Commodity Derivatives E-Book

Neil C. Schofield

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Finance Series
• Sprache: Englisch

Seitenzahl: 1088

Veröffentlichungsjahr: 2021

Beschreibung

Commodity Derivatives

In the newly revised Second Edition of Commodity Derivatives: Markets and Applications, expert trading educator and author Neil Schofield delivers a comprehensive overview of a wide variety of commodities and derivatives. Beginning with discussions of commodity markets generally before moving on to derivative valuation and risk management, the author then dives into individual commodity markets, like gold, base metals, crude oil, natural gas, electricity, and more.

Schofield relies on his extensive experience at Barclays Investment Bank to offer readers detailed examinations of commodity finance and the use of commodities within a wider investment portfolio.

The second edition includes discussions of critical new topics like dual curve swap valuation, option valuation within a negative price environment using the Bachelier model, volatility skews, smiles, smirks, term structures for major commodities, and more. You’ll find case studies on corporate failures linked to improper commodity risk management, as well as explorations of issues like the impact of growing interest in electric vehicles on commodity markets.

The text of the original edition has been updated and expanded and new example transactions are included to help the reader understand the concepts discussed within. Each chapter follows a uniform structure, with typical demand and supply patterns following a non-­technical description of the commodity at issue. Discussions of the physical markets in each commodity and the main exchange-traded and over-the-counter products conclude each chapter.

Perfect for commodity and derivatives traders, analysts, and risk managers, the Second Edition of Commodity Derivatives: Markets and Applications will also earn a place in the libraries of students and academics studying finance and the graduate intake in financial institutions.

A one-stop resource for the main commodity markets and their associated derivatives

Finance professionals seeking a single volume that fully describes the major commodity markets and their derivatives will find everything they need in the latest edition of Commodity Derivatives: Markets and Applications. Former Global Head of Financial Markets Training at Barclays Investment Bank Neil Schofield delivers a rigorous and authoritative reference on a crucial, but often overlooked, subject.

Completely revised and greatly expanded, the Second Edition of this essential text offers finance professionals and students coverage on every major class of commodities, including gold, steel, ethanol, crude oil, and more. You’ll also find discussions of derivative valuation, risk management, commodity finance, and the use of commodities within an investment portfolio.

Non-technical descriptions of major commodity classes ensure the material is accessible to everyone while still in-depth and rigorous enough to deliver key information on an area central to global finance.

Ideal for students and academics in finance, Commodity Derivatives is an indispensable guide for commodity and derivatives traders, analysts, and risk managers who seek a one-volume resource on foundational and advanced topics in commodity markets and their associated derivatives.

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Commodity Derivatives

Markets and Applications

NEIL C. SCHOFIELD

Second Edition

This edition first published 2021Copyright © 2021 by Neil C. Schofield.

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Library of Congress Cataloging‐in‐Publication Data

Names: Schofield, Neil C., author. | John Wiley & Sons, publisher.

Title: Commodity derivatives : markets and applications / Neil C. Schofield.

Description: Second edition. | [Hoboken, NJ] : Wiley, 2021. | Includes index.

Identifiers: LCCN 2021002135 (print) | LCCN 2021002136 (ebook) | ISBN 9781119349105 (hardback) | ISBN 9781119349228 (adobe pdf) | ISBN 9781119349259 (epub)

Subjects: LCSH: Commodity futures. | Commodity exchanges. | Derivative securities.

Classification: LCC HG6024.A3 S364 2021 (print) | LCC HG6024.A3 (ebook) | DDC 332.64/57—dc23

LC record available at https://lccn.loc.gov/2021002135

LC ebook record available at https://lccn.loc.gov/2021002136

Cover Design: Wiley

Cover Images: Oil refinery © Thatree Thitivongvaroon/

Moment Open/Getty Images, Airplane © cate_89/Shutterstock,

Copper rods © Aksenenko Olga/Shutterstock,

Silver © BestPix/Shutterstock,

Gold bars © boykung/Shutterstock

TO REGGIE, BRENNIE, ROBERT, AND GILLIAN

TO NICKI

Preface

Since the start of this century, the commodity markets have fallen in and out of favour with the financial community. Throughout the preparation of the manuscript for the second edition, I would often see headlines that made me wonder whether my target audience would still exist by the time of publication! Having been in finance for over 30 years, one thing I have seen is the way in which history tends to repeat itself, so fingers crossed.

