Basis in Futures Pricing – Meaning & Movement

1. Introduction

The difference between the Spot price and the Futures price of an asset is not constant. This gap is technically called the Basis. Tracking the Basis helps traders understand the market mood.

2. Definition of Basis

Basis = Spot Price - Futures Price

• Note: Some textbooks define it as Future - Spot, but in standard finance convention, Basis is Spot - Future. Since Futures usually trade at a premium, Basis is usually Negative.

3. Types of Basis Trends

A. Contango (Normal Market)

• Situation: Future Price > Spot Price.
• Basis: Negative.
• Reason: Cost of Carry (Interest) makes the future price higher.
• Significance: This is the normal state for financial futures like Nifty.

B. Backwardation (Inverted Market)

• Situation: Spot Price > Future Price.
• Basis: Positive.
• Reason: Usually happens in Commodities when there is a short-term shortage. People will pay a premium to get the asset now (Spot) rather than later.

4. Diagram: Basis Movement

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5. Exam Notes: Writing the Answer

Question: "Define Basis. Distinguish between Contango and Backwardation." (10 Marks)

Answering Structure:

1. Formula: Write Basis = Spot - Future clearly.
2. Normal Basis: Explain that due to interest cost, Futures are usually higher (Contango).
3. Positive Basis: Explain that spot becomes higher if there is an immediate shortage (Backwardation).

6. Quiz Time! 🎯

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