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  • QA 021
    Question:
    What is meant by 'washing out contracts'?
    Background:
    Recently I came across this term in a text on coffee hedging but the exact meaning was not clear. I guess it could mean that one contract cancels another?
    Asked by:
    Co-operative College student - Kenya
     
    Answer:

    Where price is the only difference between purchase and sale, then an offset or "wash out" can be arranged by settlement of that price difference. Probably the most common occurrence is in futures trading where the clearing house automatically offsets matching purchase and sale contracts belonging to the same party. Most futures contracts are liquidated in this manner. See 08.02.02 for more. Alternatively, an exporter may buy coffee for stock. To offset the price risk he sells a corresponding tonnage on the futures market. Once he sells the green coffee he will buy back the futures. The matching futures purchase and sale now offset each other and are 'washed out' through settlement of the price difference. See 09.01.01 for more.

    In the physical coffee trade occasions arise when buyers and sellers find it impractical or undesirable to perform delivery of a contract: they then have the option of a cash settlement of the contract. This is commonly referred to as a contract "wash out" and can only be done with the mutual agreement of buyer and seller. The only action necessary for a "wash out" is for buyer and seller to agree on a price. For PTBF contracts (Price To Be Fixed - see 09.02.00), price is a differential, whereas for fixed price or "outright" contracts price is the value of the goods at the time of the "wash out".  Tax authorities in most countries will insist that the wash out price reflect the general market value at time of wash out.
     
    Once a price has been determined, letters acknowledging the wash out of the original contract will be exchanged between the contracting parties. Invoices and payments will be calculated using the difference between the original contract price/differential, and the final wash out price/differential.  Sometimes an actual wash out contract is created in which the original buyer sells back the goods to the original seller. This is done more for inventory record keeping than contractual necessity.
     
    Wash outs are common to all commodity trading. Common reasons for wash outs are a seller's inability to cover, to supply the goods under contract for reasons which cannot be considered "force majeure" (see 04.05.08), or a buyer's change in manufacturing schedules.

    Posted 17 May 2005

     

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