Commodity Risk

Management
BEGINNERS MODULE
 Table of Content

1. Introduction to commodity price risk …....................................................................................................

1.1. Overview of commodity markets classification …....................................................................................
1.2. What is commodity price risk? …............................................................................................................
1.3. Producer's risk v/s consumer's risk of a commodity …............................................................................

2. Introduction to commodity price risk management …............................................................................

2.1 The commodity risk management process ….............................................................................................
2.2 Need for commodity risk management …...................................................................................................

3. Introduction to hedging and derivatives …..............................................................................................

3.1 What is hedging? …...................................................................................................................................
3.2 How is hedging undertaken? ….................................................................................................................
3.3 What is a derivative? ….............................................................................................................................
3.4 Types of derivatives instruments …...........................................................................................................
3.5 Financial derivatives vs commodity derivatives …....................................................................................

4. Introduction to commodity exchanges ….................................................................................................

4.1 What is a commodities exchange? …........................................................................................................
4.2 Major global and domestic commodity exchanges …................................................................................
4.3 Exchange traded derivatives vs over the counter derivatives …...............................................................
4.4 Margin management on exchange traded contracts ….............................................................................
4.5 Major global commodity benchmark prices …...........................................................................................

Page 2
 Table of Content

4. Introduction to commodity exchanges

4.1 What is a commodities exchange? …....................................................................................................
4.2 Major global and domestic commodity exchanges …............................................................................
4.3 Exchange traded derivatives vs over the counter derivatives …...........................................................
4.4 Margin management on exchange traded contracts ….........................................................................
4.5 Major global commodity benchmark prices ….......................................................................................

5. Key related concepts in commodities trading and risk management …......................................

5.1 Commodity trading strategies ​…...........................................................................................................
5.2 Future commodity market structures …................................................................................................
5.3 Other key risks associated with commodity businesses …..................................................................

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Introduction to Commodity Price Risk

The buying and selling of The same type of commodity will have a
commodities pre-dates trading in different quality depending on where it is
other financial assets such as stocks sourced/processed. For example, the quality
and bonds and has been practised of crude oil extracted in the USA will be
since ancient times. different in quality from that extracted in
the middle east or the north-sea in Europe.

Businesses that require commodities

This difference in quality is the
as inputs and process commodities as
primary reason as to why prices for
finished goods need to trade these Overview of Commodity the same commodities differ in
commodities to other businesses Markets different markets.
and/or consumers in locations having
limited access to them.

Today, commodities are also traded Currently, there are around 50 major
purely as an investment tool to commodity markets around the world
diversify an investor’s holdings and that offer trading in approximately
store value during times of extreme 100 primary commodities.
volatility.

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 1. Introduction to Commodity
Price Risk
1.1. Overview of commodity markets classification

Classification of As in other markets, commodity markets are driven by the basic fundamentals
of demand and supply.
commodities
Fall in supply of commodity Higher commodity prices

Hard Soft Lower commodity prices Increased production

Commodities Commodities
Owing to geographical and climatic condition differences, certain commodities are
naturally available/grown primarily in certain regions of the world. Such regions are
(Natural minerals
(commodities renowned for the superior quality of the commodities they produce The following map
mined or
grown or reared) highlights the major production hubs for some widely traded commodities:
extracted)

Agri
Com
Energ Metal Livest
m-
y s ock
oditie
s

• Live Cattle • Coffee

• Crude Oil • Copper
• Feeder • Sugar
• Natural • Gold
Cattle • Corn
Gas • Silver
• Lean Hogs
• Gasoline

Page 5
 1.2. What is commodity Price Risk? Corporates having exposure to a
commodity price risk can be
As mentioned, commodity classified into two categories:
price risk can affect the • Producer of a commodity
Commodity price risk, buyer as well as seller of • Consumer of a commodity
simply known as any commodity • Trader of a commodity
commodity risk is the depending on the It is important to remember that
financial risk for the buyer
or seller of a
commodity arising out of
02 fluctuation of either the
price of the raw material
used, or the finished
04 the producer of one (or more)
commodity can also be the
consumer
fluctuating commodity product sold for another.

01prices.
03
(or both).
05

Commodity price risk is Let us look at this from a micro

driven by the decentralised perspective. An event
market forces which are impacting the global
beyond a company’s supply of gasoline eventually
control. Increased volatility in leads to a rise in the retail price
the commodity prices can of petroleum. An individual is
create significant challenges exposed
for a corporate to commodity price risk since
leading to an impact on the increasing crude prices will
profitability, credit result in higher petrol prices for
Page 6 availability, the vehicle.
 1.3. Producer's Risk v/s consumer's risk of a commodity

Producer of a Commodity Consumer of a Commodity Trader of a Commodity

Operating sectors which are involved in the The producer of the commodity will sell the Professional trading companies and
business of obtaining (e.g. minerals and commodity to a buyer, who will either use it as raw individual traders participate act as
metals) and/or producing (e.g. agricultural material to make a finished product or consume the middlemen between
products) commodities are termed as commodity as the finished good. For the purpose of producers and consumers. Traders add
producers of a commodity. Some examples further discussion, we shall term commodity liquidity to the markets to ensure
of commodity producing sectors and consumers are corporates who have an exposure in demand & supply meet in case of an
companies are as follows: different commodities. Following are some examples imbalance, earning a spread or
of sectors and commodities which are large additional profit attached to the price of
consumers for mentioned the commodity derivative contract as
commodities: compensation for this risk undertaken.
Following are some examples of
commodity traders along with major
traded commodities:

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 2. Introduction to commodity price risk management
2.1. The commodity risk management process

Hence it is an-
• Systematic process, as opposed to being practiced on an ad
hoc basis
• It identifies the risks arising out of companies operations that
► Commodity risk management is the systematic process of
deal in commodities
identifying, evaluating and prioritizing the risks arising from
the purchase and sale of any commodity for production and/or • It then evaluates the impact of each risk on the business
pure trading followed by the coordinated and economical
financial performance and things such as how much working
application of resources to monitor, control and minimize the
impact of this risk while maximizing the available capital is required
opportunities. • Then the risks are prioritized depending on the likelihood of
their incidence and their impact
• This is all done to minimize the impact of the risk, i.e.
ensuring that the impact of movements in commodity prices
do not have an adverse effects on the company and the
company can survive even the worst case scenerios

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Page 9
2.1.1 Exposure Recognition

• Risk management policy

dictates what constitutes
exposure and how to Illustration of exposure calculation on a daily basis of a
calculate it. company trading commodities, i.e. buying and selling
commodities everyday

Table 2.1: Computation of open exposure to copper on a daily basis

Copper
• Rish threshold defined Copper Copper Open
concentrate
Day and concentrate sales exposure
according to date
purchases
purchases (daily) (daily)
(monthly)
companies risk appetite (MT)
(daily) (MT) (MT) (MT)

Monday
01st April 100 -75 25
2019
Tuesday
02nd April 100 -150 -50
• 2019
Accuracy of exposure
computation is Wednesday
03rd April 2200 100 -50 50
of utmost important as 2019
all the other processes
Thursday
in risk management 04th April 100 -80 20
follow through from this 2019
Friday
05th April 100 -160 -60
2019
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2.1.2. Risk Measurement

► Should be carried out in a Structured and Logical Manner

► Once Exposure has been calculated in terms of quantity, you need to measure the risks that could arise out of the given exposure due to
changes in prices of commodities
► You also need to keep track of commodities whose prices could have ripple effects on you, for illustration let's consider the case of a
rubber tire manufacturer-

Commodity- Crude Oil Falling Demand for Rubber tire

Fall in Price of Crude Oil

On the surface it might not be obvious as to why falling crude oil price would affect the revenue(demand) for a rubber
tire manufacturer, but on closer look it is understood that when synthetic rubber tires are cheaper(due to crude oil
being cheaper) the demand for its substitute falls, which in this case is natural rubber tire.

