Getting Started On Commodities


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Short overview of most commodity markets , some basic presentation of commodity derivatives

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Getting Started On Commodities

  1. 2. Contents <ul><li>Introduction </li></ul><ul><li>Instruments </li></ul><ul><li>Market example: LME </li></ul><ul><li>Framework for trading </li></ul><ul><li>Modeling & pricing framework </li></ul><ul><li>Conclusion </li></ul>
  2. 3. Contents <ul><li>Introduction </li></ul><ul><li>Instruments </li></ul><ul><li>Market example: LME </li></ul><ul><li>Framework for trading </li></ul><ul><li>Modeling & pricing framework </li></ul><ul><li>Conclusion </li></ul>
  3. 4. Introduction – History <ul><li>The modern commodity markets have their roots in the trading of agricultural products. </li></ul><ul><li>Late 1636 - 'Tulipomania' in Holland </li></ul><ul><li>Japan introduced what is believed to be the world's first futures exchange, the Dojima Rice Market, in the early 18th century.. (Standardized market) </li></ul><ul><li>Modern &quot;forward&quot;, or futures agreements, began in Chicago in the 1840s, with the appearance of the railroads </li></ul>
  4. 5. Introduction – Now <ul><li>More: </li></ul>Energy, Agricultural, Industrial metals, Precious metals NYMEX New-York Mercantile Exchange Agricultural, Biofuels, Precious metals CBOT Chicago Board Of Trade Industrial metals, Plastics LME London Metal Exchange
  5. 6. Contents <ul><li>Introduction </li></ul><ul><li>Instruments </li></ul><ul><li>Market example: LME </li></ul><ul><li>Framework for trading </li></ul><ul><li>Modeling & pricing framework </li></ul><ul><li>Conclusion </li></ul>
  6. 7. Instruments – Classification <ul><li>Conventional products </li></ul><ul><ul><li>Agricultural commodities </li></ul></ul><ul><ul><ul><li>Sugar, Coffee and Soybean </li></ul></ul></ul><ul><ul><li>Metals Markets and the London Metal Exchange </li></ul></ul><ul><ul><li>Energy Commodities </li></ul></ul><ul><ul><ul><li>Oil, Gas </li></ul></ul></ul><ul><li>Non-conventional products </li></ul><ul><ul><li>Tele-commodities </li></ul></ul><ul><ul><ul><li>Bandwidth </li></ul></ul></ul><ul><ul><li>Power Commodities </li></ul></ul><ul><ul><ul><li>Electricity </li></ul></ul></ul><ul><ul><li>Weather </li></ul></ul><ul><ul><ul><li>HDD & CDD </li></ul></ul></ul><ul><ul><li>Emission </li></ul></ul><ul><ul><ul><li>CO2 certificates </li></ul></ul></ul>
  7. 8. Instruments – Core instruments <ul><li>Spot / intraday trading </li></ul><ul><ul><li>Any transaction where delivery either takes place immediately or within a short delay </li></ul></ul><ul><li>Futures contracts (FUT) </li></ul><ul><ul><li>Any standardized transaction where delivery takes place in the future </li></ul></ul><ul><ul><li>Ex : Powernext </li></ul></ul><ul><ul><ul><li>3 next months, 4 next quarters, 3 next years </li></ul></ul></ul><ul><li>Forward contracts (FW) </li></ul><ul><ul><li>Any transaction where delivery takes place in the future </li></ul></ul><ul><ul><li>Ex : Counterparty X </li></ul></ul><ul><ul><ul><li>2 next weekends, 4 next weeks, 12 next months, 4 next quarters, 4 next years… </li></ul></ul></ul>
  8. 9. Instruments – Futures & Forward <ul><li>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. </li></ul><ul><li>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. </li></ul><ul><li>Example 2 : Buying 25 MW of Cal 2009 Baseload electricity at 61.65€/MWh (last settlement price on 6th Feb 2008, Powernext) </li></ul><ul><ul><li>Cash = 61.65 * 25 * 8760 = 13 501 350 € </li></ul></ul>
  9. 10. Instruments – Futures & Forward
  10. 11. Contents <ul><li>Introduction </li></ul><ul><li>Instruments </li></ul><ul><li>Market example: LME </li></ul><ul><li>Framework for trading </li></ul><ul><li>Modeling & pricing framework </li></ul><ul><li>Conclusion </li></ul>
  11. 12. Market example: LME <ul><li>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. </li></ul><ul><li>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. </li></ul><ul><li>Platinum and palladium are traded on the London Platinum and Palladium Market. </li></ul><ul><li>28/04/08 – London Metal Exchange launch steel futures trading. </li></ul>
  12. 13. Market example: LME <ul><li>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. </li></ul><ul><li>Trading </li></ul><ul><ul><li>Electronic Plateform (LME SELECT) </li></ul></ul><ul><ul><li>Telephone (70% of trading) </li></ul></ul><ul><ul><ul><li>2 sessions (morning & afternoon) </li></ul></ul></ul><ul><ul><ul><ul><li>2 ring 5min per session </li></ul></ul></ul></ul><ul><ul><ul><ul><li>1 Kerb Trading (90 min & 45 min) </li></ul></ul></ul></ul>
  13. 14. Market example: LME
  14. 15. Contents <ul><li>Introduction </li></ul><ul><li>Instruments </li></ul><ul><li>Market example: LME </li></ul><ul><li>Framework for trading </li></ul><ul><li>Modeling & pricing framework </li></ul><ul><li>Conclusion </li></ul>