My original motivation for writing the book, however, stemmed from my time working at Barclays Investment Bank, where I had tremendous difficulty in finding people who could provide classroom training on the various commodity products. Although many companies were able to provide training that described the physical market for each commodity, virtually no one provided training on over‐the‐counter (OTC) derivative structures. As they say, if you want a job done properly…

While doing research for the first edition I felt that much of the available documentation either had a very narrow focus concentrating on just one product, or were general texts on trading commodity futures with a lot of coverage of subjects like technical analysis with little insight into the underlying markets. As a result, I have tried to write a book that documents in one place the main commodity markets and their associated derivatives.

Within each chapter, I have tried to keep the structure fairly uniform. Typically, there will be a short section explaining what the commodity is in non‐technical terms. For those with a background in any one specific commodity, this may appear somewhat simplistic, but is included to ensure a reader has sufficient background to place the subsequent discussion within some context. Typical patterns of demand and supply are considered as well as the main factors that will influence the price of the commodity. The latter part of each chapter focuses on the physical market of the particular commodity before detailing the main exchange traded and OTC products.

One of the issues I faced when writing each chapter was to determine which products should be included. I was concerned that I might end up repeating ideas that had been covered in earlier chapters. Therefore, I have tried to document structures that are unique to each market in each particular chapter, while the more generic structures have been spread throughout the text.

So why a second edition? While considering the prospect of writing a second edition, I came across this wonderful quote.

‘Writing as a profession is a sequence of failed ambitions. You never succeed in writing the book you want, or you'd never bother to write the next. So for writers, ambition is irrelevant. All you can do is write as well as your talent will allow’.

—Faye Weldon, Financial Times, weekend magazine, 28/29 July 2012

Upon reflection, I pondered whether the first edition achieved a good balance between the markets and the derivatives, and so I decided to include more example transactions. I also took the opportunity to update the original text and expand the product coverage. For those of you who are wondering if it is worth upgrading to the second edition, here is a quick snapshot of the major changes. The first edition ran to about 100,000 words, while this shiny new version is twice the size.

New topics include:

Dual curve swap valuation.

Option valuation within a negative price environment (the Bachelier model).

Volatility skews, smiles, smirks, and term structures for the major commodities.

Case studies on corporate failures linked to commodity risk management.

Implications of growing interest in electric vehicles on commodity markets.

Increased coverage of oil refiners and the challenge of output optimisation.

Expanded sections on the Brent and WTI physical markets.

Expanded section on the trading of electricity.

Inclusion of iron ore and freight markets alongside coal in a chapter renamed as

‘

bulk commodities

’

.

New section on weather derivatives.

Expanded content in the agriculture chapter.

New chapter on commodity financing covering areas such as project finance, working capital management, and commodity‐linked debt structures.

Significant rewriting of the chapter on investment structures with new content illustrating why the concept of

‘

roll yield

’

is widely misunderstood.

Chapter 1 provides an overview of commodity markets and then outlines the main derivative building blocks. Chapter 2 considers the main principles of derivative valuation. This sets the scene for a discussion on the concept of risk management in Chapter 3. Two different perspectives are taken, that of a corporate with a desire to hedge some form of exposure and an investment bank that will take on the risk associated by offering any solution. Chapter 4 looks at the market for gold while Chapter 5 develops the metal theme to cover base metals. Some readers may complain that there is no coverage of other precious metals such as silver, platinum, and palladium, but I felt that including sections on these metals would amount to overkill and that gold was sufficiently interesting in itself to warrant an extended discussion. The next three chapters cover the core energy markets, the first of which is crude oil in Chapter 6. Chapter 7 covers natural gas markets while Chapter 8 looks at electricity. Chapter 9 describes the market for plastic, which at the time of the first edition was ‘the new kid on the block’. This has been rewritten to reflect how it has changed in the subsequent years. Chapter 10 has been renamed as ‘bulk commodities’ with the coverage widening to include iron ore and freight. Chapter 11 looks at the continuing interest in the trading of carbon emissions but also includes a discussion on weather derivatives. Chapter 12 covers agricultural products and has been expanded to cover more markets and a greater number of transactions. Chapter 13 is new and looks at different aspects of commodity finance. The book concludes by looking at the use of commodities within an investment portfolio.

