Commodity Derivatives A Guide for Future Practitioners

Commodity Derivatives: A Guide for Future Practitioners describes the origins and uses of these important markets. Commodities are often used as inputs in the production of other products, and commodity prices are notoriously volatile. Derivatives include forwards, futures, options, and swaps; all are types of contracts that allow buyers and sellers to establish the price at one time and exchange the commodity at another. These contracts can be used to establish a price now for a purchase or sale that will occur later, or establish a price later for a purchase or sale now. This book provides detailed examples for using derivatives to manage prices by hedging, using futures, options, and swaps. It also presents strategies for using derivatives to speculate on price levels, relationships, volatility, and the passage of time. Finally, because the relationship between a commodity price and a derivative price is not constant, this book examines the impact of basis behaviour on hedging results, and shows how the basis can be bought and sold like a commodity. The material in this book is based on the author’s 30-year career in commodity derivatives, and is essential reading for students planning careers as commodity merchandisers, traders, and related industry positions. Not only does it provide them with the necessary theoretical background, it also covers the practical applications that employers expect new hires to understand. Examples are coordinated across chapters using consistent prices and formats, and industry terminology is used so students can become familiar with standard terms and concepts. This book is organized into 18 chapters, corresponding to approximately one chapter per week for courses on the semester system.

List of figures List of tables Preface CHAPTER 1. INTRODUCTION What is a Commodity? Undifferentiated vs. Branded Products Perfect Competition Model Inelastic Supply and Demand What is a Derivative? Price Stability and Certainty Separating the Pricing and Exchange Functions Forward Contracts Futures Contracts Options Swaps Organization of this Book Forwards, Futures, and Price Discovery Summary CHAPTER 2. TRADING FUTURES AND OPTIONS Pit Trading The Trading Pit Order Types and Order Execution Open Outcry and Hand Signals Price Reporting Electronic Trading The Role of Technology Components of Electronic Trading Central Limit Order Book Matching Engine Front End Customer Protection Features Benefits vs. Costs of Electronic Trading CHAPTER 3. UNDERSTANDING AND INTERPRETING FUTURES PRICES How Futures Prices Are Quoted Futures Prices and Summary Price Measures Tick Size and Contract Size Commodity Codes and Month Codes Contract Expiration Long and Short Positions Measures of Trading Activity Volume and Open Interest Trading Impact on Volume and Open Interest Other Relationships between Volume and Open Interest Interpreting Price Differences: Time, Space, and Form Price Differences Due to Time: Carrying Costs Carrying Costs and Convenience Yield The Forward Curve Forward Curve for a Normal Market Forward Curve for an Inverted Market Effects of Seasonality Forward Curve for Nonstorable Commodities Price Differences Due to Space: Transportation Costs Locational Price Differentials Locational Premiums and Discounts Price Differences Due to Form: Processing Costs Input-Output and Quality Differentials Spreads: Processing, Intra-Commodity, and Inter-Commodity Combinations of Time, Space, and/or Form CHAPTER 4. MARGINS, CLEARING, DELIVERY, AND FINAL SETTLEMENT Margins in Futures Trading Initial Margin, Maintenance Margin, and Margin Calls The Clearing House and Clearing Firms The Clearing House as Central Counterparty The Daily Settlement Process Margin Account Example Final Settlement via Delivery The Physical Delivery Process Delivery as Arbitrage Steps in the Delivery Process Final Settlement via Cash Settlement CHAPTER 5. MARKET REGULATION Futures as Contracts Contract Specifications Par Quality Premiums and Discounts for Quality Variations Quantity Delivery Location Delivery Date Cash Settlement vs. Physical Delivery Position Limits Spot Limits Non-Spot Limits All-Months-Combined Limits Position Limits for Hedgers Reportable Levels Minimum Price Increment Daily Price Limits Expiration Date and Last Trading Date Regulation by Exchanges Regulation by the Federal Government Legislative History Regulation and the Perfect Competition Model Regulatory Purpose Creation of the Commodity Futures Trading Commission Authority and Jurisdiction Organization Self-Regulation by the Industry Applications in Other Sectors and Countries Appendix 5.1 CHAPTER 6. HEDGING WITH FUTURES The Role of Correlation Hedging Against a Price Increase Loss on Cash Position, Gain on Futures Position Gain on Cash Position, Loss on Futures Position No Gain or Loss on Cash Position, No Gain or Loss on Futures Position Stabilizing the Net Purchase Price Hedging Against a Price Decrease Loss on Cash Position, Gain on Futures