• Price risk and differential


    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.

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