As ever, it would be arrogant of me to assume that this was entirely my own work. The book is dedicated to the late Paul Roth, who was taken from us far too early in life. In the decade that I knew him, I benefited considerably from his insight into the world of derivatives. It never ceased to amaze how after days of pondering on a problem, I could half explain something I half understood to him and he would be able to explain it back to me perfectly in simple and clear terms.

Thanks to the team at Wiley who were very patient and understanding while I was preparing the manuscript. I am sorry it took so long.

General thanks go to my late father Reg Schofield who offered to edit large chunks of the original manuscript to tidy up ‘the English what I wrote’. Rachel Gillingham deserves a special mention for helping me express the underlying chemistry of a number of commodities within the book. Her input added considerable value to the overall manuscript.

At Barclays Capital I would like to thank Arfan Aziz, Natasha Cornish, Lutfey Siddiqui, Benoit de Vitry, and Troy Bowler. They all endured endless requests for help and have given generously of their time without complaint. In relation to specific chapters, thanks go to Matt Schwab and the late Jon Spall (Gold); Angus Mcheath, Frank Ford, and Ingrid Sternby (Base Metals); David Paul and Nick Smith (Plastics); Thomas Wiktorowski‐Schweitz, Orrin Middleton, Suzanne Taylor, and Jonathon Taylor (Crude Oil); Simon Hastings, Rob Bailey, David Gillbe (Electricity); Paul Dawson and Rishil Patel (Emissions); Rachel Frear and Marco Sarcino (Coal); Maria Igweh (Agricultural). Thanks also to Steve Hochfeld who made some valuable comments on the agricultural chapter.

With respect to the second edition, John Fry and Neil Scurlock at ICE were generous in their time helping me out with crude oil EFPs. All of them contributed fantastic insights into the different markets and often reviewed drafts of the manuscript, which enhanced it no end.

Very special thanks to Nicki, who never once complained about the project and has always been very interested and supportive of all I do.

If I have missed anyone, then please accept my apologies, but rest assured I am grateful. Although I did receive a lot of help in compiling the materials, any mistakes that are in the text are entirely my responsibility.

I am always interested in any comments or suggestions on the text and I can be contacted at:

[email protected]

Neil C. Schofield

P.S. Hi to Alan and Roger, who dared me to include their names. You still owe me tea and toast from the first edition!

CHAPTER 1Fundamentals of Commodities and Derivatives

After the publication of the first edition of this text, many of the author's friends not involved with financial markets often asked, ‘what are commodities’? Like many innocent questions, they are often very difficult to answer. In one sense, they are largely unprocessed or semi‐processed goods, which are either consumed or can be processed and then resold. However, this definition will not always universally apply; for example, freight and carbon emission markets do not easily fall within this category.

In general terms, commodities can be classified under different headings:

Energy markets

Crude oil and refined products (e.g. WTI/Brent, gasoline)

Power and natural gas

Natural gas liquids (e.g. propane and butane)

Coal

Industrial metals

Copper, aluminium

Precious metals

Gold, silver

Agricultural products

Grains

Softs (e.g. coffee)

Livestock

‘Specialty’ markets

Forest products (e.g. pulp and recovered paper)

Carbon emissions

Weather

Freight

1.1 MARKET OVERVIEW

Figure 1.1 is a ‘big picture’ overview of commodity markets.

