In the context securities trading, a differential refers to the extra amount of charge added to the purchase price of a security or subtracted from the selling price. This term also describes the extent of adjustment made to the grade of deliverables in a futures contract. The adjustment can also apply to their location.
In a general term, a difference refers to the difference between two classes of an item, it refers to the degree of change permitted to each class. In some futures contracts, differentials are permissible, they are also called allowances.
A Little More on What is Differential
A good instance of a differential in a futures contract is when the holder of the short position is allowed to change the grade of the underlying asset as well as the delivery location. While many futures contracts allow this, some do not, but in a futures contract, differentials are associated with the grade of deliverables or location of delivery.
A differential also relates to the degree of adjustment of the quality or quantity of a commodity, this sometimes extends to the price of the commodity. The differential of the quality, quantity, and price of a product can be plus or minus depending on the underlying market factors.
Price and Price Risk
In a futures contract, the cash price of a given commodity and the future price are often different. Although these prices move closer as the delivery date draws near, they are still not the same. However, in a perfect or efficient market, it is possible for the cash price and the future price to converge.
Given the fluctuations associated with the price of the underlying commodity in a futures contract, a price differential is introduced. This price differential is a reflection of the physical market conditions and not necessarily the quality or grade of a commodity.
The differential risk remains one of the major risks related to the price of a commodity, which can be a rise or fall in price. Generally, futures markets are designed to limit or minimize exposure to price risk but these markets have not recorded most success in doing so because differentials risk are not really dependent on the futures market but in the quality, type (grade) or location of the underlying commodities. Nevertheless, through adequate management, different risk and exposure can be minimized in the futures market.