What it means
In a forward or futures contract, two parties agree today to trade an asset, such as wheat, oil or a currency, at a later date for a price set now. That agreed price is the delivery price.
It is usually set so that the contract has no value to either side on the day it starts. When the delivery date arrives, the market price of the asset, known as the spot price, will probably differ from the delivery price.
If the spot price is higher, the buyer gains because they can buy at the lower agreed price. If the spot price is lower, the seller gains because they can sell at the higher agreed price.
Businesses use contracts like this to hedge, which means to protect against price changes. An airline can lock in a delivery price for fuel to protect its budget, and a farmer can lock in a delivery price for a crop to protect against a fall in prices.
The cost of this certainty is that the business gives up the chance to benefit if prices move in its favour. The delivery price is related to the spot price through the cost of carrying the asset until delivery.
This includes interest on the money tied up, storage and insurance, less any income earned by holding the asset. In well-functioning markets, the delivery price stays close to this level, because traders can profit if it strays too far.
In futures markets, contracts are usually closed out before the delivery date, and only the price difference is settled in cash. Even then, the delivery price remains the reference that determines the gain or loss.
Futures prices are also adjusted each day through margin payments. A finance team should record the contract in its hedging documentation, including the delivery price, quantity and date.
Auditors and lenders often ask for this evidence, and it also helps the team judge whether the hedge worked as intended.
In practice
Real-world examples.
Example
A bakery chain agrees a delivery price for flour six months ahead so that it can print a fixed menu price list. When market prices rise, the contract protects its margins.
Example
A gold miner enters a forward contract with a delivery price in three months. The miner is protected if gold prices fall, but misses the extra profit if they rise. The board accepts this because it values stable cash flow to fund new equipment.
Example
An importer agrees a delivery price for buying euros with dollars in four months, in order to pay a supplier. The importer knows the exact dollar cost of the invoice in advance. This lets the company set its selling prices with confidence.
Formula
Calculation
Gain or loss for the buyer (long position) = (spot price at delivery - delivery price) x quantity
Gain or loss for the seller (short position) = (delivery price - spot price at delivery) x quantity
A flour mill agrees to buy 5,000 bushels of wheat at a delivery price of $6.00 a bushel. At the delivery date the spot price is $6.80. The mill's gain is ($6.80 - $6.00) x 5,000 = $0.80 x 5,000 = $4,000. The seller has the opposite result, a loss of $4,000 compared with selling at the spot price.Case study
Seen in the real world.
Greenlane Foods is an illustrative, fictional company that makes breakfast cereal. Its finance director wanted to protect the company against a rise in wheat prices over the coming year, because wheat is its largest single cost.
She agreed forward contracts with a delivery price of $6.00 a bushel for 100,000 bushels. When the market price rose to $7.50, the contracts saved the company ($7.50 - $6.00) x 100,000 = $150,000.
Greenlane is a made-up company, so the numbers are for teaching only. The director reminded the board that if prices had fallen, the company would have paid more than the market, which is the price of certainty.
Watch out
Common mistakes.
- Assuming the delivery price is a forecast of the future spot price, when it reflects current prices and the cost of carrying the asset.
- Believing a hedge always saves money, when the hedge can lock in a worse price if the market moves the other way.
- Forgetting that gains and losses under the contract are measured against the delivery price, not the price at which the asset was last traded.
Questions
People also ask.
Is the delivery price the same as the strike price?
They are similar ideas, but strike price is used for options, where the holder has a right and not an obligation to trade.
Who sets the delivery price?
In a forward contract the two parties agree it, and in a futures contract it is set by trading on the exchange.
Does the delivery price ever change?
Not for a given contract, though in futures markets the gains and losses are settled daily through margin accounts, so cash moves even though the price is fixed.
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