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Commodity futures have commodities as underlying assets.

Futures on commodities help mitigate price risk.

Trading in forward and futures on commodities is not new. It has been in vogue for more than 100 years.

Chapter 3 Commodity Futures

Derivatives and Risk ManagementBy Rajiv Srivastava 2

Copyright © Oxford University Press

Futures on commodities due to its possible use as a speculative product are often thought as unwarranted and as a disservice to society.

Futures contracts on commodities result in price discovery, reducing seasonal price variations, efficient dissemination of information, reduced cost of credit, and more efficient physical markets.




The usual tools of containing the volatility in the commodity prices like buffer stocks, controlled and phased release of commodities, minimum support price etc have either failed or have proved too expensive for the economy.

Commodity futures trading in developing country can contribute a lot to the stability of fiscal management, increasing the effectiveness of price protection at national level and improving the efficiency of social programmes.




Stability to Government’s RevenueGovernment budget, developmental expenditure, and position of balance of payment are crucially dependent upon prices of commodities. Volatility in commodity prices causes volatility in budgetary provisions and government’s developmental expenditure. Therefore at national level there is a need to reduce the volatility.

Eliminating Minimum Support Price and SubsidyCommodity futures trading helps smooth out the variability in government’s revenue and transfers the price risk management from government to private participants.




Futures contracts on commodities differ significantly from those on financial assets in terms of quality specifications and delivery mechanism. The consumption value makes valuation of futures

contracts on commodities difficult. Quality of underlying asset is immaterial in case of

financial products, whereas there is ample scope of controversy over quality in case of commodity futures.

Commodity futures are governed by seasons and perishable nature of the underlying asset.

Commodities (the agricultural products) is confined to the harvesting period while the consumption is uniform throughout the year.




The pricing of futures contracts commodities cannot use “no arbitrage argument” due to convenience yield attached with commodities. Cash and carry arbitrage stipulates the

following:F ≥ (S0 + s) ert

Due to consumption value of the asset the reverse cash and carry implying shorting the asset and buying futures is not feasible. Therefore, we only have an upper bound to the futures price as below:

F ≤ (S0 + s) ert




Assume that spot price of cardamom is Rs 714 per kg. If financing cost are 10% per annum with continuous compounding what should be the price of the 3-m futures contract on cardamom? If warehousing and insurance cost are placed at 1% what would be the fair value of the 3-m futures contract?

Solution The fair value of futures contract is given only as upper

boundF1 ≤ S0 x ert , F1 ≤ 714 x e0.10 x 3/12 = Rs 732.07 per kg

Warehousing and insurance cost would be added to the financing cost for determining the upper bound of fair value of the futures

F1 ≤ S0 x ert , F1 ≤ 714 x e0.11 x 3/12 = Rs 733.91 per kg




Long and Short PositionsHedging Principle

Short HedgeLong Hedge




Long and Short Positions When one holds the underlying asset he is said to

be long on the asset. For example a jeweller holding gold or silver is long on the asset.

The one who requires the asset in future is said to be short. For example a tea exporter needs stock of tea to execute the pending orders is short on tea.

Similarly in the futures market if one buys a futures contract he is said to be

long, and if one sells the futures contract he is said to be

short.




To execute a hedge following steps are taken: One who is long on the asset, goes short on the

futures market, and the one who is short on underlying goes long in the futures market.

At an appropriate time one can neutralise the position in the futures market, i.e. go long on futures if one was originally short and go short on futures if one was originally long, and receive/pay the difference of prices.

Sell or buy the underlying asset in the physical market at prevailing price.




When one has long position in the asset he needs to take a short position in futures to hedge. It is referred as short hedge.

For example, a sugar mill would go short on the futures contract on sugar to hedge against the fall in price.

If prices fall the short position in futures would yield profit compensating for the loss due to reduced realized value of sugar in the spot market.




Consider a sugar mill. It is expected to produce 100 MT of sugar in the month of April. The current price today (the month of February) is Rs 22 per Kg. April futures contract in sugar due on 20th April is trading at Rs 25 per Kg. The sugar mill apprehends that the price lesser than Rs 25 per Kg will prevail in April due to excessive supply then.

