Basis is the value difference between the cash market for grain (physical) that you deal in and the futures market (derivative) that a hedge may be placed on. Basis risk is the risk that your hedge does not perform in line with physical market and as a result the effectiveness of the hedge may be compromised.
If a futures market is based on the domestic market then the basis risk associated with hedging on this market is going to be less than that for hedges placed on foreign exchanges priced in foreign currencies.
The divergence between the Australian market and foreign markets is well demonstrated in the below chart from 2005. The blue line is the price for January 2006 ASX Australian Milling Wheat futures. The green line is the price for December 2005 Chicago Board of Trade (CBOT) Wheat futures expressed in Australian dollars per tonne. The divergence between the two markets from mid March through to early June was driven by the dry weather conditions that existed across most of Eastern Australia.
The spike in ASX prices in late May 2005 quickly reversed when rain was forecast. The price continued to fall when rain actually fell. The price performance on ASX reflected the local supply and demand conditions. The difference between the cash market and the futures market was reduced and hedges placed on ASX better reflected the physical situation. This chart highlights two important aspects that all growers and consumers based in Eastern Australia should note.
The price spike in May 2005 saw ASX Milling Wheat trade just under $220 AUD/tonne while the CBOT AUD equivalent price was in the vicinity of $170 AUD/tonne. The ASX price was $50 AUD/tonne higher. Placing a hedge on ASX at this time would have captured this domestic price premium. Growers concerned about production risk could have considered purchasing put options over ASX Milling Wheat. A bought put option protects the buyer from price falls but does not have a production obligation. The below chart shows the price protection achieved by a January Milling Wheat $215 Put option that was purchased in late May 2005 for $18. The line in blue represents the price profile for the option buyer. A floor price was set at $197 ($215-$18). The red line represents that the option owner is protected from any market price under $197. Should the market rally and trade above the $197 floor before option expiry the market price line will again become blue as the option owner is free to sell at the improved price.
The price performance of ASX Milling Wheat during 2005 demonstrated the importance of hedging locally so that the price performance of the hedge accurately reflects the physical market exposure. Assume you are a consumer and hedged your grain requirements for January 2006 in mid March. Had you used CBOT wheat to do this your hedge performance to late May would have provided effectively no protection as it was still trading around $170 AUD/tonne. On the other hand, had you used ASX to hedge your price risk the hedge would have been in the money approximately $40 AUD/tonne, thereby offsetting higher physical costs. Had there not been a break in the season, prices would have traded towards import parity which was, at the time, estimated at $250 AUD/tonne. The ASX market would have reflected this reality, foreign markets would not. One major benefit of buying Call options is that they protect consumers from higher grain prices but also allow consumers to buy cheaper grain should it become available. The below chart shows the price protection achieved by a January Milling Wheat $175 Call option that was purchased in early March for $8. The line in blue represents the price profile for the option buyer. A price ceiling was established at $183 ($175 + $8). The option owner is protected from any market price over $183, this is represented by the red line. Had the rain event not occurred and prices reached import parity, the option owner would have paid a maximum of $183. As we know, the rain did fall and the market has since fallen below the $183 ceiling. The option owner is free to buy grain at the cheaper price available and this is represented by the blue market price line. The option owner had price protection but could still benefiit if the market moved lower.
A component of basis is explained by Foreign Exchange fluctuations. All ASX contracts are priced in Australian dollars per tonne. This not only simplifies the hedging process, but also ensures that foreign exchange movements will be incorporated in the market. The trouble experienced by many participants in the Australian cotton industry between 2000 and 2002 is an example of the potential risks associated with pricing foreign exchange separately to the underlying commodity price. Hedging using ASX Grain Futures and Options removes this risk as there is no need to convert foreign domiciled futures into Australian dollars.
Many growers have again suffered production failure and are faced with the unpleasant task of "washing out" forward contracts. Unfortunately, this year grain prices have reached record levels and 'wash out" figures in many cases have been significant.
Production risk and the need to "wash out" forward contracts is not a new phenomenon for Australia's grain industry. The droughts in 2002, 2006 and again in 2007 have all demonstrated the production risk associated with forward contracting. As a result, growers are understandably wary of over committing on forward contracts due to the associated production risk. The ASX Grain Futures & Options market provide tools that could provide solutions to help protect operations from price risk as well as actively manage production risk.
ASX Grain Futures can be used by growers to lock in grain prices when they are favourable. Like any form of forward selling, when selling futures there is an associated production risk because you are selling something you are yet to harvest. The same applies for "non deliverable" products such as swaps. If you don't grow it and the market goes against your original position you will be faced with a "wash out" scenario.
If production does become an issue there are ways the contracts can be unwound thus removing production obligations. Unlike physical forward contracts, sold futures positions can be unwound by buying back futures contracts in the same expiry month whenever the grower feels it prudent to do so. Because there is no requirement to demonstrate market failure, timely action can be performed when hedging using futures.
ASX Grain Options enable growers to hedge their price risk with no production risk. Buying put options on ASX Grain Futures contracts is one way growers can achieve price protection with absolutely no production obligation. A bought put option reserves the right, not an obligation, to sell at a certain price. Growers can therefore benefit from higher prices should they eventuate. They also know what the strategy will cost in the worst case scenario at the time of contracting.