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  • Price risk

    Chapter 4 - Cotton trading - Cotton futures and options – ICE Futures U.S. 

     
     

    Since the futures contract is standardized in terms of the quantity and quality of the commodity, the futures price represents an average price for an average range of qualities. The price for each individual grade and quality of cotton may be higher or lower than the futures price. Historically, the futures price and the cash price tend to move closer together as the futures contract delivery date draws near. While such convergence does occur in an efficient market, prices for physical cotton often fluctuate quite independently from the futures market. The physical premium or discount (the differential) represents the value the market attaches to a specific cotton compared to the futures market (plus or minus). This price differential, or basis, can reflect local physical market conditions, as well as the cotton quality and grade.

    Price risk has two components:

    • The underlying price risk. Prices for cotton futures rise and fall and reflect the overall market conditions.
    • The differential or basis risk. The difference in price between physical and futures for a particular shipment of cotton (the basis) increases or decreases compared to prices in the futures market.

    Futures markets can be used to moderate exposure to price risk because they represent the state of supply and demand for an average grade of widely available cotton. They cannot be used to moderate the differential or basis risk, which attaches entirely to a particular bale, shipment, grade or quality of cotton. Underlying price risk is almost always greater than basis risk, so the risk reduction capability of the futures market is an important management tool. Basis risk can sometimes be very high and should never be ignored, however. It is useful to examine historical differential pricing to identify periods and sources of increased differential risk, such as seasonal factors.

    Physical cotton prices are often largely determined by applying a differential to prices in the futures market; that is, the combination of the differential and the price of the selected futures position gives the price for the physical cotton. 

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