Commodity Portfolio Management

Levent Yilmaz I Summer 2019 I ISM 2019 1
ISM
M.Sc. Finance
Commodity Portfolio Management
Summer Term 2019
Levent Yilmaz
Source: Buchan, 2016, p.1

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For feedback, or improvements please contact:
Levent Yilmaz
levent.yilmaz@ism.de

Type and Duration of Exam:
Written exam 120 minutes
- Investment Banking 40 Minutes
- Commodities Portfolio Management 40 Minutes
- Real Estate Management 40 Minutes

CV – Levent Yilmaz
• 2017 – ISM, Lecturer, Commodity Portfolio Management, Rating
• 2017 - Tortorici & Partners, Geneva, Senior Director, Commodity Consultant,
• 2013 Innovative Energy GmbH, Frankfurt, Proprietary trader of oil, oil products, coal and gas
• 2011 N.M.F. AG, Frankfurt, Proprietary trader of oil/oil product futures and ETFs
• 2010 ČEZ, Prague, Proprietary trader of energy derivatives
• 2008 – 2009 Vattenfall Energy Trading, Copenhagen, Proprietary trader/analyst of energy
derivatives
• 2006 – 2008 Constellation Energy Commodities Group, London, Coal and Freight Market Analyst
• 2005 – 2006 Hadron Capital LLP, London Investment Analyst
• 2003 – 2005 Debtwire, London, Distressed Debt Analyst
• 2003 Moody’s, London, Banking Associate
• 2001 – 2002 S&P Capital IQ, London, European Banking Analyst

Content Page
1 Commodity Basics 7
2 Rationale for Investing in Commodities 36
3 Commodity Investment Vehicles 42
4. Drivers of Commodity Markets 167
5 Commodity Portfolio Management 207

1 Commmodity Basics
Page
1 Commodity Basics 7
1.1 Commodity Differentiation 9
1.2 Commodity Characteristics 15
1.3 Commodity Market Participants 18
1.4 Commitment of Traders Report 27
1.5 Open Interest 33

11 Commodity BasicsBasics
Commodity Characteristics
• Raw material or a primary agricultural resource, that can be purchased or
sold for production and/or consumption.
• These tangible assets have no credit risks and many of them are most of
time liquid.
• Commodities are traded on open markets throughout the world.
• Nearly no commodity price can go to zero, because commodities are
always likely to be worth something to somebody. Only Power Prices have
traded below 0.

11 Commodity BasicsBasics
Hull, 2012, p. 117
Commodities
Consumption Asset
- is an asset that is held primarily for
consumption.
- Usually provide no income
-- Can be subject to significant storage costs
- Examples of consumption assets are
commodities such as copper, oil, wheat,
coffee, pork bellies, etc.
Investment Asset
- It is not usually held for consumption.
- it needs not be held solely for investment
purposes.
- What is required is that some individuals hold it
for investment purposes and that these
individuals be prepared to sell their holdings and
go long forward contracts, if the latter look more
attractive.
- This explains why gold and silver, although it has
significant industrial uses, is an investment asset.

Commodities
Hard Commodities
Energy
Brent-Crude Oil,
WTI-Crude Oil,
Coal, Gas, Power
Precious Metals
Gold, Silver,
Palladium,
Rhodium,
Platinum, …
Industrial Metals
Aluminium,
Nickel, Titanium,
Chromium
Soft Commodities
Cattle
Feeder Cattle,
Livestock, Lean
Hog
Agriculture
Corn, Soybean,
Wheat, Orange
Juice
11.1 Commodity DifferentiationBasics

11.1 Commodity DifferentiationBasics
Physical Oil Market
• There are many grades of crude oil, reflecting variations in the gravity and the sulfur content.
• Two important benchmarks for pricing are Brent crude oil (which is sourced from the North Sea) and West Texas Intermediate (WTI) crude oil.
• Crude oil (= Primary form - either extracted or captured directly from natural resources) is refined into products such as gasoline, heating oil, fuel oil,
and kerosene (= secondary form - produced from primary commodities to satisfy specific market needs).
• Brent crude oil futures traded on International Continental Exchange (ICE) have a cash settlement option;
• The light sweet crude oil futures traded on Chicago Mercantile Exchange (CME) require physical delivery.
• In both cases, the amount of oil underlying one contract is 1,000 barrels. 1 oil barrel = 159 liter
• The CME Group also trades popular contracts on two refined products: heating oil and gasoline. In both cases, one contract is for the delivery of
42,000 gallons.
Geman, 2005, p.206
Crude stream Price Country/Region °API %S Pour Point (°F)
West Texas
Intermediate (WTI)
$63.92/bbl US 38-40 0.3
Brent blend $71.56/bbl North Sea 38 0.3
Dubai $70.24/bbl Middle and Far East 32 2% -5
Arabian Light $72.41 /bblSaudi Arabia 33.4 1.8 -30
Bonny Light $73.2/bbl Nigeria 37.6 0.1 +36

1.1 Commodity Differentiation
Geman, 2008, p.1
Continuosly Produced and Consumed? Seasonality in Demand?
Continuosly Produced and Consumed and are Not
Subject to significant Seasonality in Demand
Industrial Metals: Copper or Aluminium
Continuously Produced and Consumed, but exhibit
substantial Seasonality in Demand
Heating oil, Natural gas, and Gasoline
Produced seasonally, but there is also Variation
within the category of Seasonally Produced
commodities
Grains and Oilseeds: produced seasonally, but their
production is rel. flexible: major input – land – is
flexible; there is a possibility of growing Corn on a
piece of land one year and Soybeans the next, and
an adverse natural event (such as a freeze) may
damage one crop, but does not impair the future
productivity of land
Tree crops are Seasonally Produced, but Utilize
Specialized, Durable, and Inflexible Inputs (the
trees) and damage to these inputs can have
consequences for productivity that last beyond a
single crop year.
Cocoa, Coffee, Oranges

1.1 Commodity Differentiation
http://www.visualcapitalist.com/size-oil-market/

1.1 Commodity Differentiation – Commodity Exchanges
www.cmegroup.com, theice.com, lme.com, www.shfe.com.cn
Chicago Mercantile
Exchange (CME)
•Energy
•Crude Oil
Futures/Options
•Henry Hub
Natural Gas
Futures/Options
•RBOB Gasoline
Futures/Options
•NY Harbor ULSD
Futures/Options
•Agricultural
•Corn Futures
•Soybean Futures
•Soybean Oil
Futures
•Soybean Meal
Futures
•Wheat Futures
•Cattle Futures
•Metals
•Gold Futures
•Copper Futures
•Silver Futures
•Gold Options
•Platinum
Futures
•Palladium
Futures
Intercontinental
Exchange (ICE)
•Energy
•Brent Crude Oil
•Gasoil
•UK Nat Gas
•EUA
•Coal
•Agricultural
•Cocoa
•Coffee
•Cotton
•Sugar
•Metals
•Gold Future
•Silver Future
London Metal
Exchange (LME)
•Aluminium
•Copper
•Zinc
•Nickel
•Lead
•Tin
•Cobalt
•Gold
•Steel
Shanghai Futures
Exchange
•Non-ferrous
Metals Futures
•Copper
•Aluminium
•Zinc
•Lead
•Nickel
•Ferrous Metals
Futures
•Steel Rebar
•Steel Wire Rod
•Precious Metals
•Gold
•Silver
•Energy and
Chemicals Futures
•Oil
•Fuel Oil
•Bitumen
•Rubber
•Wood pulp
Dalian Commodity
Exchange
•Industrial
•Coking Coal
•Coke
•Iron or
•Ethylene Glycol
•PVC (Polyvinyl
Chloride)
•PP
(Polypropylene)
•LLDPE
(Polyethylene)
•Agricultural
•Corn
•Soybean
•Soybean Oil
•Soybean Meal
•Palm Olein
European Energy
Exchange (EEX)
•Power
•Gas
•EUA
Singapore
Exchange (SGX)
•Energy
•Coal
•Coking Coal
•Power
•Metals
•Iron Ore
•Steel
•Rubber
•Freight

1.1 Commodity Differentiation - Top Energy Products at the CME
Produ
ct
Name
Tick
er
Sym
bol
Daily
Volum
e
(Mio.)
Open
Intere
st
(Mio.)
Contr
act
Unit
Price
Quot
ation
Trading hours Listed
contracts
Settle
ment
metho
d
Termination of Trading Maintenance
Margin per contract
Mainten
ance
Volume
Scan
Crude
Oil
Future
s
CL 1.15 2.08 1,000
Barrel
s =
158,98
0
litters
USD
and
Cents
per
Barrel
CME Globex: Sunday to Friday
6:00 p.m. to 5:00 p.m. Chicago
time with 60 minutes break at
5:00 p.m.
Monthly
contracts for
the current
year and the
next 8 years.
Deliver
able
Trading in the current delivery month shall cease
on the 3rd business day prior to the 25th
calendar day of the month preceding the delivery
month. If the 25th calendar day of the month is a
non-business day, trading shall cease on the 3rd
business day prior to the last business day
preceding the 25th calendar day.
$ 4,275 for front-
month;
$ 4,100 for contracts
after the front
month
32% for
front-
month;
24%
Henry
Hub
Natura
l Gas
Future
s
NG 0.37 1.36 10000
mmBt
u
USD
and
Cents
pro
mmB
tu
See above Monthly
contracts for
the current
year and the
next 12 y.
Deliver
able
Trading of any delivery month shall cease 3
business days prior to the first day of the delivery
month.
$4,600 for front-
month
32% for
front-
month
RBOB
Gasoli
ne
Future
s
RB 0.19 0.4 42,000
Gallon
s
USD
and
Cents
pro
Gallo
n
s.a. Monthly
contracts are
listed for the
current and
next 3y.
Deliver
able
Trading of any delivery month shall cease 3
business days prior to the first day of the delivery
month.
$4,600 for Front-
month
40% for
front-
month
www.cmegroup.com

1.2 Commodity Characteristics
Trafigura, 2018a, p.9
Physical
commodities
suitable for
trading in
global markets
Delivered Globally,
including by Sea,
usually in Bulk
Economies of scale
favour bulk
delivery
Cost of
Transportation
makes Location a
significant Pricing
factor
Commodities with
similar physical
characteristics are
Exchangeable, but
these are not
Standard items.
Pricing is
determined by
product Quality
and Availability
Can be Stored

11.2.1 Commodity VolatilityBasics
Driven by Supply and Demand, Inventories, Transport Costs, Logistics, Speculation, Sentiment,
Geopolitical Factors
0
20
40
60
80
100
120
CBOE Crude Oil Volatility Index
Open High Low Close
0
5
10
15
20
25
30
35
40
45
50
Gold Volatility Index
Open High Low Close
0
1
2
3
4
5
Copper Price ($ per pound)
0.00
500.00
1,000.00
1,500.00
2,000.00
2,500.00
3,000.00
Feb-09
Aug-09
Feb-10
Aug-10
Feb-11
Aug-11
Feb-12
Aug-12
Feb-13
Aug-13
Feb-14
Aug-14
Feb-15
Aug-15
Feb-16
Aug-16
Feb-17
Aug-17
Feb-18
Aug-18
Aluminum Monthly Price - US Dollars per Metric Ton

11.2.1 Commodity VolatilityBasics
What Drives Commodity Volatility?
• Geopolitical and Headline Risk
• Commodities are sensitive to changes in the global macroeconomic landscape.
• Commodity reserves are located all over the world and the world has never been more economically
connected than we are today.
• Political events in one region can immediately affect prices everywhere.
• Wars or violence in an area can close significant logistical transportation or export/import routes.
• Tariff and trade war
• Supply and Demand
• The concept of supply and demand is the most basic of all economic fundamentals and is the backbone
of market economy.
• Commodities come from areas of the world where reserves are present in the crust of the earth and
where extraction, production and refinement occurs for a cost less than market value.
• Since almost every person in the world is a consumer and "demands" these commodities, there is rarely
a balance. This inherently leads to pricing volatility.

1.2.1 Commodity Volatility - Weather Impact on Iron Ore Supply
https://www.reuters.com/article/column-russell-ironore-idUSL3N21K1YG
Dam burst in Brazil at iron ore mine Tropical Cyclone Veronica

1.2.1 Commodity Volatility
Figure First Four Moments of Commodity Price returns over the period July 1993 – November 2000
Geman, 2005, p.59

1.2.1 Commodity Volatility
Figure Volatility comparison of commodities, interest rates and stocks
Geman, 2005, p.60
Volatility
Natural gas 66.87
Coffee 48.25
Copper 24.44
Interest-rate 10 Stock market 15-18
Gas: limited number and cost of storage facilities, the regional nature of the gas market which is not yet
today a world market, and its strong relationship with electricity, the most volatile commodity. But this
is changing with LNG.
Coffee: high risk related to weather conditions.
Metals: easier to store and inventories allow shocks in supply and demand to be absorbed

1.3 Commodity Market Participants
The Actors on Commodity Exchanges
Geman, 2015, p.13
Producers,
Consumers, and
Processors
• trade usually on the
exchange through
trading houses and
brokerage firms.
• They use the
exchange
instruments for the
purpose of hedging
commodity price
risk
Commodity Trading
Companies
• They use the
exchange to manage
the physical and
financial exposure
of their trading
activities
• E.g. Glencore, BHP,
Trafigura, Mercuria,
Brokerage Houses
• financial institutions
act as market
intermediaries
• make profits based
on fixed
commissions.
Managed Funds and
Institutional Investors
• Pensions and
insurance
companies investing
in commodities as a
way to mitigate
inflation risk.
• Since the 2000s,
hedge funds have
been attracted to
commodities to
diversify their
investments

1.3.1 Types of Futures Market Participants
Masters, 2008, p.18
HEDGER
• Reduce Price Risk
• Hedges Underlying
Position
• Consumes Liquidity
• Price Sensitive
• Take Long and
Short Positions
INDEX SPECULATOR
• Takes on Price Risk
• Profits from Price
Moves
• Consumes Liquidity
• Insensitive to Price
• Long Only
ARBITRAGEUR
• Arbitrageurs take
offsetting positions
in two or more
instruments at the
same time to lock
in a profit.
TRADITIONAL
SPECULATOR
• Takes on Price Risk
• Profits from Price
Moves
• Provides Liquidity
• Price Sensitive
• Take Long and
Short Positions
• Pretty much all decisions that are made by producers, merchants and consumers incorporates
some form of speculation.
• Commodity Trading Companies engage in speculation when determining what they are prepared
to pay now versus what the commodity will be worth in the future.