  15. 16. Framework for trading – Players <ul><li>Physical nature </li></ul><ul><ul><li>2 main behaviors </li></ul></ul><ul><ul><ul><li>Speculative & Supply </li></ul></ul></ul><ul><li>Commercials </li></ul><ul><ul><li>The entities involved in the production, processing or merchandising of a commodity </li></ul></ul><ul><li>Large Speculators </li></ul><ul><ul><li>A group of investors that pool their money together to reduce risk and increase gain </li></ul></ul><ul><li>Small Speculators </li></ul><ul><ul><li>Individual commodity traders </li></ul></ul>
  16. 17. Framework for trading – Basics <ul><li>Forward vs Spot strategies </li></ul><ul><ul><li>Backwardation or Contango? </li></ul></ul><ul><ul><ul><li>Contango = futures price > spot price </li></ul></ul></ul><ul><ul><ul><li>Backwardation (inverted curve) = futures price < spot price </li></ul></ul></ul><ul><li>Storage arbitrage </li></ul><ul><ul><li>Buy in summer sell in winter </li></ul></ul><ul><ul><li>Profitable if Cost of storage < Winter – Summer </li></ul></ul><ul><li>Physical consideration and connexity </li></ul><ul><ul><li>Storage, transport, interconnexion, convenience yield </li></ul></ul>
  17. 18. Contents <ul><li>Introduction </li></ul><ul><li>Instruments </li></ul><ul><li>Market example: LME </li></ul><ul><li>Framework for trading </li></ul><ul><li>Modeling & pricing framework </li></ul><ul><li>Conclusion </li></ul>
  18. 19. Modeling & pricing framework – Dynamic of prices 1/2 <ul><li>The physical nature… </li></ul>… implies specific properties
  19. 20. Modeling & pricing framework – Dynamic of prices 2/2 <ul><li>Yearly Seasonality and Jumps </li></ul><ul><ul><li>Ex: Gas Futures </li></ul></ul><ul><li>Mean Reversion, Spikes, Stochastic Volatility… </li></ul><ul><ul><ul><li>Source: </li></ul></ul></ul><ul><ul><ul><li>Source: </li></ul></ul></ul>
  20. 21. Modeling & pricing framework – Volatilities
  21. 22. Modeling & pricing framework – Modeling <ul><li>Basic Framework </li></ul><ul><ul><li>Vasicek [1977] Heath, Jarrow & Morton [1992], Cortazar & Schwartz [1994] </li></ul></ul><ul><li>Multifactor model </li></ul><ul><ul><li>Including factors like convenience yield, cost of carry </li></ul></ul><ul><li>Hybrid Models Financial / Physical </li></ul><ul><ul><li>Including exogenous variables </li></ul></ul><ul><li>Increasing the number of parameters </li></ul><ul><ul><li>Creates competition and conflicts (calibration) </li></ul></ul>
  22. 23. Modeling & pricing framework – Example 1 <ul><li>Deng (Oil & Electricity) </li></ul><ul><ul><li>Used for Spark Spread pricing </li></ul></ul><ul><ul><ul><li>X = Electricity, Y = Cost Oil -> Electricity </li></ul></ul></ul><ul><ul><ul><li>dNt = bidimentional jump process </li></ul></ul></ul><ul><ul><ul><li>λ (Ut) = Jump Intensity governed by a Markov Chain Ut </li></ul></ul></ul><ul><ul><li>Remark: under some conditions, analytics solution exists </li></ul></ul><ul><li>Kenyon & Cheliotis (Bandwidth) </li></ul><ul><ul><li>S = Price, V = Poisson Process, U = Markov chain, G = Gamma process </li></ul></ul>
  23. 24. Modeling & pricing framework – Example 2a <ul><li>Gas storage valuation </li></ul><ul><ul><li>Buy in April / May for ~ 19.75 </li></ul></ul><ul><ul><li>Sell in Dec / Jan for ~ 53.64 </li></ul></ul><ul><ul><li>Intrinsic Value for 2 * 500 lots = (53.64 – 19.75) * 1000 * 1000 = 33 895 000 </li></ul></ul>
  24. 25. Modeling & pricing framework – Example 2b <ul><li>Movement of Forward Curve </li></ul><ul><ul><li>New optimal position and extrinsic value </li></ul></ul>
  25. 26. Modeling & pricing framework – Example 2c <ul><li>Futures prices could be modeled as correlated Geometric Brownian motion governed by a volatility term structure and a correlation matrix </li></ul><ul><li>Monte Carlo simulation is used to simulate the forward price movement </li></ul><ul><li>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 </li></ul><ul><li>Storage Value = </li></ul>
  26. 27. Contents <ul><li>Introduction </li></ul><ul><li>Instruments </li></ul><ul><li>Market example: LME </li></ul><ul><li>Framework for trading </li></ul><ul><li>Modeling & pricing framework </li></ul><ul><li>Conclusion </li></ul>
  27. 28. Conclusion <ul><li>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. </li></ul><ul><li>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 </li></ul><ul><li>Physical delivery ,Theory of storage Transport & Convenience Yield </li></ul><ul><li>There is room for people : </li></ul><ul><ul><li>Taking into account economical and / or technical constraints </li></ul></ul><ul><ul><li>Having skills for the exploitation of low quality data </li></ul></ul>
  28. 29. Reference <ul><li>Market </li></ul><ul><ul><li>LME: </li></ul></ul><ul><ul><li>CBOT: </li></ul></ul><ul><ul><li>ICE: </li></ul></ul><ul><ul><li>Liffe: </li></ul></ul>