COMMODITY
Derivatives
Guru Raghavan
INDEX
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Derivatives Classification
Commodity Futures
Commodity Forwards
Commodity Swaps
Commodity Options
Commodity Linked Bonds
Commodity derivatives
Commodity derivative instruments can be grouped under as under
PRODUCTS
EXCHANGE TRADED
OVER THE COUNTER
Forwards
Commodity Futures
Commodity Forwards
Commodity Swaps
Commodity Options
Options
Options on
Commodity Futures
Commodity Options
(cap / floors)
Structured
Notes
Commodity Linked
Financing Structures
Commodity Linked
Notes
Commodity derivatives
Commodity Futures
Commodity forwards entail agreements to purchase or sell a
commodity at a forward date. Economically, commodity
forwards are simply forward contracts where the underlying
asset is a commodity. Commodity forwards are structured as
OTC forward contracts or commodity futures
Commodity futures are futures contracts where the underlying
asset is a commodity. The underlying commodity can be an
individual commodity or a basket of commodities
Commodity futures are available in a variety of commodities.
Commodity futures are frequently used to hedge or acquire
exposure to specific to specific commodity prices.
Commodity derivatives
Commodity Futures..
The major characteristic of commodity futures include
A number of commodity futures on individual commodities are
frequently available. The differences between individual contract
specifications include differences in quality / grade of the commodity
or delivery location. The range of similar contracts is designed to
reduce the basis risk in hedging
Commodity futures contracts are frequently capable of being settled
by delivery. This is designed to allow producers and users to deliver
or acquire the underlying commodity
Trading in commodity futures, with few exceptions, is concentrated
in a few contract months. This reflects the seasonal nature of
commodity activity. Trading is also concentrated in the near contract
months .
Commodity derivatives
Commodity Futures..
There are four main categories of commodity
futures:
-
Agricultural products
Metals
Energy and
Transport
Commodity derivatives
Agricultural futures ..
Cereals were the first products on which futures contracts
were traded. Now hundreds of different contracts are traded
on raw and processed grains and oils, live and slaughtered
animals, sugar, orange juice, coffee and inedible agricultural
products such as lumber, rubber and cotton.
Until recently global volume in agricultural futures trading was
dominated by the Chicago Board of Trade which was the first
exchange to trade agricultural futures. Since the early 2000s,
however, Chinese exchanges have emerged as centres for
trading grains, soya products, and industrial commodities
Commodity derivatives
Agricultural futures ..
Agricultural futures trading has not consolidated at a few
exchanges in the same way as trading in most other types of
futures. The survival of many contracts on many exchanges is
a result of two characteristics specific to farm products.
First many crops have a large number of varieties creating
demand for several separate contracts for each generic
commodity
Second agricultural products are processed in many locations
making it useful to have contracts with different delivery
points. Thus wheat growers and users can choose among 15
different futures contracts
Commodity derivatives
Agricultural futures ..
The specificity of agricultural futures has left room for
specialised contracts on smaller exchanges. Thus the Euronext
bread wheat contract which began trading in 1998 aims to
exploit demand for a delivery point in Continental Europe and
changes in EU agricultural policies that may lead to greater
price instability within Europe.
The Commodity and Monetary Exchange of Malaysia, in Kuala
Lumpur has built a successful agricultural futures business on
palm oil, a single commodity traded on no other exchange
Commodity derivatives
Metals futures
Precious metals, such as gold and industrial metals
such as copper have been traded in futures markets
since the middle of the 19th century. Metals prices
can be extremely volatile. Mining companies and
industrial users normally maintain large stocks of
metals and futures markets provide a means to
hedge the risk that the value of these stocks will
fall. Industrial users can also employ futures to
stabilise the prices of key raw materials
Commodity derivatives
Metals futures..
