getting started on commodities

Getting started on commodities

Nicolas Rouveyrollis

Tuesday, May 20th 2008

Getting started on commodities 2

Contents

Introduction

Instruments

Market example: LME

Framework for trading

Modeling & pricing framework

Conclusion


Contents

Introduction

Instruments

Market example: LME



Conclusion


Introduction – History

The modern commodity markets have their roots

in the trading of agricultural products.

Late 1636 - 'Tulipomania' in Holland

Japan introduced what is believed to be the world's first futures exchange, the Dojima Rice Market, in the early 18th century.. (Standardized market)

Modern "forward", or futures agreements, began in Chicago in the 1840s, with the appearance of the railroads


Introduction – Now

More: http://en.wikipedia.org/wiki/Commodities_exchange

London Metal Exchange LME Industrial metals, Plastics

Chicago Board Of Trade CBOTAgricultural, Biofuels, Precious metals

New-York Mercantile Exchange NYMEXEnergy, Agricultural, Industrial metals, Precious metals


Contents

Introduction

Instruments

Market example: LME



Conclusion


Instruments – Classification

Conventional products• Agricultural commodities

Sugar, Coffee and Soybean• Metals Markets and the London Metal Exchange• Energy Commodities

Oil, Gas

Non-conventional products• Tele-commodities

Bandwidth• Power Commodities

Electricity• Weather

HDD & CDD• Emission

CO2 certificates


Instruments – Core instruments

Spot / intraday trading• Any transaction where delivery either takes place immediately

or within a short delay

Futures contracts (FUT)• Any standardized transaction where delivery takes place in

the future• Ex : Powernext

3 next months, 4 next quarters, 3 next years

Forward contracts (FW)• Any transaction where delivery takes place in the future• Ex : Counterparty X

2 next weekends, 4 next weeks, 12 next months, 4 next quarters, 4 next years…


Instruments – Futures & Forward

FUT/FW do not trade in shares like stocks. They trade in contracts. Each FUT/FW contract has a size that has been set up.

For example, the contract size for gold futures is 100 ounces. That means when you are buying 1 contract of gold, you are really controlling 100 ounces of gold. If the price of gold moves $1 higher, that will affect the position by $100($1 x 100 ounces). You need to check each commodity or futures contract since most of them are different.

Example 2 : Buying 25 MW of Cal 2009 Baseload electricity at 61.65€/MWh (last settlement price on 6th Feb 2008, Powernext)• Cash = 61.65 * 25 * 8760 = 13 501 350 €


Instruments – Futures & Forward


Contents

Introduction

Instruments

Market example: LME



Conclusion


Market example: LME

The London Metal Market and Exchange Company was founded in 1877 but the market traces its origins back to 1571 and the opening of the Royal Exchange. At first only Copper was traded, Lead and Zinc were soon added but only gained official trading status in 1920 . The exchange was closed over WW II and did not re-open until 1952. Other metals traded extended to include aluminium (1978), nickel (1979) and aluminium alloy (1992). The exchange also started trading plastics in 2005. The total value of the trade is around $8,500 billion annually.

Contrary to popular belief, the precious metals, gold and silver are not traded on the London Metal Exchange, but on the over-the-counter market usually referred to as the London Bullion Market.

Platinum and palladium are traded on the London Platinum and Palladium Market.

28/04/08 – London Metal Exchange launch steel futures trading.


Market example: LME

The London Metal Exchange or LME is the futures exchange with the world's largest market in options and futures contracts on base and other metals. As the LME offers contracts with daily expiry dates up to three months from trade date, along with longer dated contracts, it also allows for cash trading. It offers hedging, worldwide reference pricing and the option of physical delivery to settle contracts.

Trading• Electronic Plateform (LME SELECT)• Telephone (70% of trading)

2 sessions (morning & afternoon)– 2 ring 5min per session– 1 Kerb Trading (90 min & 45 min)


Market example: LME


Contents

Introduction

Instruments

Market example: LME



Conclusion


Framework for trading – Players

Physical nature• 2 main behaviors

Speculative & Supply

Commercials• The entities involved in the production, processing or

merchandising of a commodity

Large Speculators• A group of investors that pool their money together to

reduce risk and increase gain

Small Speculators• Individual commodity traders


Framework for trading – Basics

Forward vs Spot strategies• Backwardation or Contango?

Contango = futures price > spot price Backwardation (inverted curve) = futures price < spot

price

Storage arbitrage• Buy in summer sell in winter• Profitable if Cost of storage < Winter – Summer

Physical consideration and connexity• Storage, transport, interconnexion, convenience yield


Contents

Introduction

Instruments

Market example: LME



Conclusion


Modeling & pricing framework – Dynamic of prices 1/2

The physical nature…

… implies specific properties


Modeling & pricing framework – Dynamic of prices 2/2

Yearly Seasonality and Jumps• Ex: Gas Futures

Mean Reversion, Spikes, Stochastic Volatility…

Source: www.theice.com Source: www.poxernext.fr


Modeling & pricing framework – Volatilities


Modeling & pricing framework – Modeling

Basic Framework• Vasicek [1977] Heath, Jarrow & Morton [1992],

Cortazar & Schwartz [1994]

Multifactor model• Including factors like convenience yield, cost of carry

Hybrid Models Financial / Physical• Including exogenous variables

Increasing the number of parameters• Creates competition and conflicts (calibration)


Modeling & pricing framework – Example 1

Deng (Oil & Electricity)

• Used for Spark Spread pricing X = Electricity, Y = Cost Oil -> Electricity dNt = bidimentional jump process λ (Ut) = Jump Intensity governed by a Markov Chain Ut

• Remark: under some conditions, analytics solution existsKenyon & Cheliotis (Bandwidth)

• S = Price, V = Poisson Process, U = Markov chain, G = Gamma process


Modeling & pricing framework – Example 2a

Gas storage valuation• Buy in April / May for ~ 19.75• Sell in Dec / Jan for ~ 53.64• Intrinsic Value for 2 * 500 lots = (53.64 – 19.75) * 1000 * 1000 =

33 895 000

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Modeling & pricing framework – Example 2b

Movement of Forward Curve• New optimal position and extrinsic value

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Modeling & pricing framework – Example 2c

Futures prices could be modeled as correlated Geometric Brownian motion governed by a volatility term structure and a correlation matrix

Monte Carlo simulation is used to simulate the forward price movement

Variance/covariance matrix is the primary driver that affects price movement in terms of Magnitude of move and movements (or direction) of different months together

Storage Value =


Contents

Introduction

Instruments

Market example: LME



Conclusion


Conclusion

Commodities have the same premise as any other investment – you want to buy low and sell high. The difference with commodities is that they are highly leveraged and they trade in contract sizes instead of shares.

Quite often, innovations on commodity derivatives markets come from financial markets… without taking into account some specificities of commodity markets. A large part of Quantitative Framework derives from Fx Rates

Physical delivery ,Theory of storage Transport & Convenience Yield

There is room for people :• Taking into account economical and / or technical constraints• Having skills for the exploitation of low quality data


Reference

Market• LME: www.lme.co.uk• CBOT: www.cbot.com• ICE: www.theice.com• Liffe: www.euronext.com

getting started on commodities

Business

futures exchange

lme framework

gold futures

london metal market

exchange company

royal exchange

futures agreements

contract of gold