A futures contract is a contract traded on a futures exchange for the delivery of a specified commodity at a future point in time. The contract specifies acceptable delivery methods and locations, and clearly defines the standards of the commodity such as weight, quantity, quality, and form. If a BFP contract is held open until maturity, it is settled by the cash difference between the contract price, and the actual index of basic formula price milk at the time of contract expiration. A hedger is someone taking a position in the futures market that is equal and opposite to the position he either has or expects to take in the cash market, thus providing protection against adverse price movements. Basis is the difference between the local cash price and the futures price at the time the milk is sold or the feed grain purchased.
Basis accounts for transportation costs, quality differences, and local market conditions.
The BFP contract is cash settled so that milk does not have to be delivered to settle the contract terms. When a producer opens an account and begins trading, he or she is required to put a certain percent of the value of the contract into a margin account to guarantee financial security on the part of the contract holder. If the futures market moves against the producer, additional margin money will be required. When the futures position is liquidated, the margin account is used to settle the account. The same results could have been achieved by selling the option rather than executing it.