Minimum Price Contract Example

o Therefore, merchandisers must carefully explain the elements of the MPC contract to the manufacturer. The cash portion of the transaction is completed when the reserve price is determined by buying the grain in cash and selling futures. This part of the contract is identical to any purchase of barge grain, establishes the basis of the elevator and a cash price for the producer. Period. This is the end of the cash portion of the transaction. The producer ceases to monitor the spot market to determine the outcome of the contract. Like any marketing tool, the minimum price agreement has advantages and disadvantages. Producers interested in price risk management need to be aware of this marketing alternative and understand how to use it in their marketing programs. If the December forward price has risen to $6.00 at harvest, the December $5.20 call option should be worth at least $0.80. In this case, the producer would receive the minimum price of $4.65 plus $0.80 of the call premium for a net final price of $5.45 per bushel (Fig. 3). Minimum price contracts protect the seller against losses due to unpredictable price behaviour at the time of the expiry of the contract.

A producer may also choose to use the reserve price contract when prices are rising and they are struggling to sell in a rising market. With a reserve price contract, it can get a reserve price and still has upside potential as the market recovers. In December, when the price of soybeans rose to $9.00, the $8.00 call is now worth $1.00 or the difference between the two numbers. This $1.00 is added to the reserve price, giving the producer a guaranteed total price of $6.45 per bushel. This is $1.00 above the reserve price guaranteed by the contract. The spot price is equal to the forward price at any time, adjusted for the base (+$0.10). The cash futures contract sets a price at the current level and corresponds to the current forward price, adjusted for the base ($5.20 + $0.10 = $5.30). The minimum price contract (MPC) is equivalent to the futures contract minus the premium and fees below the exercise price of the call option of $5.20 ($5.30 – $0.65 = $4.65).

For futures prices equal to or higher than the strike price, the reserve price is the spot futures contract price + option value – premium and fees. o If the farmer decides to capture a rise in the futures market, sell a reasonable number of the corresponding futures contracts in your options account in increments of at least 1000 bushels. The producer does not have to re-evaluate the entire contract at once, but can set targets at different levels for different quantities. In this second scenario, the disadvantage of the contract is obvious. The seller paid a premium of $0.50 and a service fee of $0.05 for a call option that did not bring him a better price for his harvest. You may have made a greater profit from a contract without these fees. Option-based marketing strategies, such as the minimum price agreement, work well in times of significant and sustainable price change. The threat of margin calls makes a futures-based strategy much more expensive in such situations only. However, price volatility increases the cost of option premiums and increases the costs associated with drafting and implementing reserve price agreements. A minimum price is usually set because agricultural products can spoil and lose all or part of their value if they are not distributed immediately. o Buy grain in cash, sell futures contracts in the corresponding month, just like in a cash or forward purchase contract. o Where MBM is offered as an alternative to agricultural marketing, the elevator does NOT purchase purchase options for the farmer, but for itself to cover potential obligations to the farmer.

The elevator buys a call option as a vehicle that allows it to purchase the farmer`s grain (which sets the lowest price it can get for these bushels) and leaves open the possibility of obtaining a rise in the futures market beyond a predetermined price in a given period of time for an agreed fee. Another reason producers like the minimum price contract is that it offers them additional protection in case their production falls below the contract quantity and they have to buy grain at a higher price at harvest to fulfill their futures contract. This is a particular problem in areas such as Texas and Kansas, where producers face significant production risk. The combination of a loss of production and a loss of unproduced grain, but which had to be purchased to meet a cheaper elevator contract, could be financially devastating. If, in the case of the minimum price contract, prices increase after the producer has signed the contract and production falls below the contractually agreed amount, the money earned with the call option will help offset much of the higher price of grain purchased to fulfill the elevator contract. As a result, many growers feel safer using this type of contract to sell production before harvest, and they are more likely to make pre-harvest sales than if their only alternative would be to use a lump sum futures contract. o Show the producer the fees to set a floor and stay in the market for different periods, using option exercise prices close to the current market. You can give them the choice to choose a strike price that is higher than the market, which actually gives them a higher “deductible” and lower costs. A soybean producer may decide to sell 100 bushels of soybeans to Company A in June. The cash price of these bushels is $6.00. In the contract, the breeder gives a December call with a call price of 8.00 USD. Under the minimum price agreement, the producer also pays a premium of $0.50 per bushel and a service charge of $0.05.

In this case, the producer plans to set a minimum price even before the crop is planted. During the winter (January), the grower looks at corn futures prices for next fall to see what the market could offer. Because he intends to harvest his corn in October, he looks at the December futures and sees that the price is $5.20 a bushel. He also notes that the December $5.20 call option is trading at $0.60 a bushel. When the grower sees this, he calls his local elevator and asks him at what price he can advance corn production for the coming year. The elevator manager says it will offer a $5.30 futures contract for delivery in early October (base = +$0.10). The producer decides that if this price is high enough to cover its costs, it is not high enough to meet its price target and financial objectives. As a result, the producer asks the elevator manager what he would offer as a minimum price contract. A minimum price agreement allows an agricultural manufacturer to determine the quantity of its product that it must store and the quantity it must unload in order to make deliveries and obtain an acceptable price for its products. o Ask the farmer for a reassessment target. The producer has made one decision by fixing the bottom and will have a hard time making another one by watching futures prices move, but it will be easier to procrastinate. Getting a goal in advance makes it easier for both the elevator and the farmer to reassess, and can make profits that could erode before the expiration date.


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