What is a Minimum Price Contract
A minimum price contract is a forward contract which guarantees the seller a minimum price at delivery. This type of arrangement is used with commodities to protect producers from price fluctuations in the market.
Minimum price contracts are common in agricultural sales, such as in the sale of grain. A minimum price is specified because agricultural products can spoil and lose their value if not sold promptly. Using this method, a producer can determine how much of their product they'll need to go into storage and the amount they need to unload to make deliveries and receive an acceptable price for their products.
BREAKING DOWN Minimum Price Contract
A minimum price contract specifies the quantity, minimum price and delivery period for the specified commodity. One advantage to the seller is that minimum price contracts generally specify a period during which the seller may opt to sell the product at a price above the set minimum to take advantage of higher rates in the market. In this way, minimum price contracts come with a provision akin to a put option in other types of trading.
Delivery is the final stage of a minimum price contract. The price and maturity are set on the transaction date. Once the maturity date is reached, the seller is required to either deliver the commodity if the transaction has not yet been closed out or reversed with an offsetting option.
Example of a Minimum Price Contract at Work
A soybean grower may decide to sell 100 bushels to Company A in June. The cash delivered price for these bushels is $6.00. In the contract, they’ve specified a December call, with a call price of $8.00. As part of the minimum price contract, the grower will also pay a $.50 premium per bushel and a $.05 service fee.
The contract calculation is the cash delivered price, minus the premium and the service fee. In this example, the guaranteed minimum price per bushel is $5.45 ($6.00 -$.55=$5.45).
In December, if the price of soybeans has risen to $9.00, the $8.00 call is now worth $1.00, or the difference between the two numbers. That $1.00 is added to the minimum price, for a total guaranteed price to the grower of $6.45 per bushel. This is $1.00 above the minimum price guaranteed by the contract.
Another possibility is that in December the price of soybeans will have only risen to $7.00. In this event, the call option isn’t worth anything, since the futures price has turned out to be below the call price. So, the grower receives their minimum price of $5.45.
In this second scenario, the disadvantage of the contract is clear. The seller has paid a $.50 premium as well as a $.05 service fee for a call option that did not get them a better price for their crop. They may have made a greater profit under a contract without these fees.