The term differential refers to the allowed flexibility to change the quality of the underlying asset in a futures contract. Differential allows the seller in a futures contract to deliver the underlying asset which adheres to a predetermined range of quality specifications.
To ensure uniformity and instill confidence in the value of the underlying asset in a futures contract, the agreement will outline the delivery obligations of the seller. This includes the delivery location as well as the quality of the underlying asset. While not permitted in every futures contract, differentials allow the seller some latitude with respect to delivery. The most common differentials include the quality, or grade, of the underlying asset and delivery location.
Since a futures contract will specify the quality and quantity of a commodity, the price will represent a range of qualities if differentials are specified. The premium or discount in the value of the commodity based on its delivered quality and delivery location is represented by the commodity’s differential.