1.3.2 Commodity Trading Firms
Buchan,2016, p.9
Commodity trading firms bridge gaps
between producers and consumers
Space:
transport the
commodity to
alter its
location
Time: store the
commodity to
change the
timing of
delivery
Form: blend
the commodity
to affect its
quality or
grade

https://www.commoditiesdemystified.info/pdf/CommoditiesDemystified-summary-en.pdf#downloads
Traders and the Supply Chain
Traders act as conduits between producers and consumers in both primary (crude oil) and secondary
commodity markets (gasoline).

Geman, 2015, p.4
Transporting
commodities and raw
materials across the
world
By trucks,
merchandise
trains, barges,
vessels
Store/handle in
silos, crushers,
elevators in
ports
risk
management of
commodity
prices, shipping
rates, bunker
fuel costs,
currencies, and
shipping
insurance
Credit is managed by
trade finance banks,
which secure the
transactions
A central risk
platform in big
trading houses
has to
aggregate all
exposures
value of physical
stocks against
which logistics,
crushing, and
production are
optimized.

How does Physical Arbitrage work?
• Global commodity traders seek to identify and respond to supply and demand differentials
between linked markets.
• They use Arbitrage to trade physical commodities without incurring price risk.
– Arbitrage: The simultaneous purchase of a commodity/derivative in one market and the
sale of the same, or similar, commodity/derivative in another market in order to exploit
price differentials.
• They hedge price exposure using exchange-traded contracts and over-the-counter
instruments.
https://www.trafigura.com/how-physical-arbitrage-works/

https://www.trafigura.com/how-physical-arbitrage-works/
Geographic arbitrage
• identifies temporary price
anomalies between different
locations.
• Commodity trading companies
(CommTC) employ their global
network and local storage
facilities to take advantage of
changing supply and demand
conditions.
• For example, demand for
heating oil typically rises when
the weather is cold.
• Traders can buy heating oil
during the northern
hemisphere’s summer months,
store it and deliver in winter
Time arbitrage
• seeks to benefit from the shape of the
forward curve for physical delivery.
• In contango markets, when investors are
paying a premium for forward delivery,
CommTC do a cash-and-carry arbitrage.
• An arbitrage transaction involving the
simultaneous purchase of a cash
commodity with borrowed money and
the sale of the appropriate futures
contract. See slide 56
• For instance, they would buy coal now,
store it, then sell it back on the forward
date.
• They hedge their price risk and lock in
premium by selling coal futures today
and buying them back on the forward
date.
• In backwardated markets (when forward
delivery is cheaper than immediate
delivery) the reverse cash-and-carry
arbitrage is available.
Technical arbitrage
•seeks to benefit from the different
pricing perceptions for particular
commodity grades and specifications.
•CommTC use their trading
knowledge, global network and
storage and blending capabilities to
formulate the commodities their
customers need.
•In the US, for instance, gasoline is
sold with 10% ethanol content and
the precise formulation varies state
to state.
•They can earn margin by sourcing
ethanol and gasoline separately and
blending products to meet bespoke
specifications
How does Physical Arbitrage works?

1.3.2 Commodity Trading Firms – Optimising Trade Flows
https://www.commoditiesdemystified.info/pdf/CommoditiesDemystified-summary-en.pdf#downloads

1.4 Commitment of Traders Report
What does speculative participation look like as a fraction of open interest?
• The Commodity Futures Trading Commission (CFTC) publishes a weekly commodity futures/option
report which breaks down the total open interest as of each Tuesday’s settlement.
• The reports are released every Friday and provide market participants insight on how open interest
is distributed among different groups of traders
– (Producer/Merchant/Processor/User, Swap Dealers, Managed Money, and Other Reportable). 
see example in Remark file
Open Interest
• number of long and short positions in a specific contract which have not been liquidated or offset by
an opposing purchase or sale by the same participant.
• Non-commercials are momentum, or positive feedback traders
• commercials are on average contrarians (net short).
https://bit.ly/2UuQvx3 , Gorton, 2015, p.14

Commercials and Open Interest
Open Interest
Market High
Commercials
Commercials
Market Low
Open Interest
(1) Commercials are most of the time net short of the majority of futures.
They want to secure future selling prices to calculate better their commodity exposure.
If the Commercials increase their short positions and if open interest (=number of open futures contracts) rise at
the same time, than it could reflect a High in futures prices.
Commercials open new short positions in this scenario because they expect falling prices.
(2) If open interest falls and net short positioning of commercials decrease, than a price floor could be near.
Commercials close their short positions because they expect higher prices.
Traders‘’04.2019

Sugar Futures – Higher prices/not lower prices anymore if speculators are very short and commercials are relatively
little short positioned historically
Blue= Commercials = Hedgers Green = Non-Commercials = Large Speculators
Red = Small Speculators
Traders‘’04.2019

A breakdown of the positions according to the CFTC’s Commitment of Traders report
Figure: Commercials (hedgers), Non-Commercials (speculators) and Non Reportable as a %
of Total Open Interest
Non reportables: Small Speculators
Gorton, 2015, p.14

• The figure is based on weekly CFTC’s commitment of traders report for 27 commodities
• CFTC reports
– long and short positions for commercials (hedgers),
– non-commercials (large speculators) and
– non-reportable (small speculators).
• The report provides spread positions of non-commercials.
long (short) positions across the three categories of traders
+ spread positions of non-commercials
= Total open interest
Total Gross Positions = longs + shorts + 2x spread positions
Gorton, 2015, p.14

Drawback of the CFTC’s Commitment of Traders report
• does not classify market participants as speculators or hedgers
– groups participants according to their participation in physical markets (commercials
versus non-commercials).
• Commercial position: Genuine hedging activity & swap dealers laying off their Ober-the-
counter (OTC) book in the futures markets
• If the futures hedges were for a commodity index swap, it would be recorded as a long
commercial position which is speculative in nature.
Gorton, 2015, p.14

1.5 Open Interest
Open Interest
• number of long and short positions in a specific contract which have not been liquidated
or offset by an opposing purchase or sale by the same participant.
• Increasing open interest figures are considered supportive of the underlying price trend.
– they may indicate market strength during periods of rising prices,
– or the support of a downward trend during periods of market weakness.
– But this not sufficient info to take a log or short position; one needs to look a the
fundamentals too
Kleinman, 2005, p.158

1.5 Open Interest
Bullish Sign
Prices are in
Uptrend & Open
Interest Rising
- Prices are in
Downtrend &
Open Interest is
Falling
Bearish
Sign
- Prices are in
Downtrend &
Open Interest
Rising
Price are in
Uptrend & Open
Interest is falling

1.5 Open Interest
Figure Soybean volume and open interest

2 Rationale for Investing in Commodities
2.1 Diversification Benefits of Commodities 38
2.2 Commodities as a possible Inflation Hedge 41

2 Rationale for Investing in Commodities
• Diversification Benefits relative to traditional asset classes
– Potential low-to-uncorrelated return source to traditional asset classes
• Potential to hedge against unexpected inflation
– Physical assets have tended to move in line with broad inflation measures
• Potential incremental returns from each individual commodity’s market
structure
– Commodity supply and demand is correlated to the cyclicality of the
global economy
Doubeline, 2018, p.4

2.1 Diversification Benefits of Commodities
Broad Commodities have shown low correlations to other broad asset
classes
Doubleline, 2018, p.6
2000 – 1H 2018 US Large
Caps
Equities
International
Equities
US Treasury US High
Yield Bonds
Emerging Market
Corporate Bonds
Dollar Index
Commodities 0.36 0.5 -0.11 0.41 0.36 -0.53

Diversification Benefits of Commodities with Respect to Equities
Average 12-month rolling correlation of 0.14 but with significant excursions
Picard Angst https://goo.gl/5ZcPSq p.11

Inflation-adjusted returns from equities, bonds and commodity futures – 1959 to 2014
Picard Angst https://goo.gl/5ZcPSq p.14

2.2 Commodities as a possible Inflation Hedge
• Commodities can also be a hedge against unexpected inflation
• Unexpected inflation can be defined as YoY change in YoY inflation
• Example: YoY CPI was 2.1% in 2017 and 1.3% in 2016 making unexpected inflation 0.8% for that year.
• Commodity performance over the long term rises and falls with unexpected inflation changes

3 Commodity Investment Vehicles
3.1 Commodity Forwards 46
3.2 Commodity Futures 66
3.3 Commodity Options 96
3.4 Commodity Swaps 146
3.5 Commodity Index Investments 160

Source: https://stats.bis.org/statx/srs/table/d5.2?f=pdf
notional amount outstanding = Gross nominal or notional value of all derivatives contracts concluded and not yet settled on the reporting date.

Commodity Assets Under Management by Type and Sector
A niche asset class emerging from a cyclical downturn
https://goo.gl/5ZcPSq p.6

Commodity Assets Under Management by Type and Sector
https://goo.gl/GJLEic
Commodity Index
Swaps
Commodity Exchange Traded Products
(ETP)
Commodity Medium
Term Notes (CMTN)
Futures
Description Baskets of different
commodity futures.
Long only
An ETP is a regularly priced security
which trades during the day on a
national stock exchange.
This ETPs may embed derivatives and
benchmarked to commodities.
Types of ETPs:
Exchange-traded funds (ETFs), Exchange-
traded notes (ETNs)
Form of corporate debt
issuance often made from
a pre-packaged
investment strategy
otherwise known as a
structured product.
Coupon can be linked to
commodity
A Future contract
traded on an exchange
standardized in terms of
traded maturities,
quantity, and
giving rise to physical
delivery by the seller at
maturity if not cash-
settled.
Futures contains an
obligation to buy (or sell).
Investor Insurance companies,
Pension funds,
Sovereign wealth funds
Retail, Insurance Companies, Pension
Funds, Sovereign wealth funds
Insurance Companies,
Pension Funds, Sovereign
wealth funds
Hedge Funds
Market Share Index positions are less
than 20% of open
interest in most futures
markets, and their
share in the physical
market is < 8%
ETP inflows remain heavily biased
towards physically backed precious
metals e.g gold
Institutional and retail
holdings of commodity
futures are extremely
small when considered as
a percentage of the total
physical market.

3.1 Commodity Forwards
Forward contract:
• Agreement today to buy/sell commodity at a predetermined price at a predetermined
time in the future.
• It can be contrasted with a spot contract, which is an agreement to buy or sell an asset
today.
• A forward contract is traded in the over-the-counter market (OTC).
• One of the parties to a forward contract assumes a long position and agrees to buy the
underlying asset on a certain specified future date for a certain specified price.
• The other party assumes a short position and agrees to sell the asset on the same date for
the same price.

