash price will be $3.60 but if you decide to sell December wheat futures, you can guarantee this price subject to the basis being +15 cents.

Basis Example and Futures Hedging
Suppose you decide to establish a forward price for your stored wheat which you will sell in October. To do so, you sell December wheat futures at a price of $3.45. As we stated above, your normal basis in October is +15 cents so you anticipate getting a price of $3.60.

Let's jump forward now to October and suppose that the December wheat futures price has fallen to $2.75. To offset your futures position, you buy the December contract and sell your wheat in your local market, let's say for $2.90. What will be your net-price for wheat?

Because you bought December futures for $2.75 and sold it for $3.45, you will earn a profit of $0.70. This $0.70 profit gets added on to the price you get for wheat in your local market of $2.90. Thus, your net-price is $3.60. Notice that this is exactly what you had forecasted because the basis when you sold your wheat was $0.15, just like you had expected.

If instead the basis had been higher or lower than $0.15, then this would have increased or decreased your net-price for wheat. Fortunately, however, the basis tends to be fairly predictable (especially compared to the cash price) so that the basis usually doesn't differ significantly more than what you expect.

C. Types of Cash Contracts

Aside from the standard cash forward contracts, there are numerous other contracts available to farmers from their local buyers. These contracts can usually give you flexibility in terms of delivery and pricing options. We explore a few of the more common ones here.

One of the more popular cash contracts is what is called the Basis Contract or Fix Price Later Contract. This contract allows the farmer to lock in the basis of his price, but keeps the futures component of his price open. Recall that your local cash price is equal to the basis plus the futures price so by locking in the basis, you are guaranteeing that part of the price which is related to basis. The futures price can usually be established anytime prior to delivery. The basis contract is popular because it allows you to take advantage of favorable basis in your local market, but allows you to wait and price the futures component when you want to. Some farmers will use a basis contract in conjunction with an option to establish a minimum price. However, it is important to recognize that if you only have the basis contract then you still face considerable risk from the futures price changing.

A Deferred Price Contract provides the farmer the opportunity to deliver and transfer ownership on the contract date, but without setting a sales price. The buyer generally charges an up front or monthly fee. The producer retains the basis and futures price risk and opportunity in this contract until the sales price is determined. You might decide to use this contract if you have a need to move grain off your farm but you believe the market will move higher.

A Minimum Price Contract gives the farmers protection against price declines but leaves open the possibility of getting a higher price if the market moves higher. This contract is basically a cash forward contract plus a call option. We will discuss this strategy in a later section.

One of the more controversial contracts of recent years is the Hedge-to-Arrive (HTA) Contract. There are several variations of the HTA but probably the most typical is that when the contract is initiated, the farmer establishes a futures price but leaves the basis open for pricing. In fact, some HTA contracts do not require a specific delivery date as this can also be at the discretion of the farmer. While the futures price is established when the contract is initiated, it is possible for the farmer to postpone delivery and have the futures price rolled forward to another delivery month. In fact, this is where the problems with HTA arose. It is useful to consider some examples of how HTA can work and how some of these problems occurred.

Let's suppose that in May you want to price your corn to be produced in the following fall. At the time, the December futures price is $3.00 and you decide to enter a HTA contract with your local buyer. This contract establishes a $3.00 futures price against the December contract but leaves open the basis.

Jumping forward to harvest time in November, you have the option to either deliver your corn and receive the $3.00 futures price that you contracted plus the basis at harvest or you can defer delivery and roll your contract forward on the March contract. To be concrete, suppose your harvest time basis is +5 cents, the March futures is 10 cents above the December futures, and a basis contract for February delivery is +30 cents. Should you deliver today or defer delivery into February?

To answer this, you should compute what your price would be in each case. If you deliver at harvest, you will get:

November Delivery Price = Contracted December Futures Price + Harvest Basis
= $3.00 + $0.05
= $3.05.

Therefore, delivering at harvest will get you a net-price of $3.05. If you decide to postpone delivery to February, your net-price is:

February Delivery Price = Contracted Dec. Futures + (Mar. - Dec. Spread) + Feb. Basis
= $3.00 + $0.10 + $0.30
= $3.40.

Whether you should defer delivery to February depends on your cost of storage, but most farmers can store grain for less than 5 cents per bushel per month. If so, then it would be best to deliver in February.

The advantage of the HTA is it provides some flexibility in terms of timing your delivery. However, recognize that by deferring delivery, you are subject to the risk of futures price spreads changing. This can be particularly risky when rolling from old-crop into new-crop months as the following example illustrates.

Suppose that instead of using the December futures, the farmer had priced his corn against the July futures in May when he initiated the HTA contract. Let's say that the July futures price at the time was $3.40 and the December futures was $3.00. When the farmer gets to July, he will roll forward from the July to the December contract to establish his price. His price will be based on how the spread between the July and December futures has changed between when the HTA was initiated and when the contract was rolled forward in July. Specifically, his price would be:

December HTA Price in July = Dec Futures in May + (July-Dec Spread in May - Jul-Dec Spread in July).

The spread between July and December futures when the HTA is initiated is +$0.40 so if the spread declines by July, this will increase the December futures price. Conversely, if the spread increases, this will reduce the December futures price.

The problem that occurred in 1996 was that the spread between old crop and new crop prices skyrocketed. The spread went from about +60 cents in May to +160 cents by July. Therefore, farmers who had entered HTA contracts lowered the price that they contracted for December by $1.00 per bushel loss. Instead of getting $3.00 or more for corn at the time, they were establishing a price close to or below $2.00. While 1996 was an extreme year because of shortages in corn, it points out the risks involved in using HTA to roll across crop years. Within crop years, the risks are much less severe.