COMMODITY Derivatives

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COMMODITYDerivatives

• Guru Raghavan

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INDEX

• Derivatives Classification
• Commodity Futures
• Commodity Forwards
• Commodity Swaps
• Commodity Options
• Commodity Linked Bonds

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 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
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Commodity derivativesCommodity 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.

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Commodity derivativesCommodity 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 .

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Commodity derivativesCommodity Futures..

• There are four main categories of commodity
  futures
•  
• -      Agricultural products
• -      Metals
• -      Energy and
• -      Transport

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Commodity derivativesAgricultural 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

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Commodity derivativesAgricultural 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

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Commodity derivativesAgricultural 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
•  

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Commodity derivativesMetals 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

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Commodity derivativesMetals 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 golds 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

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Commodity derivativesMetals 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

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Commodity derivativesMetals 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.
•  
• Chinas rapid industrial growth has given the
  Shanghai Exchange an important role in
  determining the world price of copper

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Commodity derivativesEnergy 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

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Commodity derivativesEnergy 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

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Commodity derivativesEnergy 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

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Commodity derivativesCommodity 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

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Commodity derivativesReading commodity futures
price tables

• Many newspapers publish data summarising the
  previous days 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

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Commodity derivativesReading 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 days 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

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Commodity derivativesReading 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

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Commodity derivativesReading 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

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Commodity derivativesReading commodity futures
price tables

• .

Month Open High Low Settle Change Lifetime High Lifetime Low Open Interest
Mar 06 100.50 100.50 99.35 99.95 -0.05 127.95 96.10 17,978
May 06 100.65 100.80 99.75 100.50 -0.15 130.00 96.50 4,105
July 06 101.20 101.20 100.25 100.80 -0.45 132.00 99.75 2,464
Nov 06 101.75 103.25 101.75 102.40 -0.15 132.75 101.75 551
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Commodity derivativesCommodity 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)

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Commodity derivativesCommodity 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
•   

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Commodity derivativesCommodity 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.

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Commodity derivativesCommodity 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 .

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Commodity derivativesCommodity 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

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Commodity derivativesCommodity 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

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Commodity derivativesCommodity 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

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Commodity derivativesCommodity 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)

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Commodity derivativesCommodity 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

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Commodity derivativesCommodity 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

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Commodity derivativesCommodity 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

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Commodity derivativesCommodity
optionsStructures

•     
• 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

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Commodity derivativesCommodity
optionsStructures

•     
• 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

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Commodity derivativesCommodity
optionsStructures

•     
• 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

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Commodity derivativesCommodity 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

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Commodity derivativesCommodity 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

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