Commodity Futures
FM 404
Prof. Preeta Sinha
Commodity Futures
• Commodity futures have the spot price of the
commodity as underlying asset. They range from
agricultural products such as wheat, rice, sugar
etc to metals such as gold ,silver, rubber, coffee
etc to energy products such as oil , furnace oil
etc.on these commodities.
 Futures on these commodities help mitigate price
risk.
 The functioning of commodities exchange in
India is regulated by Forward a market
commission (FMC)
• Holding the asset (Long Position)--- Price
decline ---- Short (sell) Futures
• Not holding asset (Short Position) ----Price
increase---- Long(buy) Futures
Benefits of Commodities Futures
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Price discovery
Seasonal Volatility
Reducing cost of credit
More efficient Physical Market
Stability to Govt Revenue
Difference between commodity and
Financial Futures
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Valuation
Delivery and Settlement
Contract features and life
Supply and consumption pattern
Futures contract on commodities
Significant differences of the commodity
futures to financial futures arises due to two
factors:
1) Quality attributes of the commodity
2) Procedure for settlement for delivery-Delivery
Quality, place of delivery etc
Pricing Commodity Futures
Cost of carry can be defined as the net cost of holding a
position . Commodities generally have storage costs, which
can be treated as negative income or a negative yield. For
continuous compounding the fair price of the futures is
given byF1 = S0 X ert
Where, F1 = Futures contract price
S0 = Spot price of the commodity
r = cost of carry (storage cost, warehousing cost etc)
t= time
Q.1) Assume that spot price of gold is Rs.14,000
per tola (1 tola= 10 gm). If financing cost is 12%
per annum with continuous compounding. what
should be the price of the 2 months futures
contract on gold? If warehousing and insurance
cost are placed at 3% per annum what would be
the fair price of the futures contract?
F1 = S0 X ert
r =12% + 3%= 15%
t= 2/12
Soln: F1 = S0 X ert
F1 =?
S0 = Rs.14000 , r =12% , t= 2/12
F1 = 14000 X 2.710.12x2/12 = Rs.14,282.82 per 10 gm
warehousing and insurance cost would be added to
the financing cost for the determination of fair value
of the futures
r= 12+ 3= 15%
F1 = 14000 X 2.710.15x2/12 = Rs.14,354.41 per 10 gm
Class work
Q.2) Assume that spot price of cardamom is
Rs.714 per kg. If financing cost is 10% per
annum with continuous compounding. what
should be the price of the 3 months futures
contract on cardamom? If warehousing and
insurance cost are placed at 1% per annum
what would be the fair price of the futures
contract?
Soln:
F1 = 714 X 2.710.10x3/12 = 732.07
F1 = 714 X 2.710.11x3/12 = 733.91
Speculation with commodity Futures
• Futures can be used for speculation if the estimate of
the future spot price is different than the futures price.
• The Initial margins are required to book futures
contract than to take equivalent position in the spot or
cash market.
To speculate on the prices of commodities one has to
do one of the following:
1) If a trader expects a price fall ,he simply has to sell a
futures contract today and buy it later
2) If a trader expects a rise in price ,he simply has to buy
a futures contract today and sell it later
Spread Strategies with futures
Spread strategies are concerned with the mispricing of futures
contracts in two assets, in two markets or of two different
maturities. Spread trading is speculation on price differential
between two contracts and involves buying one futures and selling
another.
• 1) Intercommodity spread: Buying a future contract in one
commodity and selling another in a related commodity. Ex: buying
gold futures and selling silver futures if the trader feels that the
gold is underpriced as compared to silver today and by the time
the futures matures, the market will restore the balance in the
prices of gold and silver. Crude oil vs. heating oil
– Crude oil vs. gasoline
– Crude oil vs. heating oil + gasoline
– Soybeans vs. soybean oil
– Soybeans vs. soybean meal
2) Intermarket spread: It involves opposite position in the
same commodity but at different market. Ex: Buying
cumin futures at NCDEX at Rs. 6,000 per kg and selling
at Rs. 6,050 per kg at MCX
3) Time/ Calender Spread: It involves opposite position in
the same commodity on the same exchange with
different maturity dates. Ex: Consider the prices of
cumin futures in NCDEX for Oct, Nov and Dec are
6,000, 6,150 and 6,200. The price differential in Nov
and Oct is 150 (6,150-6,000) while the differential in
Dec and Nov contracts is Rs.50 (6,200-6,150). Hence at
differential of Rs.150, Dec futures is underpriced ,we
can go long on Dec futures and short on Nov futures.
Example of Intercommodity spread
and Calender spread
Futures market can serve the useful purpose of protecting the gross
profit margin in the short run for small and frequent changes in the
prices of inputs and outputs.
