1st Edition

Commodity Derivatives A Guide for Future Practitioners

By Paul E. Peterson Copyright 2018
    280 Pages 76 B/W Illustrations
    by Routledge

    280 Pages 76 B/W Illustrations
    by Routledge

    Commodity Derivatives: A Guide for Future Practitioners describes the origins and uses of these important markets. Commodities are often used as inputs in the production of other products, and commodity prices are notoriously volatile. Derivatives include forwards, futures, options, and swaps; all are types of contracts that allow buyers and sellers to establish the price at one time and exchange the commodity at another.

    These contracts can be used to establish a price now for a purchase or sale that will occur later, or establish a price later for a purchase or sale now. This book provides detailed examples for using derivatives to manage prices by hedging, using futures, options, and swaps. It also presents strategies for using derivatives to speculate on price levels, relationships, volatility, and the passage of time. Finally, because the relationship between a commodity price and a derivative price is not constant, this book examines the impact of basis behaviour on hedging results, and shows how the basis can be bought and sold like a commodity.

    The material in this book is based on the author’s 30-year career in commodity derivatives, and is essential reading for students planning careers as commodity merchandisers, traders, and related industry positions. Not only does it provide them with the necessary theoretical background, it also covers the practical applications that employers expect new hires to understand. Examples are coordinated across chapters using consistent prices and formats, and industry terminology is used so students can become familiar with standard terms and concepts. This book is organized into 18 chapters, corresponding to approximately one chapter per week for courses on the semester system.

    List of figures

    List of tables

    Preface

    CHAPTER 1. INTRODUCTION

    What is a Commodity?

    Undifferentiated vs. Branded Products

    Perfect Competition Model

    Inelastic Supply and Demand

    What is a Derivative?