This illustrates why unrelated commodities need to be monitored to manage risk effectively

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2.1.2. Risk Measurement (Cont'd)
► To effectively measure commodity risk, it is essential to have a sound understanding of how commodity prices affect and are affected by
the financial and operational functions of the business
► One of the most common method for doing this is called Sensitivity analysis – it can also be called the What-if? Or Simulation
analysis, as the name suggests it measures the potential impact of unfavorable movements in commodity prices, this can be done by
selecting arbitrary movements or using historical commodity price data to stress test the financials and operational functions of the
business
► For example, A copper mining company will measure risk by computing the sensitivity of the downward or upward movement in copper
prices on its profitability as below:

Sensitivity analysis of movements in copper prices on profitability

Current Copper price

Scenario-1 Scenario-2 Scenario-3
INR 40000 per tonne

Copper price per tonne (in

INR 45000 INR 25000 INR 39000
different scenarios)

Monthly tonnage of
10000 tonnes 10000 tonnes 10000 tonnes
company

Movement in prices 5000 (15000) (1000)

Commodity price risk INR 50 mn gain INR 150 mn loss 10 mn loss

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2.1.2. Risk Measurement (Cont'd)

 There is also Portfolio Approach- Company measures commodity risk by undertaking a more detailed analysis of the potential impact
on its financial and operating activities of not only commodity prices, but also other quantitative and qualitative variables pertaining to
the commodity including market developments and outlooks.
 For example, under the portfolio approach, an oil refiner with exposure to crude oil price, in addition to scenario testing of movements in
crude oil prices will also analyse the potential impact of market demand and supply of crude oil, geo-political events, changes in political
policies and environmental variables on its financial and operational activities.

 Lastly there is Value at Risk(VaR) approach-

 Scientific methodology
 Uses a probability based approach
 Usually used by Financial Instiutions
 It is defined as the maximum amount expected to be lost over a specific time period, at a given level of confidence.
For example, an oil company may conduct sensitivity analysis utilising historical crude oil price trends and apply the same to current
exposure. Then it can ascertain that, given its current crude oil exposure, based on historical crude oil prices of a given time period and
given a quantified change in crude oil prices, it can be confident with a certain percentage that it will not experience losses beyond a
given threshold level.

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2.1.3 Risk Mitigation

 After identifying the commodity exposure and measuring the risk facing an organisation, the next step is to mitigate the identified risk by
using various strategies of risk management.

 The strategy for mitigating commodity risk depends on multiple factors such as the risk profile of the organisation, its production process,
the timing of purchases and sales, size and scale of operations and the availability of market instruments to reduce risk.

Size/ Availabilit Risk

Risk Timing of
Productio Scale of y of Mitigatio
profile of Purchase
n Process operation instrume n
the org and Sales
s nts Strategy

 Usually small and medium sized businesses find it difficult to access the instruments provided by financial markets for risk mitigation as their
commodity risk exposures may not be large enough to effectively utilise the financial markets characterised by increased complexities and
costs.

 Large organisations with huge exposures to commodity risks typically take the assistance of specialised financial institutions in managing their
risks using the sophisticated instruments offered by the financial markets.

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2.1.3. Risk Mitigation (Cont'd)

Page 15
v For a Producer of the commodity
Ø The risk lies in the price received for their production. This price depends on multiple factors ranging from demand, supply,
production cost to the level of international commodity trading activity.

Price risk management

► Production contracts- Producers may enter into contracts for the supply of their commodity to a consumer. These contracts fix the
quality and quantity of the commodities to be supplied and the price to be paid to the producer. As a result, these contracts ensure a
higher degree of certainty over future income but the limit the ability to change the production process at the producer’s end.
► Price pooling- Under price pooling arrangements, a commodity is collectively sold to a cooperative board, which fixes its price based on
several factors resulting in an average price for all producers in a given group. In such arrangements the price, quality and quantity of the
commodity to be sold to the board is agreed before delivery protecting producers from extreme price variations.
► Storage- This is a common technique that is adopted by even large producers to protect themselves from plunging commodity prices.
When overall commodity prices are low due to a temporary increase in supply that is not yet matched by demand, producers may choose
to store their produce in the hope that prices will become favourable in the future. However, this technique could be costly owing to
storage infrastructure, insurance, labour, transportation and spoilage
Strategic risk management
► Diversification- This technique is primarily adopted by agricultural producers. Many agricultural producers adopt crop/livestock rotation
to manage movements in commodity prices and production costs. This helps spread the risk from a single faced by the producer across
the alternative commodities produced. For effective diversification it is important to ensure that the alternative commodity is not subject
to identical risks.
► Flexibility- A flexible producer is one that has the ability to easily adapt to changes in market conditions that may adversely impact their
profitability. In other words, flexible producers can change their production processes in line with commodity price movements. This allows
the producer to shift its production from a commodity who’s price has fallen to one with a favourable price.

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 For buyers of commodities- The primary risk is a sudden increase in the price of the commodities they purchase for
consumption and/or further processing. When producers pass on increased commodity prices onto the buyers, purchasing such
commodities for use in the production process adversely affects their profitability, pricing and supply chains. In an active market,
it becomes necessary for these buyers to manage such risks to remain competitive.
► Alternative product sourcing
► Alternative product sourcing refers to the ability of a commodity buyer to source the required commodity from another supplier offering a
more acceptable purchase price as well as the ability to utilize an alternative cheaper commodity in his production process (incase of a
manufacturer). Businesses with strategies in place to review their use of commodities on a regular basis will be in a better position to
adopt this technique.
► Supplier negotiation
► Negotiating with the supplier to change the pricing plan is an effective method of managing fluctuations in the prices of commodities.
Suppliers may be open to reduce prices on the purchase of increased volumes of the commodity, may offer alternatives to the desired
commodity that meet the consumers budget requirements or recommend alterations in the supply chain to bring down the overall cost of
buying.
► Changing product offer
► Changing the product offer refers to the ability of a business that manufactures products from raw commodities to change various aspects
of their product offerings to effectively deal with increased commodity prices. Some examples include the ability to reduce their product
sizes without reducing corresponding selling prices and adding additional value their products to justify an increase in selling prices.
► Production process review
► Organizations that review their production processes on a regular basis and identify ways of optimizing these processes can easily offset
increased commodity prices. In addition to reviewing the actual production process this technique also includes reviewing the utilization of
commodities. For example, if the price of a commodity used by a company for production increases, it can look for improvements in its
production process to reduce the quantity of that high-priced commodity.