In this diagram there are two main segments, the physical and the financial markets. The diagram was designed without a specific product in mind, but if the reader prefers some context, it may be helpful to think of a popular commodity such as crude oil. Within the physical side of the market there will be three main participants: producers, refiners, and consumers. In addition, trading houses will perform a variety of tasks, which are detailed in a subsequent section. The financial side of the market will incorporate those entities offering financing and risk management services as well as investors seeking to earn a return from the asset class. One aspect that is central to commodities is price discovery, and so the role of futures exchanges is key.

To get a sense of the generic market flows associated outlined in Figure 1.1, consider the following issues faced by market participants:

Commodities are not homogeneous

– it is not particularly helpful to speak in general terms about commodities. For example, the phrase ‘crude oil’ is meaningless as the chemical properties of crude extracted in one location will vary from those in a different location. Trafigura (2016) argues that over 150 types of crude oil are traded worldwide.

FIGURE 1.1 Commodity market overview.

Commodities need to be transformed into consumer goods

– for example, oil needs to be refined to produce gasoline.

Benchmarks help participants agree on a price for non‐homogeneous products

– so with respect to crude oil, a particular grade of oil could be priced relative to an agreed benchmark such as a futures contract that references Brent Blend.

Production and consumption may not take place in the same geographical location

– this means that there is a need for transportation. The mode of this transportation can vary for a single commodity. For example, in the USA, crude oil is typically moved by pipeline or train. In other areas such as Europe, sea‐borne transport may be more common.

Consumption and production may not occur simultaneously

– a consumer may not need to take immediate delivery of a commodity, therefore storage and inventories are key factors. When there is a geographic element to the issue, it takes time for a commodity to be transported.

1.2 MARKET PARTICIPANTS

Market participants are able to manage the respective price risks using derivatives. Although risk management will be considered in greater detail in Chapter 3, it is worth considering some related motivations.

Participants can:

Avoid risk,

Retain risk,

Transfer risk,

Reduce risk,

Increase risk.

One of the key roles of derivatives is that they allow different market participants with different risk profiles and objectives to obtain a desired risk exposure. With respect to commodity derivatives the main participants will be physical market participants, price reporting agencies (PRAs), investment banks, commodity trading houses, hedge funds, or ‘real’ money accounts.

1.2.1 Physical market participants

Individual product supply chains will be considered in the respective chapter. In general terms, the commodity will need to be produced, refined, and then transformed into a product that can be consumed by the end user. Admittedly this general description does not capture all the different types of commodity supply chains, but the key point is that the participant will typically have some form of price risk at most points along the supply chain

In simple terms, producers will be exposed to falling prices, consumers will be exposed to rising prices, and refiners, processors, and utilities will be exposed to margins (e.g. the income generated from selling gasoline less the cost of buying crude oil). These participants are also faced with a variety of other risks which include:

Credit, i.e. the unwillingness or inability of a customer to pay their debts.

Logistical risks surrounding the movement of the commodity.

Sourcing the right quality of commodity.

Being able to finance day‐to‐day operations.

1.2.2 Price reporting agencies (PRAs)

One of the problems faced by various commodity markets over the years is one of price discovery. How does a market participant know if they are achieving fair market value? Consider the following quote from a market participant in 2011 with respect to the metal Rhodium, which was about to be used in the creation of an exchange traded fund aimed at the retail market:

‘With no futures benchmark…all the spot price transparency of molasses…and a risk reward with which only a supremely knowledgeable professional or those wet behind the ears would be comfortable…guess the target audience?’

(Financial Times, 2011)

Since commodities are heterogeneous products, establishing a fair price has always been a challenge for market participants and the main conventions used either involve exchange traded prices (where available) or index values determined by PRAs. IOSCO (2012) defines a PRA as:

‘Publishers and information providers who report prices transacted in physical and some derivative markets and give informed assessment of price levels at distinct points in time’.

They defined a crude oil assessment as:

‘The process of applying a methodology and/or judgement to market data and other information to reach a conclusion about the price of oil’.

