Professional Documents
Culture Documents
3 The Pricing of Commodity Contracts
3 The Pricing of Commodity Contracts
Q North-Holland
THE
PRICING
Publishing Company
OF COMMODITY
1. Introduction
The market for contracts related to commodities
is not widely understood.
Futures contracts and forward contracts arc often thought to bc identical, and
many pcoplc dont know about the cxistcncc of commodity options. One of the
aims of this paper is to clarify the meaning of each of these contracts.
The spot price of a commodity is the price at which.it can be bought or sold
for immediate dclivcry. WC will write p for the spot price, or p(r) for the spot
price at time 1.
The spot price of an agricultural commodity tends to have a seasonal pattern:
it is high just bcforc a harvest, and low just after a harvest. The spot price of a
commodity such as gold, however, fluctuates more randomly.
Predictable patterns in the movement of the spot price do not generally imply
profit opportunities.
The spot price can rise steadily at any rate lower than the
storage cost for the commodity (including interest) without giving rise to a profit
opportunity
for those with empty storage facilities. The spot price can fall during
a harvest period without giving rise to a profit opportunity
for growers, so long
as it is costly to accelerate the harvest.
*I am grateful for comments on earlier drafts by Michael Jensen. Myron Scholes. Edward
Thorp. and Joseph Williams. This work was supported in part by the Center for R&arch in
Security Prices (sponsored by Merrill Lynch, Pierce, Fenner & Smith Inc.) at the Graduate
School of Business, University of Chicago.
For an introduction to commodity markets, set Chicago Board of Trade (1973).
168
p(r).
(1)
Expression (1) holds for all times 1. For example, it says that the May futures
price will be equal to the May spot price in May, and the September futures
price will be equal to the September spot price in September.
Now let us define the three kinds of commodity contracts: forward contracts,
futures contracts, and option contracts. Roughly speaking, a forward contract
is a contract to buy or sell at a price that stays fixed for the life of the contract;
a futures contract is settled every day and rewritten at the new futures price;
and an option contract can bc exercised by the holder when it matures, if it
has not been closed out earlier.
We will write Y for the value of a forward contract, I( for the value of a
futures contract,
and w for the value o[ an option contract.
Each of these
values will depend on the current futures price x(f, I *) with the same transaction
contracrs
169
time r* as the contract. and on the current time t, as well as on other variables.
So we will write r(x, r), u(x, t), and w(x, t). The value of the short side of any
contract will be just the negative of the value of the long side. So we will treat
L,U, and H?as the values of a forward contract to buy,.a long futures contract,
and an option to buy.
The value of a forward contract depends also on the price c at which the
will take
commodity
will be bought, and the time r* at which the transaction
place. We will sometimes write r(x, r, c, r*) for the value of a long forward
contract.
From the discussion above, we know that the futures price is that
price at which a forward contract has a current value of zero. We can write
this condition
as
L(x, f, x, r*)
> 0,
x > c,
f(x, r, c, r*)
< 0,
x < c.
(3)
r *, c, r*)
X-C.
170
every day. If the investor has made money, he will be given his gains immediately.
If he has lost money, he will have to pay his losses immediately. Thus we have
U(X, r) = 0.
(5)
Technically,
eq. (5) applies only to the end of the day, after the futures contract
has been rewritten. During the day, the futures contract may have a positive or
negative value, and its value will be equal to the value of the corresponding
forward contract.
Note that the futures price and the value of a futures contract are not at all
the same thing. The futures price refers to a transaction
at times t* and is
never zero. The value of a futures contract refers to time r and is always zero
(at the end of the day).
In the organized U.S. futures markets, both parties to a futures contract must
post collateral with a broker. This helps to ensure that the losing party each
day will have funds available to pay the winning party. The amount of collateral
required varies from broker to broker.
The form in which the collateral can be posted also varies from broker to
broker. Most brokers allow the collateral to take the form of Treasury Bills or
marginable
securities if the amount exceeds a certain minimum.
The brokers
encourage cash collateral, however, because they earn the interest on customers
cash balances.
The value of a futures customers account with a broker is entirely the value of
his collateral (at the end of the day). The value of his futures contracts is zero.
The value of the collateral posted to ensure performance
of a futures contract
is not the value of the contract.
As futures contracts
are settled each day, the value of each customers
collateral is adjusted. When the futures price goes up, those with long positions
have money added to their collateral, and those with short positions have money
taken away from their ccllatcral.
