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COMMODITY Derivatives

COMMODITY Derivatives. Guru Raghavan. INDEX. Derivatives Classification Commodity Futures Commodity Forwards Commodity Swaps Commodity Options Commodity Linked Bonds.  Commodity derivatives. Commodity derivative instruments can be grouped under as under.

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COMMODITY Derivatives

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  1. COMMODITYDerivatives Guru Raghavan

  2. INDEX • Derivatives Classification • Commodity Futures • Commodity Forwards • Commodity Swaps • Commodity Options • Commodity Linked Bonds

  3.  Commodity derivatives Commodity derivative instruments can be grouped under as under

  4. 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.

  5. 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.

  6. Commodity derivativesCommodity Futures.. There are four main categories of commodity futures: -     Agricultural products -     Metals -     Energy and -     Transport

  7. 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

  8. 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

  9. 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

  10. 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

  11. 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 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

  12. 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

  13. 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. China’s rapid industrial growth has given the Shanghai Exchange an important role in determining the world price of copper

  14. 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

  15. 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

  16. 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

  17. 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

  18. Commodity derivativesReading 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

  19. 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 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

  20. 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

  21. 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

  22. Commodity derivativesReading commodity futures price tables .

  23. 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)

  24. 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

  25. 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.

  26. 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.

  27. 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

  28. 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

  29. 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

  30. 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)

  31. 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

  32. 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

  33. 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

  34. Commodity derivativesCommodity 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

  35. Commodity derivativesCommodity 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

  36. Commodity derivativesCommodity 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

  37. 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

  38. 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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