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  • QA 230
    Question:
    How are differentials determined and how to hedge them?
    Background:
    We are a new exporter/trader trying to learn about grade differentials and hedging (NY and BMF). We work here with coffee called rio minas (santos) or groupo II where there is a grade differential from NY: minus X for example, Q1- how does one calculate this deferential?
    Asked by:
    Exporter - Brazil
    Answer:

    Differentials are determined by comparing the price of individual types of physical coffee with the price traded on the futures market. Differentials can be a premium or a discount and are commonly used in the trading of both arabica and robusta.*

    Futures markets are based on standardized quantity, quality and delivery conditions: individual futures contracts therefore only differ in terms of delivery period and, of course, price. Consequently each individual physical type of coffee needs to be compared with what the futures market represents which is how the basic differentials are established. Better quality (or less costly to ship and land abroad) = a premium or positive differential. Lower quality (or more costly to ship and land abroad) = a discount or negative differential.

    General price movements for most physical or green coffee are closely correlated to movements on the main futures markets (New York for arabica - London for robusta) that in turn reflect changes in the general availability and international demand for coffee. Differentials on the other hand reflect the availability and demand for individual types or grades of coffee and fluctuate independently, alongside the international price. Much of the world's physical coffee is priced by combining the futures price with a differential to arrive at the sales or purchase price, usually basis FOB port of shipment.

    Differentials are quoted in the market and most are well known, especially for the more widely traded coffees.

    To arrive at the required asking differential for a given shipment period an exporter would compare his breakeven price with the price for the futures position that relates best to the shipping period under consideration. This will show what differential he can offer and, how this compares with the differentials quoted in the market or, with what buyers are willing to pay - see also QA 223 in the Q&A Archive. To note though that Brazilian arabica coffee is currently not tenderable against the New York futures market and as such the differentials that are quoted simply represent the market's commercial assessment of the quality that is on offer (and of course its availability). Brazilian robusta is however tenderable in London and any differential would also reflect, amongst other factors, an assessment of how the quality would be graded by the London exchange. **

    In terms of risk management futures markets can be used to offset or hedge price risk, i.e. the risk that prices generally may move against one's position. But differentials reflect market factors that affect individual origins or types of coffee and often fluctuate independently. This risk, called basis or differential risk, cannot be hedged.

    However, traders in Brazilian arabica can to a large extent hedge the differential between Brazilian arabicas and the New York futures price by using the Sao Paulo based Bolsa de Mercadorias & Futuros (www.bmf.com.br). This because the important and highly liquid Sao Paulo market will always reflect the internal market for coffee in Brazil.

    Arbitrage on the other hand is the attempt to profit from changing differences in price between related situations or commodities. In the case of Brazilian arabica the two exchanges, Sao Paulo and New York, provide ample opportunity for arbitraging or spread trading. The principle is discussed briefly in section 09.05.03 of the Coffee Guide but we cannot provide actual details of available opportunities and methods because the subject does not really fall within the scope of the Coffee Guide. Brazil avails of sophisticated and thoroughly modern commodities exchanges and as such we would rather suggest to contact BM&F itself, or to speak with local derivatives brokers.

    * Chapter 8 of the Guide deals with futures markets - Chapter 9 explains how the trade uses them.

    ** Most Brazilian arabicas are naturals or sundried whereas NYK is based on washed mild arabicas. Of course Brazil nowadays also produces washed arabica but currently this is not tenderable against the NYK C Contract.

    Posted 27 August 2009

    Related chapter(s):
    Related Q & A:
    Q&A 040, 092, 223