What Is a Minimum Price Contract?
A minimum price contract is a forward contract that 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, for example, the sale of grain.
A minimum price is typically specified because agricultural products can spoil and lose all or part of their value if not distributed promptly.
- A minimum price contract is a forward that contains a guaranteed price floor upon delivery of the underlying asset.
- This type of arrangement is most common for agricultural derivatives, as these types of commodities are prone to spoilage, which can erode their market value.
- A minimum price contract will specify the exact quantity, minimum price, and delivery period for the specified underlying commodity.
Understanding a Minimum Price Contract
A minimum price contract allows a producer of agricultural products to determine how much of their product they need to store and the amount they need to unload to make deliveries and receive an acceptable price for their products.
A minimum price contract has language that specifies the delivery details, including the precise quantity and quality of the commodity to be delivered, its minimum price, and what the delivery period for the specified underlying will be. One advantage to the seller is that a minimum price contract typically specifies a period during which the seller may opt to sell the product at a price above the set minimum to take advantage of higher market rates. 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
A soybean grower may decide to sell 100 bushels of soybeans to Company A in June. The cash delivered price for these bushels is $6.00. In the contract, the grower specifies 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, giving 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 the minimum price of $5.45.
In this second scenario, the disadvantage of the contract is clear. The seller has paid a $.50 premium and 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.