Introduction to Commodity derivatives

The Chicago Board of Trade (CBOT) defines a commodity as: “An article of commerce or a product
that can be used for commerce. In a narrow sense, products traded on an authorised Commodity
Exchange. Types of commodities include agriculture products, metals, petroleum, foreign currency
and financial instruments, to name a few.”

The physical market is the traditional market and is usually referred to as the “cash and carry
market” or the “spot market”.
A value chain comprises all activities and services undertaken along a commodity chain - from the
primary producer to the final consumer. As products move from one stage of the value chain to
another, value gets added. A typical value chain includes producers, assemblers, traders, processors,
distributors, retailers (both physical stores and online sellers) and of course, consumers.

OTC Derivatives: OTC derivatives are bilateral contracts negotiated privately between two
parties and not traded on any Exchange.

This act of the clearinghouse is called ‘novation’ and this removes the counter party risk.

Closing Out is the opposite transaction effected to close out the original futures position.
A buy contract is closed out by a sale and a sale contract is closed out by a buy in the same
contract.

The party that agrees to buy is said to have taken a long position and the party that agrees to sell is
said to have taken a short position.

LIBOR: London Inter-Bank Offer Rate (LIBOR) is a daily reference rate based on the interest rate
that the banks charge each other for unsecured funds in the London wholesale money market (or
interbank market) for various maturities starting from overnight. Similarly, MIBOR is Mumbai
Interbank Offer Rate, US Prime is rate at which US banks lend to their prime customers, Treasury
bill rates, and similar other benchmark rates are available in different markets.

Interest Rate Swap is a derivative in which one party exchanges a stream of interest payments
for another party’s stream of cash flows at regular intervals. Interest rate swaps can be used by
hedgers to manage their fixed or floating assets and liabilities.

A Currency Swap, sometimes referred to as a cross-currency swap, involves the exchange of

interest and sometimes of principal in one currency for the same in another currency. It is
considered to be a foreign exchange transaction and may not be required to be shown on a
company's balance sheet. Such swaps may be subject to local exchange regulations in those
countries where Exchange control regulations are there.

Equity Swap: A swap where payments on one or both sides are linked to the performance of
equities or an equity index.

Basis: This refers to the difference between the futures price and the spot price. For commodities,
basis is calculated using the formula [Spot Price - Futures Price] while for financial assets, the
formula [Futures Price - Spot Price] is more commonly used.
Options: An option is an agreement between two parties - one of whom is the buyer and the other the
seller. An option gives the holder or buyer of the option the right, but not the obligation, to buy or sell
an asset at a known fixed price (called the exercise price) at a given point in the future. The seller in
turn, has the obligation (and not the right) to sell or buy an asset to the buyer of the option when
called upon by the buyer of the option contract.

There are two types of options:

1. Call option: A call option is a contract that gives the buyer the right (option) to buy the
underlying asset by a certain date for a certain price. He can choose not to exercise the option.
The seller of the call option is obliged to sell the asset, if the option is exercised by the buyer.

2. Put option: A put option is a contract that gives the holder the right (option) to sell the
underlying asset by a certain date for a certain price. He can choose not to exercise the option.
The seller of the put option is obliged to buy the asset, if the option is exercised.

Options are financial instruments that convey buyers the right, but not the obligation, to engage in
a future transaction on some underlying security, or in a futures contract and vice versa for sellers.

Long position
This refers to the buying of a security such as a stock, commodity, or currency, with the
expectation that the asset will rise in value. In the context of options, it refers to the buying of
an options contract.

Short position
This refers to the sale of a borrowed security, commodity, or currency with the expectation that
the asset will fall in value. In the context of options, it is the sale (also known as “writing”) of an
options contract.

In–the-money option
This option is one that would give its holder a positive cash flow, if exercised immediately. In a
call option if the market price (spot price) is above the exercise price, it is in-the money.
In a put option, if the market price (spot price) is below the strike price, it is in the money.

Out-of-the-money option
This option is one that would give its holder a negative cash flow, if exercised immediately. In
a call option if the market price (spot price) is below the exercise price, it is out-of-the money.
In a put option, if the market price (spot price) is above the strike price, it is out of-the money.

At–the–money option
This option is one, which leads to nil or zero cash flow to its holder. This would be the situation
where the price of the underlying asset equals the option’s exercise price.

Intrinsic value for a call option is the difference between the underlying stock’s price and the
strike price. For put options, it is the difference between the strike price and the underlying
stock’s price. An option will have intrinsic value if it is in-the-money option.

Time Value is the difference between the premium paid for an option and the intrinsic value.
As an option approaches expiration, the time value erodes, eventually to zero. An option will
have only time value if it is at-the-money or out-of-the-money.
The time value is the difference between the option premium and its intrinsic value.
Other things remaining the same, the greater the time left for expiration, the greater is the
option’s time value. At expiration, the option has no time value. An option that is at-the-money
or out-of-the-money has no intrinsic value. It has only time value.