chapter 35 Energy and commodity derivatives Flashcards
What are agricultural commodities?
Agricultural commodities include products that are grown (or created from products that are grown) such as corn, wheat, soybeans, cocoa, coffee, sugar, cotton, and frozen orange juice. They also include products related to livestock such as cattle, hogs, and pork bellies.
What factors influence the price of agricultural commodities?
The prices of agricultural commodities, like all commodities, are determined by supply and demand, and are impacted by factors such as the stocks-to-use ratio, mean reversion in prices, seasonality, weather, and their use in livestock production. The volatility of the price of a commodity that is grown tends to be highest at pre-harvest times and then declines when the size of the crop is known.
What factors influence the price of metals?
The price of metals is determined by trends in their use in production processes, new sources of the metal, changes in extraction methods, geopolitics, cartels, environmental regulation, and inventory levels. Metals are not seasonal, unaffected by the weather, and are relatively easy to store. Exchange rate volatility and recycling processes also have an impact. For metals that are consumption assets, there may be some mean reversion, as changes in the price affect the attractiveness of using or extracting the metal. Metals that are investment assets are not usually assumed to follow mean-reverting processes.
What are the reasons for supposing that all three types of energy derivatives (oil, natural gas, and electricity.) follow mean-reverting processes?
The reasons for supposing that all three types of energy derivatives follow mean-reverting processes are that as the price of a source of energy rises, it is likely to be consumed less and produced more, creating a downward pressure on prices. Conversely, as the price of a source of energy declines, it is likely to be consumed more, but production is likely to be less economically viable, creating upward pressure on the price.
What are two important benchmarks for pricing crude oil?
The two important benchmarks for pricing crude oil are Brent crude oil (sourced from the North Sea) and West Texas Intermediate (WTI) crude oil.
Are virtually any derivative that is available on common stocks or stock indices available with oil as the underlying asset?
Yes, in the over-the-counter market, virtually any derivative that is available on common stocks or stock indices is now available with oil as the underlying asset.
What is a typical over-the-counter contract for natural gas?
A typical over-the-counter contract for natural gas is for the delivery of a specified amount of natural gas at a roughly uniform rate over a 1-month period.
What is the maximum supply of electricity in a region at any moment determined by?
The maximum supply of electricity in a region at any moment is determined by the maximum capacity of all the electricity-producing plants in the region.
What is a major use of electricity, and what effect does this have on its demand and price?
A major use of electricity is for air-conditioning systems, and as a result, the demand for electricity, and therefore its price, is much greater in the summer months than in the winter months.
What is the CME Group’s futures contract on the price of electricity, and what other energy derivatives are available for electricity?
The CME Group’s futures contract on the price of electricity is a typical contract that allows one side to receive a specified number of megawatt hours for a specified price at a specified location during a particular month. There is also an active over-the-counter market in forward contracts, options, and swaps available for electricity.
What are the similarities between derivative and insurance contracts used for hedging purposes?
Derivative and insurance contracts used for hedging purposes are similar in that they are designed to provide protection against adverse events.
What is a CAT bond?
A CAT bond is a bond issued by a subsidiary of an insurance company that pays a higher-than-normal interest rate in exchange for an excess-of-loss reinsurance contract. The interest or principal (or both) can be used to meet claims, and bondholders may lose some or all of their principal if losses exceed a certain threshold.
What is a key feature of weather and insurance derivatives that allows them to be priced using historical data?
The lack of systematic risk in their payoffs means that real-world estimates can be assumed to apply to the risk-neutral world, allowing them to be priced by estimating the expected payoff and discounting it at the risk-free rate.
How does uncertainty about the underlying variables in weather and insurance derivatives grow with time compared to stocks and commodities?
Uncertainty about weather and insurance derivatives grows much less marked with time compared to stocks and commodities, where uncertainty grows roughly as the square root of time or is still considerably greater than uncertainty in 1 year, respectively.
What are some examples of underlyings for commodity derivatives?
Agricultural products, livestock, metals, and energy products.