Trading in gold futures is quite different from
trading in other metals. Although some investors in
gold futures mine gold or use it in manufacturing,
most gold futures trading is related to gold’s
traditional role as a store of value in times of
inflation. Hence gold is among the most heavily
traded of all metals. However, not all gold trading
occurs on futures markets, as many speculators
trade shares of gold mining companies as an
alternative to futures contracts
Commodity derivatives
Metals futures..
Unlike users of agricultural products, users of metals
are not concerned with local variations in quality.
Although there are quality differences among ores,
metals have been extracted from ore and processed
to specific standards before they are traded in
financial markets. As a result metals users
throughout the world employ a comparatively small
number of contracts, and there is almost no local
trading of metals futures
Commodity derivatives
Metals futures..
The London Metal Exchange, the Tokyo Commodity
Exchange and the New York Mercantile Exchange
account account for almost all futures trading in
metals, but the relatively new Shanghai Futures
Exchange has established several metals contracts.
China’s rapid industrial growth has given the
Shanghai Exchange an important role in determining
the world price of copper
Commodity derivatives
Energy futures
Trading in energy related futures products dates back to the
oil crises of the 1970s and in the US, to the regulation induced
natural gas shortages of the same period. Futures contracts on
petroleum and petroleum derivatives are extremely popular.
The amount of oil traded daily in futures markets far outstrips
actual world demand for petroleum. There are also contracts
based on the spread, or difference, between the prices of
different petroleum products. After hurricanes damaged US
refineries and production facilities in August and September
2005, energy futures contracts played an important role in
helping the markets adjust to extremely high oil and natural
gas prices
Commodity derivatives
Energy futures
Natural gas futures have become well established in
North America with the New York Mercantile
Exchange offering three separate contracts for
delivery points in the US and Canada. Because each
contract is tied to the capacity of pipelines serving a
specific location, the contracts are of little use to
gas users in other countries. Many more natural gas
contracts are likely to be created on various
exchanges to meet local demands
Commodity derivatives
Energy futures
The arrival of price competition in the wholesale electric
markets has lad to the creation of futures contract on
electricity. The volume of trading in individual contracts is
small because each is tied to the price of power delivered to a
specific location. The Sydney Futures Exchange in Australia for
example trades separate contracts on electricity delivered to
the states of New South Wales and Victoria. The first contract
on electricity in UK began trading on the International
Petroleum Exchange in 200. It is likely that exchanges will
offer many other electricity contracts to serve particular
markets. Electricity deregulation also stimulated development
of first coal futures contract in 1999
Commodity derivatives
Commodity related futures
As the delivered price of physicals depends greatly upon the
cost of transport, there is a demand to hedge freight rates.
The Baltic Exchange in London a centre for arranging bulk
shipping, produces indexes of bulk maritime shipping rates,
but Euronext ceased trading a futures contract on the Baltic
rates index because of lack of volume. Freight futures are
traded on the Norwegian Futures and Options Clearinghouse
and on the New York Mercantile Exchange. Exchanges are also
developing other non physical contracts that may be used to
hedge commodity prices. The Chicago Mercantile Exchange for
example, began offering contracts on temperatures useful for
hedging agricultural or energy prices
Commodity derivatives
Reading commodity futures price tables
Many newspapers publish data summarising the
previous day’s commodity trading (forthcoming
slide)
According to the heading, this table reports trading
in orange juice futures on New York Board of Trade
The following line provides two essential pieces of
information – one contract covers 15000 lbs (6804
kg) of juice and prices are listed in cents per lb
equivalent to 0.454 kg. A listed price must therefore
be multiplied by 15000 to obtain the price of a
contract in cents, then divided by 100 to obtain the
price in dollars
Commodity derivatives
Reading commodity futures price tables
The first column lists the delivery months for which there has
been active trading. These are not necessarily the only months
available. Many contracts permit trading for delivery months
several years into the future, but there is frequently little or no
trading for more distant months and therefore no information
to publish
The next four columns list the price of the first trade for each
delivery month on the previous day (open), the high and low
prices for each delivery month, and the official closing price
(settle). As there are often many trades at various prices in the
final moments of trading, the settlement price does not
purport to be the price of the day’s final trade. It is usually a
weighted average of the prices of trades immediately before
the close of trading as computed by the exchange. Note that
the market is in contango
Commodity derivatives
Reading commodity futures price tables
The column headed ‘change’ is the difference between the
settlement price on this day and that on the previous trading
day. May orange juice is $0.0015 per lb lower, so the value of
one contract has declined $22.50 since the previous day.
