What Is a Differential?
A differential is the value or degree of adjustment to the grade of deliverables, or to their location, as permitted by a futures contract. While not true for all, some futures contracts permit differentials, also known as an allowance. Such futures contracts permit the short position to make adjustments to the location of delivery and/or the grade or standard of the commodity to be delivered. These differentials are established on the par basis grade or in relation to a central location.
Futures contracts are standardized in terms of the quality and quantity of a given commodity. Because of this, the futures price is representative of a typical range of qualities of commodities, and therefore is an average price. The price specific to origin and quality of any product is not always the same; it may be higher or lower. The premium or discount of the physical product, the differential, represents the value the market attaches to the product, plus or minus, depending on price/quality.
Price and Price Risk
Historically speaking, the cash price and the futures price of a commodity generally move closer to one another as the futures delivery date approaches. In an ideal market, or at least an efficient market, this convergence is fairly common. Still, the price on the physical commodity almost always fluctuates and moves up and down completely independent from the futures market. This is why a differential, or differentials, is (or are) introduced into the futures contract. A price differential is not always due to a commodity’s grade and quality but may also be reflective of local physical market conditions. This is why differentials, or differential risk, is one of the major components of price risk. The other major component is underlying price risk, where a certain commodity’s futures rise or fall as a whole.
In most cases, futures markets are utilized to diminish exposure to price risk because they represent supply and demand for a typical grade of available and deliverable commodities. Futures markets cannot, however, be used to moderate differentials risk because such risk is attached entirely to the type, quality or origin of specific commodities.
Differential risk and exposure are nearly always less great than underlying price risk. For this reason, the capability of the futures market to reduce such risk is an essential management tool. Differential risk should never be ignored or written off, and review of historical differentials for the same or similar products is often a wise course of action.