What Is Backpricing?
In finance, the term "backpricing" refers to the practice of entering into a commodities futures contract without initially specifying the price at which the commodity will be purchased.
Instead, the parties to a backpriced futures contract will wait until a specified date before deciding on a fair price at which to buy or sell the commodity.
- Backpricing is a way of structuring futures contracts in which the price is not set upon inception of the agreement.
- Instead, the buyer and seller agree to set a price closer to the delivery date of the underlying commodity.
- Typically, the price is agreed upon by reference to an underlying reference or index, such as the spot price of the commodity.
Typically, traders use futures contracts to buy commodities at a known price with the intention of selling the futures contract or taking delivery of its underlying commodity at a specified future date.
In some cases, however, a buyer may simply wish to commit to the purchase of a given quantity of the underlying commodity, while delaying the decision of what price to pay until a future date. In those situations, the buyer and seller will first decide how they will set a price in the future, such as by agreeing to use the prevailing spot price for the commodity at that future date. Once that date is reached, the buyer and seller will carry out the transaction at the agreed-upon price.
The basic justification for backpricing is that it helps ensure that the price paid for the commodity will closely reflect its fair market value at the time of exchange. By contrast, in typical futures contracts it is possible for the price paid for a commodity to differ markedly from its market price. This makes traditional futures contracts far more useful for traders who wish to speculate on commodity prices, as the opportunity for speculative profits would be largely, if not completely, eliminated by backpricing.
Real World Example of Backpricing
Suppose you are the owner of a commercial bakery that wishes to secure its supply of wheat for the upcoming year. Your main priority is ensuring that you will be able to maintain an adequate supply of wheat in order to maintain your production volumes, and to accomplish this you set out to purchase futures contracts that have wheat as their underlying asset.
At the same time, you would like to avoid a situation in which you purchase wheat futures only to see the spot price of wheat decline significantly afterward. Instead, you would prefer simply committing to buy a particular quantity of wheat at set dates and then negotiate the price for those purchases shortly before their delivery dates.
To agree on those prices, you propose using the prevailing spot market price existing a week before each delivery date. This way, both the buyer and the seller of the futures contract can be assured that they are transacting at or near the best available market price, eliminating the possibility for significant speculative profits on either side.