If a customer at any time has more collateral
than his broker rcquircs. hc may withdraw the excess. If he has less than his
broker requires, he will have to put up additional collateral immediately.
Commodity
options have a bad image in the U.S., because they were recently
used to defraud investors of many millions of dollars. Thcrc are no organized
commodity
options markets in this country. In the U.K., howcvcr, commodity
options have a long and relatively respectable history.
A commodity
option is an option to buy a fixed quantity
of a specified
commodity at a fixed time in the future and at a specified price. It differs from a
security option in that it cant be exercised before the fixed future date. Thus it
is a European option rather than an American option.
A commodity
option differs from a forward contract because the holder of
the option can choose whether or not he wants to buy the commodity
at the
specified price. With a forward contract, he has no choice: hc must buy it. even
if the spot price at the time of the transaction
is lower than the price he pays.
171
At maturity,
the value of a commodity
option is the spot price minus the
contract price, if that is positive, or zero. Writing c* for the exercise price of the
option,
and noting
price equals
the spot
price at maturity,
we
have
x-c*,
=o ,
w(x,r*)
Expression
(6)
maturity
looks
Changes
sponding
and losses
risk
llis
his
risk
return
An investor
of a security
option
at
for
Thcrc
arc
position
in the futures
market
is
to talk
about
in the futures
be dcfincd
tax factors
two
give
in the corre-
the behavior
iIowcvcr,
positions
return,
is zero.
it is not possible
must
at a given maturity
a position
position
have a Fositive
is zero,
cxprcssions
with
of his
on thc.invcstors
the value
long or short
in the position
futures
with
the value
may also
invcstmcnt
In &riving
for
price.
investors
his invcstmcnt
or fractional
(6)
contracts.
position
Since
the expression
cvcn though
cvcn though
x <
futures
bearing
c*,
c*.
x 2
of the security
in the futures
to gains
zero.
like
as a function
2. The behavior
rise
in dollar
gcncrally
pcculiaritics
in
the
Both
his
terms.
of the futures
will
the percentage
market.
price,
wc will
~FSUIIIC
laws
that
of the
make
them
important.
I:irht.
only
the IRS
wlicn
purposes.
cvcry
:issunics
l:or
out niorc
while
opens
the I KS
than
it treats
both
long
depends
a gain or loss
on a short
how long
and short
scttlcd
of capital
contracts,
losses
costs
contracts,
stay
unrealized
into
factors
position
this
sfGecting each
position
as a short-term
hc realizes
hc can convert
that is closed
Whether
hc pays.
on a long futures
and
and
positions
can be rcpcatcd.
on the special
futures
tax
of diGrent
are allowed
the position
for
and rewritten
the taxation
a gain or loss
or lobs no matter
contracts
gains
is realized
rccognire,
dcfcrring
the process
sis months
conlract
not
that Jevclop
trcuts
dots
a number
that develop
including
for
can open
contracts
to br profit;tblc
IRS
is cffcctivcly
stratrgics
Ihs contracts
contracts
is likely
Sccontl.
posGblc
on a futures
71~
contract
the invchtor
dilfcrcnt
tax year.
investor.
gilin
with
The
a futures
makes
cxamplc.
arc rcplitccd
proccbs
is CIOMXI out.
day. Ihis
gains.
the contract
losses
short-term
capital
if the investor
on the short
gains (from
172
other transactions)
into long-term gains. Again, whether this makes sense for a
particular investor will depend on his transaction
costs and other factors.
However. we will assume that both taxes and transaction
costs are zero.
We will further assume that the capital asset pricing model applies at each
instant of time. This means that investors will be compensated
only for bearing
risk that cannot be diversified away. If the risk in a futures contract is independent of the risk of changes in value of all assets taken together, then investors
will not have to be paid for taking that risk. In effect, they dont have to take the
risk because they can diversify it away.
The usual capital asset prjcing formula is
E(Wi)4
= /?,[E(R,)-R].
(7)
(8,).
(8)
-R
R,}/var
(I?,,,)]
x [E(R,) - RI.
For an introduclion 10 the capital asset pricing model. see Jensen (1972). The behavior
futures prices in a model of capid
marhe equilibrwm
H~F first discurscd by Dusak (1973).
(9)
of
173
Multiplying
through
on an asset,
&Pi, -Pie)-RP,,
RJvar
dollar return
(K,)][E(R,)-R].
(10)
The start-of-period
value of a futures contract is zero, so we set Pi0 equal
to zero. The end-of-period
value of a futures contract, before the contract is
rewritten and its value set to zero, is the change in the futures price over the
period, In practice, commodity
exchanges set daily limits which cot&train the
reported change in the futures price and the daily gains and losses of traders.
