Definition
In finance, the term “basis” refers to the difference between the price of a financial instrument (like a futures contract) and the price of its underlying asset (like a commodity, stock, etc.). This difference arises due to various factors such as interest costs, storage costs, and dividends. The basis can be either positive or negative, indicating whether the derivative is priced higher or lower than the spot price of the underlying asset.
Phonetic
The phonetic pronunciation of “Basis” is /ˈbeɪsɪs/.
Key Takeaways
- Basis is a stablecoin cryptocurrency with an algorithmic central bank, designed to reduce volatility.
- It uses a sophisticated system of supply management to ensure its value remains consistent, involving base coins, shares, and bonds.
- Despite its promising concept, Basis was shut down in 2018 due to regulatory complications.
Importance
The term “Basis” is essential in business and finance as it represents the fundamental value or cost of an investment, asset, or product. Generally seen in securities, the basis is the initial buying price or cost of an asset adjusted for factors like dividends, interest, and capital improvements, less disposal costs. This value is crucial for calculating capital gains or losses for tax purposes upon selling assets. It also provides valuable data to strategize future trading and investment decisions, thereby impacting profitability. Additionally, understanding the basis helps investors to mitigate their exposure to risk, allows them to effectively plan their transactions, and contributes to the optimization of returns.
Explanation
Basis, in the field of finance and business, serves a critical role as it helps investors, traders, and financial analysts to measure and analyze the profit and loss potential of an investment or financial transaction. Often used in the context of futures trading, basis describes the difference between the spot or cash price of a commodity and its futures price. It thereby aids traders in determining the optimal time to buy or sell a commodity. Its value is also paramount in hedging strategies as it allows investors to mitigate the risk of price changes in the commodities market.
Furthermore, basis points, a subdivision of basis, is specifically used to delineate changes in or differences between interest rates, yields, and other factors that influence investment returns. In mortgage loans, for instance, basis points provide a measure of the interest rate changes and assist in understanding pricing discrepancies between various lending options. Essentially, both the concepts – ‘Basis’ in futures trading and ‘Basis Points’ in interest rates – provide financial market participants with valuable tools for more precise decision-making and portfolio management.
Examples
1. Commodity Trading: In this sector, basis is commonly used term. Basis refers to the difference between the price of a particular commodity in the futures market and the price of that same commodity in the spot market. For instance, if a wheat futures contract that expires in three months is trading at $5 per bushel, and if the spot price of wheat is currently $4.50 per bushel, then the basis is $0.50. This difference in prices affects buying and selling decisions of commodity traders.
2. Stock Market: Within stock trading, basis is used to refer to the original price or cost of an asset for tax and accounting purposes. Suppose Jake buys 100 shares of a company at $10 per share. If he sells his shares later when the price is $12 per share. The original ‘basis’ of his shares was $10 per share, which is used to calculate his taxable gain, which in this case is $2 per share ($12 current price – $10 original price).
3. Foreign Exchange (Forex) Market: The forex market uses basis points to denote changes in interest rates and other financial percentages. Central banks, for example, might raise interest rates by 25 basis points. This represents a move from, say, 2.00% to 2.25%. These actions by central banks can significantly impact exchange rates and valuations of currency.
Frequently Asked Questions(FAQ)
What is the term Basis in finance and business?
Basis refers to the difference between the price or value of a financial instrument, like a security or a future contract, and its underlying asset’s price or value.
Why is the term Basis important in the financial world?
The basis is an essential piece of information for traders and investors because it gives insight into the potential profitability of financial transactions. Understanding the basis can help in making informed decisions about buying and selling securities or futures contracts.
How is the term Basis used in futures trading?
In futures trading, the basis refers to the difference between the spot price of a commodity or asset and the futures price. If the futures price is above the spot price, it is called a positive basis, and if it’s below, it is a negative basis.
Is there any relation between Basis and risk?
Yes, basis risk occurs when the value of a futures contract does not move perfectly in sync with the value of the underlying asset. This can lead to potential losses if the basis changes unexpectedly.
What is the ‘Cost Basis’?
Cost basis refers to the original value of an asset for tax purposes, which is usually the purchase price adjusted for stock splits, dividends, and return of capital distributions. This value is used to determine the taxable gain or loss when the asset is sold.
Can the ‘Basis’ change over time?
Yes, the basis can change over time due to various factors such as interest rates, market conditions, and time to maturity in case of futures contracts.
What is a ‘Basis Point’?
A basis point, often used in the context of interest rates, is one-hundredth of a percentage point (0.01%). It is a common way of expressing changes in financial rates, including yields, interest rates, or premiums.
Related Finance Terms
- Spot Price: The current market price at which an asset, like a commodity or currency, can be bought or sold for immediate delivery.
- Forward Contracts: A contract between two parties to buy or sell an asset at a specified future date at a price agreed upon today.
- Basis Risk: The risk that the futures price and the spot price may not change in sync, threatening the effectiveness of a hedging strategy.
- Basis Trade: A strategy used by commodity producers or traders to protect themselves from price fluctuation risks.
- Cost of carry: Includes all costs incurred by holding or storing a physical asset, or interests and storage costs in a financial context.
