Important Keyword: Forward Contract, Futures Contract, Price Stability, Risk Management.
Table of Contents
Introduction:
In futures and forward contracts, one of the most important components is the delivery price. This is the price agreed upon by both parties—the buyer and the seller—at which the seller will deliver the underlying asset, and the buyer will accept it. The delivery price remains fixed from the moment the contract is created until the contract’s expiry or fulfillment, even if market conditions fluctuate. In this article, we’ll explore the concept of delivery price in detail, its significance, and how it operates in the context of futures and forward contracts.
What is the Delivery Price?
The delivery price is the agreed-upon price at which a seller will provide the underlying goods, and the buyer will accept delivery, as specified in a futures or forward contract. This price is fixed when the contract is entered and does not change, even though the market price of the asset may vary over time.
In a futures contract (which is traded on a regulated exchange) or a forward contract (an over-the-counter agreement), the delivery price is critical as it defines the economic terms of the deal between both parties. The delivery price is agreed on the day the contract is initiated, not the day when the goods or underlying assets are actually delivered.
Understanding the Delivery Price in Detail
For futures contracts, the delivery price is standardized and fixed at the inception of the contract. Even though futures contracts may experience daily price fluctuations based on the settlement price or market movements, the delivery price remains static throughout the life of the contract.
For forward contracts, the forward price at the start of the contract is identical to the delivery price. However, as time passes, the forward price may fluctuate based on various market factors, but the delivery price stays constant.
In some cases, especially in futures markets, instead of the actual delivery of physical goods, an offsetting contract is used to settle the trade. This means that the trader will enter into an opposing trade to close out their position before the delivery date. Another common practice is the transfer of a warehouse receipt or another instrument representing the underlying asset instead of the physical delivery of the commodity.
When physical delivery occurs, additional costs, such as shipping and handling, may impact the total cost of fulfilling the contract. However, these external factors do not alter the delivery price specified in the contract.
Importance of the Delivery Price in Contracts
The delivery price is crucial for several reasons:
- Price Stability: Once set, the delivery price does not change throughout the contract, providing certainty for both the buyer and the seller. This is particularly beneficial for businesses looking to hedge against future price volatility in the commodities market.
- Hedging Mechanism: Many participants in the futures and forward markets use contracts to hedge against price movements. The fixed nature of the delivery price allows them to lock in the cost of raw materials or goods, which can protect them from unexpected price spikes.
- Risk Management: For traders, knowing the delivery price in advance helps manage risk. Even though the market price may fluctuate during the life of the contract, the trader can be assured that the delivery price remains constant, helping them plan and budget more effectively.
- Separation from Spot Prices: The delivery price differs from the spot price (also called the cash price), which is the current market price of the commodity or asset. While spot prices are subject to daily fluctuations based on supply and demand, the delivery price remains unaffected. This distinction allows traders to benefit from favorable market conditions while securing a set price for future delivery.
How Delivery Price Works in Futures Contracts
Futures contracts are standardized agreements that require daily adjustments based on the mark-to-market process. At the end of each trading day, gains or losses are calculated based on the market’s closing price. However, these adjustments don’t affect the original delivery price, which stays fixed from the contract’s inception.
For instance, if you enter into a futures contract to buy wheat at a delivery price of ₹3,000 per quintal, this price remains the same until the contract matures, regardless of whether the market price fluctuates to ₹3,200 or ₹2,800 per quintal. Your agreed delivery price remains ₹3,000 per quintal.
Delivery Price and Physical Delivery
In some contracts, especially those involving physical commodities, the physical delivery of goods is required. In these cases, the delivery price remains fixed, but the logistics of delivering the goods may impact the final cost.
For example, if you’re trading oil or agricultural products like wheat or sugar, the cost of shipping, handling, and storage can vary depending on where the goods are being delivered from and to. These extra costs do not alter the delivery price itself, but they are essential for calculating the total cost of completing the transaction.
Example of Delivery Price in a Real-Life Scenario
Let’s look at an example:
- Scenario: An Indian food processing company enters into a forward contract to buy 100 tons of sugar from a supplier. The delivery price is fixed at ₹35,000 per ton, agreed upon at the time of signing the contract.
- Market Fluctuations: Over the course of six months, sugar prices fluctuate due to market demand and supply chain disruptions. The spot price of sugar rises to ₹38,000 per ton, but because the company has a forward contract with a delivery price of ₹35,000, they are insulated from the rising prices. They will still pay ₹35,000 per ton upon delivery.
This example highlights how the delivery price helps companies manage costs and hedge against price volatility.
Final Thoughts on Delivery Price
Understanding the delivery price is essential for anyone involved in futures and forward contracts. It provides a level of predictability and risk management, as both buyers and sellers can plan around a fixed price regardless of market fluctuations.
For traders, the delivery price represents a key element in making informed decisions about entering or exiting contracts. For businesses, it serves as a tool for stabilizing costs and avoiding unexpected financial burdens due to sudden market shifts.
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