What is the definition of a Basis in finance?
In finance, the term basis can be used to refer to a lot of things, however, the most used is the difference between prices and expenses found within a transaction when calculating taxes. Specifically, this application of the term ‘basis’ is also known as ‘cost basis’ or ‘tax basis’ which are more appropriate when calculating capital gains or losses for income tax filings. Basis is also used to refer to the difference between an asset's spot price and its corresponding derivative futures contract.
Different Usages of Basis
As earlier stated, basis can be used to describe different financial terms such as futures market and cost basis.
In the futures market, basis is used to describe the differences between the cash price and the futures price of a commodity. Understanding the basis in the futures market would help investors and traders identify how the relationship between the cash price and futures price can affect the value of contracts used in hedging. On the contrary, when a trader deliberately takes a risk to hedge a position in a derivative of a futures contract the act can be referred to as ‘basis risk’. It is used in an attempt to hedge away price risk. However, the futures market basis is not all so accurate as it allows gaps between spot prices and the corresponding prices until the contract’s expiration date. Due to the time gap in between deviations will be created, and other variations as well. These variations are a result of delivery locations, actuals, and differences in product quality.
Another application of the term ‘basis’ is in the aspect of securities. Also known as ‘cost basis’ or ‘tax basis’, it is used in calculating capital gains or losses after a security transaction. Assuming you purchase 1,000 shares of a stock at $5 per share, the cost basis would equal $5,000 (the $5 price per share multiplied by the total 1,000 shares of stock).