• Commodity Forwards provide information about the views of the market at future dates (the ‘price
discovery’ property of Futures prices), anticipated trends, and information about future supply and
demand.
• are also essential for marking to market books of existing positions in Futures as well as for risk
management activities such as Value at Risk calculations.
Comparison of Forward and Futures contracts
Forward Futures
Private contract between two parties Traded on an exchange
Not standardized Standardized contract
Usually one specified delivery date Range of delivery dates
Settled at end of contract -> easier to Settled daily
analyse – only a single payment at
maturity
Delivery or final cash settlement Contract is usually closed out
Usually takes place prior to maturity
Some credit risk virtually no credit risk
Hull,2012, p.41

• Over-the-counter (OTC) markets are markets where companies agree to derivatives transactions without
involving an exchange.
• Credit risk has traditionally been a feature of OTC derivatives markets.
• Consider two companies, A and B, that have entered into a number of derivatives transactions.
• If A defaults when the net value of the outstanding transactions to B is positive, a loss is likely to be taken by B.
• Similarly, if B defaults when the net value of outstanding transactions to A is positive, a loss is likely to be taken by
company A.
• In an attempt to reduce credit risk, the OTC market has borrowed some ideas from exchange-traded markets.
• Central Counterparties
• These are clearing houses for standard OTC transactions that perform much the same role as exchange clearing
houses.
• Members of the CCP, similarly to members of an exchange clearing house, have to provide both initial margin and
daily variation margin.
• Like members of an exchange clearing house, they are also required to contribute to a guaranty fund.
Hull, 2012, p.31

EXCURSION: Value at Risk
• Value at Risk (VaR) is an attempt to provide a single number summarizing the total risk in a portfolio of financial
assets.
VaR Measure
• When using the value-at-risk measure, an analyst is interested in making a statement of the following form:
– I am X percent certain there will not be a loss of more than V dollars in the next N days.
• The variable V is the VaR of the portfolio.
• It is a function of two parameters:
– the time horizon (N days) and
– the confidence level (X%).
• It is the loss level over N days that has a probability of only (100 – X)% of being exceeded.
• Bank regulators require banks to calculate VaR for market risk with N = 10 and X = 99
Hull, 2012, p. 471

Value at Risk
• When N days is the time horizon and X % is the confidence level, VaR is the loss
corresponding to the (100 – X)th percentile of the distribution of the gain in the
value of the portfolio over the next N days.
• When we look at the probability distribution of the gain, a loss is a negative gain
and VaR is concerned with the left tail of the distribution.
• When we look at the probability distribution of the loss, a gain is a negative loss
and VaR is concerned with the right tail of the distribution.
• For example, when N = 5 and X = 97, VaR is the third percentile of the distribution
of gain in the value of the portfolio over the next 5 days.
Hull, 2012, p. 471

• VaR is illustrated for the situation where the change in the value of the portfolio is
approximately normally distributed in the next Figure.
• Figure: Calculation of VaR from the probability distribution of the change in the
portfolio value; confidence level is X%.
• Gains in portfolio value are positive.
• Losses are negative.
Hull, 2012, p. 471

Value at Risk
Example:
• You are a USD-based corporation and hold a EUR 140 million FX position.
What is your VaR over a 1-day horizon given that there is a 5% chance that
the realized loss will be greater than what VaR projected?
• What is your exposure?
• The first step in the calculation is to compute your exposure to market risk
(i.e., mark-to-market your position).
• As a USD based investor, your exposure is equal to the market value of the
position in your base currency.
• If the foreign exchange rate is 1.13 EUR/USD, the market value of the
position is USD 158.2 million (= 140 x 1.13).
Risk Metrics, 1996, p. 6

What is your risk?
• Moving from exposure to risk requires an estimate of how much the exchange rate can potentially move.
• The standard deviation of the return on the EUR/USD exchange rate, measured historically can provide an
indication of the size of rate movements.
• In this example, we calculated the EUR/USD daily standard deviation to be 0.42%.
• Now, under the standard RiskMetrics assumption that standardized returns (rt / σt) on EUR/USD are
normally distributed given the value of this standard deviation, VaR is given by 1.65 times the standard
deviation (that is, 1.65σ) or 0.69% (= 1.65 x 0.42).

• This means that the EUR/USD exchange rate is not expected to drop more than 0.69% per day, 95%
of the time.
• In USD, the VaR of the position is equal to the market value of the position times the estimated
volatility or:
– FX Risk: $158.2 million x 0.69% = $1.09m
– What this number means is that 95% of the time, you will not lose more than $1.09m over the
next 24 hours.
• From the standard normal tables we can read that 95 % confidence level is equal to – 1.645.
– Consequently (R* - µ) / σ equals -1.645.
• the R* stands for the cut off value,
• μ for mean return,
• (-1.645) defines alpha (α) corresponding to level of confidence (e.g. – 1.645 for a 95 % confidence
level)

The Benefits of Forward Curves
• influence storage, production, and other strategic decisions of oil/mining companies.
• Payoffs from forward contracts: (a) long position, (b) short position.
• Delivery price = K; spot price of asset at contract maturity = ST
• the payoff from a long position in a forward contract on one unit of an asset is ST - K
• Holder of the contract is obligated to buy an asset worth ST for K.
• Payoff from a short position in a forward contract on one unit of an asset is K - ST
Hull, 2012, p.6

What is a forward curve?
• A schedule of prices at which the market is willing to transact at today for delivery in
different time periods.
• A forward curve is not a prediction of future prices.
• It is today’s prices for future delivery.
www.cmegroup.com
Crude Oil Forwards/Futures; Term
Structure
Month Price
May 2019 59.25
June 2019 59.56
July 2019 59.86
August 2019 60.06
Sep. 2019 60.35
Oct. 2019 60.43

Doubleline 2017, p. 4
Term Structure of Commodity Prices
Contango
• When inventory levels are plentiful and/or demand is low, consumption today will cost less than
consuming at some point in the future
• This typically results in a contangoed (upward sloping) term strucure of commodity prices and
a negative „roll“ return
• Possible drivers are technological advances, economic slowdown, or a new discovery

Doubleline 2017, p. 4
Term Structure of Commodity Prices
Backwardation
When inventory levels are scarce and/or demand is high, consumption today will cost more than
consuming at some point in the future
• This typically leads to a backwardation (downward sloping) term structure of commodity
prices and a positive „roll“ return
• Possible drivers are adverse weather, production failure and geopolical risk

• Forward prices are determined by the price of the commodity today plus
the costs of storage and financing.
• Forward Price = Spot Price + Storage + Financing
• Difference between Forward and Spot prices -> Cost of Carry

Example:
It is 1 Nov. and Spot Prices for Coal are $66.5/mt.
Interest rate is 5% p.a.
Storage prices $0.01/mt per day.
How much should you be willing to pay for delivery on 1 Dec.?
Forward Price = Spot Price + Storage + Financing
Storage costs = 31 days * $0.01/mt per day = $0.31/mt
31 days -> from 1 Nov to 1 Dec.
Financing costs = 0.05 per year * 31 days/365 days * $66.5/mt = $0.28/mt
Implied Forward = $66.5/mt + $0.31/mt + $0.28/mt = $67.09/mt
One should not pay more than $67.09/mt for delivery on 1 Dec.

Arbitrage
• If prices are out of line with (Forward Price = Spot + Storage + Financing), then market
participants will arbitrage to make “risk free” money
• Example:
– It is 1 November. Spot Prices for Coal: $66.5/mt. mt = metric tonne
– Interest rate: 5% p.a.
– Storage prices: $0.01/mt per day.
– Coal for delivery 1 December: $67.2/mt
– Calculated before: forward price for coal 1 Dec. delivery is $67.09/mt.
– We can make $0.11/mt (=$67.20 ./. $67.09)
• by buying spot coal on 1 Nov., selling 1 Dec. coal forward.
• Taking delivery of 1 Nov. coal, storing it ($0.31/mt), financing it ($0.28/mt) and
delivering it on 1 Dec.

Synthetics
• Example: Storage Costs
– It is 1 November. Spot Prices for Coal are $66.50.
– Interest rate is 5% p.a.
– Forward price for coal on 1 Dec. is $66.80
– Financing $0.05 per year * 31 days/365 days per year * $66.5 = $0.28
– Implied Storage = $66.80 - $66.50 - $0.28 = $0.02
– If our storage costs are > $0.02 then we should sell spot and buy forward
to take advantage of virtual storage.

Financial Transaction Example: Power Station
• Standard Coal Trading Agreement (Scota) Coal for delivery in the second quarter 2007 (2Q’07) is currently trading
at $68.00/mt
– Scota combines a single, accepted set of standard terms and conditions together with a range of coal quality
specifications and delivery points for international coal sales and purchases.
• You would like to lock in these 2Q’07 prices, but your power station is not located at ARA (= Amsterdam,
Rotterdam, Antwerp) and you cannot burn generic Scota coal, you can only burn a specific type of coal
• But you still can use Scota for price risk management
• At beginning of 1Q’06, you buy a Scota contract for 2Q’07 at $68 FOB (free on board) ARA with the objective to
financially hedge your price risk for this quarter.
• You do not buy the Scota coal to burn this coal in your power station, but intend to resell it prior to physical
delivery
Constellation Energy, 2008

Levent Yilmaz I Summer 2018 I ISM 2018Constellation Energy, 2008

3.2 Commodity Futures
• Future contract
– forward contract traded on an exchange
– standardized in terms of traded maturities, quantity of the commodity underlying the Future
contract, and
– giving rise to physical delivery by the seller at maturity
• If the settlement is specified as financial, there must be a liquid reliable index to represent the
underlying at date T (=maturity)
• Unlike an option, a Futures contains an obligation to buy (or sell).
• For both the buyer and the seller, the counterparty is the Clearing House of the Exchange.
• As the two parties to the contract do not necessarily know each other, the exchange also provides a
mechanism that gives the two parties a guarantee that the contract will be honored.
Geman, 2015, p.43

• Long Futures Hedge -> you will purchase an asset in the future and want to
lock in the price
• Short Futures Hedge -> you will sell an asset in the future and want to lock
in the price
• Basis Risk:
– Difference between Spot and Futures
– Arises because of the uncertainty about the basis when the hedge is
closed out
Geman, 2015, p.43

Basis Risk
• Understanding it is fundamental to hedging
Basist, T = Spot pricet – FT (t)
• the cash price is quoted as a premium or discount to the Future price.
• Pricing point other than the benchmark
• Examples of basis: Quality (e.g. coal > 1% sulphur, <5800 kcal/kg ,etc.)
• Idea: Price of particular type of coal will move with price of generic coal, just a system of
premiums/discounts
Geman, 2005, p.14

Basis Risk
• Basis Risk: if what you trade is not exactly what you need you have basis risk
• It is the risk that the value of a futures contract will not move in line with that of the underlying
exposure.
• It is the risk that the cash-futures spread will widen or narrow between the dates at which a hedge
position is implemented and liquidated.
• It may reflect different time periods, product forms, qualities and locations
• One way to manage it is with a basis swap
• Basis swaps are used to hedge exposure to basic risk, such as locational risk or time exposure risk
Geman, 2005, p.14, p.360

Several types of basic risk
• In the case of a trading desk which neds to cut at date t (e.g. to avoid negative margin
calls) – a position in Futures, which was meant to hedge a position in the spot commodity
– the basis risk is represented by the quantity
• Basis risk exists when Futures and spot prices do not change by the same amount over
time and, possibly, will not converge at maturity T:
– because the Futures contracts were written on an underlying similar but not identical to
the source of risk, such as an airline company hedging exposure to a rise in jet fuel
prices with NYMEX heating oil Futures contracts;
– because of the optionalities left to the seller at maturity in the physical settlement of
the Future contract: grade of the commodity, location, chemical attributes
Geman, 2005, p.14

Typical pay-off structures of a futures contract
Deloitte, 2018, p.30
Example:
• A Commodity manufacturer that sells finished goods where the underlying commodity is linked to a specific
pricing benchmark and
• enters into a short futures contract to lock a fixed price on a fixed volume of the commodity over a
predetermined period of time

Initial Margin:
• In order to avoid any credit event with the counterparty, the clearing house requires all
exchange participants to pay a margin deposit at the start.
• This one can be paid in cash or Treasury bills; recently, some exchanges have started
accepting gold.
• Margin calls have to be paid/received every day: if a trader holds a long Future contract
with maturity T, the value of his position has changed between date t and t + 1 day by
F(t + 1 day, T) – F(t, T)
• If this quantity is negative, a margin call equal to the loss has to be added to the account
of the trader with the exchange, otherwise the position is closed and the margin deposit is
used to offset the loss.
Geman, 2015, p.44

Margin: Example
• Operation of margins for a long position in two gold futures contracts.
• 1 x Gold Futures Contract = 100 troy ounces
• Gold futures price = $1,250/ounce
=> 1 x Gold Futures Contract amount = 100 x $1,250/ounce = $125,000
• Initial Margin = $6,000 per contract (=> 6000 / 125000 = 5% of total amount), or $12,000
in total for 2 contracts;
• Maintenance Margin is $4,500 per contract, or $9,000 for 2 contracts in total.
• The contract is entered into on Day 1 at a gold price of $1,250/ounce
Hull, 2012, p.28, https://bit.ly/2FZCaAG

Margin
Hull, 2012, p.28
Day Trade Price ($) Settlement price ($) Daily Gain/Loss ($) Cumulative
Gain / loss ($)
Margin account
balance ($)
Margin Call ($)
1 1,250 12,000
1 1,241.00 -1,800 ( = 9 x 2 x 100) -1,800 10,200 (= 12000
- 1800)
2 1,238.30 -540 (= 2.7 x 200) -2,340 (= -1800 -
540)
9,660 (= 10200 –
540)
3 1,244.60 1,260 (= (1244.6 –
1238.3) x 200)
-1,080 10,920
4 1,241.30 -660 -1,740 10,260
5 1,240.10 -240 -1,980 10,020
6 1,236.20 -780 -2,760 9,240
7 1,229.90 -1,260 -4,020 7,980 4,020
8 1,230.80 180 -3,840 12,180

• The Exchange must also provide information on
– Daily traded volume
– Open interest, namely the number of contracts ‘open’ for a maturity T
with a buyer and a seller at each end
• important information to decide on the size of the order one may
want to place
– Amount of inventory held by the exchange (in fact its affiliated
warehouses) in the given commodity.
Geman, 2015, p.44

