Commodity Derivatives: A Guide for Future Practitioners (Paperback) book cover

Commodity Derivatives

A Guide for Future Practitioners

By Paul E. Peterson

© 2018 – Routledge (Textbook (Premium) (DRM-Protected))

262 pages | 76 B/W Illus.

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Description

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.

Table of Contents

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

About the Author

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.

Subject Categories

BISAC Subject Codes/Headings:
BUS000000
BUSINESS & ECONOMICS / General
BUS070010
BUSINESS & ECONOMICS / Industries / Agribusiness