In response to IOSCO, one of the PRAs, Platts (2012) described their activities in relation to crude oil as follows:

‘Platts publishes assessments of spot prices for crude oil and refined products in various geographic regions based on a range of factual inputs including information on individual transactions supplied by market participants…Given the heterogeneous nature of the underlying transactions (in terms of trading parties, product quality, location, timing, delivery terms and other factors), the analysis conducted by Platts in determining its published price assessments is essentially qualitative, albeit based on a range of quantitative and factual inputs’.

Price indexes can be used as the basis for settling commercial supply contracts (as could futures prices) or, in some cases used to determine the value of cash‐settled futures transactions.

1.2.3 Investment banks

The services offered by investment banks will vary according to the business model that they adopt. Some banks may consider themselves to be a ‘full service’ entity, offering the ability to deal not just in derivatives, but to become counterparty to a physical trade. Other banks may offer more limited services, such as having a derivative service without the capability to execute physical transactions.

A ‘full service’ bank will be able to offer several solutions to physical participants with some hypothetical examples shown in Table 1.1.

1.2.4 Commodity trading houses

The commodity trading house Glencore Xstrata describe themselves as follows (Glencore, 2011): ‘(the company) is a leading integrated producer and marketer of commodities, with worldwide activities in the marketing of metals and minerals, energy products and agricultural products and the production, refinement, processing, storage and transport of these products. Glencore operates globally, marketing and distributing physical commodities sourced from third party producers and own production to industrial consumers’. Traditionally, commodity trading houses would have simply bought commodities from producers and then sold them to consumers. However, the definition presented by Glencore Xstrata suggests that over time these entities have evolved to own and operate significant parts of various commodity supply chains. So, the notion of one company being fully integrated along a supply chain is no longer the norm. Indeed, many of the investment banking services highlighted in Table 1.1 could conceivably be offered by trading houses.

A report by the Financial Times (2013) highlighted the extent of trading house involvement in the market:

TABLE 1.1 Examples of services that could be provided by banks to facilitate commodity production and consumption.

Sector

Problem

Solution

Crude oil and refined products

Inventory is working capital intensive

Bank agrees to own inventory

Natural gas

Cold weather creates increased demand, but there are delivery constraints with existing pipeline infrastructure

Banks buy pipelines or own storage facilities

Base metals

Consumers seek favourable payment terms

Banks provide finance along the logistics chain or act as an intermediary between consumers and producers

Those trading oil handled more than 15m barrels of oil a day.

The main agricultural trading houses handled about half of the world's grain and soybean trade flows.

Two trading houses controlled about 60% of the zinc market.

Relatively unknown companies can dominate smaller niche markets such as coffee.

Their growth was attributed to four main factors:

The economic boom after 2000 in several emerging economies.

A strategic decision to acquire physical assets.

Their ability to exploit price arbitrage opportunities because of their increasing presence along the supply chain.

Consolidation in the period prior to 2000 which reduced competition.

1.2.5 Hedge funds

There is no single definition of a hedge fund given the wide range of structures and strategies used in this section of the market. However, they can be defined in terms of their characteristics:

Investment ‘vehicles’ that pool the proceeds of their investor base.

Access tends only to be available to a limited group of investors.

Proceeds are actively managed.

They aim to generate a return irrespective of underlying market conditions.

They are often associated with aggressive ‘view driven’ strategies and Chapter 3 includes a case study of the commodity hedge fund Amaranth that failed when its strategy in the US natural gas markets resulted in substantial losses.

1.2.6 ‘Real money’ accounts

A real money participant is usually classified as an entity that is not able to borrow money to boost their available investment proceeds. Typically, this could include entities such as pension funds and insurance companies. Their participation in the commodity market is primarily for investment purposes. Also within this category it may be possible to include private and commercial banks that are offering commodity investment products to their retail customers.

1.3 TRADED VERSUS NON‐TRADED COMMODITIES

One of the subtle characteristics of commodity markets is the difference between traded and non‐traded commodities. What is the difference?

