Commodities and Commodity Futures
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Commodities and Commodity Futures
- 1. Commodities and Commodity Futures By Martin, Rishab, and Siao
- 2. What is a Commodity? Types Interchangeable and Uniform Basis Grade Exchanges CBoT, NYBoT
- 3. History of Commodities China and Sumer Exchanges Amsterdam Stock Exchange 1864 CBoT Forex Oil: Q: CND/JPN
- 4. Differences Between Commodities and other Assets Stocks Bonds Leverage
- 5. Commodity Prices Supply and Demand driven. Factors that drive the prices: ● Production ● Inventory levels ● Costs of Storage and Transportation
- 6. 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
- 7. Spot Commodity Spot Price vs. Futures Price Physical delivery in one month or less “Physical Market” or “Cash Market” Money exchanged immediately
- 8. Commodity ETFs Futures Backed Contango Risk Physical Backed UWTI DWTI UGLD DGLD VelocityShare 3* leverage Leverage
- 9. Commodity Stocks Market Factors + Company Specific Factors Ex: Oil Companies
- 10. Futures Speculators and Hedgers Inverted Market Types of Future Contracts: Commodity, Political, Forex Front Month, Back Month
- 11. History of Futures ● Early futures market started with trading of wheat ● Farmers wanted a fixed return for their products ● Forward contracts to Futures contracts
- 12. Futures re: Commodities Main way of trading commodities - Long or Short Buy the obligation to buy or sell the commodity.
- 13. Commodity Futures Contract Trade: Example Example of how a crude oil trade would look: CL16K @ 105.52
- 14. Futures Prices for Commodities ● Price Discovery ● Convenience Yield ● Spot-forward Relationship - No arbitrage condition - Arbitrage condition
- 15. Spot-Forward relationship under no arbitrage Spot 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
- 16. Spot-Forward Relationship under arbitrage ● Cash and Carry Arbitrage Normal backwardation Contango
- 17. 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.
- 18. Risk What’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
- 19. Risk in Commodities Unsystemic Commodity Price Risk Catastrophes and Global Events Terrorism Natural Disasters Change in Policy Systemic Natural market fluctuations
- 20. Speculation What is it? High Risk High Reward Speculating vs. Investing
- 21. Arbitrage Market Inefficiencies Inter-Exchange Cash and Carry HFT: e.g. Renaissance Technologies, Jim Simons Statistical arbitrage-- pairs trading: Eg. Long Gold + short Copper
- 22. 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
- 23. E.g. XOP Call Option
- 24. E.g. XOP Put Option
- 25. Option Pricing Black 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
- 27. 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 )
- 28. 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…..
- 29. 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
- 30. 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?
- 31. Legality and Standardization International Bank of Settlement: Basel III minimum bank capital requirement ISDA and Over The Counter (OTC) Derivatives
- 32. Central Counterparty Clearing Houses CFTC (Commodity futures trading commission) Dodd-Frank Act (Effective 2010) European and American clearing houses E.g. CME Clearing LCH. Clearnet
Notas do Editor
- “So what are commodities? Can you guys list some things you consider commodities? Alright good. So there are 4 main types of commodities: Metals, agriculture, energy, and livestock and meat. Metals includes precious metals like gold and silver and also industrial metals like iron and steel. Agriculture is crops like wheat and other grains, among others. Energy is stuff like crude oil, natural gas, and coal. And livestock and meat is stuff like cattle and beef. The umbrella that makes all these different things commodities is that they are all interchangeable and uniform, which means that the product doesn’t depend on the producer, which means that if evan co goes and mines some gold ore and martin co goes and mines some other gold ore, the two products we produce are going to be very similar, even interchangeable without losing any value. That being said, when you trade commodities on an exchange there is a minimum quality standard, called the basis grade, set by the exchange. an example of this is regulations on the amount of hydrogen and sulfur in crude oil. Speaking of exchanges, all commodities trades take place on an exchange which ensures fairness and reduces the risk of credit failure and default. These exchanges are all over the world because commodities trading is a worldwide industry, but some local ones are the chicago board of trade and the new york board of trade. Not every exchange will trade every commodity, so it is important to look at many different exchanges when trading. For example, the Chicago Mercantile Exchange & Chicago Board of Trade trades Grains, Ethanol, Treasuries, Equity Index, Metals, Meats, the Kansas City Board of Trade trades only agricultural commodities Agricultural, and the nyme trades energy and metal commodities”
- “So a brief history of commodities. Commodity trading has existed since the dawn of human civilization. In ancient Sumer and ancient china, in 4000 to 4500 bce, there were commodities trades, usually for things like rice and wheat. These trades were standardized enough that the governments had tax regulations for them and could gain revenue through commodities trades, but there was a high risk of default and there were no exchanges to enforce quality standards. Exchanges didn’t really come about until at least the 16th century when the first ever stock exchange, The Amsterdam Stock Exchange, started as a means to trade commodities. They still weren’t completely regulated, but it was a step in that direction. The first ever standardized, future contract for commodities through and exchange happened in 1864 at the chicago board of trade and took place in “the pit” where people yell and each other and make hand signs to signal their intentions. Another aspect of commodities is their effect on the value of a country’s currency. If a country is a big exporter of a commodity, and the value of that commodity goes up, the value of their currency also increases relative to the currency of a country that is a big importer of that commodity. An example of this is canada and japan. Canada is a big exporter of oil and japan is an importer, so when the price of oil goes up, the value of the canadian dollar increases relative to the value of the japanese yen.”