Position Gain on Cash Position, Loss on Futures Position No Gain or Loss on Cash Position, No Gain or Loss on Futures Position Stabilizing the Net Sale Price More on the Role of Correlation: An Example from the Corn Market Price Changes vs. Prices Levels: The Importance of Returns CHAPTER 7. HEDGING AND THE BASIS Hedging and Basis Changes Actual Values and Expected Values Basis Behavior and the Correlation of Returns Long Hedging and Basis Behavior Rising Prices, Positive Initial Basis, and Basis Strengthens Rising Prices, Positive Initial Basis, and Basis Weakens Rising Prices, Negative Initial Basis, and Basis Strengthens Rising Prices, Negative Initial Basis, and Basis Weakens Falling Prices, Positive Initial Basis, and Basis Strengthens Falling Prices, Positive Initial Basis, and Basis Weakens Falling Prices, Negative Initial Basis, and Basis Strengthens Falling Prices, Negative Initial Basis, and Basis Weakens Basis Impact on Long Hedging Results Short Hedging and Basis Behavior Falling Prices, Positive Initial Basis, and Basis Strengthens Falling Prices, Positive Initial Basis, and Basis Weakens Falling Prices, Negative Initial Basis, and Basis Strengthens Falling Prices, Negative Initial Basis, and Basis Weakens Rising Prices, Positive Initial Basis, and Basis Strengthens Rising Prices, Positive Initial Basis, and Basis Weakens Rising Prices, Negative Initial Basis, and Basis Strengthens Rising Prices, Negative Initial Basis, and Basis Weakens Basis Impact on Short Hedging Results CHAPTER 8. HEDGING ENHANCEMENTS Types of Hedges Anticipatory Hedge Inventory Hedge Rolling a Hedge Reasons for Rolling a Hedge Rolling Forward a Long Hedge Rolling Back a Short Hedge Limits on Rolling Forward or Rolling Back Cross-Hedging Why Cross-Hedging is Necessary Cross-Hedging Grain Sorghum Using Corn Futures Regression Equation Hedge Ratio Converting the Hedge Ratio into Futures Contracts Hedging Effectiveness Using Price Changes vs. Price Levels in Regressions CHAPTER 9. PROFIT MARGIN HEDGING AND INVERSE HEDGING Profit Margin Hedging Soybean Crush Margin Crude Oil Refining Margin Cattle Feeding Margin Other Processing Spreads Inverse Hedging Long Inverse Hedge with a Short Forward Contract Using Long Futures to Offset a Short Forward Drawbacks of a Long Inverse Hedge Short Inverse Hedge with a Long Forward Contract Using Short Futures to Offset a Long Forward Drawbacks of a Short Inverse Hedge CHAPTER 10. HEDGING AND BASIS TRADING Redefining the Basis and the Cash Price Basis as a Tangible Value Defining the Impact of Basis Changes Commercial Hedging Short Hedging – Buying the Basis Long Hedging – Selling the Basis CHAPTER 11. BASIS TRADING AND ROLLING A HEDGE Rolling a Hedge to Capture a Favorable Basis Rolling Forward a Long Hedge Spread-Adjusted Futures Prices Spread-Adjusted Basis Values Rolling Back a Short Hedge Spread-Adjusted Futures Prices Spread-Adjusted Basis Values Spreads, the Forward Curve, and Basis Behavior Spread Impact on Hedging Results Basis Impact of an Implicit Bear Spread Basis Impact of an Implicit Bull Spread CHAPTER 12. SPECULATION IN FUTURES Speculation vs. Investment Speculative Styles Scalping Position Trading Spreading Intra-Market Spreads Inter-Market Spreads Speculators and Speculative Impact Commitments of Traders Open Interest as the Measure of Commitment Reportable Traders by Specific Occupation or Activity Producer/Merchant/Processor/User Swap Dealers Managed Money Other Reportables Total Reportable Positions Nonreportable Positions Percent of Open Interest Held by Largest Traders Speculative Participation in Commodity Futures Speculative Vehicles Returns to Speculation CHAPTER 13. INTRODUCTION TO OPTIONS ON FUTURES How Options Work An Example from Real Estate Options on Futures Option Buyers and Sellers Exercise or Abandon In the Money vs. Out of the Money Intrinsic Value of an Option Similarities between Options and Insurance Option Trading Time Value of an Option Time Value Decay Exercise and Assignment Potential Gains and Losses, Margins and Margin Calls Automatic Exercise Option Expiration Date and Futures Delivery Trading Venue and Method Clearing and Settlement Market Regulation Options on Actuals CHAPTER 14. OPTION PRICING The Black Model Call Option Formula Call Option Pricing Example Put Option Formula Put Option Pricing Example Measuring Volatility Model Assumptions and Shortcomings Put-Call Parity Pricing with Put-Call Parity Identifying and Arbitraging Price Discrepancies Option Sensitivity and the Greeks Properties of Delta and Trading Applications Properties of Gamma Properties of Theta Properties of Rho Properties of Vega Summary CHAPTER 15. PROFIT TABLES AND PROFIT DIAGRAMS Futures and Cash Positions: Linear Profits Long Futures Sh

Paul E. Peterson is a Clinical Professor of Finance at the University of Illinois at Urbana-Champaign. His primary focus is futures and options markets, particularly in relation to commodity prices and risk management. Other interests include marketing practices and pricing issues.