Commodity Derivatives

Commodity Derivatives Definition

Commodity Derivatives are the commodity futures and commodity swaps that use the price and volatility of price in underlying as the base to change in prices of the derivatives so as to amplify, hedge, or invert the way in which an investor can use them to act on the underlying commodities.

In economics, a commodity is a marketable item produced to satisfy wants or needs. The commodity is generally Fungible (Fungibility is the property of a good or commodity whose individual units are capable of being substituted in place of one another). For example, since one ounce of pure gold is equivalent to any other ounce of pure gold, gold is fungible. Other fungible goods are Crude oil, steel, iron ore, currencies, precious metals, alloy, and non-alloy metals.

Commodity Derivatives

In this article, we are going to discuss commodity derivatives, including Commodity Forwards, Commodity, Futures, and Commodity Options.

Commodity Trade


A commodity market is a market that trades in the primary economic sector rather than manufactured products.  Soft commodities are agricultural products such as Wheat, coffee, sugar, and cocoa. Hard commodities are mined products such as gold and oil. Futures contracts are the oldest way of investing in commodities. Futures are secured by physical assets. The commodity market can include physical trading in derivatives using spot prices, forwards, futures, and options on futures. Collectively all these are called Derivatives.

Example of Commodity Derivative instrument


There is a concert of Coldplay happening in an auditorium in Mumbai next week. Mr. X is a very big fan of Coldplay, and he went to the ticket counter, but unfortunately, all the tickets have been sold out. He was very disappointed. Only seven days left for the concert, but he is trying all possible ways, including the black market where prices were more than the actual cost of a ticket. Luckily his friend is the son of an influential politician of the city, and his friend has given a letter from that politician to organizers recommending one ticket to Mr.X at the actual price. He is happy now. So still six days are left for the concert. However, in the black market, tickets are available at a higher price than the actual price.

So, in this example, the letter of that influential politician is an underlying asset, and the value of the letter is the difference between the “Actual price of the ticket” and “Ticket price in the black market.”

Day Actual price

(a)

Price in the black market

(b)

Value of underlying instrument(Letter of Politician)[(a)-(b)]
Day- 1 500 600 100
Day- 2 700 200
Day-3 800 300
Day-4 900 400
Day-5 1000 500
Day-6(Day of the concert) 0 0

In this example, the derivative contract is the compulsion of the organizers to provide tickets at a normal price based on the letter of the politician. A derivative is the letter of the politician; the value of the derivative is the difference of actual and price in the black market. The value of an underlying instrument becomes zero on the due date/honoring of the contract.

I hope you now understand what the derivative contract is. Commodity contract is being traded-in both spot and derivative (Futures/options/swaps) now; let us understand how to calculate the returns from various commodity contracts in both spot and derivative trade.

Commodity Spot contract & how to calculate the return


A spot contract is a contract of buying or selling a commodity/security/currency for settlement on the same day or maybe two business days after the trade date. The settlement price is called a spot price.

In the case of nonperishable goods

In the case of nonperishable goods like gold, metals, etc., spot prices imply a market expectation of future price movements. Theoretically, the difference between spot and forward should be equal to finance charges plus any earnings due to the holder of security (Like dividend).

For example: On a company stock, the difference between the spot and forward is usually the dividends payable by the company minus the interest payable on the purchase price.  In practicality, the expected future performance of the company and the business/economic environment in which a company operates also causes differences between spot and futures.

In the case of perishable/soft commodities:

In the case of perishable commodity, the cost of storage is higher than the expected future price of a commodity (For ex: TradeINR prefer to sell tomatoes now rather than waiting for three more months to get a good price as a cost of storage of tomato is more than the price they yield by storing the same). So, in this case, the spot prices reflect current supply and demand, not future movements. There spot prices for perishables are more volatile.

For example, Tomatoes are cheap in July and will be expensive in January; you can’t buy them in July and take delivery in January since they will spoil before you can take advantage of January’s high prices. The July price will reflect tomato supply and demand in July. The forward price for January will reflect the market’s expectations of supply and demand in January. July tomatoes are effectively a different commodity from January tomatoes.

Commodity Forward contracts 


A forward contract is simply a contract between two parties to buy or to sell an asset at a specified future time at a price agreed today.

For example, A trader in October 2016 agrees to deliver 10 tons of steel for INR 30,000 per ton in January 2017, which is currently trading at INR 29,000 per ton.  In this case, trade is assured because he got a buyer at an acceptable price and a buyer because knowing the cost of steel in advance reduces uncertainty in planning. In this case, if the actual price in January 2017 is INR 35,000 per ton, the buyer would be benefitted from INR 5,000 (INR 35000-INR 30,000). On the other hand, if the price of steel becomes INR 26,000 per ton, then the trader would be benefitted by INR 4,000 (INR 30,000- INR 26000)

The problem arises if one party fails to perform. The trader may fail to sell if the prices of steel go very high like, for example, INR 40,000 in January 2017; in that case, he may not be able to sell at INR 31,000. On the other hand, if the buyer goes bankrupt or if the price of steel in January 2017 goes down to INR 20,000, there is an incentive to default. In other words, whichever way the price moves, both the buyer and seller have an incentive to default.

How is Commodity Forward Price determined?


Before going determined how to calculate Forward price, let me explain the concept of forwarding spot parity.