Ex: Consider a sugar mill that use sugarcane for producing
sugar.100kg of sugarcane yields 9 kg of sugar and it takes about a
month for converting sugarcane into sugar.2-m futures on
sugarcane is 180/quintal and 3-m futures contract on sugar is
Rs.25/kg. Assume basis as zero at the end of 2 month( Future price
at T=2m =Spot price at T=2m).Determine the aggregate profit under
the following scenario:
a) Spot price of Sugar(T=3m)=Rs.22/kg,
Spot price of Sugarcane (at T=2m)=Rs190/quintal
b) Spot price of Sugar(T=3m)=Rs.27/kg,
Spot price of Sugarcane(T=2m)=Rs.170/kg,
• Soln: Gross profit= Price of 9 kg of sugar- cost of 1 quintal
of sugarcane.
The sugar mill needs to buy sugarcane and sell sugar.
Exposure can be hedged by going short on future contract
on sugar (holds a long position and anticipates the price to
fall)and going long on futures contract on sugarcane (holds
short position and anticipates the price to rise).therefore to
hedge the gross profit margin the sugar mill will take
simultaneous position of
a) Long on future contract on sugarcane
b) short on futures of sugar
Hedging for Gross profit
T=0
T=2m
Buy
2-m sugarcane futures
Buy
Sell
Sugarcane
3-m sugar futures with 9% exposure in
sugarcane futures
Sell
sugarcane futures
T=3m
Sell
Sugar
Buy
Sugar futures
Hedging for gross profit: Sugar Mill
Price scenario
Sugarcane
Rs.190/quintal
Rs.170/quintal
Sugar
Rs.22/kg
Rs.27/kg
Bought at
180
180
Sold at
190
170
10
-10
Sold at
25
25
Bought at
22
27
b) Profit/loss on sugar futures
9X3=27
9X(-2)= -18
c) Profit on futures contract(a+b)
37
-28
Price realised for sugar
9X22= 198
9X27= 243
Price paid for sugarcane
190
170
d) Gross Profit on spot position
8
73
Aggregate profit(c+d)
45
45
Sugarcane futures
a) Profit/loss on sugarcane futures
Sugar Futures
Spot position
Calender spread with commodity
Futures
Q.3) The spot price of crude oil is Rs. 3,000 per barrel. In the futures
market 3 months and 6 months contract are trading at Rs. 3,125
and Rs. 3,200. The cost of carry (r) inclusive of storage and
insurance is placed at 15% per annum. If cost of carry model applies
find the following:
a) Fair price of the futures contract for 3 months and 6 months. What
action can an arbitrageur take in this situation?
b) If at the end of 3 months the spot price were Rs.3,500 and the
future market stood corrected, what would be the profit of the
arbitrageur?
c) ) If at the end of months the spot price were Rs.2,700 and the
future market stood corrected, what would be the profit of the
arbitrageur?
a)The fair price of 3 months and 6 months futures with cost of carry
15% and spot rate of Rs. 3,000
F1 = S0 X ert
F3 = 3000 X e0.15X3/12 = Rs.3,111.64,
Actual Price = 3,125
F6 = 3000 X e0.15X6/12 =Rs. 3,233.64
Actual Price = 3,200
An arbitrageur would act as follows:
• 3-m future is overvalued and must be sold
• 6-m future is undervalued and must be bought
c)If at the end of three months the spot price increased to
Rs.2700 and future price stand corrected then the fair value of
future would be Rs.2700 and Rs.2803 (2700 X e0.15tx3/12 ) at
which the investors square off . The position of investors
would be:
Original 3 m futures
Sold at 3125
Bought at 2700
Profit/loss +425
Original 6 m futures
Bought at 3200 sold at 2803
Profit/loss -397
Net profit on the calender spread
Rs.28
b)If at the end of three months the spot price increased to
Rs.3500 and future price stand corrected then the fair value of
future would be Rs.3,500 and Rs.3,634 (3500 X e0.15tx3/12 ) at
which the investors square off . The position of investors
would be:
Original 3 m futures
Sold at 3,125
Bought at 3,500
Profit/loss -375
Original 6 m futures
Bought at 3,500
sold at 3,634
Profit/loss + 434
Net profit on the calender spread
Rs.59
Forward Rolling of the Hedge
The non availability of the futures contract for
the period of hedge give rise to Forward
Rolling of hedge.
Ex: When the hedge is required for 12 months
and the hedge is available for a maximum of 6
months, the hedger faces the problem of
remaining exposure for the period beyond
which futures contract are not available
 If one is long in an asset for 12 months and futures are available
for maximum of six months, the hedger can take the following steps
1) Initially short futures for six months
2) Six months later unwind the position of the original contract by
going long and take a fresh short position in the new contract for
next six months
3) After 12 months unwind the position in the second futures
contract.
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Even if futures are available for the extended period, the rolling
over of hedge is considered abetter option because near futures
have greater liquidity and are more fairly priced than the distant
futures as they suffer from liquidity
Strategies in Futures
• Long Position- holds asset-Short hedge in
futures (farmer)
• Short Position- requires underlying assetLong hedge in futures (computer Co.)
Takes Opposite position in Futures
Assignment
Q.2
Q.3 (C)
Q. Short notes on:
i) Cross Hedge
ii) Optimal Hedge ratio