Premium and discount for quality

A futures contract names the quality it expects. The workbook calls that the minimum acceptable criteria the deliverable commodity must possess for a valid delivery.

Real goods do not arrive exactly to specification. A consignment is a little richer or a little poorer than the standard.

Rejecting every such lot would make delivery almost impossible. So the contract allows variation and adjusts the price instead.

Better than specification earns a premium. Worse than specification takes a discount. Both are set out in the contract specification, not argued about at the warehouse gate.

But the tolerance has a floor. Below a stated level the goods are simply rejected.

So there are three zones, not two. At or above specification; within tolerance at an adjusted price; and outside tolerance and refused.

The principle. Quality specification is an indication of the minimum acceptable criteria which the exchange deliverable commodity must possess to provide for a valid delivery conforming to the contract's quality specifications. Quality variations in the goods delivered are generally accepted by the buyer subject to adjustment in the originally contracted price, either as a premium or a discount, as mentioned in the contract specifications.

Discount — the castor seed rule. The contract specification reads:

• from 45 per cent to 47 per cent accepted at a discount of 1:2 or part thereof;
• below 45 per cent rejected.

What that means: if the content of the relevant element is below 47% but within 45%, the contracted price attracts a discount. For every 1 per cent decrease in oil content, or part thereof, there is a discount of 2 per cent, or part thereof, in the price.

The workbook's worked case. Contracted price Rs 6,000 per ton at a quality specification of 47 per cent; on actual delivery the quality content is 46 per cent. The contracted price is discounted 2 per cent because the quality fell 1 per cent:

6,000 x 98 / 100 = Rs 5,880

Premium — the gold rule. The price of gold is calculated on .995 purity. A seller who delivers .999 purity gets a premium, and the price is calculated as contract rate multiplied by 999/995.

The workbook's worked case. A gold futures contract bought at Rs 25,000 per 10 grams with a quality specification of .995 fineness; .999 fineness delivered:

Gold price = 25,000 x 999 / 995 = Rs 25,100.50

The buyer pays Rs 25,100.50 against the original contract price of Rs 25,000 per 10 grams.

Note the two different shapes. Castor seed uses a stepped percentage with a rejection floor. Gold uses a straight ratio with no step at all. Do not apply one form to the other.

A second, separate premium and discount system. Quality is not the only reason the price is adjusted. A contract may have 2 delivery centres, and premium or discount may differ for each delivery centre. Exchanges separately disclose the premium or discount of different locations and quality, which indicates the additional price or discount for deliveries at locations other than the basis centre. Two systems, both called premium and discount, and both in the contract specification.

Castor seed, across the whole tolerance band. Contract specification 47%, contracted price Rs 6,000 per ton, lot size 5 MT.

Two things to see in that table.

The or part thereof phrase rounds against the seller. A 0.6% shortfall is charged the full 2% step, exactly as a 1.0% shortfall is. There is no pro-rating.

And the cliff at 45% is brutal. At exactly 45.0% the goods are accepted at a 4% discount, worth Rs 28,800 on the lot. At 44.9% they are rejected altogether, and the seller has a delivery default rather than a discount.

Gold, the premium side. Contract rate Rs 25,000 per 10 grams, specification .995, lot 1 kilogram — which is 100 units of 10 grams.

The seller earns Rs 10,050 more on the kilogram for delivering .999 instead of .995. Note the size of it: 999/995 is about a 0.4% uplift, not 4%. A candidate who reads the ratio as a percentage step overstates the premium tenfold.

Chapter 7 (Clearing, Settlement and Risk Management), section 7.5 (Premium/Discount). Understanding the calculation of premium and discount for quality variations is a stated learning objective of the chapter, and the section is almost entirely arithmetic, which is why it is examined directly.

Expect both of the workbook's calculations to come back: the castor seed 6,000 x 98/100 = Rs 5,880 and the gold 25,000 x 999/995 = Rs 25,100.50. Expect also the two boundary facts — the 1:2 discount ratio and the below 45 per cent rejected floor — and a question that tests whether you know the gold adjustment is a ratio rather than a percentage step.

• The ratio is 1:2, not 1:1. A 1% quality shortfall costs 2% of the price. Halving the discount is the commonest arithmetic error here.
• Or part thereof rounds against the seller. A 0.6% shortfall attracts the full 2% step. Nothing is pro-rated.
• 45% is the rejection floor; 47% is the specification. At exactly 45.0% the goods are accepted at a 4% discount; below 45% they are rejected, which is a delivery default, not a discount.
• Gold uses a ratio, not a percentage step. Contract rate times 999/995 is an uplift of roughly 0.4%, not 4%.
• Quality premium is not location premium. A contract may have two delivery centres with different premiums or discounts, and exchanges disclose the adjustment for delivery away from the basis centre separately.
• The adjustments come from the contract specification. They are not negotiated between the assigned buyer and seller, who never chose each other in the first place.
• A discount reduces the price, not the quantity. The seller still delivers the whole lot; only the invoice changes.
• Better quality is paid for, not confiscated. The .999 seller genuinely receives more than the contract rate.