Least Price Contract
What Is a Minimum Price Contract?
A base price contract is a forward contract that guarantees the seller a base price at delivery. This type of arrangement is utilized with commodities to safeguard producers from price changes in the market. Least price contracts are common in agricultural sales, for instance, the sale of grain.
A base price is typically indicated on the grounds that agricultural products can ruin and lose all or part of their value in the event that not distributed immediately.
Understanding a Minimum Price Contract
A base price contract permits a producer of agricultural products to decide the amount of their product they need to store and the amount they need to dump to make deliveries and receive an acceptable price for their products.
A base price contract has language that indicates the delivery subtleties, including the exact quantity and quality of the commodity to be delivered, its base price, and what the delivery period for the predefined underlying will be. One advantage to the seller is that a base price contract typically determines a period during which the seller might opt to sell the product at a price over the set least to exploit higher market rates. Along these lines, least price contracts accompany a provision similar to a put option in different types of trading.
Delivery is the last stage of a base price contract. The price and maturity are set on the transaction date. When the maturity date is reached, the seller is required to either deliver the commodity in the event that the transaction has not yet been closed out or switched with an offsetting option.
Illustration of a Minimum Price Contract
A soybean cultivator might choose to sell 100 bushels of soybeans to Company An in June. The cash delivered price for these bushels is $6.00. In the contract, the cultivator determines a December call, with a call price of $8.00. As part of the base price contract, the cultivator will likewise pay a $.50 premium for each bushel and a $.05 service fee.
The contract estimation is the cash delivered price minus the premium and the service fee. In this model, the guaranteed least price per bushel is $5.45 ($6.00 - $.55=$5.45).
In December, on the off chance that the price of soybeans has ascended to $9.00, the $8.00 call is currently worth $1.00, or the difference between the two numbers. That $1.00 is added to the base price, giving a total guaranteed price to the producer of $6.45 per bushel. This is $1.00 over the base price guaranteed by the contract.
Another possibility is that in December, the price of soybeans will have simply ascended to $7.00. In this event, the call option isn't worth anything, since the futures price has ended up being below the call price. In this way, the cultivator receives the base price of $5.45.
In this subsequent scenario, the disadvantage of the contract is clear. The seller has paid a $.50 premium and a $.05 service fee for a call option that didn't get them a better price for their crop. They might have created a greater gain under a contract without these fees.
Features
- A base price contract will indicate the specific quantity, least price, and delivery period for the predefined underlying commodity.
- A base price contract is a forward that contains a guaranteed price endless supply of the underlying asset.
- This type of arrangement is generally common for agricultural derivatives, as these types of commodities are inclined to spoilage, which can disintegrate their market value.