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 2.1.4. Risk Monitoring and reporting

► Extremely important to monitor the performance of risk

management strategies already implemented
► Findings used to improve on the strategies
Implementati
► In most cases, organisations do not hedge the entire
exposure they face from a commodity. Hence it also on of
becomes necessary to monitor the proportion of risk not strategies to
hedged to ensure that it does not translate into major mitigate risk
losses for the organisation.
► Monitoring is Vital as risk is not static
► Effective risk reporting is essential as:
► It ensures risk management as a discipline is embedded
into the company leadership, decision making, oversight
and business operations
► It focuses on evaluating exceptions in depth to understand Findings
their underlying causes used to Tracking and
► It increases the company’s ability to foresee business risks develop new Evaluating
before they occur by analysing historical results strategies the
► It facilitates continuous improvement – as red flags within and push out effectiveness
the business operations are highlighted through increased the of these
transparency over exposures ineffective strategies
► It assures regulators, management and Boards of the ones
soundness of the risk management strategy

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 2.2. Need for commodity risk management: More important than ever

► In the past, the primary use of commodity risk management has been to protect a business from a significant rise in raw commodity
prices (used as inputs by manufacturing/processing organisations) and a significant fall in commodity product prices (sold by
manufacturing/processing organisations as finished goods)

► Exponential Rise or Plunges have been a common, but recently volatility has increased due to the following factors-
o Geopolitical Rivalries- As in the case of Russia-Ukraine war, which has driven energy prices through the roof in Europe, this has
inturn driven up the prices of manufactured goods that Europe produces. This would even be important for a company not directly
dealing in commodities as it will most likely have to purchase atleast European made Capital goods, prices for which will have
increased.

o Global Crisis Situations- Such as the Pandemic which led to Demand loss for Oil, pushing the price down.

o Environmental Effects- Climate change has disturbed weather patterns and made prices of Agro commodities fluctuate a lot, Take the
case of Cocao, the raw ingredient in Chocolate, whose price has increased manifold due to effects of climate change.

o Increase in the number and complexitiy of regulation imposed on organisations dealing in the commodity markets has led to there
being an increase need for sound, systematic and documented risk management process, as this is required to fulfill the demands
placed by governing bodies and regulatory authorities

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3. Introduction to hedging and derivatives
3.1. What is hedging?
► Hedging is a financial strategy adopted by commodity market participants for minimising the possibility of incurring losses on their
commodity exposures in an unpredictable market. In the world of commodities, consumers, producers as well as traders of commodities
use the concept of hedging to manage the commodity risks arising in their businesses.
► Commodities are historically more volatile than other asset classes because of economic conditions, geopollitical issues, seasonsality,
weather etc.
► Traditional commodity procuring strategies and techniques for controlling costs are no longer sufficient to manage risk in high volatility
markets. Today most companies are unable to transfer higher costs to their customers and hence will incur losses in case of wide
fluctuations in raw material prices. Hedging facilitates the locking-in of commodity prices in advance reducing the potential risks resulting
from unexpected price movements and has become a necessity for market participants of all sizes across the globe.

3.2. How is hedging undertaken?

► Hedging is undertaken by taking an opposite position of equal quantity of the exposed commodity in the futures market to the company’s
existing physical market position. The logic behind establishing equal and opposite positions in the cash and futures markets is that a loss
in one market will be offset by a profit in the other market thereby minimising the overall losses incurred by the company in the event of
unfavourable market movements. In other words, hedging is a method to minimise one’s risk exposure by undertaking an offsetting
position in the underlying commodity.
► For example, in April 2020, an oil refiner estimated a requirement for 100 barrels of crude oil which will be processed in June 2020. To
fulfil this demand, the refiner entered into an agreement with an oil producing company to supply the 100 barrels at the price prevailing
in the market in June. However, the refiner is worried that the price of a barrel of crude oil will increase in June as compared to the current
market price. By hedging, the refiner can lock-in the price for its future purchases in the present which protects it against the possibility of
rising prices.

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► 3.3. What is a derivative?
► A derivative is a contract between two or more parties; its value is based on an agreed-upon underlying financial asset (like a security) or
a set of assets (like an index). In addition to commodities, some of the other common underlying instruments include bonds, currencies,
interest rates, market indexes and stocks.
► A company faces various financial risks due to its business operations. The major financial risks that can impact a company’s profitability
and cash flows are as follows:
► Commodity price risk: Any company that uses a commodity as input or sells the commodity to a customer faces a risk due to changes
in commodity prices
► Foreign exchange (FX) risk: Any company that imports or exports in foreign currency faces a risk due to changes in foreign currency
prices
► Interest rate risk: Any company that has borrowed money at floating rate faces the risk of interest rate going up. Similarly, a company
that has borrowed at fixed rate faces a risk of falling interest rates because it is locked at a fixed rate and the interest rates have lowered
Futures- A futures Forwards- They are Option gives you the
contract is an futures options that right but not the
agreement to buy or don't trade on an open obligation to buy or sell
sell an asset at a future exchange. Each a given commodity at
date contract is custom the strike price

► 3.4. Types of derivatives Instruments Swaps- A contract

through which two
parties exchange cash
flows or liabilities from
two different financial
instruments

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3.4.1. Forwards
No money changes hands
Betting that price will go until the settlement date Betting that price will go
up down
Buyer Seller
• A forward contract is a customised contract between two parties wherein settlement takes place on a specific date in future at a price
agreed at the time of signing the contract. It enables a buyer or seller of the contract to protect itself from adverse movements in the
price of the underlying by locking–in an agreed rate until an agreed date, that is, the buyer of forward contract is locked into the contract
price even when the rate movement is advantageous to the buyer.
• They are just an agreement between two parties, hence do not trade on exchanges. Over the counter(OTC) instruments.
• Can be customised and transacted for any amount or date.
• Element of counterparty, default risk, that is the probability that the other party will not perform the contract on maturity date
Forward contract on delivery basis
•Company X is an oil producer and expects to produce 1 million barrels of oil at the end of 6 months. It is concerned about a fall in prices of
crude oil. It enters into a forward contract with Bank ABC to sell 1 million barrels of oil at a price of $67.00 per barrel at the end of 6 months
on delivery basis.
•At the end of 6 months, irrespective of the price of crude oil, Company X will sell 1 million barrels of oil to Bank ABC at $67.00 per barrel.
Forward contract on cash basis
•Company X is an oil producer and expects to produce 1 million barrels of oil at the end of 6 months. It is concerned about a fall in prices of
crude oil. It enters into a forward contract with Bank ABC to sell 1 million barrels of oil at a price of $67.00 per barrel at the end of 6 months
on cash settlement. At the end of 6 months, there can be three scenarios.
Spot price of exactly $67 per barrel: There is no exchange of money between Company X and Bank ABC and the contract is closed.
Spot price is higher than the contract price – Spot price is $70 per barrel: Company X will pay the difference between the current spot price
($70) and the contracted rate ($67). Company X will pay $3 per barrel to Bank ABC, that is, Company X will pay $3 million.
Spot price is lower than the contract price– Spot price is $60 per barrel: Company X will receive the difference between the current spot
price ($60) and the contracted rate ($67). Company X will receive $7 per barrel from Bank ABC, that is, Company X will receive $7 million.
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3.4.2. Futures contracts
► Futures contracts are exchange-traded contracts to buy or sell the underlying at a future date at an agreed price. A futures contract is a
standardised version of a forward contract, that is, the amount that can be bought or sold is a multiple of the amount specified by the
exchange. The settlement date is also defined by the exchange.
► The main advantages of futures over forwards are price transparency and elimination of counterparty credit risk. Exchanges stand as the
counterparty for each transaction by acting as a buyer to every seller and seller to every buyer. This ensures that the buyer or seller need
not worry that the counterparty will not perform the contract. In the event of a default, the exchange will step in and fulfil the obligations
of the defaulting party and then proceed to recover dues and penalties from the defaulter.

