Types of commodity derivatives traded on the financial market
As we have mentioned in the beginning, our focus within the financial market will be on
the commodity derivatives traded. Our aim is to find out what are the main differences
and the link between trading the commodities on the real and on the financial markets.
The commodity derivatives is a financial instrument, which value depends on the
value of the underlying commodity. The futures and options are the main derivatives
traded on the exchange market, while forwards and swaps are usually traded outside
the exchange, on so called “Over –The- Counter” or OTC markets, between financial
institutions and corporate clients ( Hull, 1997)1.
The spot prices published every day on the financial markets, should represent the
trade on the real market of the underlying physical commodity. The specific part in the
spot prices on the financial market is, that they are determined also by some financial
market players, which are not directly involved in the production, stocking or the
transportation phases of the real delivery of the commodity, but are using the
commodities just as investments. The spot prices published on the financial markets are
used also to calculate further the futures and forward commodity prices. In order to
facilitate the trade on the financial markets, price or stock indexes are traded instead of
the spot prices. The benchmark price indexes are giving more representative and
standardized information about prices on global or regional scale, they are easier to be
used for forecasts of consumption and economic growth, facilitate the exercising of
futures and options both from hedgers processing the underlying commodities, and for
those who wish to invest without dealing with the physical commodity ( Geman, 2005)2
The forward contract is “agreement to buy or sell an asset at a certain future time for a
certain price” ( Hull, 1997 ).3 The forwards are usually traded between financial
institutions or financial institution and corporate client. The Buyer’s long position is when
the buyer agrees to buy the underlying asset on a certain date for a certain price. At the
same time the seller has a short position, agreeing to sell the same asset on the agreed
with the buyer date and price. The contract is settled at maturity date and the holder of a
short position is obliged to deliver the negotiated asset to the holder of a long position.
In return, the holder of the short position receives cash amount equal to the delivery
price. The major determinant for the value of the forward contract is the market price of
the asset. At the beginning of the contract, it’s value is zero, but later when the spot
market price changes, and differentiates from the forward delivery price, the value of the
contract changes, and determines the negative or positive value of the forward contract
for the holders of the long or short positions. The forward price at any given time varies
with the contract maturity – it is different for three, six or other months forwards.
Hull C, John, “ Options, Futures and Other derivatives”, Third Edition, Prentice Hall International Inc.,
1997, p.1
2 Geman, Helyette, “Commodities and Commodity Derivatives : Modeling and Pricing for Agriculturals,
Metals and Energy”, John Wiley & Sons, 2005, p.45
3
Hull C, John, “ Options, Futures and Other derivatives”, Third Edition, Prentice Hall International Inc.,
1997, p.1
1
Future contracts are agreements to buy or sell assets at a certain time in the future for
a certain price. Futures are traded on the exchange, while the forwards are not. The
difference is that the exchange requires standard features of the contract, while the
forward contracts could be customized. Some of the terms specified in the future
contracts are the amount of the assets required for one contract, how is the future price
will be quoted, the commodity quality and delivery location, minimum and maximum of
the daily price moves, contract size and number of contracts and margins. The clearing
house on the exchange is also giving guarantee that the future contract will be fulfilled,
even if the buyer and the seller doesn’t know each other. Another difference with the
forwards, is that the delivery date in the futures is usually not specified. The futures
specify only the month of the delivery. The one who holds the short position has the
right to choose the time to make the delivery. The vast majority of future contracts are
closed out before the maturity term and the delivery of the underlying assets is relatively
rare ( Hull, 2007)4. In cases when no real delivery is fulfilled, the clearing house is
protecting the fulfillment of the agreement by “marking to market” the account. This
means, that the initial margin amount is deposited with entering the contract. Than
every day during the period of the future, the margin loss or gain is updated according
to the level of the current spot price, and the future contract could be settled daily, rather
than at the maturity date. This mechanism is in fact closing and rewriting the gain or
loss of both parties on the future contract every day. The updated price is called “ cash
and settlement “ and refers to a price of commodity derivative without being actually
delivered, but when both parties are closing the futures and are settling in cash only the
difference in the accumulated margins trough the “ marking to market” account system.
Futures are facilitating the trade of commodities as financial instruments , and also
serve the producers and suppliers of commodities as hedging instrument against price
risk, locking the price of the commodity in the future ( Geman, 2005)5
Options could be traded both on the exchange and on the OTC market by banks and
other financial institutions. The underlying assets could be commodities, future
contracts, stock indices, currencies, different contracts and etc. What distinguish options
from futures, forwards and swaps is the fact that, the holder of the option is not obliged
to buy or sell the underlying asset, while the other three derivatives are binding
commitments. The option is giving the holder only the option to exercise this right. But
to enter an option contract there is an initial cost, which is not the case with the futures
and forwards. The options are two types- Call ( Buy) and Put ( Sell) options. Options
have fixed size of contract, so called exercise (strike) price, expiration (exercise) date.
According to the exercise date, the options are divided as American and European. The
American options could be exercised any time before their expiration, while the
European options are executed only at the end of the option’s life (Hull, 1997) 6 The
option trade on the exchange is using the “market-marker”system, where a person is
Hull C, John, “ Options, Futures and Other derivatives”, Third Edition, Prentice Hall International Inc.,
1997, pp.3,4, 17, 18, 23, 24, 25
5
Geman, Helyette, “Commodities and Commodity Derivatives : Modeling and Pricing for Agriculturals,
Metals and Energy”, John Wiley & Sons, 2005, p.4
6
Hull C, John, “ Options, Futures and Other derivatives”, Third Edition, Prentice Hall International Inc.,
1997, pp.5, 138,139, 154
4
both bidding and asking for option prices. This system improves the market liquidity, and
the market makers are profiting from the spread between their bid and ask prices. The
clearing house on the exchange is specifying limits for those spreads, as well as is
fixing certain requirements for broker commissions, cash into the margin accounts,
minimum amount of capital for a member of the exchange and guarantees the fulfilment
of the obligations of the members under the option contracts.
The swaps are extensions of the forwards and the futures, representing private
agreement of two parties to exchange cash flows in the future according to prearranged
formula ( Hull, 1997)7. Usually the swap represents a long position in one financial
instrument combined with short position in another financial instrument. It also could be
seen as portfolio of forward contracts. In commodity swaps the floating spot price is
exchanged for a fixed price in the future. Swaps could be used to hedge the risk or to
speculate the direction of prices of the underlying asset. Since the swap depends on the
value of one or more underlying assets, big variety of swaps could be expected. Swaps
are traded usually on the OTC market.
Hull C, John, “ Options, Futures and Other derivatives”, Third Edition, Prentice Hall International Inc.,
1997, pp.111, 130,133,134
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