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  • A practical example

    Chapter 4 - Cotton trading - Guaranteed minimum price contracts 

    Imagine it is September 2007, and a producer in Senegal wishes to sell his or her cotton to a trader. He or she knows that between January 2008 and March 2008 he or she will have 2,000 tons per month. The producer therefore calls the trader to ask for a price, and the trader gives a fixed price of 60.00 cents per pound for the cotton, with delivery January through March 2008.

    At the same time, assume the March 2008 contract on ICE futures is at 62.00 cents per pound.

    The producer agrees with the market price, and knows that at this price he or she will not lose money, but believes that the ICE market may continue to rise over the next few months. So he or she asks the trader how much it will cost to change the contract to a guaranteed minimum price contract. As explained above, this cost will be deducted from the price of the contract. In this example, the trader says that the cost of the guaranteed minimum price contract is 2.00 cents per pound, and so the final price of the contract will be 58.00 cents per pound.

    At 58.00 cents per pound the producer is still comfortable with the sale, and as a bonus he or she gets to participate in any potential upside to ICE futures. If the March 2008 ICE contract moves up to 67.00 cents per pound before a specific date mentioned in the contract, the producer has the right to fix the guaranteed minimum price contract and add 5.00 cents per pound to the price, making the final price 63.00 cents per pound.

    If the ICE futures market does not move up, or moves down, then there will be no change to the contract price. If this is the case, then the producer may say that he or she would have been better off just selling the cotton, rather than buying guaranteed minimum price insurance. With hindsight, this is true – but hindsight is a luxury the producer does not have. If the producer wishes to speculate, and take the risk that the market can move up or down, then that is his or her decision to take. If the producer wishes to be protected from a market collapse, and also retain the possibility of benefiting from potential price increases, then he or she should consider the guaranteed minimum price contract.

    Remember that the prices of ICE futures are published live online, so a producer selling with a guaranteed minimum price contract can follow the price of the market and decide when to fix the price of the contract.