We will assume that these limits do not exist. So we set p,, equal to Ap, the
change in the futures price over the period,
E(AP)
(R,)][E(B,)-R].
(11)
In effect, we have applied expression (10) to a futures contract, and have come
up with expression (I I), which refers to the change in the futures price. For
the rest of this section, we can forget about futures contracts and work only
with the futures price.
Writing /I* for the first factor on the right-hand side of eq. (1 I), we have
E(AP) = j?*[E(l?,)-R].
(12)
Expression (12) says that the expected change in the futures price is proportional to the dollar beta of the futures price. If the covariance of the change
in the futures price with.the return on the market portfolio is zero, then the
expected change in the futures price will be zero,
E(AP)
= 0,
when
= 0.
(13)
Expressions (12) and (13) say that the expected change in the futures price can
be positive, z&o, or ncgativc. It would be very surprising if the p* of a futures
price were exactly zero, but it may be approximately
zero for many commodities. For these commodities,
neither those with long futures positions nor
those with short futures positions have significantly
positive expected dollar
returns.
corn,
Dusak
(1973)
found
co-
174
contracrs
I+, will be equal to the current futures price. The mean of the distribution
of
possible futures prices at time I will be the current futures price.
But the futures price at time I* is the spot price at time t*, from expression
(1). So the mean of the distribution
of possible spot prices at time I* will be the
current futures price, when eq. (13) always holds.
Even when (13) doesnt hold, we may still be able to use eq. (12) to estimate
the mean of the distribution
of possible spot prices at time I*. To use (l2),
though, we need to know j?* at each point in time between t and r *, and we need
to know E(l?,)-R.
A farmer may not want to know the mean of the distribution
of possible spot
prices at time f*. He may be interested in the discounted value of the distribution of possible spot prices. In fact, it seems plausible that he can make his
investment decisions as if fl* were zero, even if it is not zero. He can assume that
the j? is zero, and that the futures price is the expected spot price.
To see why this is so, note that he can hedge his investments by taking a short
position in the futures market. By taking the right position in the futures market,
he can make the fl of his overall position zero. Assuming that the farmer is not
concerned about risk that can be diversified away, he should make the same
investment decisions whether or not he actually takes offsetting positions in the
futures market.
In fact, futures prices provide a wealth of valuable information
for those who
produce, store, and use commodities.
Looking at futures prices for various
transaction
months, participants
in this market can decide on the best times to
plant, harvest, buy for storage, sell from storage, or process the commodity.
A change in a futures price at time I is related to changes in the anticipated
distribution
of spot prices at time I l. It is not directly related to changes in the
spot price at time f. In practice, however, changes in spot prices and changes in
futures prices will often be highly correlated.
Both spot prices and futures prices are affected by general shifts in the cost
of producing the commodity,
and by general shifts in the demand for the commodity. These are probably the most important
factors affecting commodity
prices. But an event like the arrival of a prime producing season for the commodity will cause the spot price to fall, without having any predictable effect on
the futures price.
Changes in commodity
prices are also affected by such factors as the interest
rate, the cost of storing the commodity, and the /3 of the commodity itself. These
factors may affect both the spot price and the futures price, but in different ways.
Commodity
holdings are assets that form part of investors portfolios, either
directly or indirectly. The returns on such assets must be defined to include
The question of the relation between the futures price and theexpected spot price is discussed
under somewhat diGrent assumptions by Cootner (I 9603, 196Ob) and Telser (I 960).
Some of the factors affecting changes in the spot price are discussed by Brennan (1958)
and Telser (I 958).
175
176
F. Black, Pricing
of commodity
contracts
We have already discussed the pricing of futures contracts and the behavior
of futures prices. In order to derive formulas for the other kinds of commodity
contracts, we must make a few more assumptions.
First, let us assume that the fractional change in the futures price over any
interval is distributed
log-normally,
with a known variance rate s. The derivations would go through with little change if we assumed that the variance
rate is a known function of the time between I and I*, but we will assume that
the variance rate is constant.
Second, let us assume that all of the parameters of the capital asset pricing
model, including the expected return on the market, the variance of the return
on the market, and the short-term interest rate. are constant through time.
Third, let us continue to assume that taxes and transaction COSISare zero.
Under these assumptions,
it makes sense to write the value of a commodity
contract only as a function of the corresponding
futures price and time. If we
did not assume the parameters of the capital asset pricing model were constant,
then the value of a commodity contract might also depend on those parameters.