• The exchange must specify the type (Arabica versus Robusta for coffee) and grade
of the commodity underlying the Future contract
• grades acceptable for delivery at date T (=maturity)
– in which case the seller will choose the least expensive one, exercising her
cheapest to deliver option, meaning that she will choose the least expensive
type accessible to her.
• Termination of a Futures position: a Futures position can be closed by
– Taking delivery of the goods according to rules specified by the exchange, each
exchange defining its warehousing and delivery rules.
– Entering a Futures position offsetting the existing one.
Geman, 2015, p.44

Futures prices of commodities that are investment assets such as gold and silver.
Income and Storage Costs
• The hedging strategies of gold producers leads to a requirement on the part of investment banks to
borrow gold.
• Gold owners such as central banks charge interest in the form of what is known as the gold lease
rate when they lend gold.
• Gold and silver can therefore provide income to the holder
• they have storage costs
• Consider a forward contract on an investment asset with price S0 that provides no income.
• T is the time to maturity,
• r is the risk-free rate,
• F0 is the forward price.
• The relationship between F0 and S0 is
Hull, 2012, p..118, p.52

• In the absence of storage costs and income, the forward price of a commodity that is an investment
asset is given by
• Storage costs can be treated as negative income.
• when an investment asset will provide income with a present value of “I” during the life of a forward
contract, we have
• If U is the present value of all the storage costs, net of income, during the life of a forward contract,
it follows that
Hull, 2012, p..118

Example
• Consider a 1-year futures contract on an investment asset (e.g. gold) that provides no income.
• It costs $2 per unit to store the asset, with the payment being made at the end of the year.
• Assume that the spot price is $450 per unit and the risk-free rate is 7% per annum for all maturities.
• This corresponds to r = 0.07,
• S0 = 450,
• T = 1,
=> U is the present value of all the storage costs, net of income, during the life of a forward contract,
• the theoretical futures price, F0 , is given by
• If the actual futures price is greater than 484.63, an arbitrageur can buy the asset and short 1-year
futures contracts to lock in a profit.
• If the actual futures price is less than 484.63, an investor who already owns the asset can improve
the return by selling the asset and buying futures contracts.
Hull, 2012, p..118

• If the storage costs (net of income) incurred at any time are proportional to the price of
the commodity, they can be treated as negative yield.
• In this case, from equation ,
• q = average yield per annum on an asset during the life of a forward contract with
continuous compounding.
• u = storage costs per annum as a proportion of the spot price net of any yield earned on
the asset.
Hull, 2012, p..118

• Commodities that are consumption assets rather than investment assets usually provide no income,
but can be subject to significant storage costs.
• We now review the arbitrage strategies used to determine futures prices from spot prices
• For some commodities the spot price depends on the delivery location.
• We assume that the delivery location for spot and futures are the same.
• Suppose we have:
• To take advantage of this opportunity, an arbitrageur can implement the following strategy:
– 1. Borrow an amount S0 + U at the risk-free rate and use it to purchase one unit of the commodity
and to pay storage costs.
– 2. Short a futures contract on one unit of the commodity.
Hull, 2012, p..118

• If we regard the futures contract as a forward contract, so that there is no daily settlement, this
strategy leads to a profit of at time T.
• However, as arbitrageurs do so, there will be a tendency for S0 to increase and F0 to decrease until
equation is no longer true.
• This equation cannot hold for any significant length of time.
• Suppose next that
• When the commodity is an investment asset, we can argue that many investors hold the commodity
solely for investment.
• When they observe , they will find it profitable to do the following:
• 1. Sell the commodity, save the storage costs, and invest the proceeds at the risk-free interest rate.
• 2. Take a long position in a futures contract.
Hull, 2012, p..119

• The result is a riskless profit at maturity relative to the position the
investors would have been in if they had held the commodity.
• It follows that equation cannot hold for long.
• Because neither of these equations can hold for long, we must have
• This argument cannot be used for a commodity that is a consumption asset rather than an
investment asset.
• Individuals and companies who own a consumption commodity usually plan to use it in some way.
• They are reluctant to sell the commodity in the spot market and buy forward or futures contracts,
because forward and futures contracts cannot be used in a manufacturing process or consumed in
some other way.
Hull, 2012, p..119

Consumption Commodities
• There is therefore nothing to stop equation from
holding, and we can
assert for a consumption commodity:
• If storage costs are expressed as a proportion u of the spot price, the
equivalent result is
Hull, 2012, p..119

Convenience Yield
• We do not necessarily have equality in equations and
– because users of a consumption commodity may feel that ownership of the physical commodity
provides benefits that are not obtained by holders of futures contracts.
• Oil refiner is unlikely to regard a futures contract on crude oil in the same way as crude oil held in
inventory.
• The crude oil in inventory can be an input to the refining process
– futures contract cannot be used for this purpose.
• Ownership of the physical asset enables a manufacturer to keep a production process running and perhaps
profit from temporary local shortages.
• A futures contract does not do the same.
Hull, 2012, p..120

Convenience Yield
• The benefits from holding the physical asset are sometimes referred to as the convenience yield
provided by the commodity.
• If the dollar amount of storage costs is known and has a present value U, then the convenience yield
y is defined such that
• If the storage costs per unit are a constant proportion, u, of the spot price, then y is defined so that
• The convenience yield simply measures the extent to which the left-hand side is less than the right-
hand side in equation or
Hull, 2012, p..120

Convenience Yield
• For investment assets the convenience yield must be zero;
• otherwise, there are arbitrage opportunities.
• the futures price of soybeans decreased as the maturity of the contract increased from July 2010 to Nov. 2010.
 convenience yield (y) > r + u.
• The convenience yield reflects the market’s expectations concerning the future availability of the commodity.
• The greater the possibility that shortages will occur, the higher the convenience yield.
• If users of the commodity have high inventories, there is very little chance of shortages in the near future and the
convenience yield tends to be low.
• If inventories are low, shortages are more likely and the convenience yield is usually higher.
Hull, 2012, p..120
Table: Futures quotes for Soybean (= consumption asset) contracts - 5,000 bushels, cents per bushel on May 26, 2010
Contract period Settlement price Open interest
July 2010 938 220,712
Aug. 2010 929.5 15,674
Sept. 2010 916.5 12,983
Nov. 2010 910 157,826

The Cost of Carry
• The relationship between futures prices and spot prices can be summarized in terms of the cost of
carry (= c).
Measures  storage cost + interest that is paid to finance the asset ./. income earned on the asset.
• for a commodity that provides income at rate q and requires storage costs at rate u,
c = r - q + u
• For an investment asset, the futures price is
• For a consumption asset, it is
• y = convenience yield; r = risk-free rate
Hull, 2012, p..120

Geman,2005, p.6
Spot Trading Forward Contracts Futures Contracts
- Commercial Contract
- Flexible covenants
- Juridical commitments
of the buyer and seller
until execution of the
contract
- Long transaction
- Illiquid and
discontinuous market
- Allows the transfer of
goods in conditions
suiting the demand
- Bilateral agreement
- Flexible covenants
- Replace spot
transactions on many
occasions (e.g., in the
case of non-storable
commodity such as
electricity)
- Form of contracting
totally appropriate for
commodities
- Credit risk fully present
- Flexibility regarding the
optimal transfer of
goods
- Standardised
instruments
- Necessity of a physical
delivery or termination
of the position before
maturity
- Buyer and seller only
refer to the clearing
house
- Central clearing
mechanism generating
“market prices”
- Price transparency
- Liquidity
- Low transaction costs

3.2.1 Price Discovery in Futures Markets
Geman, 2005, p.23
Futures
markets
provide highly
visible prices
against which the
current cash
prices of dealers
can be compared
any difference being
explained by the
transportation costs
involved in moving the
commodity
or the storage
costs implied in a
cash and carry
relationship

3.2.2 Commodity Futures - Return Components
Commodity Futures have 3 Return Components
Total Return = Spot Return + Roll Yield + Collateral Yield
Spot Price Return
• Absolute price change of the commodity.
• Commodity selection
• Portfolio component weights
• Rebalancing strategy (-> diversification return)
Spot Return + Roll Yield = Excess Return
Geman, 2015, p.52

3.2.2 Commodity Futures - Return Components
Total Return = Spot Return + Roll Yield + Collateral Yield
• Roll Yield
– Depending on the shape of the forward curve, an additional gain / loss can be earned by rolling
commodity futures forward.
– Impact of the commodity futures term structure
– Contango – upward sloping forward curve -> negative roll yield
– Backwardation – declining forward curve -> positive roll yield
• Collateral Yield
– Management of the underlying funding of an unleveraged investment
– For futures investments only a certain margin needs to be posted (typically 5% - 10% of notional).
• No money is transferred to the counterparty for the purchase!
• The remaining capital is invested usually in money market or government bonds and
earns interest.
Geman, 2015, p.52

3.2.2. Commodity Futures - Return Components
Commodity Futures Term Structure – Contango and Backwardation
Indicator of the supply/demand balance and determining factor of roll returns

Commodity Beta Return Drivers
Roll yield as the primary long-term driver of commodity beta returns

Roll Yield vs. Returns
https://blog.pimco.com/en/2018/04/with-inflation-rising-commodities-may-shine

3.3 Commodity Options
Options Basics
• Options are traded both on exchanges and in the over-the-counter market.
• There are two types of option.
– A call option gives the holder the right to buy the underlying asset by a certain date for a certain price.
– A put option gives the holder the right to sell the underlying asset by a certain date for a certain price.
• The price in the contract is known as the exercise price or strike price;
• the date in the contract is known as the expiration date or maturity.
• American options can be exercised at any time up to the expiration date.
• European options can be exercised only on the expiration date itself.
• Most of the options that are traded on exchanges are American.
Hull, 2012, p.8

Options Basics
• European options are generally easier to analyze than American options, and some of the properties
of an American option are frequently deduced from those of its European counterpart.
• Option gives the holder the right to do something.
• The holder does not have to exercise this right.
• This is what distinguishes options from forwards and futures, where the holder is obligated to buy or
sell the underlying asset.
• Whereas it costs nothing to enter into a forward or futures contract, except for margin
requirements, there is a cost to acquiring an option.
Hull, 2012, p.8

Nature of Options of Futures
• In options on futures, also known as futures options contracts, exercise of the option gives
the holder a position in a futures contract.
• Futures Option is the right, but not the obligation, to enter into a futures contract at a
certain futures price by a certain date.
• Call Futures Option is the right to enter into a long futures contract at a certain price;
• Put Futures Option is the right to enter into a short futures contract at a certain price.
• Futures options are generally American; that is, they can be exercised any time during the
life of the contract.
Hull, 2012, p.361

• If a call futures option is exercised, the holder acquires a
– long position in the underlying futures contract + a cash amount equal to the most recent settlement
futures price ./. the strike price.
• If a put futures option is exercised, the holder acquires a
– short position in the underlying futures contract + a cash amount equal to the strike price ./. the most
recent settlement futures price.
• effective payoff from a call futures option is max(FT –K, 0) and the
• effective payoff from a put futures option is max(K – FT, 0),
– FT is the futures price at the time of exercise
– K is the strike price.
Hull, 2012, p.361

Example
Suppose it is August 15 and an investor has one September futures call option contract on copper with a strike price
of 240 cents per pound.
One futures contract is on 25,000 pounds of copper.
Suppose that the futures price of copper for delivery in September is currently 251 cents, and at the close of trading
on August 14 (the last settlement) it was 250 cents.
If the option is exercised, the investor receives a cash amount of
25,000 x (250 – 240) cents = $2,500
plus a long position in a futures contract to buy 25,000 pounds of copper in September.
If desired, the position in the futures contract can be closed out immediately.
This would leave the investor with the $2,500 cash payoff plus an amount
25,000 x (251 – 250) cents = $250
reflecting the change in the futures price since the last settlement.
The total payoff from exercising the option on August 15 is $2,750, which equals 25,000(FT – K), where FT is the
futures price at the time of exercise and K is the strike price.
Hull, 2012, p.361

Example
An investor has one December futures put option on corn with a strike price of 400 cents per bushel.
One futures contract is on 5,000 bushels of corn.
Suppose that the current futures price of corn for delivery in December is 380, and the most recent settlement
price is 379 cents.
If the option is exercised, the investor receives a cash amount of
5,000 x (400 – 379) cents = $1,050
plus a short position in a futures contract to sell 5,000 bushels of corn in December.
If desired, the position in the futures contract can be closed out.
This would leave the investor with the $1,050 cash payoff minus an amount
5,000 x (380 - 379) cents = $50
reflecting the change in the futures price since the last settlement.
The net payoff from exercise is $1,000, which equals 5,000(K – FT)
Hull, 2012, p.362

Expiration Months
• Futures options are referred to by the delivery month of the underlying futures contract —not by the expiration
month of the option.
• Most futures options are American.
• The expiration date of a futures option contract is usually on, or a few days before, the earliest delivery date of
the underlying futures contract.
Hull, 2012, p.362

Call option
• Buyer of the call option earns a right (not an obligation) to exercise the option to buy a
particular asset from the call option seller for a stipulated period of time.
• Once the buyer exercises his option, the seller has no other choice than to sell the asset at
the strike price at which it was originally agreed.
• The buyer expects the price to increase and thus earns capital profits.
• While exercising a call option, the option holder buys the asset from the seller
https://goo.gl/1iWtQU

Put option
• buyer of the put option earns a right (not an obligation) to exercise his option to sell a
particular asset to the put option seller for a stipulated period of time.
• Once the buyer of put exercises his option (before the expiration date), the seller of put
has no other choice than to purchase the asset at the strike price at which it was originally
agreed.
• The buyer of put expects the value of asset to decrease so that he can purchase more
quantity at lower price.
• Strike price is the pre-determined price at which the buyer and seller of an option agree
on a contract or exercise a valid and unexpired option.

