What is 'Backpricing'

Backpricing is a pricing method used in specific futures contracts whereby the price of the commodity to be delivered is priced by the purchaser at some future date after entering into the position.

BREAKING DOWN 'Backpricing'

In backpricing, the price at which the purchaser can set the deliverable commodity must be relative to any monthly or periodic price found in the futures market for that particular actual. Backpricing is a way to reduce risk. The idea is that as the transaction date approaches, the price of the commodity will get closer to what its fair market value will be on the transaction date. The parties will typically use the futures market to set the price.

Not all futures contracts are the same; their specifics will differ depending on the respective commodity being traded. The market price of a commodity that is quoted in the news is often the market futures price for that respective commodity. As with equity securities, a commodities futures price is determined primarily by the supply and demand for the commodity in the market. For example, let's look at oil. If the supply of oil increases, the price of one barrel of oil will decrease. Conversely, if the demand for oil increases, which often happens during the summer, the price of oil will increase.

There are many economic factors that will have an effect on the price of a commodity. Although commodities are traded using futures contracts and futures prices, events that occur now will affect the futures prices. As with other securities, many traders use commodity futures to speculate on future price movements. These investors analyze various events in the market to speculate on future supply and demand. They subsequently enter long or short futures positions depending on which direction they believe supply and demand will move.

Example of ‘Backpricing’

The backpricing method is a useful tool for both producers and consumers, allowing them to plan their operation. For example, a factory can ensure it gets the raw materials and its production is not interrupted. Delivery is confirmed. The price also is not discretionary; it is linked to some index.

Backpricing also works in person-to-person exchanges. For example, let's assume that John wants to buy some corn. On July 1, he approaches Bill, who agrees to sell John 100 bushels of corn on September 30. John doesn't want to pay Bill the July 1 price, so the two of them agree that they will set the price on September 1. When September 1 rolls around, John and Bill backprice the corn and agree to conduct the transaction on September 30, as originally planned.

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