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  • 10.8.4-RISK AND THE RELATION TO TRADE CREDIT-DIFFERENTIAL RISK OR BASIS RISK

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  • Differential risk or basis risk

     
     
    Banks are well aware that the differential risk can be substantial, especially for those trading single origin coffee, but also that for them insight into the way differentials move is difficult and that as yet there is no immediately obvious solution for this. They mostly depend on the borrower's track record and judgement, especially when coffee is bought against offsetting fixed price sales.

    But where purchases are made against an open price sales contract, a PTBF contract that specifies only a selling differential, then the buying differential will only be determined when the physical coffee is bought and 'fixed'. If the market differential for that type of coffee has substantially changed since the sale was made, then the difference between the hedge price and the buying price of the physicals may be substantially different as well, which could cause the transaction to be unprofitable.

    NB: Differentials tend to be lower when futures prices are high, and higher when futures are low.

    A differential of 'plus 10' on arabica when the 'C' contract is at 60 cts/lb may change to 'even money' in the producing country when the 'C' for example goes to 120 cts/lb. This is favourable for exporters who need to buy physicals against a PTBF sale because when they fix the purchase the physicals will only cost 'even money'.

    A differential of 'minus 50' on robusta when LIFFE is at 700 US$/ton may perhaps change to 'even money' in the producing country when London goes to 500 US$/ton. This is unfavourable for exporters who need to buy physicals against a PTBF sale because when they fix the purchase the physicals will cost 'even money' against an open sale of 'minus 50'. Differentials in producing countries may also buck the general market trend, for example because of drought or other production problems.