Derivatives and Risk Management By Rajiv Srivastava Copyright © Oxford University Press

 Commodity

futures have commodities as underlying assets.  Futures on commodities help mitigate price risk.  Trading in forward and futures on commodities is not new. It has been in vogue for more than 100 years.

Derivatives and Risk Management By Rajiv Srivastava

Copyright © Oxford University Press Chapter 3
Commodity Futures

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reducing seasonal price variations.  Futures contracts on commodities result in      price discovery. Futures on commodities due to its possible use as a speculative product are often thought as unwarranted and as a disservice to society. efficient dissemination of information. reduced cost of credit. Derivatives and Risk Management By Rajiv Srivastava Copyright © Oxford University Press Chapter 3 Commodity Futures 3 . and more efficient physical markets.

minimum support price etc have either failed or have proved too expensive for the economy. Derivatives and Risk Management By Rajiv Srivastava Copyright © Oxford University Press Chapter 3 Commodity Futures 4 .  Commodity futures trading in developing country can contribute a lot to the stability of fiscal management. increasing the effectiveness of price protection at national level and improving the efficiency of social programmes. The usual tools of containing the volatility in the commodity prices like buffer stocks. controlled and phased release of commodities.

Volatility in commodity prices causes volatility in budgetary provisions and government’s developmental expenditure. and position of balance of payment are crucially dependent upon prices of commodities.Stability to Government’s Revenue Government budget.  Derivatives and Risk Management By Rajiv Srivastava Copyright © Oxford University Press Chapter 3 Commodity Futures 5 . developmental expenditure.  Eliminating Minimum Support Price and Subsidy Commodity futures trading helps smooth out the variability in government’s revenue and transfers the price risk management from government to private participants. Therefore at national level there is a need to reduce the volatility.

whereas there is ample scope of controversy over quality in case of commodity futures. Futures contracts on commodities differ significantly from those on financial assets in terms of quality specifications and delivery mechanism.  Quality of underlying asset is immaterial in case of financial products.  Derivatives and Risk Management By Rajiv Srivastava Copyright © Oxford University Press Chapter 3 Commodity Futures 6 .  Commodities (the agricultural products) is confined to the harvesting period while the consumption is uniform throughout the year.  Commodity futures are governed by seasons and perishable nature of the underlying asset. The consumption value makes valuation of futures contracts on commodities difficult.

we only have an upper bound to the futures price as below: F ≤ (S0 + s) ert Copyright © Oxford University Press Chapter 3 Commodity Futures Derivatives and Risk Management By Rajiv Srivastava 7 .   Cash and carry arbitrage stipulates the following: F ≥ (S0 + s) ert Due to consumption value of the asset the reverse cash and carry implying shorting the asset and buying futures is not feasible. Therefore. The pricing of futures contracts commodities cannot use “no arbitrage argument” due to convenience yield attached with commodities.

F1 ≤ 714 x e0.91 per kg  Derivatives and Risk Management By Rajiv Srivastava Copyright © Oxford University Press Chapter 3 Commodity Futures 8 . F1 ≤ 714 x e0.07 per kg  Warehousing and insurance cost would be added to the financing cost for determining the upper bound of fair value of the futures F1 ≤ S0 x ert .11 x 3/12 = Rs 733. If financing cost are 10% per annum with continuous compounding what should be the price of the 3-m futures contract on cardamom? If warehousing and insurance cost are placed at 1% what would be the fair value of the 3-m futures contract? Solution  The fair value of futures contract is given only as upper bound F1 ≤ S0 x ert .Assume that spot price of cardamom is Rs 714 per kg.10 x 3/12 = Rs 732.

Long and Short Positions Hedging Principle Short Hedge Long Hedge Copyright © Oxford University Press Chapter 3 Derivatives and Risk Management Commodity Futures By Rajiv Srivastava 9 .

For example a tea exporter needs stock of tea to execute the pending orders is short on tea.  The one who requires the asset in future is said to be short.  Similarly  in the futures market if one buys a futures contract he is said to be long. Derivatives and Risk Management By Rajiv Srivastava Copyright © Oxford University Press Chapter 3 Commodity Futures 10 . For example a jeweller holding gold or silver is long on the asset. Long  and Short Positions When one holds the underlying asset he is said to be long on the asset. and  if one sells the futures contract he is said to be short.

 At an appropriate time one can neutralise the position in the futures market. and receive/pay the difference of prices. i. go long on futures if one was originally short and go short on futures if one was originally long. goes short on the futures market.  Sell or buy the underlying asset in the physical market at prevailing price.e. Derivatives and Risk Management By Rajiv Srivastava Copyright © Oxford University Press Chapter 3 Commodity Futures 11 . To  execute a hedge following steps are taken: One who is long on the asset. and the one who is short on underlying goes long in the futures market.

 When one has long position in the asset he needs to take a short position in futures to hedge. a sugar mill would go short on the futures contract on sugar to hedge against the fall in price.  If prices fall the short position in futures would yield profit compensating for the loss due to reduced realized value of sugar in the spot market. Derivatives and Risk Management By Rajiv Srivastava Copyright © Oxford University Press Chapter 3 Commodity Futures 12 .  For example. It is referred as short hedge.

The current price today (the month of February) is Rs 22 per Kg. Therefore it needs to sell the futures contract today. How can the sugar mill hedge its position against the anticipated decline in sugar prices in April?   To execute the hedging strategy the sugar mill takes opposite position in the futures market. It is expected to produce 100 MT of sugar in the month of April. The sugar mill is long on the asset in April. April futures contract in sugar due on 20th April is trading at Rs 25 per Kg.  Consider a sugar mill. The sugar mill apprehends that the price lesser than Rs 25 per Kg will prevail in April due to excessive supply then. Copyright © Oxford University Press Chapter 3 Commodity Futures Derivatives and Risk Management By Rajiv Srivastava 13 .