How can the sugar mill hedge its position against the anticipated decline in sugar prices in April? To execute the hedging strategy the sugar mill takes

opposite position in the futures market. The sugar mill is long on the asset in April. Therefore it

needs to sell the futures contract today.




If price falls to Rs 22 per Kg. Cash flow (Rs per Kg.) Sold futures contract in February + 25.00 Bought futures contract in April - 22.00

Gain in the futures market + 3.00 Price realised in the spot market +22.00 Effective price realised Rs 25.00 per Kg.

Here the loss of Rs 3 (Rs 25 – Rs 22) in the spot market is made up by an equal gain in the futures market.




If price rises to Rs 26 per Kg. Cash flow (Rs/Kg.) Sold futures contract in February + 25.00 Bought futures contract in April - 26.00

Loss in the futures market - 1.00 Price realised in the spot market +26.00 Effective price realised Rs 25.00 per Kg.

Here the gain of Rs 1 (Rs 26 – Rs 25) in the spot market is offset by the equal loss in the futures market.




When one has short position in the asset he needs to take a long position in futures to hedge. It is referred as long hedge.

For example, an importer of oil would go long on the futures contract on oil to hedge against the rise in price.

If prices indeed rise the long position in futures would yield profit compensating for the loss due to increased price of oil in the spot market.




A perfect hedge is one where loss on the physical position is exactly offset by gain in the financial position and vice-versa.



The Perfect Hedge

Short on underlyingGain Long on Futures

Gain inphysical market

PriceLoss in futures market

Loss


Except by coincidence futures hedge is imperfect. The gains/losses in the futures do not exactly offset the loss/gains in the physical position because: the exposure in the underlying and futures market is

not on the identical asset of same quality, the value of exposure in the underlying and the

futures are not same because futures contract have fixed size.

the time of maturity of the futures contract is not same as the time of exposure in the physical position because maturities of futures contract are specific.




Basis is difference of futures price, F and spot price, S. It declines as time to maturity approaches. Basis at the beginning is B0 = F0 – S0

Basis at the end is B1 = F1 – S1

With futures hedge we have opposite positions in physical and futures markets. Gain/loss in the spot market = S1 – S0

Gain/loss in the futures market = F0 – F1




In a hedged portfolio consisting of long/short position in the spot and short/long position in futures we have net gain/loss on the portfolio

= S1 – S0 + F0 – F1 = (F0 – S0) – (F1 – S1) = B0 – B1

The risk in the hedged portfolio would be equal to the difference of basis at start and end of hedge.

Hedging risk with futures is not perfect. Price risk gets replaced by much smaller basis risk.






Hedge ratio is the number of futures contract to have minimum risk. It depends upon the risks in the spot prices, futures prices and the co-efficient of correlation between the two.

Where h* = Optimum Hedge Ratioρ = Correlation coefficient of spot and futures priceσs, σf = Standard deviations of spot & futures prices

respectively

f

s*hσσ

ρ=




Futures can also be used for hedging against the quantity uncertainties as price and quantity have inverse relationship.

Hedge ratio for quantity hedging depends upon the ratio of covariance of revenue and variance of price.

price of Varianceprice withrevenue of Covariancehedging for Quantity =


Futures can be used for speculation if the estimate of future spot price is different than the futures price.

To speculate on the prices of commodities one has to do one of the following: If a trader expects a price fall he simply has to

sell a futures contract today and buy it later; If a trader anticipates a rise in prices he simply

has to buy the futures today and sell later;




Spread strategies in futures are concerned with the mispricing of futures contracts

a) in two different assets called Inter-commodity spread

b) in two different markets called Inter-market spread

c) of two different maturities called Calendar spread




Spread strategies can be used for protecting gross profit margin where futures are available on inputs and outputs. For example sugarcane and sugar.

Variations in gross profit margin can be minimized By going long on futures of raw material we can

have assured raw material price and hence the cost.

By going short on futures on finished goods items we can have assured prices for finished goods.

With revenue and cost hedged the gross profit margin can be protected or made more stable.




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