What Is an Advance Commitment?
An advance commitment is a promise or agreement to take some future action. In finance, it is typically related to the buying or selling of an asset at some future time, often with pre-agreed terms.
Futures contracts are a type of advance commitment, except that the buyer or seller of the contract can back out of the contract by taking an offsetting position as long as the offsetting occurs before the expiry date.
- An advance commitment is an agreement to do something in the future.
- A form of advance agreement is a futures contract. Getting engaged is an advance commitment to marriage.
- With a futures contract, an offsetting position can be taken prior to expiry to remove the advance commitment obligation.
Understanding Advance Commitments
Advance commitments occur in the financial markets, business, and other areas of life.
In the financial markets, parties may make an advance commitment to buy or sell an asset. This is commonly done with a futures contract. The person buying the contract is agreeing to buy the underlying asset at the agreed price when the contract expires. The seller of the contract is agreeing to provide the underlying asset to the buyer, and in exchange receives the funds from the buyer.
Exchange-traded futures contract can be offset prior to expiry. The buyer and/or seller receives their gain or loss on the contract, but removes their obligation to buy or deliver the underlying asset.
Short selling a stock is also a form of advance commitment. When a trader sells a stock they don't yet own, hoping to buy it back at a lower price, they are creating an obligation to buy back the shares they short sold at a future date. Although, in this case, the price they will buy the shares at, and when, is unknown at the time of the initial short sale.
In banking, a financial institution will make an advance commitment to a borrower to lend funds on a specified date with agreed-upon terms. This is often the case with a mortgage, as the day the loan is granted is different than the day when the funds are sent to the home seller on behalf of the buyer. A home buyer may go through the process of getting the loan approved before they fully commit to buying a house. In doing so, they know the bank has made a commitment to fund the purchase even if they don't take possession of the house for several weeks or even months. In mortgage banking, an advance commitment is called a "standby commitment."
With investment firms, committed capital is an example of advance commitment. It is the amount the limited partners (LP) have pledged to the fund over the entire life of the investment, or what has already been called in by the general partner (GP) to make investments or generally operate the fund.
In everyday life, getting engaged to be married is an advance commitment, with the action of getting married to come at a later date. Offering to borrow a friend's money next Friday is also a form of advance commitment.
Example of an Advance Commitment
Assume that a gold miner will have an estimated 3,000 ounces of gold to sell in June. It is currently December. They decide to get an advance commitment on the price they will receive on 2,000 ounces.
They sell 20 gold futures contracts (20 contracts x 100 ounces per contract = 2,000 ounces), locking in a price of $1,476. They are now committed to sell 2,000 ounces at that price.
They can back out of the deal by buying the 20 contracts back prior to expiry, nullifying their position. They realize a gain or loss on the position based on the difference between the price they sold at and the price they buy back at.
They could also buy back some of the contracts, lessening their obligation. This could be beneficial if they only end up producing 1,000 ounces. They could buy back 10 contracts and then deliver 1,000 ounces via the remaining 10 contracts.
Businesses typically do these types of transactions to lock in a price. That said, if come June the price of gold is trading at $1,600, the gold miner potentially lost out on some additional profit since they are still committed to sell their gold at $1,476. The buyer is happy as they are getting a better price than what is currently available in the market place.
On the other hand, if come June the price of gold is $1,300, the miner still has a locked in an agreement from a buyer to purchase the gold at $1,476. The miner is happy to sell it at this price, and the buyer is paying a higher cost than the current market price.