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.