Study on the application of basis trade with option in Chinese maize contract farming using the BAW model

Contract farming is one of the key indicators of agricultural modernization in a country. However, due to the lack of fair pricing and risk management mechanisms, the default rate in China’s contract farming has remained high. This paper explores the feasibility of using basis trade with option as a solution for China’s maize contract farming. Basis trade with option, based on futures prices, integrates the difference between spot and futures prices (basis) and the rights of options, incorporating pricing and risk management into spot trade. This paper employs an analytical pricing method and hedging formula suitable for American futures options in the Chinese market using the Barone-Adesi and Whaley (BAW) approach. The accuracy of the pricing model and the effectiveness of the hedging strategy, as well as their feasibility for contract farming, are comprehensively verified through Monte Carlo simulation. The results show that this solution can provide fair pricing for both parties of the contract, offer a minimum price guarantee and favorable price fluctuation benefits for the contract seller, and allow traders as contract buyers to transfer risk through hedging. This fundamentally reduces the possibility of contract default.