    Price Stability and Certainty

    Separating the Pricing and Exchange Functions

    Forward Contracts

    Futures Contracts

    Options

    Swaps

    Organization of this Book

    Forwards, Futures, and Price Discovery

    Summary

    CHAPTER 2. TRADING FUTURES AND OPTIONS

    Pit Trading

    The Trading Pit

    Order Types and Order Execution

    Open Outcry and Hand Signals

    Price Reporting

    Electronic Trading

    The Role of Technology

    Components of Electronic Trading

    Central Limit Order Book

    Matching Engine

    Front End

    Customer Protection Features

    Benefits vs. Costs of Electronic Trading

    CHAPTER 3. UNDERSTANDING AND INTERPRETING FUTURES PRICES

    How Futures Prices Are Quoted

    Futures Prices and Summary Price Measures

    Tick Size and Contract Size

    Commodity Codes and Month Codes

    Contract Expiration

    Long and Short Positions

    Measures of Trading Activity

    Volume and Open Interest

    Trading Impact on Volume and Open Interest

    Other Relationships between Volume and Open Interest

    Interpreting Price Differences: Time, Space, and Form

    Price Differences Due to Time: Carrying Costs

    Carrying Costs and Convenience Yield

    The Forward Curve

    Forward Curve for a Normal Market

    Forward Curve for an Inverted Market

    Effects of Seasonality

    Forward Curve for Nonstorable Commodities

    Price Differences Due to Space: Transportation Costs

    Locational Price Differentials

    Locational Premiums and Discounts

    Price Differences Due to Form: Processing Costs

    Input-Output and Quality Differentials

    Spreads: Processing, Intra-Commodity, and Inter-Commodity

    Combinations of Time, Space, and/or Form

    CHAPTER 4. MARGINS, CLEARING, DELIVERY, AND FINAL SETTLEMENT

    Margins in Futures Trading

    Initial Margin, Maintenance Margin, and Margin Calls

    The Clearing House and Clearing Firms

    The Clearing House as Central Counterparty

    The Daily Settlement Process

    Margin Account Example

    Final Settlement via Delivery

    The Physical Delivery Process

    Delivery as Arbitrage

    Steps in the Delivery Process

    Final Settlement via Cash Settlement

    CHAPTER 5. MARKET REGULATION

    Futures as Contracts

    Contract Specifications

    Par Quality

    Premiums and Discounts for Quality Variations

    Quantity

    Delivery Location

    Delivery Date

    Cash Settlement vs. Physical Delivery

    Position Limits

    Spot Limits

    Non-Spot Limits

    All-Months-Combined Limits

    Position Limits for Hedgers

    Reportable Levels

    Minimum Price Increment

    Daily Price Limits

    Expiration Date and Last Trading Date

    Regulation by Exchanges

    Regulation by the Federal Government

    Legislative History

    Regulation and the Perfect Competition Model

    Regulatory Purpose

    Creation of the Commodity Futures Trading Commission

    Authority and Jurisdiction

    Organization

    Self-Regulation by the Industry

    Applications in Other Sectors and Countries

    Appendix 5.1

    CHAPTER 6. HEDGING WITH FUTURES

    The Role of Correlation

    Hedging Against a Price Increase

    Loss on Cash Position, Gain on Futures Position

    Gain on Cash Position, Loss on Futures Position

    No Gain or Loss on Cash Position, No Gain or Loss on Futures Position

    Stabilizing the Net Purchase Price

    Hedging Against a Price Decrease

    Loss on Cash Position, Gain on Futures Position

    Gain on Cash Position, Loss on Futures Position

    No Gain or Loss on Cash Position, No Gain or Loss on Futures Position

    Stabilizing the Net Sale Price

    More on the Role of Correlation: An Example from the Corn Market

    Price Changes vs. Prices Levels: The Importance of Returns

    CHAPTER 7. HEDGING AND THE BASIS

    Hedging and Basis Changes

    Actual Values and Expected Values

    Basis Behavior and the Correlation of Returns

    Long Hedging and Basis Behavior

    Rising Prices, Positive Initial Basis, and Basis Strengthens

    Rising Prices, Positive Initial Basis, and Basis Weakens

    Rising Prices, Negative Initial Basis, and Basis Strengthens

    Rising Prices, Negative Initial Basis, and Basis Weakens

    Falling Prices, Positive Initial Basis, and Basis Strengthens

    Falling Prices, Positive Initial Basis, and Basis Weakens

    Falling Prices, Negative Initial Basis, and Basis Strengthens

    Falling Prices, Negative Initial Basis, and Basis Weakens

    Basis Impact on Long Hedging Results

    Short Hedging and Basis Behavior

    Falling Prices, Positive Initial Basis, and Basis Strengthens

    Falling Prices, Positive Initial Basis, and Basis Weakens

    Falling Prices, Negative Initial Basis, and Basis Strengthens

    Falling Prices, Negative Initial Basis, and Basis Weakens

    Rising Prices, Positive Initial Basis, and Basis Strengthens

    Rising Prices, Positive Initial Basis, and Basis Weakens

    Rising Prices, Negative Initial Basis, and Basis Strengthens

    Rising Prices, Negative Initial Basis, and Basis Weakens

    Basis Impact on Short Hedging Results

    CHAPTER 8. HEDGING ENHANCEMENTS

    Types of Hedges

    Anticipatory Hedge

    Inventory Hedge

    Rolling a Hedge

    Reasons for Rolling a Hedge

    Rolling Forward a Long Hedge

    Rolling Back a Short Hedge

    Limits on Rolling Forward or Rolling Back

    Cross-Hedging

    Why Cross-Hedging is Necessary

    Cross-Hedging Grain Sorghum Using Corn Futures

    Regression Equation

    Hedge Ratio

    Converting the Hedge Ratio into Futures Contracts