Implicitly, of course, the value of the contract still depends on the transaction
price and the transaction
time.
Now let us use the same procedure that led to the formula for an option on
a security.6 We can create a riskless hedge by taking a long position in the
The original option formula *as derived by Black and Schulc~ (1973). Iurlhcr rcbuIt> \rc:re
obtained by Merton (1973).
177
option and a short position in the futures contract with the same transaction
date. Since the value of a futures contract is always zero, the equity in this
position is just the value of the option.
The size of the short position in the futures contract that makes the combined
position riskless is the derivative of W(X, I) with respect to x, which we will
write wt. Thus the change in the value of the hedged position over the time
interval Af is
Aw-w,Ax.
(14)
Expanding Aw, and noting that the return on the hedge must be at the instantaneous riskless rate r, we have the differential equation
w2
= rw - fS2X2W,, .
(15)
Note that this is like the differential equation for an option on a security, but
with one term missing. The term is missing because the value of a futures
contract is zero, while the value of a security is positive.
The main boundary
condition
for this equation
is expression (6). Using
standard methods to solveeqs. (15) and (6). we obtain the following formula for
the value of a commodity
option:
w(x, I) = e- [xN(d,)
d, =
-c+fV(d2)],
lns+G(r*-r)
(16)
sd(r+-r),
31
d, =
In:-;(,*-I)
sd(r+-r).
II
178
Eq. (16) applies to a European commodity option, that can only be exercised
at maturity.
If the commodity
option can be exercised before maturity, the
problem of finding its value becomes much more complex.
Among other things,
its value will depend on the spot price and on futures prices with various
transaction
dates before the option expires.
Eq. (16) also assumes that taxes are zero. But if commodity options are taxed
like security options, then there will be substantial
tax benefits for high tax
bracket investors who write commodity options.
These benefits may be passed
on in part or in full to buyers of commodity options in the form of lower prices.
So taxes may reduce the values of commodity
options.
Compared
with the formula for a commodity
option. the formula for the
value of a forward contract is very simple. The differential equation it must
satisfy is the same. Substituting
r(x, r) for W(X, I) in eq. (15), we have
L2 = rv--fs2x2v11.
The main boundary
(17)
condition
c(x, f) = x-c.
The solution
(18)
c(x. r) = (x-c)
boundary
conditions
e(- *).
is
(19)
Expression
(19) says that the value of a forward contract is the diffcrcnce
between the futures price and the forward contract price. discounted
to the
present at the short-term interest rate. It is indcpcndcnt
of any me;lsure of risk.
It dots not depend on the variance rate of the fractiontil chungc in the futures
price or on the covariance rate bctwcen the change in the futures price and the
return on the market.
See Mcrton (1973) for a discussion of some of the complexities in finding n value for an
option that can bc exercised early.
For ;1 discussion of tax factors in the pricing of options. SW Black (1975).
References
Black, F.. 1975. Fact and fantasy in the use ofoptions. Financial Analysts
Black. F. and M. &holes. 1973. The pricing of options and corporate
Pdlitical Economy 81. May/June. 6j7-6%.
Brennan. M.J.. 1958. The supply of smragc. Amcricun Economic Rcriew
Chicago Board of Trade. 1973, Commodity
trading manual (Gourd of
Chicago, Chicago. III.).
Coorner,
P.H..
19603. Returns IO speculators: Tclber versus liryncc,
Economy 68. Aug.. 396403.
Cootner. P.H., I96Ob. Rcjoindcr.
Journal
of Political
Economy
Trudc
Journ;ll
of Polirical
179
Dusak, K.. 1973, Futures trading and investor returns: An investigation of commodity market
risk premiums, Journal of Political Economy 81, Nov./Dee.,
1387- 1106.
Jensen, h1.C.. 1971, Capital markets: Theory and evidence, Bell Journal of Economics and
hlanagement
Science 3, Autumn, 357-398.
Merton,
R.C., 1973, The theory of rational option pricing, Bell Journal of Economics and
Management
Science 4, Spring, 111-183.
Telser. L., 1958, Futures trading and the storage of cotton and wheat, Journal of Political
Economy 66, June, 233-255.
Telser. L.. 1960, Returns to speculators:
Telser versus Keynes, Reply, Journal of Political
Economy 67, Aug., 304415.
Thorp. E.. 1973, Extensions of the Black-Scholes
options model, Bulletin of the International
Statistical Institute. Proceedings of the 39th Session, 5X-529.