- “So there are some major differences between commodities and some other common assets you guys may decide to invest or trade in. Investing in stocks means you become a part owner in a corporation and inherit rights to the company’s earnings. The stock prices rise and fall based on a company’s earnings and outside economic factors. Bonds are lending your money to a company or the government and receiving coupon payments in exchange. Stocks and bonds are typically investments, or have a large investment aspect, which means that you buy the asset for long term profit, not as a short trade to make a quick buck. Commodities are different. Commodities are traded using futures contracts which are almost always speculative or used for hedging. We’ll go into that more later but basically you only trade in commodities if you think the price of the commodity is going to go up in the relative short term, or if you’re just trying to make sure you don’t lose too much money if another trade goes sour. Another big difference is the amount of leverage used in commodities trades compared to stocks or bonds. In an example we have a little later, in some commodities trades you only have to put up about 8% of the trade yourself, the rest can be covered by a margin account, or credit.”
- “The pricing of a commodity is pretty simple. it’s almost entirely supply and demand driven. So factors that increase the supply of the good decrease the price and factors that increase the demand of the good increase the price. So inventory levels and how good or bad production has been directly influence price. For example, A huge oil spill decreases inventory levels, reduces supply, and increases the price of oil. Another factor that influences the price of commodities is the cost of storing or transporting the commodity. If a farmer has to pay a relatively large amount of money to store his grain, he is more likely to sell the good now at a cheaper price rather than later when he has had to pay large storage fees.”
- “So how do you go about trading commodities in the modern age, since we’ve graduated to exchanges? Well first there’s the commodities exchange act of 1936 which set many many more regulations on commodities trading than it ever had before. It explicitly defined commodities, how to trade them, who’s liable, and enforcement of the contracts. One thing i thought was kind of funny was there very long definition of commodities, given here. Its very important to trading commodities and if you ever decide to trade them you should look through it. its also really really long. Anyway, when trading commodities the main way is through futures contracts, i’m going to talk about all of them aside from futures contracts and rishab will cover them later. So i’m going to cover spot commodities, commodity etfs, and stocks.”
- “So with spot commodities we first have to cover the difference between a spot price and a futures price. The spot price is the price of the commodity if you wanted to buy it right now and have it delivered to your doorstep. This is the price we discussed earlier that is determined almost purely by supply and demand. The futures price is different, its the price of the good traded through the futures contract. Anyway, when buying spot commodities you actually intend to have the good delivered to you, within one month or less, which is not true for futures contracts. The money is exchanged immediately and you assume immediate ownership which is why this is often called the physical of cash market. Again, you only trade on the physical market if you actually want the product, not just to profit from the trade.”
- “Then there are commodity ETFs. ETF stands for exchange-traded funds. ETFs are commonly used as a way to invest in something “passively”, because the value of an ETF increases or decreases as the market for the underlying good changes. So if you invest in a crude oil etf, and the price of crude oil goes up, the etf should also go up. The popularity of commodity etfs has soared recently because they give investors exposure to the commodities market without having to deal with the annoyance of futures contracts and also without have the good delivered to you. You will never have a 1000 cattle delivered to your house if you trade a commodities etf. There are two kinds of commodity ETFs. The first is futures backed, so the ETF purchases futures contracts of a commodity, so that when the futures price goes up, the value of the share of the etf also goes up. The problem with this is that futures contracts expire and need to be repurchased over time, which can increase the fees you need to pay as an owner of the etf, this is called the contango risk. The other type is physical commodity backed etfs, where the etf will basically just purchase the commodity on the spot market and store it. if the spot price of the etf goes up, the value of the etf goes up. There are also inverse etfs, which is similar to shorting a commodity. if you expect the price of gold to go down, for example, then you would buy an inverse gold etf. So there are tons of different etfs you can buy. There are some that track the entire ‘type’ of commodity i mentioned earlier, like the entire metal commodity market, or energy commodity market. Then there are more specific ones like just gold or just crude oil. ETFs are often considered passive investing because they just move with the market, and you just sit on them as they increase in value, instead of looking for a huge jump. On the screen you’ll see some different etf ticker symbols. UWTI is a crude oil etf, and DWTI is the inverse crude oil etf. same with gold. ETFs can also be leveraged so that part of your investment is covered by debt, to increase potential returns.”
