What Are Allowances?

Allowances are a deviation from the basis grade or location allowable when delivering commodities under the terms of a futures contract. Allowances represent a premium or discount to the standards outlined in the futures agreement. They are the permissible deviations in product quality and delivery location to the contract stipulations that are permitted before violating the terms of the futures contract.

Key Takeaways:

  • Allowances represent a premium or discount to the standards outlined in the futures agreement.
  • Allowances are permissible deviations in product quality and delivery location to the contract stipulations that are permitted so that the terms of the futures contract are not violated.
  • Allowances allow for flexibility in the timely and efficient delivery of futures and forward contracts.
  • Allowances are applied to standards because it might not be possible to find the required goods in a reasonable amount of time.

Understanding Allowances

Allowances provide important flexibility required to ensure the timely and efficient delivery of futures and forward contracts. Under a futures contract, the deliverables are standardized to a specific quality of good or delivery location. For example, an oil futures contract might require a producer to deliver 1,000 barrels of crude with an 850 kg/m³ density and 2% sulfur content.

Allowances are made to standards since it might not be possible to find the specific good in a reasonable amount of time. To prevent a default on the contract, allowances permit the seller to deliver within a range of 10 kg/m³ for density and 0.5% for sulfur. This deviation is not considered a large enough material difference to the product's quality to necessitate contract cancelation and default on the part of the seller.

Permitted Allowances and Differentials

Traders are not permitted to arbitrarily decide what allowances and differentials are permitted. The world's major commodity exchanges have strict definitions for the level and amount of deviation that is acceptable. For example, the ICE Futures Europe exchange publishes a list of allowances and discounts permitted in its cocoa bean contract. Some of the allowance specifications defined include grading, weight, quality, deficiencies, salt content, and bean count.

For example, the ICE Futures Europe exchange gave the following information in 2017 regarding the allowance for the cocoa bean for which a standard deviation is calculated to determine the homogeneity of beans:

The standard deviation of the bean count test (homogeneity) is designed to assess the uniformity of bean size within a delivery unit. The formula used is based on a standard deviation calculation whereby the average number of beans per 100g for the whole delivery unit is measured and then compared against the overall variability of bean sizes within the delivery unit. Excessive variability will result in the award of allowances or, above the maximum permitted value, in the delivery unit being graded as not tenderable.

In the United States, the Commodity Futures Trading Commission (CFTC) works with major commodity exchanges to agree on a definition for allowances and differentials permitted in futures contracts to ensure the integrity of the futures markets.