What Are Allowances?
Allowances are a deviation from the basis grade or location allowable when delivering commodities under the terms of a futures contract. 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.
- Allowances are the legally permissible deviations from the terms of a futures contract.
- They relate to the quantity and quality of the commodities being sold.
- Allowances are an important measure in allowing the smooth functioning of the futures markets, helping to prevent potential legal disputes and delivery delays.
How Allowances Work
When entering into futures contracts, the buyer and seller agree ahead of time on important terms such as the quantity of commodity being purchased, the price paid by the buyer, and the date and location for delivery. But another important clause in these contracts are the allowances that set out the acceptable standards of quality and quantity that the seller must provide in order to have honored their agreement. Without these allowances, there would be far greater room for disagreement between buyers and sellers regarding whether the terms of the contract were actually fulfilled.
Importantly, allowances in futures contracts are not negotiated by the buyer or the seller. Instead, they are established by the operators of the commodity exchanges, who apply one set of allowances for each type of futures contract. Naturally, different commodities will have different allowances, based on their unique attributes and the standard practices of the industries that use them. For instance, a commodity such as coffee beans might use statistical methods to estimate the number of beans delivered, whereas a futures contract for gold might rely on the counting and testing of individual gold bars. An oil futures contract, for instance, might require the seller to deliver 1,000 barrels of crude oil with an 850 kg/m³ density and 2% sulfur content.
Allowances are an important component of the commodity futures markets. Without them, it might not be possible for sellers to source the exact type of goods requested in a reasonable amount of time, since even minute variances could cause the contract to be deemed null and void. In the case of oil, for example, an allowance might permit the seller to deliver within a range of 10 kg/m³ for density and 0.5% for sulfur. For oil buyers, this deviation is not considered a large enough difference to the product's quality to necessitate contract cancelation and default on the part of the seller.
Real World Example of an Allowance
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.