- “Another way to trade in commodities is to buy stocks in a company that deals with commodities, like oil companies. This is a very indirect way of getting into the commodities market because the value of the company’s stock isn’t directly related to the price of the commodity, there are other market factors, like is the market bullish (generally going up) or bearish (generally going down) or is there a recessions, and also company specific factors (like did BP just have a massive oil spill) outside of just the commodity price.”
- A contractual agreement, generally made on the trading floor of a futures exchange, to buy or sell a particular commodity or financial instrument at a predetermined price in the future. Different prices for different dates and different commodities. Higher risk for longer term contracts. Often use very high leverage (Margins/borrowed money) Volume in the futures market increases when the stock market looks shaky People who trade futures are either speculators or hedgers they are either betting on changes in the goods price, or they produce the good and are trading futures in an attempt to minimize losses in the event of a price drop/secure profits Backwardation - When the futures price is lower than the spot price. Follows a disaster. Demand is VERY HIGH Forwardation(Contango) - when the futures price is higher than the spot price (normal). Normal because people who buy the commodity don’t have to pay for carrying costs when they buy a future Inverted Market - short term contracts are more expensive than long term contracts, because short term demand is very high. People can use futures for things that aren’t just commodities. Political futures bets on the results of a political election Front Month vs. Back Month Front month - very liquid, expiration date is soon; the month the nearest expiration date is in. may actually need to buy or sell the good that the contract is for Back month - longer amount of time to expiration Tons of intricacies, like put or call options on futures, etc.
- Futures Price - In pricing commodity futures, the futures price is determined using the commodity's spot price, the risk free rate and time to maturity of the contract (along with any costs associated with storage or convenience). Calculate commodity futures prices by adding storage costs to the spot price of a particular commodity. Multiply the resulting value by Euler's number raised to the risk-free interest rate multiplied by the time to maturity.
- Crude Oil Trade: CL is the ticker symbol 8 is the year, 2008 K is the month, May $105.52 is the price of a barrel of crude oil at the time. The futures contract is for 1,000 barrels of crude oil, as stated by the exchange. $105.52 a barrel, times 1,000 barrels/futures contract => $105,520.00 value of the contract Obviously very few people are expected to put up $100,000 up front, so investors use margin to cover the rest of the cost. NYMEX would require you to put up $8775 or ~8%. So it is HEAVILY leveraged So if the price of a barrel of crude goes up to $110.52, that is a profit of $5 per barrel, times 1,000 barrels = $5,000 profit So you would make $5,000 on an $8,775 investment
- “Alright i’m back. I’m going to briefly talk about risk. Risk is the chance that an investment’s actual return will be different than its expected return. Every investment or trade you make will have at least a tiny bit of risk, though government treasury bonds are really really safe. The risk is calculated by taking the standard deviation of either the historical or the average returns of a company or commodity or other asset. Risk is important because investors need to be compensated more for taking on more risk. This is common sense; if there’s a chance you can receive a lot less money than you would expect, then you also want there to be a chance to receive a lot more money than would be typical. How you control your risk is called risk management, and everything you do to make sure you don’t lose all of your money is risk management. This includes sophisticated decisions like hedging, and also simpler decisions like choosing safer investments like treasury bonds over speculative trades like commodities. There are a couple different kinds of risk. Event risk is the chance that an unforeseen event will affect your assets value. something like a natural disaster. Systemic risk is risk that is inherent to the market as a whole, stuff like government collapses or recessions or war. Unsystemic risk is risk that is inherent to a particular industry, like new competitors, regulation changes, or product recalls. Unsystemic risk can be reduced by diversifying your portfolio so that if one of your assets gets negatively affected, not all of them are.”
- “So in commodities there is a mixture of system and unsystemic risk, just like in every other market. commodity price risks are factors that can affect commodity prices. these include political and regulatory changes, seasonal variations, weather, technology, and market conditions. An example could be oil trading. Oil can suffer from economic recessions, changes in OPECs policies, terrorism or instability in the middle east, emergence of other energy sources like wind or solar. When you are trading commodities you need to be on the lookout for possible commodity price risks.