Table 3.1: Differences between futures and forwards

Criterion Futures Forwards

Location Exchange No fixed location

Size of conduct Standard Customised

Maturity Standard Customised

Counterparty Clearing house Known bank/client

Valuation Marked to market daily None

Variation margins Daily None

Regulations By exchange Self-regulated

Credit risk Almost non-existent Counterparty risk

Settlement Clearing house Terms of contract

Page 23
Long Futures Short Futures

When a company purchases a futures contract for a When a company sells a futures contract for a
commodity it is said to be long that contract. The pay- commodity it is said to be short that contract. The pay-
off for a company which buys a commodity futures off for a company which sells a futures contract is like
contract is like the pay-off for a company which holds a the pay-off for a company which shorts (sells) a
physical commodity itself. It has a potentially unlimited physical commodity. It has a potentially unlimited
upside as well as a potentially unlimited downside. This upside as well as a potentially unlimited downside.
means that neither its profit nor its loss is capped at
any level. Price movement of the underlying
commodity can cause its final profit/loss to The figure below shows the profits/losses for a short
increase/decrease infinitely. futures position. Company Y sold futures when the
price of WTI crude oil was at $67 per barrel. If the price
The figure below shows the profits/losses for a long goes down, its futures position starts making profit. If
futures position. Company X bought futures when the the price rises, its futures position starts showing
price of WTI crude oil was Rupees 6000 per barrel. If losses.
the price goes up, its futures position starts making
profit. If the price falls, its futures position starts
showing losses.

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Valuation of futures
► The price of a future contract is dependent upon spot price of the underlying commodity, the risk-free rate and maturity date of the
contract. The theoretical price of futures is derived from the cash and carry arbitrage model. At the initiation of the futures contract, no
money is exchanged and the contract at initiation is valueless. The futures price at initiation is the spot price of the underlying commodity
compounded at the risk-free rate over the life of the contract.
► In commodity futures, due to the physical nature of the asset, storage cost is a relevant factor and it includes warehouse cost, insurance
cost and other costs associated with physically storing the underlying as well as interest paid to acquire and hold the asset, financing
costs, and so on. These costs are collectively known as the carry cost which basically means the cost of holding the asset till the futures
contract matures.
► Hence, the value of commodity futures can be calculated as follows:

► where,
► F = Futures price of the commodity
► S = Spot price of the commodity
► rf = Risk free rate of return
► s = Storage cost, expressed as percentage of the spot price
► t = Time to maturity, expressed in fraction of 1 year
Example
Spot price of cotton is INR 22,400, the risk-free rate is 6% and storage cost is 0.5%. The 3-month future price will be as follows:
F = 22,400 + [22,400 * (6% + 0.5%) * 3/12] = 22,764
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 3.4.3. Options

Options are contracts between two parties where the buyer of the option has the right but not the obligation to enter into the derivative
transaction at a future date (the exercise date) and at an agreed price (strike price). If the buyer exercises his right to enter into the contract,
the seller of the option contract has the obligation to perform the derivative transaction at a future date (the exercise date) and at the agreed
price (strike price). There are two types of options. To buy this optionality, the buyer of option has to pay a premium to the seller.

Basis Contractual terms Basis exercise type

Type of Sr.
Buyer of Option Seller of Option American
Option No Attributes European Options
Options
.
1. Call • Termed as long call • Termed as short call
option • Has the right to buy the • If the buyer of call option exercises
underlying commodity at a his right to buy, then the seller of Can be exercised
When to Can be exercised
future date (the exercise call option has the obligation to sell 1 on or before the
exercise only on expiry
date) and at an agreed price the underlying commodity at a expiry
(strike price) future date (the exercise date) and
• Pays a premium to seller of at an agreed price (strike price)
option • Receives premium from buyer of Can be valued by
option using both binomial
Cannot be valued
tree technique and
2. Put • Termed as long put • Termed as short put 2 Valuation using the BSM
the Black Scholes
option • Has the right to sell the • If the buyer of put option exercises model
Merton (BSM)
underlying commodity at a his right to sell, then the seller of model
future date (the exercise put option has the obligation to buy
date) and at an agreed price the underlying commodity at a
(strike price) future date (the exercise date) and Not allowed to
Legality in Allowed to be
• Pays a premium to seller of at an agreed price (strike price) 3 be traded in
India traded in India
option • Receives premium from buyer of India
Page 26 option
Option terminology
► Brent call option with strike price of $3200 maturing on 31 December is trading for a premium of $100 in June.

Terminology used in an options contract is as follows:

► Underlying commodity: Brent crude oil
► Maturity date: 31 December
► Strike price/Exercise price: $3200
► Premium: $100
Usually, following is the terminology used with respect to an options contract.
► X – Strike price or exercise price specified in the options contract (a fixed value)
► St – Price of the underlying asset at time t
► Ct – Market value of call option at time t
► Pt – Market value of put option at time t
► t –Time subscript, where t can be taken as any value between 0 and T
► T –Expiration date of the options contract
► C0 – Option premium, the price paid for the purchase of the call options contract
► P0 – Option premium, the price paid for the purchase of the put options contract

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Options pay-offs
► Example- Brent call option with strike price of $3200 maturing on 31 December is trading for a premium of $100 in June. On entering the
contract, the buyer of option pays $100 to the seller. On maturity of the contract (31 December)
► Buyer of call has right to buy Brent crude oil at $3200
► Seller of call has obligation to sell Brent crude oil at $3200
Scenario 01: On maturity of the contract, price of Brent crude oil is above strike price (i.e., 3200). Assume that on maturity, Brent crude oil is
at 3600. In this case, the buyer will exercise his right to buy Brent crude oil at 3200 and sell it in the market at the current price of 3600. The
seller has the obligation to sell Brent crude oil at 3200. For the buyer, the profit/loss (or pay-off) on the transaction is as follows:
► Pay-off from the transaction = Current price − Exercise price − Premium paid = 3600 – 3200 − 100 = 300
► For the seller, the profit/loss (or pay-off) on the transaction is as follows:
► Pay-off from transaction = Exercise price − Current price + Premium receive = 3200 – 3600 + 100 = −300
Scenario 02: On maturity of the contract, price of Brent crude oil is below the strike price (3200). Assume that on maturity, Brent crude oil is
at 2800. In this case, the buyer will not exercise his right to buy Brent crude oil that he can buy it at the current price (2800), which is lower
than the strike price (10,600). Since the buyer is not exercising his right, the seller has no obligation. For the buyer, the profit/loss (or pay-off)
on the transaction is as follows:
► Pay-off from the transaction: Premium paid = −100
For the seller, the profit/loss (or pay-off) on the transaction is as follows:
► Pay-off from the transaction: Premium received = 100
The amount of profit to the buyer is the amount of loss to the seller and vice versa. One way to understand these alternative
scenarios are through drawing option pay-offs.

