• QA 185
    Do margin calls impact on Price To Be Fixed or PTBF contracts?
    One of our buyers just advised that for the time being "they are only prepared to entertain back-to-back business until such time as the behaviour of the futures markets returns to normality". When asked to explain they said that for the moment buying Price to be Fixed causes them too much exposure to margin calls. What should we make of this?
    Asked by:
    Exporter - Ethiopia

    Margin calls result from changes in futures prices. Importers and traders who buy and sell basis Price To Be Fixed (at a differential to a futures trading month) usually enter into offsetting futures transactions when either their seller or their buyer decides to 'fix' the price.  Until these futures transactions themselves 'match' (purchase and sale cancel each other out), the importer is exposed to potential margin calls, depending on how the market moves. *

    Trading PTBF is the opposite of outright or fixed price trading where the price is set when the transaction is concluded. Back-to-Back trading is where the importer or trader buys and sells matching contracts simultaneously - in this case at fixed prices as your buyer's intention obviously is to avoid additional exposure to futures. This strategy is typical of times when the market is extremely volatile.

    The background…

    Late 2007 through 1st quarter 2008 commodity markets became extremely volatile and coffee has been no exception. The May 2008 arabica futures contract in New York closed end October 2007 at 128.90 cts/lb versus 167.50 cts/lb at the end of February 2008. A gain of nearly 40 cts/lb. **

    Assume that in October 2007 an importer bought 170 tonnes of physical (green) coffee from you for April shipment at 10 cts/lb over May 2008, price to be fixed at seller's option. And, this was subsequently resold at 18 cts/lb over May 2008, price to be fixed buyer's option. If you, the exporter, called to 'fix' your price end December 2007 when the May 2008 position stood at around 138.75 cts/lb, your final sales price would be 148.75 cts/lb FOB.

    The importer 'fixed' the base price by selling ten May futures - selling futures means having to put up an original or initial margin deposit. Margins are usually linked to the value of the contract itself or the maximum amount by which the value of a contract can vary in one day. So, margins are variable and, usually, go up when volatile times arrive on the exchange. Funding margins is part of the credit facilities the trade needs to keep things moving…

    As the market moved up the importer was called upon to also deposit variation margins, in cash and on demand! Every day the price moved up a new variation margin would have been imposed. But, the buyer at the other end of the transaction was not prepared to fix, presumably because he considered that market fundamentals did not warrant the price rises. Normally the buyer would have until the first notice day of the fixation month (in this case May futures) to fix the price. 

    In a strongly rising market the monetary difference between the importer's price fix selling of the futures (for the exporter) and the eventual price fix buying of the futures (for the final buyer) has to be covered by the importer!  The importer only recovers the market variation margins he has paid once the physical coffee has been shipped (April), the shipping documents are passed and payment is received from the final buyer.

    By the end of February the total variation margin on just this one example would have been over USD 100,000. For importers or trade houses conducting extensive business with numerous producing countries, variation margins might run into the millions of US Dollars.

    It is possible that such a situation could temporarily discourage some in the trade to from entering into further PTBF transactions although back-to-back trading is not only difficult but also not without its problems… ***

    *  Selling Price To Be Fixed or PTBF is fully discussed in section 02 of Chapter Nine of the Guide: "Hedging and other operations".  Briefly, when the market outlook is very uncertain, many traders and roasters are reluctant to purchase physical coffee outright on a forward basis. The international trade has therefore developed a system of selling coffee without specifying a price for it, i.e. at a price to be fixed (PTBF). A relevant delivery month of the futures market is chosen: its price at a given moment will determine or fix the price of the physicals contract. If the quality of the physicals is worth more or less than the quality on which the futures contract is based, the price stipulation will read (for example) 'New York "C" December plus (or minus) 3 cts/lb', or 'London robustas November plus (or minus) US$ 30/ton': the plus 3 or plus 30 is the differential. The contract constitutes a firm agreement to deliver and accept a quantity of physical coffee of a known quality and under established conditions. These conditions are based on the quotation for the specified delivery month of the futures market at the time of fixing, plus or minus the agreed differential. The advantage to the buyer and seller is that each has secured a contract for physical coffee, but the price remains open. In other words the buyer has now separated the operational decision to secure physical coffee (thereby avoiding problems of shortages), from the financial decision to fix the cost of that coffee, which they prefer to postpone. This arrangement provides flexibility for both buyer and seller. The obligation to deliver and accept physicals now exists but as the price remains open, both parties can continue to play the market. The system of PTBF has been honed to such an extent that prices are sometimes fixed only when coffee is delivered to the roaster's premises.

    **   In London (robusta) the increase was from USD 1,793/tonne to USD 2,723/tonne or USD 930/tonne  
            i.e. almost 52%.

    *** For more on PTBF trading see section 09.02 of the Guide.

    Posted 22 March 2008

    Related chapter(s):
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    Q&A 051, 054, 171