What it means
Businesses often know they will need to transact months ahead of the actual date, and the risk in between is that prices move against them. An advance commitment converts that uncertainty into a known number by getting the counterparty to agree today to the terms that will apply later.
In mortgage lending this is standard practice. A lender that will originate loans over the next quarter obtains a forward commitment from an investor to buy those loans at an agreed price, so it can quote fixed rates to borrowers without gambling on where bond markets will be at settlement.
The same logic runs through commodities and manufacturing. A food producer commits to buy grain at a set price for delivery in six months; a builder commits to a steel price before starting a fixed-price contract; a utility commits to gas volumes for a whole heating season.
Advance commitments are not free. The provider usually charges a commitment fee, expressed as a percentage of the amount committed, and the price offered will already reflect the market's view of where things are heading.
The nuance that catches people out is that a commitment removes the upside as well as the downside. If prices move in your favour you are still bound by the agreed terms, and if you fail to deliver the promised volume you may owe a pair-off fee to unwind the commitment.
In practice
Real-world examples.
Example
A regional bank makes advance commitments to buy $40,000,000 of completed loans from three mortgage brokers each quarter. The arrangement gives the brokers certainty on pricing and gives the bank a predictable flow of assets without maintaining its own origination team.
Example
A brewery signs an advance commitment for aluminium cans at a fixed price for the following calendar year. Metal prices climb 18% during that year, and the commitment holds the company's packaging cost flat while competitors raise prices.
Example
A property developer secures an advance commitment from a lender to provide $25,000,000 of permanent financing once construction is complete. The commitment is a condition of the short-term construction loan, because the construction lender wants proof of how it will be repaid.
Formula
Calculation
Net proceeds under an advance commitment = face amount x agreed price - commitment fee.
A mortgage lender expects to originate $10,000,000 of loans over the next 90 days. It obtains an advance commitment from an investor to buy them at a price of 101.5, meaning 101.5% of face value, with a commitment fee of 0.25% of the committed amount.
Gross proceeds = $10,000,000 x 1.015 = $10,150,000.
Commitment fee = $10,000,000 x 0.0025 = $25,000.
Net proceeds = $10,150,000 - $25,000 = $10,125,000.
Suppose rates rise and, by settlement, the loans would only fetch 99.0 in the open market, which is $10,000,000 x 0.99 = $9,900,000. The commitment has protected $10,125,000 - $9,900,000 = $225,000 of value, comfortably more than the $25,000 fee it cost.Case study
Seen in the real world.
Rosehill Grain Cooperative is a fictional farming cooperative used here as an illustrative case study. Its members grow feed grain, and its board decided to use advance commitments to reduce the swings in member income between good and bad price years.
In the first season the cooperative committed 400,000 bushels for delivery at harvest at $5.80, which locked in 400,000 x $5.80 = $2,320,000. Prices sagged and the spot market at harvest was $5.20, worth 400,000 x $5.20 = $2,080,000, so the commitment protected $2,320,000 - $2,080,000 = $240,000 of member income.
The second season went the other way. Rosehill committed 300,000 bushels at $5.95, worth $1,785,000, while the harvest spot price reached $6.45, which would have produced 300,000 x $6.45 = $1,935,000, so members gave up $150,000. The board kept the policy anyway and explained the reasoning plainly: across the two seasons the cooperative was $90,000 ahead, and more importantly it could now budget with confidence rather than guess.
Watch out
Common mistakes.
- Committing more volume than the business can realistically deliver or absorb, which turns a hedge into a speculative position with a pair-off cost attached.
- Judging a commitment a failure whenever prices move favourably, when the point was certainty rather than beating the market.
- Ignoring the commitment fee when comparing options, since a fee of a quarter of a percent on a large amount is real money that belongs in the comparison.
Questions
People also ask.
Is an advance commitment the same as a futures contract?
They serve a similar purpose, but a futures contract is standardised and exchange-traded, while an advance commitment is a negotiated agreement between two specific parties.
What happens if you cannot deliver?
Most agreements provide for a pair-off or cancellation payment based on the difference between the agreed price and the market price at that point.
Does a commitment guarantee the counterparty will perform?
No, it carries counterparty risk, which is why the financial strength of the party giving the commitment matters as much as the price.
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