Page 28
Moneyness of options

Table 3.5: Moneyness of call and put options

► Moneyness of an option indicates whether an option is worth exercising, that is, if the option is
exercised by the buyer of the option, whether he will receive money. At any given point of time, it CALL OPTION

is a function of the spot price and the strike price. The premium paid is not considered to Scen
Spot > Spot < Spot =
Exercise Exercise Exercise
determine moneyness. ario
Price Price Price

ITM ü
► In the money(ITM)- When beneficial for the option holder to exericse it. In case of a call option,
option is in the money when spot price is more than the exercise/strike price. In case of put OTM
ü
options, option is in the money when spot price less than the strike price.
ATM ü
PUT OPTION
► Out of the money(OTM)- An option is said to be OTM when it is not beneficial for the option holder
Spot > Spot < Spot =
to exercise it. In case of a call option, option is OTM when spot price less than the exercise/strike Scen
Exercise Exercise Exercise
price. In case of a put options, option is OTM when the spot price more than the strike price. ario
Price Price Price

ITM ü
► At the money(ATM)- An ATM option is one in which the option holder is indifferent towards
exercising the option, that is, the strike price of the call/put option contract is equal to the spot OTM ü
price of the underlying commodity
ATM ü

Page 29
Components of options premium

► Option premium has two components: intrinsic value (IV) and time value (TV).
► Option premium=IV+TV
► Intrinsic Value of option
► IV is the difference between the underlying commodity spot price and the strike price of an option.
► It can either be positive (if the option is ITM) or zero (if the option is either ATM or OTM). An option cannot have a
negative IV.of an option
Table 3.6: IV
IV Formula Positive IV
IV (Call) Underlying IV (Call) will be positive only if
price − Strike current price of underlying > strike
price price
IV (Put) Strike price − IV (Put) will be positive only if strike
Underlying price > current price of underlying
price

► Time Value of option

► The component of the premium amount that is more than the option’s IV is called its TV. In other words, TV is the
premium for the time left to exercise an options contract.
► Time Value =Option premium−Intrinsic Value
► Typically, higher the time left to expiry of an option contract, greater is the TV of the option. It represents the time left
in the option contract during which the position may become profitable due to a favourable move in the underlying
price.

Page 30
 Factors affecting option pricing
Option variable Effect Impact on option price

Underlying Spot Moneyness of option A call option allows you to buy a commodity at a fixed price(strike) in future, hence the more
price the spot goes above the strike, the more the option is worth, hence spot price has a direct
relation to option price,
for a put option, spot price is inversely related to option price.
Strike price Moneyness of option At the same spot price, if strike price increases, that is, the option will be more OTM/less ITM.
Hence, the option value will decrease. Hence, strike price has an inverse relation with call
option price, that is, a higher strike price will reduce the value of call option while a lower
strike price will increase the call option price.
For a put option strike price has a direct relation with put option price, that is, a higher strike
price will increase the value of put option while a lower strike price will reduce the put option
price
Time to expiry Probability of an option Options have a fixed maturity, that is, time is limited. Hence, with each passing day, the time
being ITM/OTM on left to expiry decreases.The more time an option has till expiration, the more time the option
expiry must be ITM on expiry.

As the time to expiration get closer, the value of the option begins to decrease since it has
less time left to be ITM at maturity, that is, the probability of being ITM decreases.

Time to expiry has a direct relation to option, that is, a higher time to expiry will increase the
option price (for both call and put) while a lower time to expiry will decrease the option price.
In most cases, investors are willing to pay a higher premium for more time (if different options
have the same exercise price) since time increases the likelihood that the position will become
profitable. Time value decreases over time and decays to zero at expiration. This phenomenon
Page 31
is known as time decay
 Option variable Effect Impact on option price

Volatility Probability of an option Volatility is the variable that is the estimated factor while pricing an option. The volatility
being ITM/OTM on expiry used is the implied volatility of the underlying for the period of option tenor.
Higher the volatility, higher the probability of underlying commodity being ITM at expiry of
option. Lower the volatility, lower is the probability of the underlying commodity being ITM
at expiry of option.
Hence, volatility has a direct relation to option price, that is, a higher volatility will increase
the option price (for both call and put) while a lower volatility will decrease the option
price
Risk-free interest Opportunity cost of Interest rates have a direct relation with option price, that is, a higher interest rate will
rate money increase the option price while a lower interest rate will reduce the option price.
It can be shown with the following example.
There are two ways to invest in 100 barrels of Brent crude, which is trading at $60.
1. We can buy 100 barrels of crude outright which would cost us $ 6,000.
2. Instead of buying in cash, we can buy an ATM call option for $ 4. Our total cost here
would be $ 400. Our initial cash investment would be smaller, and we will have the
same reward potential. This would leave us with $ 5,600, which can be invested in
risk-free FD or federal bonds that generate guaranteed returns.
Higher the interest rate, the more attractive the second option becomes. Thus,
when interest rates go up, call option price also goes up since the opportunity
cost of money increases.

By the same, Price for Put options are reduced when interest rates are high and
vice-versa

Page 32
3.4.4. Swaps
► Swap is bascially two counterparties agreeing to exchange one stream of cash flow against another stream on an agreed notional
principal.
► They are OTC contracts mainly between corporates and financial institutions
Fixed-floating commodity swap
► It is better to understand this through an example- to hedge against a potential increase in fuel prices in the future an airline company
enters into a fuel swap contract with a bank. The company agrees to pay a fixed price of $6 per gallon (current market price for fuel) for
100,000 gallons of fuel each at the end of 3 months. The market price of fuel at the end of 3 months was $6.3 per gallon.

The airline company has to pay a fixed price of $6 per gallon of fuel to the bank and
the bank has to pay the prevailing market price of fuel which is $ 6.3 per gallon to the
company. As the swap contract is cash settled the difference between the fixed and
floating prices of fuel has to be paid at settlement. Since the floating price ($6.3)
exceeds the fixed price ($6),

Net settlement payment = [$6.3 - $6] X 100,000 = $0.3 X 100,000 = $30,000

In total, the bank will pay the airline company $30,000.

This $30,000 receipt offsets the increased amount that the airline company now has to
pay for fuel. Currently to buy 100,000 gallons of fuel the airline company has to pay
$630,000 ($6.3 per gallon). However, due to the swap contract the net amount
payable is $630,000 – $30,000 = $600,000. This equals the same amount that the
airline company would have to pay for 100,000 gallons of fuel at the time of entering
into the fuel swap contract.

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Commodity-for-interest swap

Fixed leg payer Commodity price difference Interest rate (fixed or

(commodity price) floating) payer
Interest rate difference

► In a commodity-for-interest swap contract, one party (usually the commodity producer) agrees to pay a cashflow based on the underlying
commodity price prevailing in the market,

► While the other party (usually a bank) agrees to pay a floating interest rate such as the LIBOR or an agreed-upon fixed interest rate. This
swap contract includes a notional principal or face value – a predetermined amount on which the contracted interest payments are
computed, a fixed duration and pre-specified forward payment dates. Like the fixed-floating swap, on each forward payment date these cash
flows will net out and the counterparty having to pay more based on the commodity market price, interest rate and face value will pay the
difference.

► This type of swap contract protects the commodity producer from the risk of incurring losses due to poor returns in the event of a fall in the
concerned commodity's market price.

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► 3.5. Financial derivatives vs commodity derivatives

Characteristic Commodity Derivative Contract Financial Derivative Contract

Settlement In case of commodity derivatives, Most financial derivative contracts traded

certain commodities have existing across the globe are cash settled while
derivative contracts which can only be few maybe physically settled.
settled physically.

Complexity in physical Commodities are tangible assets and in Financial assets are usually intangible and
settlement most cases are bulky and large. As a not bulky in nature. As a result, the
result, there is a requirement for requirement for specialised and
specialised and sophisticated storage sophisticated storage and transportation
(warehousing) and transportation facilities when financial derivatives are
facilities when commodity derivatives physically settled is eliminated.
are physically settled.