• Option gives the holder the right to do something.
• The holder does not have to exercise this right.
• This is what distinguishes options from forwards and futures, where the holder is
obligated to buy or sell the underlying asset.
• There is a cost to acquiring an option - premium
– it costs nothing to enter into a forward or futures contract.
Hull, 2012, p.8

• Determinants of an Options Premium
• In return for the rights they are granted, options buyers pay options sellers
a premium.
• The four major factors affecting the premium are:
– Futures price relative to options strike price.
– Time remaining before options expiration.
– Volatility of underlying futures price.
– Interest rates.

Option on Crude Oil Futures – at the money monthly option

Hull, 2012, p.12
Fundamental difference between the use of forward contracts and options for
hedging
Forward contracts are designed to
neutralize risk by fixing the price that
the hedger will pay or receive for the
underlying asset.
Option contracts, by contrast,
provide insurance.
They offer a way for investors to
protect themselves against adverse
price movements in the future while
still allowing them to benefit from
favorable price movements.
Unlike forwards, options involve the
payment of an up-front fee.

Constellation Group, 2008

6

Example: A gold manufacturer
• A put option available in MCX exchange effectively creates a floor price in exchange for an option
premium.
• This premium reflects the likelihood that the option will be exercised.
• the further the strike price is from trading levels, the lower the amount of premium paid upfront.
• The put option will reference to the underlying MCX gold futures price.
• At the end of each period, the price of the underlying is compared to the option "strike" price.
• If the price of underlying < the strike price, the Company can either close of the Options position and profit
from rise in value of Option, as with the fall in gold prices, the premium for gold put option will rise.

Example: A gold manufacturer
• Assumption: European based options -> on expiry of the options, the put buyer can exercise his
option, which will result in creating a sell position in the underlying futures at the ‘strike price’,
which can be closed at the current market price, to realise profits.
• This payment offsets lower prices in the physical market.
• If the settlement price > the strike price, the purchased option expires and is rendered worthless.
• But the Company benefits from higher prices in the physical market.

Options pay-off
Deloitte 2018, p.31
Put options can be
compared to
buying
insurance. The
Company
is protected
against fall in
price, but
participate fully
when price is
rising

Example: Call Option
• European options. Expiry/declaration date fixed on the 1st of the month preceding the quarter. E.g. 1st of
September for a Q4 (=4th quarter) option.
• Assume a buyer buys today a call option for API2 (= Coal index delivered into North West Europe)
– Quantity 25KT/month (75KT total); because a quarter has 3 months = 25 x 3 = 75
– Delivery Q4 2008 (25KT/month)
– Forward curve today Q4 2008 at $165/ton
– Strike price: $165/ton (at the money option)
– Premium: $10/ton
– Expiry date: 1st Sep. 08
• The buyer pays upfront $10/ton ($750,000 in total) to the option's seller, to have the right but not the obligation
to be long of 75KT of API2 at $165/ton for the period Q4 2008.
• Exercise: draw the graph of the P&L of the call option from the buyer's perspective, by varying the API2 price at
expiry date
Perret, 2008, p.7

Example: Call Option
• Premium is a sunk cost whatever happens: 10 USD/MT paid upfront; Option's buyer pays the premium to option's seller
• If on 1st Sep. (expiry date), Q4 2008 > 165 USD/MT -> Buyer exercises option; It is cheaper to be long at option's strike price (165
USD/MT) than market price
• If on 1st Sep., Q4 2008 API2 < 165 USD/MT -> Buyer doesn't exercise option; It is cheaper to buy at market
• If Q4 2008 > 175 USD/MT (165+10 ), break even positive
Perret, 2008, p.8
08

Call option: Volatility
• Volatility = Standard Deviation
– Historical volatility: based on historical price movements
– Implied volatility: based on the view on volatility from traders
– The higher the volatility, the higher the premium
• Black Scholes model, calculates an option premium when inputs given:
– Forward price of underlying
– Strike
– Historical volatility
Black Scholes model provides implied volatility when inputs given:
– Forward underlying
– Strike
– Premium
– In that case it gives a view a forward view on volatility
Perret, 2008, p.12

N = Cumulative standard normal distribution
Standard deviation
Perret, 2008, p.13

Perret, 2008, p.13

• As a European futures option has the same payoff as a European spot option when the
futures contract matures at the same time as the option, the model used to value
European futures options (Black’s model) can also be used to value European spot options.
• However, American spot options and other more complicated derivatives dependent on
the spot price of a commodity require more sophisticated models.
• A feature of commodity prices is that they often exhibit mean reversion (similarly to
interest rates) and are also sometimes subject to jumps.
• Some of the models developed for interest rates can be adapted to apply to commodities.
Hull, 2012, p.748

Option Basics
Holder (Buyer) Writer (Seller)
Call Option Right to Buy Obligation to Sell
Put Option Right to Sell Obligation to Buy
Call Put
In-the-Money (ITM) Strike Price < Commodity Price Strike Price > Commodity Price
At-the-Money (ATM) Strike Price = Commodity Price Strike Price = Commodity Price
Out-of-the-Money (OTM) Strike Price > Commodity Price Strike Price < Commodity Price
Intrinsic Value = value of the contract
at expiration  only affected by
moves in the underlying security
= Commodity Price - Strike Price = Strike Price – Commodity Price
Time Value  an at-the money or
out-of-the-money option has only
time value. Subject to primarily time
to expiration and implied
volatility.
= Option Price - Intrinsic Value
= Option Price – Commodity Price -
Strike Price
= Option Price - Intrinsic Value
= Option Price - Strike Price –
Commodity Price
The premium of an option has two components, intrinsic value and time value.

Implied volatility
• market’s expectation of the future volatility of the underlying stock
• derived from the option price
• represents demand for the option
• The higher the implied volatility, the more expectation that the underlying commodity will
make big moves
– increasing the option’s chances of being in-the-money
– option’s premiums (that is, its time value) are higher
– value of time decays as expiration nears
Perret, 2008, p.7

Example: Seller of Call Option
• European options. Expiry/declaration date fixed on the 1st of the month preceding the quarter. E.g.
1st of September for a Q4 (=4th quarter) option.
• Assume a seller sells today a call option for API2 (= Coal index delivered into North West Europe)
– Quantity 25KT/month (75KT total); because a quarter has 3 months
– Delivery Q4 2008 (25KT/month)
– Forward curve today Q4 08 at $165/ton
– Strike price: $165/ton (at the money option)
– Premium: $10/ton
– Expiry date: 1st Sep. 2008
• The seller received upfront $10/ton ($750,000 in total) from the option's buyer, to have the right but
not the obligation to be short of 75KT of API2 at $165/ton for the period Q4 2008. (Whatever the
price of API2 Q4 08 is on the 1st of Sep. 2008).
• Exercise: draw the graph of the P&L of the call option from the seller's perspective
Perret, 2008, p.7

Example: Seller of Call Option
P&L profile for seller of a API2 Call, strike 165 USD/MT, premium 10 USD/MT
10
P&L in USD/MT
165 175 Market price for Q4 2008 at expiry date
• If coal trades anywhere below $165 then we keep the $10 that we received when we sold the call option - the option premium.
• However, if the market rallies then our losses become unlimited.
Perret, 2008, p.7
0

Perret, 2008, p. 17
Risk Analysis: why selling options?
• "Money talks", get cash premium upfront
- If an API2 option is sold at 10 USD/MT for a tonnage of 75,000 tonnes the total premium received
is $750,000 now
• Long term view underlying market: bearish (sell call), bullish (sell put)
• Long term view volatility:
- An option seller sells option with the view that the volatility will reduce
• Possibility to hedge I arbitrage when linked to physical position
- It is less dangerous for a supplier who is naturally long to sell a call option
• Make sure risk management is in place before selling options
- Nick Leason at Barings sold straddles (which involves buying a European call and put with the same
strike price and expiration date) and lost $1.4bn
- LTCM the option trader was one of the inventor of the Black Scholes model and he lost $3.7bn

Perret, 2008, p. 17
Call Option: Application Physical Market
• A supplier sells a cargo for Q4 2008 at 165 USD/MT and gives the buyer the option to buy
another cargo at the same price
• This means that the supplier sells an at the money call option for free
• As a buyer: buy as much as you can!
• Still it is more complex
• Take into account the existing and future business relationship. Is it the price to pay to
acquire a new customer?
• Can the buyer really sell the option in the market? And at what price?
• The Mark-to-Market and valuation can become an academic exercise

Perret, 2008, p. 17
Call Option: Greeks
Delta
• Is the daily change in an option tonnage for each change in the forward underlying
• It is also the probability that the option finishes in money. E.g.: an at the money call option has an
estimated delta of 0.5.
• This means that the seller of a naked call option for 100 KT with a delta of 0.5 should buy 50 KT to
protect himself
• It increases if the option is in the money and decreases if out of the money
• Delta hedging can be difficult and costly as it implies permanent small adjustments of the position.
• Hence trader often prefer to trade options in large chunks which makes delta hedging more efficient

Perret, 2008, p. 17
Example: Put Option
• A supplier buys today an API2 put option
- strike at 160 USD/MT, period Q4
- Forward curve Q4 2008 at 165 USD/MT
- expiry date 1st Sep.
- Premium: 7 USD/MT
- Note: out of the money put, premium is lower than for the call at the money option studied previously (10
USD/MT)
• The supplier pays 7 USD/MT upfront to have the right but not the obligation to sell API2 Q4 2008 at 160 USD/MT
whatever the price of API2 Q4 2008 will be on 1st September 2008.
• The put option seller may be "forced" to buy API2 at 160 USD/MT if the put option buyer decides to exercise the
option
• Exercise: Build the P&L graph for the option buyer

Perret, 2008, p. 17
Example: Put Option
Exercise: Build the P&L graph for the option buyer by varying the price of API2 at expiry date
• Premium:
- 7 USD/MT paid upfront
- Option's buyer (supplier) pays the premium to the option's seller
• If on 1st Sep. 2008 Q4 2008 API2 < 160 USD/MT -> Supplier exercises option; more interesting to sell at 160 USD/MT (strike) than
market price
• If on 1st Sep. 2008, Q4 2008 > 160 USD/MT -> Supplier doesn't exercise option; more interesting to sell at market price than strike
(160 USD/MT)
• If Q4 08 < 153 USD/MT (160 -7), break even positive

Perret, 2008, p. 17
Put Option: Application Physical Market
Example
• a supplier sells a cargo for Q4 ‘08 at 165 USDIMT and has the option to sell another cargo at same
price (or has the option to increase the tonnage)
• Supplier buys an at the money put option for free
• Supplier side: sell as much as you can under those terms!

Perret, 2008, p. 29
Option pay-off Chart

Perret, 2008, p. 29
Example: Call Option Application
Utility buys a call option to hedge physical position
• 3rd July 2008:
• A utility sells electricity for Q4 2008 at fixed price
• The corresponding coal price for dark spread (= electricity price ./. Coal price -> margin of utility!)
calculation is at 160 USD/MT for Q4 2008, quantity 150 KT
• The trader at the utility has the market view that coal prices will ease during the summer and that he
may be able to purchase coal cheaper later on
• buy on 3rd of July an API2 call option
• strike 170 USD/MT (out of the money)
• premium 5 USD/MT
• expiry date 1st Sept. 2008
• Exercise: Build the P&L profile for the deal

Perret, 2008, p. 29
Example: Call Option Application
Utility buys a call option to hedge physical position
Third scenario:
Advantage still has the upside if market goes down
Protection in case wrong market view and market goes up
But have to pay a cost = premium
In this example total cost: 5*150,000 = $750,000
The shape of resulting deal looks familiar? Long Put Option

https://bit.ly/2DIxNs6
FEBRUARY 2019 CRUDE OIL
Selling the February Crude Oil 90 call/45 put strangle

https://bit.ly/2DIxNs6
Example: Selling Option Strangle
• Selling the February crude 90 call, 45 put strangle for premiums of $600 per side.
• Margin per trade $1875.
• If worthless at expiration, the options would produce a 64% [(2 x 600 / 1875] return on investment.
• Strangle writers are NOT trying to predict what prices will do – only pick a price window where prices
will likely remain.
• Option strangles: offsetting nature (one side balancing out the other in an adverse move).
• By selling the option, the seller’s other risk is that the value of the option could increase during the
life of the option, thus increasing margin requirement to remain in the trade.
• The Option Seller wants to sell an option that is far enough out of the money and with low enough
volatility that the market can move a long way without greatly affecting the price or margin
requirement of her option.
• The strangle is most effective when the price of the underlying market remains in a defined range.
• While trending markets are not best for this approach, this does not mean that volatile markets
should be overlooked for strangling opportunities.
• Volatile markets often can still trade in wide trading ranges, and the volatility can boost option
premiums, meaning that a strangle often can be sold with a very wide profit zone.

