Backpricing (Forward Contracts) - Explained
What is Backpricing?
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Table of ContentsWhat is Backpricing?How Does Backpricing Work?Example of Backpricing
What is Backpricing?
Backpricing is a pricing method used for standardized forward contracts in which prices for the commodity to be delivered at a future date is set at a later date. That is, the seller and the buyer agree to follow through a future contract without fixing the price for the commodity to be delivered. Backpricing is a pricing method in which an agreement to buy or sell a commodity in a future contract is made without fixing a price for the commodity. The price would however be fixed at a later date.
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How Does Backpricing Work?
In a backpricing agreement, the price of a commodity in a future contract is fixed by a purchaser after taking the position. Usually, the price index or average price fund in the futures market for that period is used in fixing a backprice. Purchasers use the backpricing method in order to get a fair market value or price for the commodity they are purchasing in the futures market. The nearer the transaction date, the closer they are to getting a fair market price which is then used in setting the price of the commodity. Different futures contracts exist, so also is how they are traded. Many factors can affect the price of a commodity in the futures market, such as the supply and demand for a commodity in the futures market. An analysis of these market events determine prices set for commodities in the market.
Example of Backpricing
Backpricing is beneficial to both purchasers and sellers (consumers and producers) because the price fixed for commodities in a future is determined by the market index or average price in the future market for that particular time. For producers, back pricing method allows them to carry out their operation with little or no interruption while the purchaser is also guaranteed to get a fair market price for the commodity on the transaction date. For example, if Stanley wants to buy a commodity and the transaction date for the contract is December 15, Stanley can agree with the seller to set the price for the commodity at a later date close to the transaction date, and not at present price which might be on February 15 when the seller was approached.