22.00  Price realised in the spot market +22.00  Effective price realised Rs 25.00 per Kg.00 Gain in the futures market + 3. Cash flow (Rs per Kg.)  Sold futures contract in February + 25. Here the loss of Rs 3 (Rs 25 – Rs 22) in the spot market is made up by an equal gain in the futures market. Derivatives and Risk Management By Rajiv Srivastava Copyright © Oxford University Press Chapter 3 Commodity Futures 14 .If price falls to Rs 22 per Kg.00  Bought futures contract in April .

00  Price realised in the spot market +26. Cash flow (Rs/Kg.00 per Kg.If price rises to Rs 26 per Kg.26. Here the gain of Rs 1 (Rs 26 – Rs 25) in the spot market is offset by the equal loss in the futures market.00 Loss in the futures market .1. Derivatives and Risk Management By Rajiv Srivastava Copyright © Oxford University Press Chapter 3 Commodity Futures 15 .)  Sold futures contract in February + 25.00  Bought futures contract in April .00  Effective price realised Rs 25.

Derivatives and Risk Management By Rajiv Srivastava Copyright © Oxford University Press Chapter 3 Commodity Futures 16 . It is referred as long hedge.  For example.  If prices indeed rise the long position in futures would yield profit compensating for the loss due to increased price of oil in the spot market. When one has short position in the asset he needs to take a long position in futures to hedge. an importer of oil would go long on the futures contract on oil to hedge against the rise in price.

A perfect hedge is one where loss on the physical position is exactly offset by gain in the financial position and vice-versa. The Perfect Hedge Gain Short on underlying Gain in physical market Loss in futures market Long on Futures Price Loss Derivatives and Risk Management By Rajiv Srivastava Copyright © Oxford University Press Chapter 3 Commodity Futures 17 .

 the time of maturity of the futures contract is not same as the time of exposure in the physical position because maturities of futures contract are specific.  the value of exposure in the underlying and the futures are not same because futures contract have fixed size.Except by coincidence futures hedge is imperfect. The gains/losses in the futures do not exactly offset the loss/gains in the physical position because: the exposure in the underlying and futures market is not on the identical asset of same quality.  Derivatives and Risk Management By Rajiv Srivastava Copyright © Oxford University Press Chapter 3 Commodity Futures 18 .

Gain/loss in the spot market  Gain/loss in the futures market = S1 – S0 = F0 – F1 Derivatives and Risk Management By Rajiv Srivastava Copyright © Oxford University Press Chapter 3 Commodity Futures 19 . Basis at the beginning is  Basis at the end is  B0 = F0 – S0 B1 = F1 – S1  With  futures hedge we have opposite positions in physical and futures markets. Basis is difference of futures price. S. It declines as time to maturity approaches. F and spot price.

 In a hedged portfolio consisting of long/short position in the spot and short/long position in futures we have net gain/loss on the portfolio = S1 – S0 + F0 – F1 = (F0 – S0) – (F1 – S1) = B 0 – B1  The risk in the hedged portfolio would be equal to the difference of basis at start and end of hedge. Price risk gets replaced by much smaller basis risk. Derivatives and Risk Management By Rajiv Srivastava Copyright © Oxford University Press Chapter 3 Commodity Futures 20 .  Hedging risk with futures is not perfect.

 Hedge ratio is the number of futures contract to have minimum risk. Where h* = Optimum Hedge Ratio ρ = Correlation coefficient of spot and futures price σs. futures prices and the coefficient of correlation between the two. σf = Standard deviations of spot & futures prices respectively σs h* = ρ σf Derivatives and Risk Management By Rajiv Srivastava Copyright © Oxford University Press Chapter 3 Commodity Futures 21 . It depends upon the risks in the spot prices.

Quantity for hedging = Covariance of revenue with price Variance of price Derivatives and Risk Management By Rajiv Srivastava Copyright © Oxford University Press Chapter 3 Commodity Futures 22 . Futures can also be used for hedging against the quantity uncertainties as price and quantity have inverse relationship.  Hedge ratio for quantity hedging depends upon the ratio of covariance of revenue and variance of price.

 Derivatives and Risk Management By Rajiv Srivastava Copyright © Oxford University Press Chapter 3 Commodity Futures 23 . Futures can be used for speculation if the estimate of future spot price is different than the futures price.  If a trader anticipates a rise in prices he simply has to buy the futures today and sell later.  To speculate on the prices of commodities one has to do one of the following: If a trader expects a price fall he simply has to sell a futures contract today and buy it later.

 Spread strategies in futures are concerned with the mispricing of futures contracts a) in two different assets called Inter-commodity spread b) in two different markets called Inter-market spread c) of two different maturities called Calendar spread Derivatives and Risk Management By Rajiv Srivastava Copyright © Oxford University Press Chapter 3 Commodity Futures 24 .

 With revenue and cost hedged the gross profit margin can be protected or made more stable. For example sugarcane and sugar.  Variations in gross profit margin can be minimized By going long on futures of raw material we can have assured raw material price and hence the cost.  Derivatives and Risk Management By Rajiv Srivastava Copyright © Oxford University Press Chapter 3 Commodity Futures 25 .  By going short on futures on finished goods items we can have assured prices for finished goods. Spread strategies can be used for protecting gross profit margin where futures are available on inputs and outputs.