An interesting case study that illustrates the key differences is the market for iron ore. Iron ore is used in the production of steel and, combined with steel, represents the world's second largest commodity bloc by value (ICE, 2009). Macquarie Bank (2013) points out that prior to 2003 the concept of a spot market for the metal did not exist in any meaningful sense. At this time, the traditional buyers were Japanese and Korean steel producers who purchased their metal using annual, fixed price, bilateral contracts with suppliers based mainly in Brazil and Australia. The annual benchmark price typically ran from 1 April–31 March in the following year. Emerging new consumers such as China struggled to purchase the required amount of metal under this market mechanism as the traditional sources of supply could not keep pace with the extra demand. This coincided with a new source of supply from India that was able to react quickly. This led to more ‘one‐off’ transactions that resulted in the emergence of a spot market. At the same time commodities that were inputs to the steel making process, which already had developed spot markets, became more volatile. This increased the pressure on iron ore to respond accordingly.

However, the phrase ‘spot’ within the context of commodities can sometimes be applied ambiguously. For example, in certain markets (e.g. gold), spot transactions will have a similar maturity to those seen in traditional financial markets (e.g. trade date plus two good business days). In other instances (e.g. crude oil), delivery is unlikely to occur in such a short time frame. ‘Spot pricing’ could also indicate that the contract is for short‐term delivery with prices possibly referencing exchange traded futures prices.

The increase in spot transactions meant that price‐reporting companies now disseminated information on physical transactions on a more regular basis. One of the characteristics noted earlier is that commodity markets lack homogeneity and therefore pricing from a single benchmark has become the accepted practice. For iron ore a popular benchmark that has emerged is iron ore with a grade of 62%1.

The development of pricing benchmarks is an important step in the development of a commodity's tradable status:

They represent a standard reference point, which is based on actual market activity and is understood by market participants.

Participants can enter commercial contracts or reference financial contracts to a price that is transparent, representative of the most liquid market, and is determined by a publicly available process.

The benchmark price is

the

price of the commodity if it is used by many and varied participants.

Once a benchmark price emerges, market participants can trade different grades of the commodity as a differential. So, iron ore with a grade of 58% would trade below the benchmark price, while a 65% grade would trade above the price. These differentials may also reflect the products' country of origin and its availability.

The emergence of a benchmark may result in the development of financial markets (e.g. derivatives) that can facilitate the hedging of underlying exposures.

The increased reporting of iron ore prices meant that the spot price provided a reference point for those entities still using the annual benchmark negotiations. Indeed, because of the financial crisis the spot price of the metal fell below the annual benchmark. This resulted in several consumers defaulting on their fixed price agreements in order to take advantage of the lower spot price. Once price assessments started to appear daily, which reported a standard grade of iron ore, financial products began to emerge. Exchange traded iron ore swaps were the first derivative that referenced this product. Thereafter, a forward curve for iron ore started to form, which was later boosted by the emergence of over‐the‐counter swaps and iron ore futures.

1.4 FORWARD CONTRACTS

A forward contract will fix the price today for delivery of an asset in the future. Gold sold for spot value will involve the exchange of cash for the metal in two days' time. However, if the transaction required the delivery in, say, one month's time, it would be classified as a forward transaction. Forward contracts are negotiated bilaterally between the buyer and seller and are often characterized as being ‘over‐the‐counter’ (OTC).

The forward transaction represents a contractual commitment and so, if gold is bought forward at USD 1,430.00 an ounce, but the price of gold in the spot market is only USD 1,420.00 at the point of delivery, one cannot walk away from the forward contract and try to buy it in the underlying market. However, it is possible for both parties to mutually agree to terminate the contract early. This could be achieved by agreeing upon a ‘break’ amount, which would reflect the current economic value of the contract. Typically, this is done using a process that is referred to generically as ‘marking to market’. An easier way to understand the issue is to use the concept of an exit price. This is typically taken to be the amount for which an asset could be sold, or a liability settled in an ‘arm's length’ transaction.