    Hedging Effectiveness

    Using Price Changes vs. Price Levels in Regressions

    CHAPTER 9. PROFIT MARGIN HEDGING AND INVERSE HEDGING

    Profit Margin Hedging

    Soybean Crush Margin

    Crude Oil Refining Margin

    Cattle Feeding Margin

    Other Processing Spreads

    Inverse Hedging

    Long Inverse Hedge with a Short Forward Contract

    Using Long Futures to Offset a Short Forward

    Drawbacks of a Long Inverse Hedge

    Short Inverse Hedge with a Long Forward Contract

    Using Short Futures to Offset a Long Forward

    Drawbacks of a Short Inverse Hedge

    CHAPTER 10. HEDGING AND BASIS TRADING

    Redefining the Basis and the Cash Price

    Basis as a Tangible Value

    Defining the Impact of Basis Changes

    Commercial Hedging

    Short Hedging – Buying the Basis

    Long Hedging – Selling the Basis

    CHAPTER 11. BASIS TRADING AND ROLLING A HEDGE

    Rolling a Hedge to Capture a Favorable Basis

    Rolling Forward a Long Hedge

    Spread-Adjusted Futures Prices

    Spread-Adjusted Basis Values

    Rolling Back a Short Hedge

    Spread-Adjusted Futures Prices

    Spread-Adjusted Basis Values

    Spreads, the Forward Curve, and Basis Behavior

    Spread Impact on Hedging Results

    Basis Impact of an Implicit Bear Spread

    Basis Impact of an Implicit Bull Spread

    CHAPTER 12. SPECULATION IN FUTURES

    Speculation vs. Investment

    Speculative Styles

    Scalping

    Position Trading

    Spreading

    Intra-Market Spreads

    Inter-Market Spreads

    Speculators and Speculative Impact

    Commitments of Traders

    Open Interest as the Measure of Commitment

    Reportable Traders by Specific Occupation or Activity

    Producer/Merchant/Processor/User

    Swap Dealers

    Managed Money

    Other Reportables

    Total Reportable Positions

    Nonreportable Positions

    Percent of Open Interest Held by Largest Traders

    Speculative Participation in Commodity Futures

    Speculative Vehicles

    Returns to Speculation

    CHAPTER 13. INTRODUCTION TO OPTIONS ON FUTURES

    How Options Work

    An Example from Real Estate

    Options on Futures

    Option Buyers and Sellers

    Exercise or Abandon

    In the Money vs. Out of the Money

    Intrinsic Value of an Option

    Similarities between Options and Insurance

    Option Trading

    Time Value of an Option

    Time Value Decay

    Exercise and Assignment

    Potential Gains and Losses, Margins and Margin Calls

    Automatic Exercise

    Option Expiration Date and Futures Delivery

    Trading Venue and Method

    Clearing and Settlement

    Market Regulation

    Options on Actuals

    CHAPTER 14. OPTION PRICING

    The Black Model

    Call Option Formula

    Call Option Pricing Example

    Put Option Formula

    Put Option Pricing Example

    Measuring Volatility

    Model Assumptions and Shortcomings

    Put-Call Parity

    Pricing with Put-Call Parity

    Identifying and Arbitraging Price Discrepancies

    Option Sensitivity and the Greeks

    Properties of Delta and Trading Applications

    Properties of Gamma

    Properties of Theta

    Properties of Rho

    Properties of Vega

    Summary

    CHAPTER 15. PROFIT TABLES AND PROFIT DIAGRAMS

    Futures and Cash Positions: Linear Profits

    Long Futures

    Short Futures

    Long Cash

    Hedging Long Cash with Short Futures

    Options Positions: Nonlinear Profits

    Long Calls

    Short Calls

    Long Puts

    Short Puts

    Hedging Long Cash with Long Puts

    Short Hedging with Long Puts vs. Short Futures

    Hedging Long Cash with Short Calls

    Short Hedging with Short Calls vs. Short Futures

    Hedging Short Cash with Long Futures

    Hedging Short Cash with Long Calls

    Long Hedging with Long Calls vs. Long Futures

    Hedging Short Cash with Short Puts

    Long Hedging with Short Puts vs. Long Futures

    Discussion

    CHAPTER 16. HEDGING WITH OPTIONS

    Option-Based Hedging Strategies

    Floor

    Ceiling

    Collar

    Zero-Cost Collar

    Inverse Collar

    Covered Call and Covered Put

    Delta-Neutral Hedging

    Impact of Changing Intrinsic Value and Time Value

    Profit Diagrams Prior to Expiration

    Dynamic Hedging Example
    Discussion

    Delta Hedging by Option Market Makers

    Synthetic Futures and Options

    Synthetic Options

    Synthetic Futures

    Profit Diagram for Synthetic Long Futures

    Profit Diagram for Synthetic Short Futures

    Other Uses for Synthetic Positions

    CHAPTER 17. SPECULATING WITH OPTIONS

    Intrinsic Value Strategies

    Time Value Strategies

    Volatility Strategies

    Straddle

    Strangle

    Other Volatility Strategies

    Spread Strategies

    Conversion and Reversal

    Box Spread

    Bull Spreads and Bear Spreads

    Bull Call Spread

    Bear Call Spread

    Bull Put Spread

    Bear Put Spread

    Identical Results from Bull and Bear Spreads

    Box Spread using Bull and Bear Spreads

    CHAPTER 18. COMMODITY SWAPS

    Swaps and Forwards

    Swap Features and Applications

    Fixed and Floating, Long and Short

    Commodity Swap Example

    First Settlement Results

    Second Settlement Results

    Subsequent Settlements

    Swap Contract Specifications

    Flexibility vs. Liquidity

    The Market for Commodity Swaps

    Index

    Biography

    Paul E. Peterson is a Clinical Professor of Finance at the University of Illinois at Urbana-Champaign. His primary focus is futures and options markets, particularly in relation to commodity prices and risk management. Other interests include marketing practices and pricing issues.