Since the futures contract is standardized in terms
of the quantity and quality of the commodity, the futures price represents an
average range of qualities and is therefore an average price. The price for each
individual origin and even quality of physical coffee is not necessarily the
same: it may be higher or it may be lower.
Historically the futures price and the cash price tend
to move closer together as the futures delivery date draws near. While such
convergence does occur in an efficient market, prices for physical coffee often
fluctuate quite independently from the futures market. The physical premium or
discount, the differential, represents
the value (plus or minus) the market attaches to such a coffee compared to the
futures market. This price differential can reflect local physical market
conditions, as well as coffee quality and grade.
Price risk therefore has two components:
- The underlying price
risk: prices for arabica or robusta futures as a whole rise or
fall;
- The differential
risk or basis risk: the difference in
price between physical and futures for a particular physical coffee (the basis)
increases or decreases compared to prices on the futures market.
Futures markets can be used to moderate exposure to
the price risk because they represent the state of supply and demand for an
average grade of widely available deliverable coffee. They cannot be used to
moderate the differential or basis risk, which attaches entirely to a particular
origin, type or quality of coffee.
Price risk is almost always greater than differential
risk, so the risk reduction capability of the futures market is an important
management tool. Differential or basis risk can, admittedly, be very high at
times and should never be ignored. It is helpful to examine historical
differential pricing to identify periods of increased differential risk. There
might be seasonal patterns, for example.