November juice is 15 hundredths of a cent higher, so a
contract worth $15,337.50 at the previous close (15000 times
the price of $1.0225) is now worth $15,360 (15000 times the
price of $1.0240)
Life time high and life time low are the highest and lowest
prices at which contracts for that delivery month have ever
traded and show that orange juice for future delivery in all
four contract months is about 30% cheaper now than it was a
few months ago
Commodity derivatives
Reading commodity futures price tables
Open interest gives the number of contracts that are still
active. Although many other contracts have been sold, in most
cases the buyers have liquidated them by buying or selling
offsetting contracts. According to these numbers most trading
in orange juice futures occurs within a few months of delivery.
This table also furnishes the total number orange juice
contracts traded this day and the previous day, the total open
interest in all delivery months (including those not listed in this
table) and the change in the number of open contracts from
the previous day
Commodity derivatives
Reading commodity futures price tables
.
Month
Mar ‘06
May ‘06
July ‘06
Nov ‘06
Open
100.50
100.65
101.20
101.75
High
100.50
100.80
101.20
103.25
Low
99.35
99.75
100.25
101.75
Settle
Change
99.95
Lifetime
High
Lifetime
Low
Open
Interest
-0.05
127.95
96.10
17,978
-0.15
130.00
96.50
4,105
-0.45
132.00
99.75
2,464
-0.15
132.75
101.75
551
100.50
100.80
102.40
Commodity derivatives
Commodity Forwards..
In practice, commodity forwards take a number of
forms. The most common structures are commodity
forwards or commodity swaps (economically, a
portfolio of forwards on the underlying commodity
or index)
Commodity derivatives
Commodity Forwards..
Commodity forwards are generally structured as simple outright
purchases or sales of commodity. The OTC commodity forward market
operates as an alternative to t he commodity futures market. The
principal drivers include
Traditional advantages of OTC products, including ability to customize
the asset, select specific maturity and avoid the margining
requirements of futures contracts
Commodity derivatives
Commodity Forwards..
Commodity forwards are used for longer maturities than those traded
in commodity futures market. Commodity forwards may also be used
where the commodity futures market has low liquidity
Commodity forwards are structured on a physically delivered or cash
settlement (contract for differences) basis. Physically settled
commodity forwards are used where access to the underlying
commodity and price hedging is required. Cash settled commodity
forwards are used where the objective is price risk management
Commodity forwards are used because of the availability of structured
commodity forwards products. The structures generally create trading
opportunities or generate additional value for the participant.
Commodity derivatives
Commodity Forwards.. Structures
Flat forwards
This refers to a transaction where a series of forwards are structured
with a constant price. This involves transacting the series of forwards
at a weighted average price. This structure is frequently used to
accelerate cash flows due over time (by extracting value from the
contango in the forward price curve). The accelerated cash flows are
generally used to match the higher costs (debt servicing and / or the
per unit production cost as production is low) in the early phase of a
project. The lower cash flows in the later part of the flat forward
matches the lower costs (reduced debt service) and /or lower per unit
production cost as production is higher) in the mature phase of the
project .
Commodity derivatives
Commodity Forwards.. Structures
Spot deferred contracts
this structure allows a producer to hedge its forward production sales
price, normally to take advantage of the forward prices available. The
structure also allows the producer the ability to defer delivery
(effectively rolling the contract) where spot prices are higher than the
forward price under the contract
Commodity derivatives
Commodity Swaps
The principal type of commodity swap is a fixed for floating commodity
swap
A fixed for floating commodity price swap is an agreement where a
consumer (producer) fixes the purchase (sale) price of its commodity
relative to an agreed established market pricing benchmark for the
commodity for an agreed period of time
Commodity derivatives
Commodity Swaps - Features
The commodity price swap is purely financial. There is no physical
exchange of commodities between the counter parties.
