What is Backpricing
BREAKING DOWN Backpricing
When 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, becasue as the transaction date nears, the price of the commodity gets closer to fair market value on the transaction date. The parties will typically use the futures market to set the price.
There are different kinds of futures contracts and the specifics of each contract differ depending on the commodity that is being traded. For the most part, a commodities futures price is determined by supply and demand for the commodity in the market. For example, if the supply of oil increases, the price of one barrel of oil will decrease; if demand for oil increases, the price of oil will increase.
A number of economic factors, including current events, have an effect on the price of a commodity. Investors may analyze various events in the market to speculate on future supply and demand. Depending on the direction they believe supply or demand will move in, investor will subsequently enter long or short futures positions.
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.