- “Finally, there’s speculation. i mentioned earlier that trading commodity futures is speculative. Speculation is the trading of an asset that has a substantial risk of losing a lot/all of your initial outlay. Because the risk is high, the possible reward is also high. Commodities are speculative because you’re essentially guessing whether or not the future price of the commodity is going to go up or down. Another example of speculation is condo flipping where you pay the minimum down payment on the condos and hope you can quickly sell them for a profit. The difference between speculating and investing is investing is less risky, and you’re usually in it for the long hall like with buy and hold stocks. Investments are unlikely to make huge swings in either direction whereas a speculative new tech startup could either be the next google or the next bankruptcy”
- Markets are not 100% efficient. Just because the price of rice is $2.00/bushel on the Chicago Board of Trade doesn’t mean it is $2.00/bushel on the Kansas City Board of Trade The simultaneous purchase and sale of an asset in order to profit from a difference in the price. Markets are getting more and more efficient everyday, with tech advancements. Arbitrages can only be done with computer programs that monitor for small inefficiencies and act on them immediately. “HFT” typically arbitrage opportunities are corrected by the market within seconds, because everyone buys the cheaper version of the good until the price is equal. Cash and Carry - The Spot price and the futures price are not the same, so you can buy the physical commodity and sell the future to make a profit of the difference. http://www.investopedia.com/terms/c/cash-and-carry-arbitrage.asp Spread - You only purchase futures contracts with different expiration dates and buy or sell in accordance to discrepancies you find.
- Exchange-traded (Not OTC): Futures: Daily average turnover 2014: 5034 Billion USD, Options 1341 Billion USD At some point, options could be viewed as an insurance products. Option is not an obligation for long side. Thousands of companies of all shapes and sizes, in all industries and in all regions use commodity derivatives. Manufacturers, energy companies, farmers, agriculture and food companies, IT companies – these and other types of firms make up the global commodity derivatives markets. They all contribute to the supply of needed commodities for ever-rising earth’s population.
- XOP: S&P Oil & Gas Exploration & Production Select Industry Index
- Monte Carlo Option Model: option with multiple sources of uncertainty or with complicated features This could also be used in European Options
- Both of them involves complex mathematics, but investors do not actually need to know about them . They only need to input into a finance calculator. Equities tend to have skewed curves: compared to at-the-money, implied volatility is substantially higher for low strikes, and slightly lower for high strikes. Currencies tend to have more symmetrical curves, with implied volatility lowest at-the-money, and higher volatilities in both wings. Commodities often have the reverse behavior to equities, with higher implied volatility for higher strikes. Black and Scholes' insight is that the portfolio represented by the right hand side is riskless: thus the equation says that the riskless return over any infinitesimal time interval, can be expressed as the sum of theta and a term incorporating gamma. For an option, theta is typically negative, reflecting the loss in value due to having less time for exercising the option (for a European call on an underlying without dividends, it is always negative). Gamma is typically positive and so the gamma term reflects the gains in holding the option. The equation states that over any infinitesimal time interval the loss from theta and the gain from the gamma term offset each other, so that the result is a return at the riskless rate.
- futures: control cost and protect profit 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 Delta Neutral: (Frequent adjustments could severely hurt liquidities) Commodity Swap + long hedge/short hedge R Structured, Risk management strategies Structured products Eg: zero coupon bond + call option
- http://www.cftc.gov/IndustryOversight/ClearingOrganizations/index.htm http://sirt.cftc.gov/sirt/sirt.aspx?Topic=ClearingOrganizations List of clearing organizations deliver operational and financial efficiencies to market participants, while reducing the risk inherent in trading activities. central counterparty (CCP) imposes itself as the legal counterparty to every trade. This substitution of counterparties is accomplished through the legal process of contract novation, which discharges the contract between the original trading counterparties and creates two new, legally binding contracts – one between each of the original trading counterparties and CME Clearing. Initially devised as a mechanism to reduce transaction costs by calculating members’ net obligations to post margin and to settle contracts, the role of the CCP has expanded over time to include: Robust transaction processing Post trade management functions Financial management of members collateral deposits Final settlement of outstanding obligations through financial payment or physical delivery The overall risk management of market participants A financial guarantee of performance of its contracts “The Wall Street reform bill will – for the first time – bring comprehensive regulation to the swaps marketplace. Swap dealers will be subject to robust oversight. Standardized derivatives will be required to trade on open platforms and be submitted for clearing to central counterparties. The Commission looks forward to implementing the Dodd-Frank bill to lower risk, promote transparency and protect the American public.”