What is a Narrow Basis?
In the futures market, a narrow basis occurs when the spot price of a commodity is close to the futures price of the same commodity.
How Does a Narrow Basis Work?
For example, let's say the price of a bushel of wheat is $1 right now (this is called the spot price). You could buy the wheat right now for $1, or you could buy a futures contract that gives you the right to purchase one bushel of wheat for $1.05 a year from now. The higher price later suggests that sellers of one-year wheat contracts expects wheat to be slightly more scarce a year from now, but the difference between the price now and the expected price later is only 5 cents, and this might be a very narrow basis by wheat standards.
Accordingly, the spot prices and the futures price should be very close to equal at the time of the futures contract's maturity. In other words, one year from now, the spot price of one bushel of wheat ought to be darn close to $1.05. If isn't, an arbitrage opportunity exists.
Why Does a Narrow Basis Matter?
In general, the narrower the basis, the more efficient the market for the security or commodity. In turn, the market for the security or commodity is relatively liquid and active. In the futures market, a narrow basis also suggests that the market expects the supply and demand for the commodity to change very little between now and when the futures contract expires.