Collar
• Way to get benefits of a call or put option without the pain of an upfront premium
• If consumer, can sell a put (floor) and , with earned put premium, can buy a call (cap)
• Gives consumer desired protection against price increases, allowing him to benefit from some
price decreases, although not 100%
• If producer, can sell a call and buy a put
• Often called costless caller or zero premium collar

Hedging with Costless Collar
A costless collar is the combination of two options.
In the case of a producer it is generally the combination of buying a put option (floor) and
selling a call option (ceiling)
Example: how an oil and gas producer can hedge with "producer costless collar" on Brent
crude oil, a strategy which will include buying a Brent crude oil put option and selling a Brent
crude oil call option.
To make the option costless, the options will be structured so that the premium paid for the
put option will be offset by the premium received from selling the call option.
https://www.mercatusenergy.com/blog/bid/106577/the-fundamentals-of-oil-gas-hedging-costless-collars

Hedge your December crude oil production with a Brent crude oil costless collar.
• Need to be hedged against December Brent prices trading below $40/BBL.
• Buy a $40 December Brent crude oil put option for a premium of $1.50/BBL.
• In order to offset the cost of the $1.50 premium associated with the $40 put option
– Sell a $59 December Brent crude oil call option for a premium of $1.50/BBL
 December Brent $40/$59 producer costless collar
 $40 floor and a $59 ceiling.

Hedging with costless Collar
• Hedging Gain: Brent crude oil prices during December average less than $40/BBL
• Hedging Loss: Brent crude oil prices during December average more than $59/BBL
• Neither a Hedging Gain nor Loss: If the price is between $40 and $59
• How will the $40/$59 costless collar perform if Brent crude oil prices during the month of
December average less $40/BBL and more than $59/BBL?

Average settlement price for the prompt Brent
crude oil futures, during the month of December, is
$70.00/BBL.
The price you receive at the wellhead for your
December crude oil production will be
approximately $70.00/BBL.
Because you sold the $59 call option as part of your costless collar, you would have a hedging loss of
$11 on the call option.
The net price you receive for your December production, excluding the basis differential, (gathering
and transportation fees) will be $59/BBL.

Average settlement price for the prompt Brent
crude oil futures, during the month of December =
between $40 and $59  not incur a hedging gain or
loss.
Average settlement price for the month = $50.00 
the net price you receive for your December
production will be appr. $50/BBL.

Hedging strategy of an oil consumer
• Hedging strategy of an oil consumer (like an airline) buying an out-of-the-money call option,
financed by selling an out-of-the-money put option in 2014.
• As the price of oil became closer to the put option strike, the consumer may have decided to close
out this hedge. Finalizing a transaction by making an equal and opposite trade to an open position.
Till, 2018, p.13

Airline Fuel Hedging
• Jet fuel accounts for around 25% of operating expenses.
• Hedging duration: 12 to 18 months
• Around 40% to 80% of fuel hedged
• Hedging instruments: Swaps, call options and costless collars
• Purpose:
– mitigate cash flow volatility
– obtain protection against short-term fuel price increases
• Hedging Index: Northwest Europe Jet Fuel (shorter tenors), ICE Brent Crude Oil (longer tenors)
Mercatus, 2004, p.2

• The price of a call option decreases as the strike price increases
• option tend to become more valuable as their time to maturity increases.
Hull, 2012, p.8; CME https://goo.gl/pZ7cx3
Settle Price of Crude Oil American CALL Options 22 March 2019 – May 2019 Futures settled at $59.04; June at
$59.29, July at $59.53
Strike Price in $ May 2019 June 2019 July 2019
Settlement Price in $
58 2.23 3.25 4.06
59 1.63 2.66 3.47
60 1.14 2.13 2.93
61 0.76 1.68 2.45

• The price of a put option increases as the strike price increases.
• option tend to become more valuable as their time to maturity increases.
Hull, 2012, p.8; CME https://goo.gl/pZ7cx3
Settle Price of Crude Oil American PUT Options 22 March 2019 – May 2019 Futures settled at $59.04; June at
$59.29, July at $59.53
Strike Price in $ May 2019 June 2019 July 2019
Settlement Price in $
58 1.2 1.97 2.54
59 1.59 2.37 2.95
60 2.1 2.84 3.4
61 2.72 3.38 3.91

Hull, 2012, p.12
Options Forwards
A linear product is one whose value at any given
time is linearly dependent on the value of an
underlying market variable
Are not linear products Are linear products
Which one provides insurance?
Purpose of the design?
Option contracts provide
insurance.
They offer a way for
investors to protect
themselves against adverse
price movements in the
future while still allowing
them to benefit from
favorable price
movements.
designed to
neutralize risk by
fixing the price that
the hedger will pay
or receive for the
underlying asset.
payment of an up-front fee options involve the
payment of an up-front
fee.
Forwards don’t
involve the payment
of an up-front fee.

Hull, 2012, p.12
Strategies for Commodity Buyers Strategies for Commodity Sellers
Buy futures for protection against rising prices Sell futures for protection against falling prices
Buy calls for protection against rising prices and
opportunity if prices decline
Buy puts for protection against falling prices and
opportunity if prices rally
Sell puts to lower your purchase price in a stable
market
Sell calls to increase your selling price in a stable
market
Buy a call and sell a put to establish a purchase
price range
Buy a put and sell a call to establish a selling price
range
Cash purchase without risk management Cash sale without risk management

3.4 Commodity Swaps
Hull,, 2012, p.148
• Commodity swaps are in essence a series of forward contracts on a commodity with
diﬀerent maturity dates and the same delivery prices.
• A swap is an over-the-counter agreement between two companies to exchange cash
flows in the future.
• The agreement defines the dates when the cash flows are to be paid and the way in
which they are to be calculated.
• Usually the calculation of the cash flows involves the future value of an interest rate,
an exchange rate, or other market variable.
• A forward contract can be viewed as a simple example of a swap.
• Whereas a forward contract is equivalent to the exchange of cash flows on just one
future date, swaps typically lead to cash flow exchanges on several future dates.

3.4 Commodity Swaps
https://bit.ly/2wHKse7
• Swap Transaction: Agreement today to buy/sell commodity at a predetermined fixed
price over a predetermined period of time. (often financial)
• A commodity swap is a type of swap agreement whereby a floating (or market or spot)
price based on an underlying commodity is traded for a fixed price over a specified
period.
• A Commodity swap is similar to a Fixed-Floating Interest rate swap.
• A commodity swap is usually used to hedge against the price of a commodity
• Swaps are arguably the most popular - because swaps can be customized while futures
contracts cannot - hedging instrument used by oil and gas producers to hedge their
exposure to volatile oil and gas prices as hedging with swaps allows them to lock in or
fix the price they receive for their oil and gas production.

3.4 Commodity Swaps
Hull, 2012, p.744
• Ten-year fixed-price supply contracts have been commonplace in the over-the-counter
oil market for many years.
• These are swaps where oil at a fixed price is exchanged for oil at a floating price.
• Example:
• A company that consumes 100,000 barrels of oil per year could agree to pay $8
million each year for the next 10 years and to receive in return 100,000S, where S
is the market price of oil per barrel.
• The agreement would in effect lock in the company’s oil cost at $80 per barrel.
• An oil producer might agree to the opposite exchange, thereby locking in the
price it realized for its oil at $80 per barrel.

3.4 Commodity Swaps
Hull, 2015, p.101
Examples:
Suppose it is March 1, 2016, and a company enters into a forward contract to buy 100 ounces of gold for
$1,300 per ounce in one year.
The company can sell the gold in one year as soon as it is received.
The forward contract is therefore equivalent to a swap where the company agrees that on March 1,
2017, it will swap 100 times the spot price of gold for $130,000.
Whereas a forward contract is equivalent to the exchange of cash flows on just one future date, swaps
typically lead to cash flow exchanges taking place on several future dates.

3.4 Commodity Swaps

3.4 Commodity Swaps
LIBOR = London Interbank Borrowing Rate; CIF = delivered coal price into UK inclusive of freight and insurance

3.4 Commodity Swaps

3.4 Commodity Swaps
https://goo.gl/NKs6fv
Example:
An oil producer who needs to hedge its November crude oil production to ensure that its November revenue meets or
exceeds its budget estimate of $45.00/BBL.
If it had sold a November Brent crude oil swap at the close of business yesterday, the price would have been approximately
$48.78/BBL.
If the prompt month Brent crude oil futures contracts during the month of November average $10 higher and $10 lower than
the $48.78 price at which it sold the swap, what would be the outcome?

3.4 Commodity Swaps
1st Scenario: average settlement price for the prompt Brent crude oil futures for each
business day in November is 58.78/BBL.
The price you receive at the wellhead for your November crude oil production would
be approximately $58.78/BBL.
However, because you hedged with the $48.78 swap, you would incur a hedging loss
of $10/BBL which equates to net revenue of $48.78/BBL.
While you did experience a hedging loss of $10/BBL, the hedge did perform as
anticipated and allowed you to lock in a price which was $3.78/BBL more than your
budgeted price of $45/BBL.

3.4 Commodity Swaps
2nd Scenario:
Average settlement price for the prompt Brent crude oil futures, for each business day
in November, is $38.78/BBL.
As the settlement price is $38.78, you would receive approximately $38.78/BBL for
your November crude oil production.
However, due to the fact that you hedged with the $48.78 swap, you would incur a
hedging gain of $10/BBL.
Your net revenue in this case will be $48.78/BBL as well as the hedging gain offsets
the lower, actual price.
The hedge did perform as expected and allowed you to lock in a price of $48.78/BBL
or $3.78/BBL more than your budgeted price of $45/BBL.

3.5 Commodity Index Investing
• A commodity index fund is a fund whose assets are invested in financial instruments based on
or linked to a commodity price index.
• In just about every case the index is in fact a commodity futures index
• New source of liquidity to commodity Futures contracts and allows pension funds and other
institutional investors to add commodity exposure to their portfolio.
Geman, 2015, p.236

• We can recognize essentially two families of indexes:
– The first one where the main choices in the definition of the index were:
• the number of commodities in the index (small versus large)
• the choice of these commodities
– the weights of these commodities. For commodities, the choices vary between
constant weights (CRB) to weights related to production, or consumption, or
volume traded in the Futures where the money related to a commodity in the
index will be invested
• the frequency and choice of the rebalancing rule
– Second generation indices are superior to their first generation counterparts.
• This improvement comes from their systematic attempt to minimize the harmful impact
of negative roll yield (or contango) on performance, or
• from their use of active long-only signals based on momentum or roll-yields.
Geman, 2015, p.236

Frist generation indices
Exposure concentrated in major beta benchmarks, systematic alpha strategies gradually gaining
ground

• Goldman Sachs Commodity Index
– It involves 24 components
– Only includes Futures denominated in dollars
– It is world production weighted; hence the weights fluctuate over time
• Reuters CRB Commodity Index
– It is the oldest and most published index
– It involves 17 components with equal weightings
• Dow Jones-UBS Commodity Index (previously DJ-AIG)
– The index is rebalanced annually
– It is US centered – only 12% of the Futures it uses are traded outside the USA
– It involves 19 components
Geman, 2015, p.237

What is Commodity Beta?
• Traditional asset classes define “beta” using market capitalization, or a similar price-based metric, as
the basis for determining the weighting scheme
• Since commodity investments are typically, obtained via commodity futures there is a challenge
with defining commodity “beta” in a similar vein
– For each Futures contract outstanding there is one entity which is long the exposure and one
offsetting entity that is short the exposure
– Therefore the market capitalization of each futures market is zero
• Index providers have turned to other factors to determine how to allocate capital across various
commodities
– These include, but are not limited to open interest, volume, production and fixed weights
• Since there is no agreeable definition of how to define the market weights of various commodities,
all commodity indices are actually rules-based commodity strategies

Second generation indices are superior to their first generation counterparts.
• This improvement comes from their systematic attempt to minimize the harmful
impact of negative roll yield (or contango) on performance, or from their use of
active long-only signals based on momentum or roll-yields.
• Second generation indices suffer from two major drawbacks.
– First, many of them hold distant contracts that are less liquid and thus are costly
to trade;
– as they are long-only, they cannot fully benefit from the price depreciation
associated with contango.
Miffre, 2013, p.31

An interesting alternative: the third generation indices that accurately take into
account the fundamentals of commodity futures markets by going long
backwardated assets and short contangoed ones, simultaneously reducing overall
volatility.
• In their design, they are closer to actively managed commodity trading strategies
than they are to first or second generation indices.
• They offer good performance in periods of market downturn, good diversification
to equity investors, high liquidity and full transparency at a low cost.
• They might become serious contenders to commodity trading advisors that merely
replicate strategies based on momentum or term structure.
Miffre, 2013, p.31

3.5 Commodity Index Investments
Main contributor to total return was Collateral Yield

3.5 Commodity Index Investments
Roll Yield is quite volatile
Geman, 2015, p.52

4. Drivers of Commodity Markets
4.1 Fundamentals of Commodity Pricing 179
4.2 Inventory and Theory of Storage 180
4.3 Supply and Demand 186
4.4 Marginal Cost of Production 198
4.5 USD vs. Commodities 201
4.6 Commodity Performance throughout Economic Cycle 202
4.7 Stock-to-Usage Ratio 204
4.8 Commodity Markets vs Other Markets 206
4.9 Technical Analysis 208

4. Drivers of Commodity Markets
Key Drivers
for
Commodity
Markets
Supply,
Demand,
Inventories
Marginal
cost of
production,
Technology
Economic
growth,
inflation,
interest rates
Geopolitics,
Weather
Currencies
Investment
and
Speculation

4.1 Fundamentals of Commodity Pricing
Buchan,2016, p.9
Fundamentals
of Commodity Pricing
Where?
Delivery
Location
When?
Delivery
Timing
What?
Product
Quality or
Grade
Supply and
Demand,
Trading by
Speculators,
Production
Costs

4.2 Inventory and Theory of Storage
Figure: Inventories vs. Brent Time Spreads
Till, 2018, p.7
OECD Commercial Stocks in Days of OECD Demand Coverage vs. 3-Year Average (LHS) vs. 1-Month to
5-Year Brent Time Spreads (%, RHS, Inverted).

