The difference between the spot price of a commodity and its futures price — a measure of the relationship between cash and derivatives markets.
In futures markets, basis is calculated as: Spot Price − Futures Price (or sometimes Futures − Spot, depending on convention). When spot is below futures (normal contango conditions), the basis is negative. When spot is above futures (backwardation), the basis is positive. The basis changes over time as supply and demand conditions evolve and as futures contracts approach expiration.
Basis risk is the risk that the relationship between spot and futures prices changes unexpectedly, reducing the effectiveness of a hedge. A farmer who hedges wheat by selling futures is exposed to basis risk — the futures price and the local cash price may not move in perfect lockstep, leaving some residual price risk even with the hedge in place. The basis at the time of lifting the hedge may differ from the basis when the hedge was established.
As a futures contract approaches expiration, the basis converges toward zero — spot and futures prices must be nearly identical at delivery because arbitrageurs would otherwise exploit any significant discrepancy. This "basis convergence" is a fundamental property of futures markets that makes them effective hedging instruments over the long run, even though short-term basis fluctuations create residual risk.
This definition is for informational and educational purposes only. Nothing on Finance Compass constitutes financial, investment, or trading advice. Always conduct your own research and consult a qualified professional before making financial decisions.