5. Commodities Flashcards
Spot Market
For immediate delivery
Forward Contract
Is a bilateral contract that obligates one party to buy and one party to sell a specific quantity of an asset, at a set price, on specific date in the future.
Futures Contract
Is a forward contract that is standardized and exchange-traded.
**Main difference between the two is that futures are traded in an active secondary market, are regulated, backed by a clearinghouse, and require daily settlement of gains and losses.
Regulated by CFTC
CFTC
Commodity Futures Trading Commission
Open Interest in Futures Market
- Number of outstanding contracts.
- A long position and a short position on the same contracts are counted as one contract towards open interest.
Commodity Swaps
Custom, privately negotiated packages of forward contracts that have a pre-specified prices (which may vary) and different expiration dates.
- OTC instruments with limited liquidity
Marking-to-market
Change in contact value is transferred in cash from the margin account of the counterparty with a loss in value to the margin account of the counterparty with a gain in value.
Initial Margin
- collateral that must be deposited in a futures account before trading takes place.
- generally, relatively low amount.
Maintenance Margin
Amount of margin that must be maintained in a futures account and is usually set at 75-80% of the initial margin.
Nearby Contract
Futures contract with the shortest time to expiration
Deferred Contract
Longer maturity futures contracts.
Term Structure of Forward Prices
- relationship between he forward prices and time.
- concerned with asset’s spot price,S, and it’s forward price, F(T), where T represents the time until the contract maturity in years.
Simple Forward Pricing Model
F(T) = S for all maturities, T
where,
F(T)= current forward price of a contract expiring at time T
S = spot price
For the above to hold true, following assumptions:
- no transaction costs
- risk free rate zero
- underlying assets can be borrowed at zero
- no div yield, convenience yield, storage costs
- underlying asset can be easily obtained
Contango
A price pattern where forward prices are above the spot price and converge to the spot price from above over time.
- Upward sloping forward curve
Backwardation
Instances in which forward prices are less than the current spot price
Cost of Carry
Measure of financial difference between holding a position in a spot market and hooding a position in a forward market.
Cash and Carry Arbitrage Strategy
At initiation of strategy:
- sell forward contract at F(T)
- borrow cash at risk free, for term of contract, T
- use borrowed funds to buy underlying asset
At contract expiration:
- deliver underlying asset, receive forward price F(T)
- repay interest and principal on the loan
Price of Future Contract > Price Implied
cash and carry arbitrage strategy
Reverse Cash and Carry Arbitrage Strategy
At initiation of strategy:
- buy forward contract at F(T)
- sell underlying asset short at current spot, S
- lend cash received from short at risk free, r
At contract expiration:
- collect loan proceeds, plus interest
- use collect loan proceeds to take delivery of asset at the forward price and cover the short- sale commitment
Forward Pricing Arbitrage Equation
F(T) = S x e^(rxT)
where:
F(T) = price of forward contract
S = spot price of the underlying asset
e = transcendental number used to calculate, ~2.718
r = risk free rate
T = time to maturity of the forward contract
Financial forward equation
F(T) = S x e^[(r-d)xT)]
where:
d= continuously compounded dividend or coupon rate
Financial Forward Pricing Relationships
- F(T) >S when r>d, resulting in an upward sloping forward curve (i.e. contango); slightly convex
- F(T) < S when r <d, resulting in a downward sloping curve (i.e.) a backwardation market; slightly concave
Explanation of Why Forward Prices are Reduced when
r < d
- dividends and coupons cause the value of financial assets to decrease on the day of the distribution. Forward contracts with maturities after the distribution date must reflect the decline in value.
- Forward contracts only account for the present value of the market price at time T, not the PV of dividends or coupon rates, therefore the forward contract price must be less than the spot.
Convenience Yield
Reflects the return form holding the physical asset