Asset quality Commodity assets, being tangible, the Financial assets, being intangible, the
issue of varying quality of the issue of varying quality of the asset does
commodity is a major concern and not really exist in case of financial
must be in alignment with contracted derivatives contracts.
terms in case of financial derivative
contracts.

Page 35
 4. Introduction to Commodity Exchanges
4.1. What is a commodities exchange?
A commodity exchange is an organized and regulated market
that facilitates the purchase and sale of derivative contracts
whose values are tied to the prices of underlying commodities.

It is a legal platform that establishes and enforces rules and

processes for trading standardized commodity derivative
contracts. In other words, a commodities exchange can also be
called a physical central location where trading in commodities
occurs.

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4.1.1 Types of Trading done on commodity exchanges

• Historically, commodity exchanges have conducted trading via two mediums - Pit Trading and Electronic Trading​
Electronic trading is a mode of trading in which traders and
exchange brokers place orders for buying and selling commodity
derivatives by simply entering the details of these orders onto the
Pit trading was traditionally the most common method, it used a software of the concerned commodity exchange. The exchange then
mechanism know as open outcry system does the task of matching demand and supply. Today majority of the
derivative exchanges trading commodities as well as other asset
classes have adopted this mode of trading.

It has benefits like-

► Transparency
As electronic trading platforms are operated over the internet,
market participants can view all trading details for the day like
the market size, market quote and last trades including
competitor trades in near real time.
Cost
Traders have to pay a lower commission to their brokers as
trades are being placed directly with the exchange and exchange
also saves money.
► Simplicity
As these trades are directly placed with the exchange the need
Page 37 for intermediaries is eliminated and trades can be placed in near real
time with a greater degree of accuracy.
4.1.2. Importance of Commodity exchanges

Page 38
4.1.3. Commodity Exchange participants

Industrial End-
Producers Speculators Traders
Users
• Create the • Create demand, • Take advantage • Act as middlemen
underlying End users of volatility to between
commodity i.e. • industrial end- make gains by producers and
supply users include betting on end-users
• This includes food processing direction of price • Purchase surplus
farmers that grow companies, oil • Take on the risk and sell from
agricultural refineries and passed by the inventory
commodities, oil manufacturing participants • Make gains by
and gas and construction hedging their releasing or
companies that companies. exposures, i.e. buying inventory
extract and • Trade to get Suppliers and end depending on
produce crude oil favourable prices users Demand-Supply
and mining for their input or • Key source of situation
companies that raw materials liquidity in the • Unlike
extract ores and market Speculators,
produce metals. Traders do take
• Trade to lock in physical delivery
favourable prices
Page for
39 their future
production
4.2. Major global and domestic commodity exchanges

Exchange Description
Chicago Mercantile Exchange The CME is one of the largest global organized exchanges for the trading of commodity derivatives. Founded
(CME) in 1898 as the Chicago Butter and Egg Board, an agricultural commodities exchange, the CME group at
present offers futures and options contracts in agriculture, energy, metals, real estate, stock indices, foreign
exchange, interest rates as well as weather.
London Metal Exchange The LME is a commodity exchange that trades in futures and options contract for non-ferrous base metals.
(LME) Established in 1877, the LME is the world centre for the trading of industrial metals. It offers tradable
contracts for metals including copper, aluminium, zinc, gold, silver and cobalt.
Intercontinental Exchange The ICE was founded in 2000 in Atlanta, Georgia to function as a pure electronic trading platform for the
(ICE) buying and selling of energy commodities and derivatives. It offers market participant physical and derivative
exchange traded as well as Over the Counter (OTC) contracts in a wide range of energy commodities
including oil, natural gas, jet fuel, electric power and emissions. It also offers trading in interest rates, credit
default swaps and foreign exchange.
Multi Commodity Exchange The Multi Commodity Exchange of India Ltd is a commodity derivatives exchange providing an online platform
of India Ltd (MCX) for price discovery and risk management in commodities. The exchange was established in 2003 and is
currently the largest commodity trading and clearing exchange in India operating in the bullion, industrial
metals, energy and agricultural commodities sectors. Its offerings include futures contracts in aluminium,
copper, nickel (industrial metals), gold, silver and some of their variants (bullion), crude oil and natural
gas (energy) and cardamom, cotton, palm oil and its variants and black pepper (agricultural commodities).

National Commodities The National Commodity and Derivatives Exchange is a major commodity exchange based in India that offers
and Derivatives Exchange derivatives trading in agricultural commodities.. Wheat, soybean and barley are the most traded commodities
(NCDEX) on the NCDEX. It also offers trading in sugar, cotton and spices including pepper, turmeric and coriander.

Page 40
4.3. Exchange traded derivatives vs over the counter derivatives

Parameter Exchange Traded Derivative Over the Counter Derivative

Definition Exchange traded derivatives are financial contracts that Over the counter derivatives are financial contracts that
are traded and regulated by a central platform known are not traded on a central platform and are directly
as a commodity exchange. entered into by two or more counterparties.
Centralization These derivatives trade on the exchange which serves These derivatives are not traded on a centralized platform
as a central platform that connects and mediates and different dealers compete to connect and mediate
buyers and sellers. buyers and sellers.
Standardization These derivatives are standardized in terms of the These derivatives are non-standardized and can be
quantity and quality of the commodity underlying the customized in terms of the quantity and quality of the
contract, the maturity of the contract and the type of commodity underlying the contract, the maturity of the
settlement. contract and the type of settlement based on the
requirements and preferences of the counterparties and
requires negotiating.
Counterparty risk As these derivatives are regulated by an exchange, the As these derivatives are not regulated by an exchange,
exchange acts as the opposite counterparty to the there is a possibility that one or more parties to the
buyer and seller of the contract and ensures the contract may default on their obligations. Hence OTC
commitment of the contract to both parties. Hence derivatives carry counterparty risk.
exchange traded derivatives carry zero counterparty
risk.
Visibility The exchange being a transparent platform, details of As OTC contracts are not traded on exchanges, details of
the contracts traded like price, start date, maturity the contracts traded like price, start date, maturity date,
date, underlying quantity etc are openly visible for all underlying quantity etc are known only by the parties to
market participants. the trade and are not openly visible to all other market
participants.
Market makers Exchange acts as the market, demand-supply Dealers bring together buyers and sellers and determine
determine price price
Page 41
Regulation Formally regulated by the exchange Not formally regulated, no rules to govern
4.4. Margin management on exchange traded products

• In forwards and futures, there is only a promise to buy or sell at a future date, there is no exchange of money at the start of the
contract
o This beings an element of risk for both the buyer and the seller
o In forward contracts, since its between two counterparties, there is an element of counterparty risk
o In futures, since exchange is the counterparty, the exchange leies margin on each contract to ensure that the counterparty
risk is eliminated. Margin is a performance guarantee and is collected by the exchange from both the buyer and the seller.
 Initial There are two types of margins levied by exchanges.
margin
This is the money to be deposited by the buyer and seller before entering into the contract. The amount of initial margin depends on the
underlying and the exchange.
For example, Company X buys 10 lots of gold futures for a December 2020 expiry at the rate of INR 31,000 per lot. The initial margin
requirement is INR 1,500 and a maintenance margin of INR 1,000 per lot. Hence, the initial margin to be deposited before trading is INR 1,500
× 10 lots = INR 15,000. At any point in time, the margin amount should not fall below INR 1,000 × 10 lots = INR 10,000. If it falls below INR
10,000, additional funds need to be deposited to restore the margin level back to INR 15,000.
 Maintenance margin Table 4.3: Price and margin movement on gold futures contract
This is the amount of margin that must be maintained at any point in time. Day Margin Price on Change in Mark-to- Margin
If the margin balance in the account falls below the maintenance margin due to change in require exchange price market balance
ment amount on 10
futures price, additional funds must be deposited to restore the margin balance back up to lots
the initial margin.
 Variation margin/mark-to-market margin At time 15,000 31,000
of
Mark-to-market margin is the margin amount that reflects the change in the closing value of
purchas
futures price from the previous day’s closing price. e
For example, over the next 5 days, prices of gold futures for a December 2020 expiry and 1 the 0 30,600 −400 −4,000 11,000
mark-to-market requirement are as follows: At the close of Day 02, the margin balance has
2 0 30,300 −300 −3,000 8,000
gone below the initial margin requirement, and hence, a deposit of INR 7,000 is required to
restore the margin balance back to the initial margin requirement. 3 7,000 30,800 +500 +5,000 20,000