Figure: Brent Crude Oil Prices and Spare Productive Capacity
Till, 2018, p.9
.

Bloomberg Intelligence - Commodity Outlook Webinar March 2018

Commodities are stored for several reasons:
• Buffer against uneven or seasonal supply
• Reserve against uneven demand, which are typically used more in winter for heating.
• Hedge against any other supply or logistical disruption
– expensive pause of an industrial process.
• Investment purposes within physically-backed ETFs.
• Cash and Carry Strategies
Geman, 2015, p.49

Cash and Carry Arbitrage
• At a certain point, the possibility of so-called ‘cash and carry arbitrage’ emerges,
– whereby a risk-free profit can be obtained by buying the commodity in the spot market,
– simultaneously selling a Futures contract at a higher price, and
– storing (‘carrying’) the commodity until the delivery date of the Futures contract.
• This possibility limits the degree of contango for storable commodities.
• limit to the strength of backwardation
• Given sufficiently high spot prices, some consumers will cancel or postpone their demand,
or possibly substitute their demand to another commodity.
Geman, 2015, p.49

Example: Wheat forward curve on Sep. 15, 2011
• Interest rates were very low worldwide
• By buying the wheat spot at 630 cents/bushel using a loan (20 cents/bushel), leasing part of a silo
(30 cents/bushel) to store it, and selling a forward contract maturing in October 2012 at 720
cents/bushel,
• -> generate a sure profit (720 – 630 – 20 - 30 = 40 cents/bushel) at maturity after receiving the
forward price and repaying the loan with accrued interest and the lease rate.
Figure Wheat forward curve in contango like corn in December 2011
Geman, 2015, p.57

4.3 Supply and Demand
Christian, 2006, p.216
Figure: The Price of Copper
Figure : Copper Supply and Demand

Source: http://www.visualcapitalist.com/chinas-staggering-demand-commodities/

http://www.glencore.com/investors/speeches-and-presentation

Rogers, 2005, p.45
How much production is there
worldwide?
• How much production is there
worldwide?
• How many tons of reserves are
there?
• Is the production in areas that
might experience turmoil?
• Are the reserves rich with
copper or only marginally
productive?
• What are the existing
inventories?
• How many mines exist
worldwide?
• How productive are these
mines?
• What is the potential supply
over the next 10 years?
Are there new sources of
supply?
• Old mines expanding?
• When?
• How much will this cost?
• How much copper will this
expansion produce?
• How long will it take before
additional supplies get to
market?
Are there new potential
supplies?
• How much?
• How expensive to develop and
then produce?
• How long before these new
sources will be available?
• When will the new supplies
get to market?
Copper Market

Rogers, 2005, p.46
Fundamental Analysis of Copper - Demand
What is this commodity most used for?
Which of the current uses will continue?
What alternatives are available to replace it if the prices go too high?
What new technological advances might require this commodity that did not exist
before?
So if your research indicates that supply is high and demand is not likely to improve,
learn to sell short or move on-but not before you consider the alternatives.

http://www.kitcometals.com/charts/copper_historical_large.html
Copper Spot Price vs. Copper Warehouse Stocks

http://www.kitcometals.com/charts/nickel_historical_large.html#5years
Nickel Spot Price vs. Copper Warehouse Stocks

4.4 Marginal Cost of Production
The cost curve is a graph that plots the production capacity and costs of an entire industry.
On the X-Axis, cumulative production is ranked. Producers (or projects) are laid out from low to high
cost and bars are used to indicate their output — the wider the bar the more they churn out.
On the Y-Axis is the cost of production.
https://goo.gl/VKKQLn

• It provides a quick snapshot of the industry. Investors can overlay the current price if a commodity on to the cost
curve to and judge which producers are economic — and which are not.
• Generally, producers want their operations be in the lowest quartile.
• That’s especially true in a falling price environment.
• Cost curves have other uses.
• They can also be used to estimate price support levels and where the high-cost producer sits in a given industry.
Is that where the 90th percentile comes in?
• Beyond the 90th percentile are the projects that produce the 10 per cent of global output at the highest cost.
They are generally considered the “marginal producers”.
• If prices fall below the cost of production for these higher-cost producers for a sustained period, the theory is
that they should stop producing and so bring supply and demand back into balance.
• In that way, the 90th percentile can be seen as offering a measure of price support and a rough idea of the break-
even price.
https://goo.gl/VKKQLn

Figure: Marginal Cost (defined as the Average of the Highest Cost Producers vs. 5-Year WTI Futures
Price in $/Bbl
Till, 2018, p.13

4.5 USD vs. Commodities
http://www.schroders.com/en/insights/economics/outlook-2018-commodities/

4.6 Commodity Performance throughout Economic Cycle
https://www.valuewalk.com/2017/09/the-economic-clock/
Figure: The Theoretical Economic Cycle – Output Gap and Inflation

Gorton, 2004, p. 21
Table: Average Returns by Stage of the Business Cycle
• During the Early Recession phase the returns on both Stocks and Bonds are negative, –18.64% and
–3.88% respectively.
• But, the return on Commodity Futures is a positive 3.74%.
• During the Late Recession phase the signs of the returns reverse, stocks and bonds are positive,
while commodity futures are negative.

https://summerhavenindex.com/assets/sector_analysis_paper.pdf
Table Business cycle analyses, January 1970 – December 2012
Note: Table displays the monthly returns of commodities and stocks during various stages of the
business cycle. We divide the individual recession/expansion periods in equal halves to define early
and late recession/expansion. The period of expansion subsequent to June 2009 is not categorized as
either early or late expansion. Business cycle dates are based on National Bureau of Economic
Research’s Business Cycle Dating Committee.

4.7 Stock-to-Usage Ratio
Hull, 2012, p.749
• The prices of agricultural commodities, like all commodities, is determined by supply
and demand.
• The United States Department of Agriculture publishes reports on inventories and
production.
• One statistic that is watched for commodities such as corn and wheat is the stocks-to-
use ratio.
stocks-to-use ratio = year-end inventory / year’s usage
• Typically it is between 20% and 40%.
• It has an impact on price volatility.
• As the ratio for a commodity becomes lower, the commodity’s price becomes more
sensitive to supply changes, so that the volatility increases.

4.7 Stock-to-Usage Ratio
https://bit.ly/2wcFgMa https://bit.ly/2LUtjVN

4.8 Commodity Markets vs Other Markets
Geman, 2005, p.xvi
Commodities Stocks/Bonds
Commodity spot prices are defined by the interactions of supply and demand curves in a
given location
net present value of receivable cash
flows.
Commodity prices do not generally exhibit trends over long periods (mean-reverting of
commodity prices over time).
stock prices grow on average - since
the investor is rewarded for the time
value of his money augmented by a
risk premium
Demand for commodities is generally inelastic to prices, given the indispensable nature of the
good. Inventories when they exist in sufficient volumes allow a smooth balance of supply and
demend over time to be created
Physical transactions still have a crucial importance today. They provide a reference spot price
or index against which derivative transactions are financially settled
Supply is defined by production and inventory. But, in the case of energy commodities,
underground reserves also play a role since they have an impact on long-term prices
Financial transactions (forwards, futures, options) represent today a huge volume. They
involve prices closely related to spot prices in particular because physical delivery is a choice
that is left to the buyer.
The understanding of spot markets and their characteristics is a necessary step in the analysis
of commodities and commodity derivatives
Commodities represent today an asset class in its own right. Some institutional investors and
funds are turning to it for potential diversification benefits and returns

4.8 Commodity Markets vs Other Markets
Geman, 2005, p.xvi
Commodities Stocks/Bonds
commodity investments are typically, obtained via commodity futures; there is a challenge
with defining commodity “beta” in a similar vein.
Therefore the market capitalization of each futures market is zero.
Index providers have turned to open interest, volume, production and fixed weights to
determine how to allocate capital across various commodities.
Since there is no agreeable definition of how to define the market weights of various
commodities, all commodity indices are actually rules-based commodity strategies
Traditional asset classes define “beta”
using market capitalization, or a
similar price-based metric, as the
basis for determining the weighting
scheme
Physical delivery attached to spot, forward contracts and futures positions not closed prior to
maturity and translates into good transfer, with the corresponding constraints for both parties
in terms of shipping arrangements, warehousing
Quantitiy Risk exists in Commodity Marketes Stock and bond investors are
concerned by the price risk attached
to the instruments they are holding.
exotic options such as Asian, exchange or spread, are the most appropriate options in
commodity markets.
exotic options are now familiar in
securities markets
„Take or pay“ contacts or „swing“ contracts are playing a key role in commodity markets since
they are designed to provide a hedge against volumetric risk.

4.9 Technical Analysis
Nymex, 1999, p.20
• The word “technical” is often used in connection with the action of prices in the futures
market.
• Often heard phrases are, the market declined because of a “technical reaction,” it went
up on a “technical rally,” the market is “technically weak” or “technically strong.”
• Technical is used to mean a price movement based on a continuation of, or deviation
from, an observed price pattern.
• The market price of a specific commodity is considered by technical traders to be the
most important determinant of the environment which will affect futures prices.
• Through the use of the information revealed from charting daily futures prices,
technicians attempt to make accurate predictions regarding futures price behavior.

Nymex, 1999, p.20
• Charting Price Trend Lines is the practice of recording, in graph format, the market price movements of a particular commodity over time
with the objective of defining price levels at which commodities should be bought or sold.
• Daily price movements are plotted as high, low, and closing prices to help the trader determine trends, resistance points at which prices
should not be easily exceeded, and support points below which prices should not easily fall.
• These technical signals are used by traders to indicate when to buy or sell.
• Trend lines are the simplest form of technical analysis.
• Connecting a series of high points to draw a downtrend can give the trader his first set of clues to current market direction.
• Using lows and highs together, in either direction, will yield a price channel between the two lines, indicating if and when a piece
breakout beyond the channel may occur.
• Moving averages represent a more complex way of identifying these underlying trends.
• Technical traders always trade with the trend, never against it.
• While there will always be moderate rallies in downtrends and moderate reactions in uptrends, countertrend movement is seldom
sustained.

Nymex, 1999, p.21
• A variety of patterns have been identified to help recognize changes in a trend.
• Market cycles have been variously depicted at “double tops,” (when the market rises but hits
resistance at a certain level, retreats, rises again, but still cannot breach the previous resistance
point, and falls back again);
• “double bottoms,” an inverse pattern that shows resistance to a falling market; “head-and-shoulder
formations,” again the same general pattern, but with the resistance points being hit at
succeedingly lower (or higher) levels;
• “triangular flag patterns,” when the market consolidates sideways;
• and “price gaps,” when the low price of one bar on a chart is higher than the high of the preceding
bar (or inversely, the high is lower than the low of the preceding bar, a price or price range where
no trades take place)

Nymex, 1999, p.21
Other techniques and terms which are commonly used in technical analysis include:
• Historical Volatility: Analysis of a commodity’s past price variability based on time frame (for example, 20-day) and price interval.
• Moving Average: Moving average (open, high, low, close, midpoint, average) to follow the trend signal data fluctuations, and signal long
and short positions.
• Ratio: Despite large fluctuations in price, many commodities have price relationships. By calculating and analyzing their ratio, overvalued
and undervalued markets can be found.
• Rate of Change: Monitors and calculates the market’s rate of change relative to previous trend intervals, as specified in the value input
(also known as peaks and valleys).
• Relative Strength Index (RSI): Study to measure the market’s strength and weakness. A high RSI (>70) indicates an overbought or
weakening market, and a low RSI (>30) an oversold, bear market.
• Stochastic Oscillator: A computer-generated overbought/oversold indicator whose traditional interpretation is similar to that of the RSI. A
high stochastic reading (>80) indicates an overbought, or weakening, market and a low reading (>20) indicates an oversold market.
• Support/Resistance/Reversal: Levels determined through technical analysis that indicate trading support, resistance, or the reversal
(inverse) of a market price in a specific time frame.

https://www.linkedin.com/feed/update/urn:li:activity:6536197920444698624
• Commodity, Inflation Risks Shift Downward With Chinese Yuan.
• The disinflationary trends of declining Treasury bond yields and futures priced for Federal Reserve rate easing
are soon to be joined by commodity prices.
• In the absence of a definitive U.S.-China trade accord, broad commodities appear to be in the early days of a
downshift.