The
transaction assumes that both parties continue to operate in the spot
market for the commodity, normally to purchase or sell the required
amount of oil or other commodity being swapped. The commodity price
swap itself is totally independent of the underlying physical
transactions. The purchaser or seller in the spot transaction does not
enter into contractual relationships with the commodity swap counter
party. In fact, the spot participant would not necessarily be aware that
the commodity swap had been undertaken
Commodity derivatives
Commodity Swaps - Features
The financial settlement undertaken is on a net basis only. The
amounts owed to and from each counter party are netted at each
settlement date. The party owing the greater amount pays the
difference to the other party. There are no intermediate cash flows and
the commodity price swap would not generally be subject to any
margin or mark to market requirement
(except where credit
enhancement provisions were incorporated)
Commodity derivatives
Commodity options
Commodity options are options where the underlying asset is a
commodity or commodity index. In all fundamental aspects commodity
options are identical to conventional options. They exhibit the same
behaviour and have similar applications to options generally. They are
primarily used to manage risk or generate premium income through
asymmetric risk exposures to the underlying asset price movements
Commodity derivatives
Commodity options
Commodity options are available in exchange traded and OTC form.
OTC commodity options are structured as follows
Commodity call/put options – this entails standard call and put options
on the underlying commodity
Commodity caps/floors – commodity options in the OTC market are
sometimes packaged as commodity cap and floor contracts. The cap is
a series of call options on the commodity itself. The floor is a series of
put options on the commodity. The cap and floor structures are
commonly used to manage ongoing price exposures to the underlying
commodity
Commodity derivatives
Commodity options
Commodity options are structured on a cash settlement or physical
settlement basis. Exchange traded options are exercised into a
position in the underlying commodity futures contract. The futures
contract will generally be settled by physical delivery if held till
maturity. OTC commodity options are frequently cash settled
Commodity derivatives
Commodity options…Structures
Collars – this entails combinations of options (bought puts / sold calls
for producers or bought calls / sold puts for consumers) to restrict
price exposure to within a known range. Collars are used in
commodity markets as option premium financing strategies to reduce
the cost of hedging
Commodity derivatives
Commodity options…Structures
Option spreads – this entails simultaneous purchase and sale of
options at different strikes. For example, a producer may purchase a
put at a given strike price and sell a put at a lower strike price. Both
options have the same maturity. Similar structures using calls are
available for consumers. Option spreads are used to provide protection
within a given band. The premium cost of such structures is lower as
the sold option partially finances the purchases of the option. Option
spreads are frequently structured to monetise commodity price
expectations, including mean reverting behaviour
Commodity derivatives
Commodity options…Structures
Participation structures – this entails the use of ratio option spread
(the face value of options used is not matched) to create structured
exposure to commodity price movements. The primary objective is to
maintain (some) exposure to favourable commodity price movements.
The structure is designed to create the favourable price exposure at
reduced or zero premium cost
Commodity derivatives
Commodity linked bonds
Commodity linked bonds are fixed interest securities where a
commodity derivative is embedded within the structure. The principal
types of commodity linked bonds are
commodity financing transactions
commodity linked structured notes
Commodity derivatives
Commodity linked bonds
The distinguishing characteristics of the two types of transactions are
the underlying issuer and the embodied commodity exposure.
Commodity based financing relates to the issue of debt linked to
commodities, where the linkage is predicated upon the position of the
issuer in the underlying commodity. Commodity linked structured
notes are issues of debt where the commodity price exposure is
deliberately engineered into the return profile of the instrument. The
issuer has no position in the commodity. The issuer is insulated from
this exposure through derivative transactions completed with a
derivative dealer. Commodity structured notes are designed for
investors seeking commodity price exposure