4 0 31,100 +300 +3,000 23,000

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5. Key related concepts in commodities trading and risk management

5.1. Commodity trading strategies

Hedging is a financial strategy adopted by commodity market participants for minimising the possibility of incurring
losses on their commodity exposures in an unpredictable market. Hedging is undertaken by taking an opposite position
Hedging of equal quantity of the exposed commodity in the futures market to the company’s existing physical market position.
The logic behind establishing equal and opposite positions in the cash and futures markets is that a loss in one market
will be offset by a profit in the other market thereby minimising the overall losses incurred by the company in the event
of unfavourable market movements.

Speculation is a trading strategy in which a trader undertakes a significant amount of risk in order to make higher gains
in the short term. This strategy is mainly dependent on assumptions made by the trader on the future direction of
Speculation commodity prices. Although the risk of loss is significantly higher in speculative trading, it is offset by the expectation
of substantial gains. It plays a key role in the commodity markets as it creates liquidity, in the absence of which it would
be difficult to find buyers and sellers. This strategy is also criticized by some experts for being the reason behind the
extreme volatility experienced in commodity markets, particularly in recent times.

Arbitrage is a trading strategy in which a trader simultaneously purchases a commodity in one market at a lower price
and sells the same or similar commodity in another market at a higher price to earn a risk-free profit. In other words,
Arbitrage arbitrage exploits the price differences in two different markets for the same or similar financial asset in order to make
a profit. It exists due to the inefficiencies in the overall financial markets. As arbitrageurs attempt to profit from small
price differences, these trades usually involve taking large positions. As a result, this trading strategy is usually adopted
by institutional investors like hedge funds instead of individual investors.

Page 43
5.2. Future commodity market structures

Contango vs Backwardation

Contango Backwardation

Spot prices of a commodity are Spot price of a commodity is

lower than its futures price is higher than its future price
called as Contango. called as Backwardation
 Causes  Causes
 Temporary and unusual fall  Temporary and
in spot price. unusual hike in spot price.
 Hike in futures prices  Unusual decline in futures
prices

Difference

Contango Backwardation

Spot price < futures price Spot price > Futures price
 Upward sloping futures  Downward sloping futures
curve curve
 Difference between the spot  Difference between the spot
price and futures price is price and futures price is
negative positive
 Selling more in future  Selling more in future

Page 44
5.3. Other key risks associated with commodity businesses

Basis Risk
► Basis risk is the risk that a commodity trader will incur a loss if the spot price and the futures price for a commodity do not converge when
the futures contract expires. In other words basis risk is the risk arising from a mismatch in hedged positions (imperfect hedges) so that
losses incurred on the exposure to a commodity are not fully offset by the instrument used to hedge that exposure.
► Basis risk arises due to two main reasons;
► A quantity mismatch between the commodity price exposure and the instrument used to hedge the exposure (especially standard
instruments like commodity futures).
► A need to resort to cross hedging due to the absence of hedging instruments with underlying commodities to which the trader has a price
exposure. This occurs when either the maturity, quantity or the quality of the commodity hedging instrument cannot be matched with the
price exposure that needs to be hedged. In this case the trader is forced to use the derivative of a highly similar commodity to hedge his
price exposure.
Basis risk can be computed by simply subtracting the futures price of a commodity derivative contract from its current spot price. For
example, today, if the spot price of gold is $1210 and the price of gold futures maturing in 2 months is $ 1212 the basis is the
difference between the two prices, that is $2. When this basis is multiplied by a large quantity of commodity contracts, the total
amount of gains/losses resulting from the basis risk can be significant.
► There are different forms of basis risk as follows:
► Locational basis risk- For example, an oil producer in Houston has locational basis risk if it uses a derivative contract deliverable in New
York to hedge this exposure. If the Houston contracts are trading at $64 per barrel and the New York contracts are trading at $65 per
barrel, the locational basis risk is $1 per barrel.
► Quality basis risk - Quality basis risk is the risk that arises due to differences in the physical attributes of the underlying commodity of
the derivative contract being used for hedging with those of the commodity to which a trader may have price exposure.
► Calendar basis risk- Calendar basis risk is the risk that arises when the commodity derivative contract used to hedge commodity
exposure by a trader or company does not mature on the same date as the position being hedged.
Page 45
 Inventory Risk Freight Risk Foreign Exchange Risk
► Inventory risk is the risk that a company will ► Freight risk refers to all the risks that a company ► Foreign exchange risk is the risk of loss on
not be able to sell its existing commodity operating in the commodity markets faces owing international transactions due to the
inventory or its commodity inventory will to its shipping activities. In case of international fluctuation in foreign currencies involved in the
decrease in value due to volatile markets. This commodity trade, shipping companies are hired transactions. It arises when a commodity
risk is mainly prevalent in manufacturing and to transport commodities from the procurement company undertakes transactions
refining companies that hold huge volumes of locations to the locations of sale. For a company denominated in currencies other than the
inventory as part of their business operations. which processes commodities into finished domestic currencies of the countries in which
Various risks can affect the commodity products, shipping services are required to they are located. Any
inventory of a company such as: transport raw material inputs from the places of appreciation/depreciation in the domestic
production to the company’s plant locations and currency vis-à-vis the transactional currency
► Low shelf life – this risk is prevalent in
the finished goods need to be transported from will influence the cashflows arising from that
almost all agricultural commodities as they
the company’s plant/warehouse locations to the transaction.
are perishable and can be held in inventory for
very short periods of time. places of consumption. ► For example, an American sugar producer
► Freight price risk is the most important freight enters into an agreement with a sugarcane
► Inventory loss and damage – loss and
risk, this is the shipping container cost, this has supplier in India to buy 100 tonnes of
damage of inventory due to mismanagement,
been extremely volatile recently due sugarcane at INR 500 per tonne, or INR 50,000
improper handling by employees and in some
to geopolitical tensions. total. At the time of the agreement, USD 1=
cases in the course of the company’s normal
INR 50. Hence the America producer USD
operations is a major risk affecting the ► Bunker fuel, which is used by shipping
1000. Due to unforeseen circumstances the
inventory of a company. companies, due to regulations forcing companies
value of USD in INR terms depreciates and
► Theft – theft of high value commodity to use cleaner fuels, shipping companies have
now USD 1 = INR 45. Although the contract
inventories by both outsiders and internal passed on the risk to consumers
value is still INR 50,000, the American
employees is one of the biggest risks when it ► Lost or damage in transit has also been on the producer is now forced to pay USD 1,111 to
comes to controlling inventory. rise due to world events. fulfil the contract. Hence due to foreign
exchange fluctuation the American producer
has incurred a loss of approximately USD 110.
Page 46
This is a basic example of the foreign
exchange risk prevalent in commodity
6. Introduction to some derivative strategies
6.1. Crack Spread
• Adopted by Oil refiners who process crude oil into its various products.
Strategy
• Crack Spread- It is the margin Oil refiners earn, i.e
•
Price of Crude Oil (input) - Price of refined products like diesel galosline etc (output) =
Crack spread

• It is basically locking in of refinding margins- Buying crude oil derivatives and

simultaneously selling the same quantity of refined product derivatives.

