Commodities and Commodity

FuturesBy Martin, Rishab, and Siao

What is a Commodity?Types

Interchangeable and Uniform

Basis Grade

Exchanges

CBoT, NYBoT

History of Commodities China and Sumer

Exchanges

Amsterdam Stock Exchange

1864 CBoT

Forex

Oil:

Q: CND/JPN

Differences Between Commodities and other Assets

Stocks

Bonds

Leverage

Commodity Prices Supply and Demand driven.

Factors that drive the prices:

●Production

●Inventory levels

●Costs of Storage and Transportation

Trading Commodities in the Modern Era Commodities Exchange Act 1936 -- https://www.law.cornell.edu/uscode/text/7/1

Direct:

Futures Contract, Speculation, Hedging, Spot Commodity, Arbitrage

Indirect:

Commodity ETF, Stocks in companies that deal with commodities

Spot CommoditySpot Price vs. Futures Price

Physical delivery in one month or less

“Physical Market” or “Cash Market”

Money exchanged immediately

Commodity ETFs Futures Backed

Contango Risk

Physical Backed

UWTI DWTI UGLD DGLD VelocityShare 3* leverage

Leverage

Commodity StocksMarket Factors + Company Specific Factors

Ex:

Oil Companies

FuturesSpeculators and Hedgers

Inverted Market

Types of Future Contracts:

Commodity, Political, Forex

Front Month, Back Month

History of Futures●Early futures market started with trading of wheat

●Farmers wanted a fixed return for their products

●Forward contracts to Futures contracts

Futures re: CommoditiesMain way of trading commodities - Long or Short

Buy the obligation to buy or sell the commodity.

Commodity Futures Contract Trade: ExampleExample of how a crude oil trade would look:

CL16K @ 105.52

Futures Prices for Commodities●Price Discovery

●Convenience Yield

●Spot-forward Relationship

- No arbitrage condition

- Arbitrage condition

Spot-Forward relationship under no arbitrageSpot Forward equation:

f T (t) = S(t) e(r-y)(T-t)

f T (t) = Forward rate

S(t) = Spot rate

r = interest rate; y = convenience yield

Spot-Forward Relationship under arbitrage●Cash and Carry Arbitrage

Normal backwardation

Contango

Margin Accounts●Borrowing money to trade in the market

●Typical margin accounts for equities is 50%

●But, for commodities trading, typical margin requirements is 5%-15%

For example, if you want to buy a contract of wheat futures, the margin is about $1,700. The total contract is worth about $32,500 ($6.50 x 5,000 bushels). Thus, the futures margin is about 5% of the contract value.

RiskWhat’s risky?

The chance that an investment’s actual return will be different than expected

Calculating Risk

Risk Management

Hedging, speculation, investing

Event Risk, Unsystemic Risk, and Systemic Risk

Risk in CommoditiesUnsystemic

Commodity Price Risk

Catastrophes and Global Events

Terrorism

Natural Disasters

Change in Policy

Systemic

Natural market fluctuations

SpeculationWhat is it?

High Risk High Reward

Speculating vs. Investing

ArbitrageMarket Inefficiencies

Inter-Exchange

Cash and Carry

HFT: e.g. Renaissance Technologies,

Jim Simons

Statistical arbitrage-- pairs trading: Eg. Long Gold + short Copper

What are Derivatives?Basic statistics: refer to: www.bis.org Futures

Exchange-traded & Over The Counter Traded

Underlying Asset: Almost all asset classes

E.g. ...Swaption=swap+option...is also possible (Physical Execution involved)

Vanilla options: (European & American Options)

Options on Commodity ETFs : E.g. XOP

E.g. XOP Call Option

E.g. XOP Put Option

Option PricingBlack Scholes model (European Options)

Binomial Option Pricing Model (American Options)

Monte Carlo Option Model (Exotic Options, e.g. Bermuda Options)

Option Premium = Intrinsic Value + Time Value

Intrinsic Value = |Underlying Price - Strike Price| // (ATM, ITM, OTM)

Time Value: Decreases over the time, and equals to zero at expiration

Black-Scholes Model

Assumptions: It is Theoretical

The instantaneous log returns of the stock price is an infinitesimal random walk with drift

risk free interest rate is constant

There is no arbitrage opportunity (a.k.a. No chance for riskless profit)

It is possible to borrow, lend, buy, and sell any amount, even fractional, of cash at the riskless rate.Friction free market (No transaction fee )

Leave Quants’ work with Quants…Only need to input variables:

E.g. Price of underlying

Strike, Days to Expiration,

Interest Rate,

Volatility (Implied v. Historical),

Dividend…..

Return… Greeks

Delta Sensitivity to Underlying Price Call (0,1 ) Put(-1, 0)

Vega Sensitivity to Volatility “Volatility is good”

Gamma Sensitivity to Delta Increase as option ATM, and decrease when ITM/OTM

Theta Sensitivity to Time Decaying Long: Positive theta; Short: Negative theta

Rho Sensitivity to Risk Free Rate

Hedging, “Time is valuable”Buying/ selling futures contracts to offset the risks of CHANGING PRICES in the cash market.

If a commodity to be hedged is not available as a futures contract, an investor will buy a future contract in something closely follows the movement of that commodity.

Long hedge/ Short hedge

basis = cash price - futures prices (cash refers as underlying product)

Over: P(cash) > P(future); Under: P(cash) <P(future)

Options: A right, not an obligation. What is the underlying?

Legality and StandardizationInternational Bank of Settlement:

Basel III minimum bank capital requirement

ISDA and Over The Counter (OTC) Derivatives

Central Counterparty Clearing HousesCFTC (Commodity futures trading commission)

Dodd-Frank Act (Effective 2010)

European and American clearing houses

E.g. CME Clearing

LCH. Clearnet