Reading 34: Commodities and Commodity Derivatives - An Introduction

Page No. 41Date//Reading 34: Commodities And CommodityDerivativesAn introduction*Life Cycle of CommoditiesEnergylost- oil : Stored briefly before refined transported- Natural gas : Little liquid processing ship by pipeline Exp to SQ ShipGrains - Production is seasonal but StorableMetals - Req large plane : storables Q easy & cheap to storefoodLivestock - Production cycles vary with animal size depend on $ of fromSofts - Cash Crops produced in warm climatesCoffee Coco etc Gtton Sugar VanilaCharacteristics of Commodity SectorsCrude oil - Shipped / stored in natural form later refieedNatural gas- - Must be liquefied to ship over geasMetals- - storable demand varies wl biz cycleGrains & Softs - Production sensitive to weather degeaseLivestock - Supply sensitive to price of feed grainsI] Energy:Most valuable sectorActively traded : crude oil, natural gas & refined productsCrude oil: can be stored in its natural state Req processing Page No. 42Date//20th Jan 23 FriNature Gas : Can be used directly Stolage 4 transportation costsare high because it needs to be liquified.Refined products ; Short storage periodII Grains :Includes wheat , rice, corn, & sy soybeansRisks : Droughts + floods, pests & diseaseWeather plays importants role in determining yield.Tech & politics play a key lole in food supply & demandLong storage periodIIIIIndustrial MetalsIncludes Copper + aluminum , nickel + zinc f lead 7 tin & ironAka base metalDemand associatedis directly with GDP growthDemand is also effected by weather & biz cycleLong Storage period.IV LivestockInclude hogs & cattle sheep & poultryThis sector is dependent on prices of grains & GDP per capitaWeather has impact on health & weight on animalsRisk : Diseaselong Storage periodVPrecious MetalsInclude gold silver & platinumWeather has no impact on availability of preciousUsed in electronics t auto parts & jewelryon Long Storage period Page No.43Date//VI] Softsincludes Cotten, coffee + Sugar & CocoaAka Cash cropsDemand is associated with global wealthWeather plays important role in determining yieldShort storage periodCycle Valuation of CommoditiesItEEngyNo cash flow Cannot use DCFCommoditiesprices based on supply Vs demandCommodity Spot price z PV[future selling price)- Storage costs Cause forward price > SpotpricesevelPV of a Commodity = Spot price + PV of storage Costs - PV of KnnfitsCommodity Future Markets Participants1] Informed Investor (hedge & Speculators) have information aboutthecommodity they tradeHedge Can be producers of ConsumersSpeculators provide liquidity to the market and seektoprofit from information advantage2 ArbitrageursSeek to profit from mispricing in forward I Spot markets3 ExchangesProvide venue 1 performance guranteesOperate all over the word Page No. 44Date //4 AnalystsPerform analysis for data firms, govt , forecests etcNon-market participantsTheir research affectsmarket behaviour5]RegulatorHedging maturi fg etMonitor commodity marketBasisPerioddenivationRiskEx - CFTCSpot Prices vs Expected Futures Pricesspot X ltr + Storage CostContango Future pricesspot price-Vo basis & Calendar spreadBackwardation Future pricesSpot tve Basis & colender spreadCause g Conviniense of holdingBasis = Spot price future price 0 at expireCalender Spread ; Near- term futures price - Longer - tern futures priceTheories of Commodity Future ReturnsInsurance Theory Kegnesinan TheoryLongs rewarded for providing protection to producersHedgingImplies backwardationis a normal conditionAssumption:- Market is dominated by short hedgers (producer)Speculator take long positionFuture price < Expected spot priceResults in backwardation normally i it is also Known asthe theory of normal backwardation Page No. 45Date//HedgingPressureHypothesis:Expand oninsuranceTheorybyConsider producerwellincludinglonghedgersasasbuyersperspectiveIfmarketsaredominatedbyShorthedge:Backwardationofmarkets are dominated by longhedge :Normal backwardation ContangoContangoTheoryofStorageComobilitywithjustin-timeinventryCanavoidthatFuturespricesrelatetospotthroughlettopricesstoragecosts&backwalkConvenienceyield.Future=priceFVofspotprice+FVofstoragecosts-FV of convenienceyieldif Costsbenefits: BackwardationsStorge costPrice of ContractIfCostsbenefits:ContangoConvience Yield"-FullyCollateralizedFuturesContractThecomponentsoftotalreturnforaCommoditycontractfullyCollateralizedfutureconsistof:Roll ReternByCollateral returnYieldNear term future priceonsecdepositedFuther term pricet Price Returnfrom changeinspotpricNear term future price+Roll ReturnOpening longer -datedcontX= Total Returnyour Contract%3mof position in theConvert annual tourreqlegx0.6)12annual collater olfuture Contracts beingRollReturn:/ BackwardationsoldContangoORFutherY. ofNearPositisRollreturnistveformarketbackwardation-Longholderwillbuylonger - datedcontrac tsthat are pricedlowerthantheexpiringcontracts. Page No. 46Date//Rollreturnis-VewhenmarketisinContan goLong-datedcontractperiodhigherthanexpiring.ContangoBackwardationLong ; -ve Short +veLong : tve , short : -VeTotal return for a fully collateralized Commodity futureintuctsSpot price: 100FV ; 95toSpot price ti : 105 Futures price to : 105Return on T-Bill (collatoral) S 3.5,Total Return: 19.02%Spot YieldRoll YieldCollateral yieldChange in Spot pricesChange in Future pricesReturn on CollateralReturn: 105-100 = 5%Return: 105-95 = 10-52%Return: 3.5%10095Aony on tommodiliesReturn on commboli byCommodity Swaps7%LongTBS1] Total Return Swap , ;fixed 5%ps)WoflourastounoLong- payn based on the change in lvlVariable Receives Pay" are based on the change in price of 9 CommodityofCommodity index.Short - Pays series of fixed pay" Page No. 47Date / /Generally used by large institutional investor Ceg Pension plans2] Excess return swap :Pay" on diff bet" Commodity price and benchmark valuePay" are made or received by either party based onreturn calculated by the change in index relative to abenchmark 65 fixed lvl3Basis Swap :The variable pay" are based on the diff in price oftwo commoditiesPay" are based on diff bet" the prices of two CommoditiesOne commodity has highly liquid futures Contract and theother (used by buyer in production) has no futures contracts4.Volatility Swap :Based on volatility of pricevolatilityVolatility buyer receives the pay" if : Actual volatility > ExpecedVolatility Seller receives the pay" if: Actual volatility < Expected vdS Variance Swap:Variance buyer receives the pay" if : Actual Var > Expected VarVariance seller receives the pay" if : Actual Var < Expected Var Page No. 48Date / /Index Construction Vs Retuin1. Breadth and selection methology2. Weightings on each component / commodity3. Methodology for rolling future Contract4. Method of robalancing commodities & Sectors5. Govt of indexGreatest influences on the index return :-Index - Components- Weighting methodRolling methodology may be passive or activeFreq rebalancing of folio weights :- Decreases index returns in trending markets- for single Commodity position- Is Increases 0 index returns in choppy markets