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.

BREAKING DOWN 'Allowances'

Allowances provide important flexibility needed to insure 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 these standards, since it might not be possible to find the specific good in a reasonable amount of time. In order 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 viewed as a large enough material difference to the quality of the product to necessitate the 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 about 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 here include grading, weight, quality, deficiencies, salt content, and bean count.

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

RELATED TERMS
  1. Differential

    A differential is the value or amount of adjustment of the delivery ...
  2. Cash Contract

    A cash contract is a financial arrangement that requires delivery ...
  3. Futures Contract

    An agreement to buy or sell the underlying commodity or asset ...
  4. Approved Delivery Facility

    Approved delivery facility is a location authorized by an exchange ...
  5. Spot Delivery Month

    The spot delivery month, also known as nearby month or front ...
  6. Closing Range

    Closing range refers to the range of high and low prices, or ...
Related Articles
  1. Investing

    Currency Futures: An Introduction

    Find out why forex market is not the only way for investors and traders to participate in foreign exchange.
  2. Investing

    Fueling Futures In The Energy Market

    The energy market influences every aspect of our lives, and these four options are its driving force.
  3. Investing

    How to Trade Futures Contracts

    Futures is short for Futures Contracts, which are contracts between a buyer and seller of an asset who agree to exchange goods and money at a future date, but at a price and quantity determined ...
  4. Investing

    Commodities trading: An overview

    Trading commodities can seem challenging to a novice trader but we break it down for you. Learn more about the history of commodities, the types of commodities, and how to invest in them.
  5. Investing

    A Quick Guide for Futures Quotes

    Here is a quick guide for reading and understanding futures markets quotes.
RELATED FAQS
  1. How do I set a strike price for a future?

    Find out why futures contracts don't have set strike prices like options or other derivatives, even though price change limits ... Read Answer >>
  2. What is the difference between the expected return and the standard deviation of ...

    Learn about the expected return and standard deviation and the difference between the expected return and standard deviation ... Read Answer >>
Trading Center