A variation on the standard contract is a floating forward. In this type of transaction, a market participant commits to buy or sell the underlying at a future date, but the applicable price is only set at the point of delivery. The final price that is agreed upon may be based on some pre‐agreed formula. For example, the price could be the average of daily spot prices in the month prior to settlement.

1.5 FUTURES

A futures contract is traded on an organised exchange, with the CME Group being one example. Economically, a future achieves the same result as a forward by offering price certainty for a period in the future. However, the key difference between the contracts is in how they are traded. The contracts are uniform in their trading size, which is set by the exchange. For example, the main features of the contract specification for the gold future appear in Table 1.2.

TABLE 1.2 Gold futures contract specification.

Source: CME Group

Trading unit

100 troy ounces

Price quotation

US dollars and cents per troy ounce

Trading months

Trading is conducted for delivery during the current calendar month; the next two calendar months; any February, April, August, and October falling within a 23‐month period; and any June and December falling within a 72‐month period beginning with the current month.

Minimum price fluctuation

USD 0.10 (10c) per troy ounce (USD 10.00 per contract)

Last trading day

Trading terminates at the close of business on the third to last business day of the maturing delivery month.

Settlement method

Deliverable

Delivery period

The first delivery day is the first business day of the delivery month. The last delivery day is the last business day of the delivery month.

Margin requirements

Margins are required for open futures positions.

Traditionally, there are some fundamental differences between commodity and financial products traded on an exchange basis. Historically, one of the key differences is that futures require collateral to be deposited when a trade is executed (known as initial margin). As a rule of thumb, the initial margin will be about 5% of the market value of the contract. Although different exchanges will work in different ways, the remittance of profits and losses may take place on an ongoing basis (variation margin) rather than at the maturity of the contract. However, financial markets have evolved such that OTC forward contracts will now have very similar margining requirements to futures contracts.

Another difference between forwards and futures relates to the grade and quality specification. If one is delivering a currency, the underlying asset is homogenous – a dollar is always a dollar. However, because metals vary in shape, grade, and quality, it is important to ensure an element of standardisation so the buyer knows what they are receiving. Some of the criteria that CME Group apply include:

The seller must deliver 100 troy ounces (+/‐5%) of refined gold.

The gold must be of a fineness of no less than 0.995.

It must be cast either in one bar or three one‐kilogram bars.

The gold must bear a serial number and identifying stamp of a refiner approved and listed by the Exchange.

Anecdotal estimates suggest that the vast majority (ca. 95%) of futures contracts are terminated prior to their expiry date. This is perhaps a reflection that most participants will use the instruments for risk management purposes rather than as a source of supply.

1.6 SWAPS

In a swap transaction two parties agree to exchange cash flows, whose size are based on different price indices. Typically, this is represented as an agreed fixed rate against a variable or floating rate. Swaps are traded on an agreed notional amount, which is not exchanged but establishes the magnitude of the fixed and floating cash flows. Swap contracts are typically of longer‐term maturity (i.e. greater than one year) but the exact terms of the contract will be open to negotiation. For example, in many base metal markets a swap transaction is often nothing more than a single period forward. This is because the forward transaction may be cash settled which would involve the payment of the agreed forward price against the spot price at expiry.

The exact form may vary between markets, with the following merely a sample of how they may be applied in a variety of different commodity markets.

Gold – Pay fixed lease rate vs. receive variable lease rate

Base metals – pay fixed aluminium price vs. receive average price of near dated aluminium future

Oil – pay fixed West Texas Intermediate (WTI) price vs. receive average price of near dated WTI future

Swaps will usually be spot starting and so become effective two days after they are traded. However, it is also possible for the swap to become effective sometime in the future – a forward starting swap. The frequency with which the cash flows are settled is open to negotiation but they could vary in tenor between 1–12 months. Where the payments coincide, there is a net settlement between the two parties. One of the features of commodity swaps not shared by financial swaps is the use of an average rate for the floating leg. This is because many of the underlying exposures that commodity swaps are designed to hedge will be based on some form of average price.