The “forward spot parity” provides the link between the spot and forward markets for the underlying forward contract.  For example, if the price of steel in the spot market is INR 30,000/tonne and the price of steel in the forward market is definitely not the same. Then why is the difference???

The difference is due to many factors. Let me generalize the same in simple terms.

  1. A major factor of difference is storage cost from today to till the date of a forward contract; it generally takes some cost to store & insure the steel; let us take 2% p. a cost is the cost of storage & insurance of steel.
  2. Interest cost, for example, is 10% p.a

Therefore parity implies

Forward(f) = Spot(s) * Cost of storage * Interest cost

So in this case 3 months forward will be INR 30,000+ (INR 30,000*2%*10%)*3/12= INR 30,900

But INR 30,900 may not be actual forward after three months. It may be less or more. This is due to the following factors.

  1. Market expectations of commodity due to variations in demand and supply (If the market feels commodity may go up and traders are bullish about commodity, then forward prices are higher than forwarding parity price, whereas, if the market feels that prices may go down, then forward prices may be lesser) The expectations are mainly dependent on demand-supply factors.
  1. Arbitrage arguments:  When the commodity has plentiful supply, then the prices can be very well dictated or influenced by Arbitrage arguments. Arbitrage is basically buying in one market and simultaneously selling in another, profiting from a temporary difference. This is considered a riskless profit for the investor/trader. For example, if the price of gold in Delhi is INR 30,000 per 10 grams and in Mumbai gold price is INR 35,000, then the arbitrageur will purchase gold in Delhi and sell in Mumbai.
  1. Regulatory factors Government policies on commodities may be a major factor in determining prices. If the government levies taxes on imports of steel, then domestic steel prices will go up in both spot and forward markets
  1. International markets: The prices of commodities in international markets, to some extent, influence commodity prices in spot and forward markets.

Now let us go into futures contracts.

Commodity Futures contracts 


What is a Futures contract?

In a simple sense, futures and forwards are essentially the same except that the Futures contract happens on a Futures exchanges, which act as a marketplace between buyers and sellers.

In the case of futures, a buyer of a contract is said to be a “long position holder,” and a seller is a “Short position holder.” In the case of futures, to avoid the risk of defaulting contract involves both parties lodging a certain percentage margin of the value of the contract with a mutually trusted third party. Generally, in gold futures trading, the margin varies between 2%-20% depending on the volatility of gold in the spot market.

How are futures price determined?

The pricing of futures contracts is more or less the same as forwards, as explained above.

Futures Traders:

Futures traders are generally Hedgers or speculatorsHedge traders generally have an interest in the underlying asset and are willing to hedge the commodity/currency/stock for risk of price changes.

For example, A steel manufacturer importing coal from Australia currently and in order to reduce the volatility of changes in prices, he always hedges the coal purchases on a three-monthly forward contract where he agrees with the seller on day one of the financial quarter to supply coal at defined price irrespective of price movements during the quarter. So, in this case, the contract is forward/future, and the buyer has an intention to buy the goods and no intention of making a profit from price changes.

Speculators

These one make a profit by predicting market moves and opening a derivative contract(Futures or forward) related to the commodity and while they have no practical use of the commodity or no intention to actually take or make delivery of the underlying asset.

Commodity Options contracts 


An option is a contract that gives the buyer (Who is the owner or holder of the option) a right, but not the obligation, to buy or sell an underlying asset at a specified strike price on a specified date, depending on the form of the option.

The strike price is nothing but a future expected price determined by both buyer and seller of the option of the underlying commodity or security. The strike price may be set by reference to the spot price of underlying commodity or security on the date of purchase of an option, or it may be fixed at a premium (More) or discount(Less)

Let’s say that on Oct 1, the stock price of Tata steel is INR 250 and the premium (cost) is INR 10 per share for a Dec Call the strike price is INR 300. The total price of the contract is INR 10 x 100 = INR 1,000. In reality, you’d also have to take commissions into account, but we’ll ignore them for this example.

Remember, a stock option contract is the option to buy 100 shares; that’s why you must multiply the contract by 100 to get the total price. The strike price of INR 300 means that the stock price must rise above INR 300 before the call option is worth anything; furthermore, because the contract is INR 10 per share, the break-even price would be INR 310(INR 300 + INR 10).

When the stock price is INR 250, it’s less than the INR 300 strike price, so the option is worthless. But don’t forget that you’ve paid INR 1000 for the option, so you are currently down by this amount.

In December, if the stock price is INR 350. Subtract what you paid for the contract, and your profit is (INR 350- INR 310) x 100 = INR 4000. You could sell your options, which is called “closing your position,” and take your profits – unless, of course, you think the stock price will continue to rise.

On the other hand, by the expiration date, if the stock price drops to INR 230. Because this is less than our INR 300 strike price and there is no time left, the option contract is worthless. We are now down to the original investment of INR 1000 (INR 10*100).

Valuation or pricing of an Options contract:

The value of an option can be derived using a variety of quantitative techniques. The most basic model is the Black Scholes model.

In general, standard option valuation models depend on the following factors.

  1. The current market price of an underlying security
  2. The strike price of the option (In relation to the current market price of the underlying commodity)
  3. Cost of holding a position of the underlying security( Incl Interest/dividends)
  4. We estimated future volatility of the underlying security price over the life of the option.
  5. The time to expiration together with any restrictions on when exercise may occur.

I hope now you understand what commodity derivatives (Forwards/Futures/Options) and pricing mechanisms are.

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