For example, refining company M wants to hedge its December Diesel crack spread. Typically,
refiner’s procure crude oil in a given month for subsequently processing and selling the refined
products during the following month. As a result, for using the crack spread hedging strategy,
company M has to purchase the November crude oil future and sell the December Diesel future
to hedge its refining margin for December. Currently, the December WTI Diesel crack spread is
currently trading at $20/BBL based on the December Diesel future trading at $65/BBL and the
November WTI future trading at $45/BBL.
Assuming that in the month of November the prompt NYMEX WTI futures contract is trading at
$50/BBL. As a result, company M incurs a gain of $5/BBL on the long crude oil future. In
addition, because the WTI cash (physical) market and the WTI futures market are highly
correlated, company M purchases physical crude oil in the cash market for $50/BBL as well.
Also, assuming that during the month of December the prompt NYMEX Diesel futures contract is
trading at $68.5/BBL. As a result, company M incurs a loss of $3.5/BBL on the short Diesel
future. However, the Diesel cash market and the Diesel futures market also have a strong
correlation, leading company M to sell its Diesel production in the cash market for $68.5/BBL.
As a result of all of the above, company M earns a refining margin of $20/BBL while incurring a
net hedging gain of $0.06/BBL, resulting in a gross profit of $15.16/BBL (refer below table).
Page 47
6.2. Calendar spread strategy

 It is a less volatile way of hedging than outright short or long positions, Calendar spread is of two types depending on the traders strategy-

Bull calendar spread – purchase the nearby contract and sell the deferred contract
Bear calendar spread – sell the nearby contract and purchase the deferred contract

 The main benefits of using a calendar spread strategy are-

 Reduced margin requirement

The margin requirements for trading calendar spread futures are significantly lower than outright long and short future positions. This is because
in this type of spread, due to the opposite positions in the same futures contract, one contract is hedged by the other.
 Reduced risk
Calendar spread trades carry minimal risk. This is because the trader has active long and short positions in the futures contract and hence is not
unfavourably impacted by extreme bullish or bearish volatilities in the underlying commodity prices.

 For example-
A popular spread in the soybean market is the July/November spread. Assume a trader purchases a nearby soybean futures contract in July for
USD 845 and simultaneously sells the futures contract expiring in November for USD 852.
If the July contract expires at USD 850, the trader will make a profit of USD 5 on the nearby long soybean futures position. Assuming that the
trader closes his short position at the same time at USD 854, he will incur a loss of USD 2. As a result, his overall pay-off from this calendar
spread position will be a net profit of USD 3.
Alternatively, if the July contract expires at USD 840, the trader will incur a loss of USD 5 on the nearby long soybean futures position. Assuming
that the trader closes his short position at the same time at USD 850 (price at which November contract is trading) he will make a profit of USD 2.
As a result, his total loss will reduce to USD 3 owing to this calendar spread position.

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 6.3. Inter-exchange spread 6.4. Covered Call Strategy 6.6. Married Put Strategy
trading strategy ► In this strategy the trader holding onto a long ► A trader purchases a specific quantity of a
► The inter-exchange spread trading strategy is position sells a call option for the equivalent commodity (physical) and simultaneously
one in which a trader purchases a commodity quantity of the same commodity. The trader’s purchases a put option for an equivalent
long position in the commodity acts as a cover quantity of the same commodity at the same
futures contract on one exchange for a given
as he can deliver it to the buyer of the call time. It is basically an insurance policy
expiry and simultaneously sells a futures option if he chooses to exercise the same. making a price floor for the given
contract for the same or similar underlying commodity.
commodity for the same expiry on another
► This strategy is best suited for
exchange. traders/organisations which do not expect the ► The only downside to this strategy is that the
price of the commodity to move much in the trader has to pay a premium amount for the
► The objective of this strategy is to profit from near term, making it a neutral strategy. It option position which at times can be high if
the arbitrage opportunity provided by provides a short-term hedge on a long the underlying commodity prices are volatile in
the widening and narrowing of the price physical position while simultaneously nature.
differences of the two traded contracts. allowing the trader to earn a premium ► For example, a trader purchases 100 barrels of
► For example, as part of an inter-exchange from the short call position. physical WTI crude oil for USD 65 per barrel
spread strategy, a trader purchases a ► For example, a trader purchases 100 barrels of and simultaneously buys a NYMEX WTI put
December wheat futures contract on the physical WTI crude oil for USD 65 per barrel option (size=100 barrels) at a strike price of
Chicago Mercantile Exchange for USD 4.5 and and simultaneously sells a NYMEX WTI call USD 63.5 per barrel and pays a premium of
simultaneously sells a December wheat option (size=100 barrels) at a strike price of USD 5. At the time of expiry if the price for a
futures contract on the Kansas City Board of USD 66 per barrel and receives a premium of barrel of WTI crude oil is USD 58 the trader will
Trade for USD 4.8 to take advantage of the USD 5. At the time of expiry if the price for a exercise the option contract and earn a profit
price difference (USD 0.3) between the futures barrel of WTI crude oil is USD 64 the option of USD 5.5 (63.5 – 58). On the other hand, the
contracts for the same underlying commodity contract will not be exercised by the buyer. trader will incur a loss of USD 7 (65-58) on his
(wheat) and the same expiry (December). Hence even though the trader will incur a loss physical long position. As a result, his total loss
of USD 1 (64-65) on his physical long position is reduced to USD 6.5 (5+7-5.5) as against
he will pocket the short call premium of USD 5 USD 7 (had the put option not been
Page 49 that is a net gain of USD 4. purchased)
 6.6. Trading Average Price Options (TAPO)

► Settlement based on average price of commodity over a period as against the strike price of the contract.
► Primarily traded an OTC instrument, also known as Asian options contract
► The type of average to be considered at the time of settling the contract (arithmetic or geometric) along with the dates on which the
prices of the underlying commodity are to be considered for averaging are fixed at the time of entering into the option contract.
► The averaging of the commodity prices reduces the overall volatility making such contracts less risky. As a result, the premium to be paid
on such contracts are lower as compared to standard option contracts.
► Traders primarily use such contracts when they expect the volatility in commodity prices to increase in the short to medium term and in
thinly traded markets characterised by low liquidity.

► For example, on April 1st, a trader purchases a 90-day arithmetic copper call option with an exercise price of $6500 per Metric Tonne (MT),
where the averaging is based on the value of copper per MT after each 30-day period. The LME copper price after 30, 60, and 90 days was
$6495, $6500 and $6510 per MT. The arithmetic average (mean) is (6495 + 6500 + 6510) / 3 = 6501.67. The profit is the average minus
the strike price, that is, 6501.67 - 6500 = 1.67 per MT of the contract. In case the average price of copper is below the strike price of the
option contract, the trader will not exercise the contract limiting his loss to the premium paid for the call option.

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