The motivation for entering a swap will differ between counterparties. For a corporate entity one of their main concerns is risk transference. Take a company that purchases a particular commodity at the market price at regular periods in the future. To offset the risk that the underlying price may increase, they would receive a cash flow under the swap based on movements in the market price of the commodity and pay a fixed rate. If the counterparty to the transaction were an investment bank, the latter would now have the original exposure faced by the corporate. The investment bank would be receiving fixed and paying a variable rate, leaving them exposed to a rise in the price of the underlying commodity. In turn, the investment bank will attempt to mitigate this exposure by entering some form of offsetting transaction. The simplest form of this offsetting deal would be an equal and opposite swap transaction. To ensure that the bank makes some money from this second transaction, the amount they receive from the corporate should offset the amount paid to the offsetting swap counterparty.

Swaps are typically traded on a bid‐offer spread basis. From a market maker's perspective (that is the institution giving the quote) the trades are quoted as follows:

Bid

Offer

Pay fixed

Receive fixed

Receive floating

Pay floating

Buy

Sell

Long

Short

Although the terms buy and sell are often used in swap quotes, the actual meanings are often confusing to anyone looking at the market for the first time. In the author's opinion, the most unambiguous way to trade these instruments is to state who is the payer and who is the receiver of the fixed rate. The convention in all swap markets is that the buyer is receiving a stream of variable cash flows for which the price is a single fixed rate. Selling a swap requires the delivery of a stream of floating cash flows for which the compensation is a single fixed rate.

1.7 OPTIONS

A forward contract offers price certainty to both counterparties. However, the buyer of a forward is locked into paying a fixed price for a particular commodity. This transaction will be valuable if the price of the commodity subsequently rises, but will be unprofitable in the event of a fall in price. An option contract offers the best of both worlds. It will offer the buyer of the contract protection if the price of the underlying moves against them, but allows them to walk away from the deal if the underlying price moves in their favour.

This leads to the definition of an option as the right, but not the obligation, to either buy or sell an underlying commodity sometime in the future at a price agreed upon today. An option that allows the holder to buy the underlying asset is referred to as a call. Having the right to sell something is referred to as a put. The price at which the two parties will trade if the option is exercised is referred to as either the strike price or the exercise price. The strike can be set at any level and is negotiated between the option buyer and seller.

Options may be either physically settled (that is, the commodity is delivered/received) or cash settled. The process of cash settlement removes the need to make or take delivery of the underlying asset, but retains the economics of a physically settled option. Cash settlement involves the seller paying the buyer the difference between the strike and the spot price at the point of exercise. The payoff for a cash‐settled call option is:

Where: MAX means ‘the maximum of’

The payoff for a cash‐settled put option is:

Options come in a variety of styles relating to when the holder can exercise their right. A European style option allows the holder to exercise the option only on the final maturity date. An American style option allows the holder to exercise the option at any time prior to final maturity. A Bermudan option allows the holder to exercise the option on a pre‐agreed set of dates prior to maturity.

An option that is in‐the‐money (ITM) describes a situation where it would be more advantageous to trade at the strike rather than the underlying market price. Take for example an option to buy gold at USD 1,400 an ounce when the current spot price is say, USD 1,425. The option to buy at the strike is more attractive than the current market price. Where the option is out‐of‐the‐money (OTM), the strike is less attractive than the market price. If the same option had a strike rate of USD 1,430, the higher strike makes the option less attractive than buying the underlying at a price of USD 1,420. Finally, an option where the strike is equal to the current market price is referred to as an at‐the‐money (ATM).

Since options confer rights to the holder, a premium is payable by the buyer. Typically, this is paid upfront, but certain option structures are constructed to be zero premium or may involve deferment of the premium to a later date. Premiums on options are quoted in the same units as the underlying asset. So, since physical gold is quoted in dollars per troy ounce, the premium will be quoted in the same manner.