What is a minimum price contract?
A minimum price contract is a forward contract that guarantees the seller a minimum delivery price. This type of arrangement is used with commodities to protect producers from price fluctuations in the market. Minimum price contracts are common in agricultural sales, for example the sale of grain.
A minimum price is usually specified because agricultural products can deteriorate and lose some or all of their value if they are not distributed quickly.
Key points to remember:
- A minimum price contract is a forward contract that contains a guaranteed floor price upon delivery of the underlying asset.
- This type of arrangement is most common for agricultural derivatives, as these types of products are prone to spoilage, which can erode their market value.
- A minimum price contract will specify the exact quantity, minimum price and delivery time for the specified underlying commodity.
Understanding a minimum price contract
A minimum price contract allows a producer of agricultural products to determine how much product he must store and how much he must unload in order to make deliveries and receive an acceptable price for his products.
A minimum price contract has language that specifies delivery details, including the precise quantity and quality of the commodity to be delivered, its minimum price, and what the delivery period will be for the specified underlying. An advantage for the seller is that a minimum price contract usually specifies a period during which the seller can choose to sell the product at a price above the minimum set to take advantage of higher market rates. In this way, minimum price contracts have a provision similar to a put option in other types of negotiation.
Delivery is the final step in a minimum price contract. The price and maturity are fixed on the date of the transaction. Once the due date has been reached, the seller is obligated to deliver the goods if the transaction has not yet been closed or canceled with a clearing option.
Example of a minimum price contract
A soybean farmer may decide to sell 100 bushels of soybeans to Company A in June. The returned cash price for these bushels is $ 6.00. In the contract, the producer specifies a December call, with a call price of $ 8.00. As part of the minimum price contract, the producer will also pay a premium of $ 0.50 per bushel and a service charge of $ 0.05.
The contract calculation is the cash price less the premium and the service charge. In this example, the minimum guaranteed price per bushel is $ 5.45 ($ 6.00 – $ 0.55 = $ 5.45).
In December, if the price of soybeans rose to $ 9.00, the call to $ 8.00 is now worth $ 1.00, the difference between the two digits. This $ 1.00 is added to the minimum price, resulting in a total guaranteed producer price of $ 6.45 per bushel. That’s $ 1.00 above the minimum price guaranteed by the contract.
Another possibility is that in December the price of soybeans will only have increased to $ 7.00. In this case, the call option is worth nothing, since the futures price has been found to be lower than the purchase price. Thus, the producer receives the minimum price of $ 5.45.
In this second scenario, the downside of the contract is clear. The seller paid a premium of $ 0.50 and a service charge of $ 0.05 for a call option that did not get him a better price for his crop. They may have made a greater profit under a contract without these fees.