• Futures Show Copper on Cusp of Indicating Risk-Off Is Back On
• The CME-traded copper future is at elevated risk of breaking below 2018's high-volume price support level, indicating
risk-off for most assets.
• Our graphic depicts copper revisiting key support on the back of a weakening yuan.
• If copper follows the path of China's currency, we expect it to revisit January lows, with macroeconomic implications.
• Copper was one of the first risk-off indicators last year, when it broke down below its 52-week mean in June.

• Remember the 2014-15 Crude Oil Bear Market? Similarities Abound.
• Its unlikely that dominant trends in increasing U.S. fuel production and decelerating global
demand will subside absent lower crude oil prices.
• Conditions for West Texas Intermediate are similar to the 2014-15 bear market.
• Geopolitical events that boost prices in the short-term also support more U.S. production

• Hedge Funds' Big Grain Short Set for Similar Fate as Gold, Bonds.
• After last year's big short positions in gold and Treasury bonds supported price bottoms, BBG thinks corn, soybeans and wheat
are ripening for a similar fate.
• The current setup in the grains has the makings of a historic bear-market bottom. Increasing prices remain the aftermath of
similar extreme 2H net shorts in gold and bonds

5 Commodity Portfolio Management
5.1 Commodity Matrix 217
5.2 Overbought/Oversold Indicator 219
5.3 Alternative Risk Premia in Commodities 221
5.4 Risk Premium Strategy 224
5.5 Commodity Strategies Based on Momentum and Term Structure 229
5.6 Combined Momentum, Term Structure and Idiosyncratic Volatility Signals 231

5.1 Commodity Matrix
https://etfs.wisdomtree.eu/Documents/Commodities-see-saw-amidst-geopolitics-and-rising-yields.pdf

5.1 Commodity Matrix
Commodity Monthly Matrix Explained
Green = returns positive, inventories falling, positioning rising, roll yield positive
Red = returns negative, inventories rising, positioning falling, roll yield negative
Black = neutral
Score based on unweighted sum of four fundamental/technical measures with each measure awarded a possible
score of -1, 0,or 1 depending on whether variable is viewed as fundamentally negative, neutral or positive.
The four fundamental/technical measures are as follow:
- price vs. 200 days moving average: 1 when price is above 200dma and return is positive, -1 when price is below
200dma and return is negative, 0 otherwise
- % change in net positioning over the past month: 1 when % change is positive, -1 when % change is negative, 0
when no change
- % change in inventory level over the past 3 months: 1 when % is negative, -1 when % is positive, 0 when no
change
- roll yield between the front and second month futures contracts: 1 when in backwardation, -1 when in
contango, 0 when no change
https://etfs.wisdomtree.eu/Documents/Commodities-see-saw-amidst-geopolitics-and-rising-yields.pdf

5.2 Overbought/Oversold Indicator
https://goo.gl/Kk1WHU p.12

5.2 Overbought/Oversold Indicator
• The SG OBOS indicator defines and identifies “oversold” (“overbought”) commodities on a
weekly basis as those that are lying at the intersection of extremes in both short (long)
positioning and price weakness (strength).
• Commodities within the “oversold” (“overbought”) box are trading in the bottom (top)
25% of their price range and have a short (long) position (calculated as the short [long]
Money Manager [MM] open interest [OI] as a percentage of total OI) more than 75% of
the historical maximum.
• These commodities are vulnerable to short-covering (profit-taking).
https://goo.gl/Kk1WHU p.12

5.3 Alternative Risk Premia in Commodities
Commodity Beta vs Alternative Risk Premia
Characteristics, return drivers, implementation
Picard Angst, 2016, p.31
Commodity Beta Alternative Risk Premia
Characteristics • cyclical return profile
• inflation protection
• diversification due to on
average low correlation with
traditional asset classes
(equities, bonds)
• absolute returns
• moderate to low volatility
• diversification due to
persistently low correlation
with traditional asset classes
and commodity beta
Return Drivers risk premium compensating for
the assumption of general asset
class risk
(beta)
• momentum
• value
• carry
• volatility
• etc.
Implementation long only long/short market-neutral

Sources of systematic commodity alpha
• The rich structure of commodity derivatives markets enables investors to access targeted
alternative risk premiums by accepting exposure to specific risk factors.
• Such risk factors typically exhibit behaviour that is largely independent of the general
trend in commodity markets (beta)
• Momentum
– Markets in commodities are highly cyclical.
– The economic cycle produces sustained divergences between supply and demand
dynamics resulting in persistent trending behaviour of commodity prices during the up-
and downswing phases of cycles

Sources of systematic commodity alpha
• Value
– Value strategies are intended to take advantage of situations of scarcity or excess of supply
relative to demand. To that end, the inverse relationship between inventories and prices is
exploited
• Carry / Seasonality
– Given the pronounced influence of weather and seasons on the demand and supply of energy
and agricultural commodities strong seasonal elements are evident in their price dynamics.
– By arbitraging the term structure investors can take advantage and profit from this phenomenon
• Volatility
– Volatility premium strategies aim to earn the premium at which implied volatility is traded in
option markets relative to realized volatility. In doing so they accept the risk of unanticipated
peaks in realized market volatility

5.4 Risk Premium Strategy
Combination of momentum and value factors vs commodity beta

5.5 Commodity Strategies Based on Momentum and Term
Structure
• When inventories are high, the Term Structure is upward-sloping which encourages inventory
holders to buy the physical commodity at a cheap price and
• Sell it forward at a premium that exceeds the cost of storing and financing the commodity.
• The Term Structure strategy recommends selling such contangoed commodities as their price tends
to decline with contract maturity.
• Inventories low -> Term Structure downward sloping
– -> convenience yield derived from owning the commodity spot > costs of storage and financing
incurred in the spot market.
• The Term Structure strategy recommends buying such backwardated commodities as their price
tends to rise with contract maturity.
Fuertes, 2014, p.3

5.5 Commodity Strategies Based on Momentum and Term Structure
• Simultaneously buying contracts with high past performance (Momentum) and high roll-yields (term
structure), and
• Shorting contracts with poor past performance and low roll-yields
• Sharpe ratio 1985 to 2011: 5x S&P-GSCI.
• long-short portfolios based on various signals can capture the risk premium of commodity futures
• Term Structure (TS) signal: taking long positions in commodities with downward-sloping term
structures (or positive roll-yields) and
• short positions in commodities with upward-sloping term structures (or negative roll-yields)
– relates to the theory of storage and thus to inventory considerations
• long-short Momentum strategy that buys recent winners and shorts recent losers
Fuertes, 2014, p.3

• Performance: The table presents summary statistics for the returns of fully-collateralized long-short portfolios.
• The asset allocation is based on double-screen strategies that exploit momentum (Mom) and term structure (TS).
The signals are measured over ranking periods R = 3 months.
• The sample covers the period from February 1985 to August 2011.
Fuertes, 2014, p.34
Ranking period 3 Months
Panel A: Excess returns Minimum 12M rolling return ‐0.1272
Annualized arithmetic mean 0.0904 Skewness 0.3877
Annualized geometric mean 0.0852 Kurtosis 4.4026
Panel B: Risk measures 99% VaR (Cornish‐Fisher) 0.0611
Annualized volatility 0.1028
Annualized downside volatility (0%) 0.0565 Panel C: Risk‐adjusted performance
% of positive months 0.5962 Sharpe ratio 1.9418
Maximum drawdown ‐0.1605 Sortino Ratio (0%) 0.8749
Drawdown length (months) 9 Omega ratio (0%) 0.4629
Maximum 12M rolling return 0.3837

Data
• The analysis is based on the daily settlement prices of 27 commodity futures contracts over the
period January 2, 1979 to August 31, 2011
• most liquid futures contracts (i.e., nearest or second-nearest to maturity) are held in the long-short
portfolios.
– using the prices of the nearest contract until the last day of the month prior to maturity, when we
roll then to the prices of the second-nearest contract.
• Unless we explicitly refer to total (i.e., excess plus collateral) returns, the empirical results presented
are based on excess (i.e., total minus collateral) returns and will be simply referred to as returns.
• Proxying the risk-free rate by the 3-month US Treasury-bill rate implies that the collateral mean
return over our effective sample period (1985-2011) stands at 4.10%.
• Assuming no margin calls, the gross performance of the unlevered portfolios reported hereafter is
understated by that amount.
Fuertes, 2014, p.6

Design and Performance of the Strategy with highest sharpe ratio
• At the time of portfolio formation we extract the signals for Ranking
windows (R = 3 months) and sort the available cross-section of
commodities accordingly.
• The sorting signal for Momentum is the past performance of each
commodity over the past R = 3 months.
• The sorting signal for TS is the roll-yield of each commodity measured as
the log price differential between front and second nearest contracts and
averaged out over the past R = 3 months
Fuertes, 2014, p.9

Design and Performance of the Strategy with highest sharpe ratio
• In each of them, the long portfolio is the quintile that is expected to outperform based on the
corresponding signal; i.e.,
– the 20% of commodities with best past performance or highest average roll-yields.
• The short portfolio is the quintile that is expected to underperform based on the signal; i.e., the 20%
of commodities with the worst past performance or the lowest average roll-yields.
• the long-short portfolios are held for one month, at the end of which the portfolio formation process
is repeated again and so forth.
• choice of percentile to form the long and short portfolios (i.e., top and bottom quintiles)
• diversification, equal weights are given to the constituents of each (top and bottom) quintile
Fuertes, 2014, p.9

5.6 Combined Momentum, Term Structure and Idiosyncratic
Volatility Signals
Design and Performance of Double-Screen Strategy with R = 3
• Two scores are assigned to each of the N commodities at the time of portfolio formation
according to past performance (Momentum) and roll-yields (TS) over the previous R = 3
months window.
• The highest score of N is given to the commodity with the best past performance
• lowest score of 1 is given to the commodity with the worst past performance.
• highest score of N is given to the commodity with the highest average roll-yield
• lowest score of 1 is given to the commodity with the lowest average roll-yield.
• We sort the commodities based on their total score, buy the quintile with the highest total
score, sell the quintile with the lowest total score and hold the long-short portfolio for one
month.
Fuertes, 2014, p.13

5.6 Combined Momentum, Term Structure and Idiosyncratic
Volatility Signals
Design and Performance of Triple-Screen Strategy
Figure: Future value of $1 invested in commodity portfolios. The figure plots the future
value of $1 invested in January 1985 in the S&P-GSCI, the novel triple-screen strategy
proposed, and each of the three individual strategies based on momentum, term structure
or idiosyncratic volatility.
Fuertes, 2014, p.36

Literature and other Sources
Compulsory Reading:
Geman, H. (Hrsg.) (2009): Risk Management in Commodity Markets: From Shippings to Agriculturals and Energy. New York: Wiley.
Supplementary literature
• Eller, R. (Hrsg.) (2010): Management von Rohstoffrisiken. Strategien, Märkte und Produkte. Wiesbaden: Gabler.
• https://activetrader.cmegroup.com – What drives Commodity Volatility?
• Basu, Devraj, Miffre, Joëlle (2012). Capturing the risk premium of commodity futures: The role of hedging pressure.
• Bhardwaj, Geetesh, 2013, How many commodity sectors are there, and how do they behave? https://summerhavenindex.com/assets/sector_analysis_paper.pdf
• BIS, OTC Derivatives Market - Source: https://stats.bis.org/statx/srs/table/d5.2?f=pdf
• Bredin, Don, Poti, Valerio, Salvador, Enrique (2018). Commodity Pricing
• Buchan, David, Commodities demystified, Trafigura, 2016
• Constellation Energy Commodities Energy, 2008, internal document
• Cordier, James, Gross, Michael (2009). The complete guide to option selling
• Deloitte, Managing extreme price volatility. https://goo.gl/BEpFcG
• Deloitte, (2018): Commodity Risk Price Management, https://bit.ly/2UvusGG
• Doubleline, (2017), https://bit.ly/2Z8EfSo
• Doubeline, (2018), Commodity Playbook, https://goo.gl/ee6kK1
• EY, Managing Commodity Volatility, https://goo.gl/dAPKpb
• Financial Times, 2015, Cost Curves, https://goo.gl/VKKQLn
• Fuertes, Ana Maria, Miffre, Joelle (2014), Commodity Strategies Based on Momentum, Term Structure and Idiosyncratic Volatility
• Geman, Helyette (2005) Commodities and and commodity derivatives
• Geman, Helyette (2008), Risk Management in Commodity Markets

Literature and other Sources
• Geman, Helyette (2015) Agricultural Finance
• Glencore, Annual Report, 2017
• Gorton, Gary, Rouwenhorst, K. Geert (2004). Facts and Fantasies about commodity future
• Gorton, Gary, Rouwenhorst, K. Geert (2015). Facts and Fantasies about commodity future ten years later
• Hull, John C., (2012), Options, Futures, and other Derivatives, 8th edition
• Hull, John C., (2012b), Options, Futures, and other Derivatives, 8th edition, Solution Manual
• Hull, John C., (2015), Risk Management and Financial Institutions, 4th edition
• Kleinman, George (2005). Trading Commodities & Financial Futures
• Masters, Michael, 2008, Testimony before Committee on Homeland Security, https://goo.gl/dmectk
• Mercatus Energy Advisors (2014). The State of Airline Fuel Hedging and Risk Management in 2013
• Miffre, Joëlle (2013). Comparing First, Second and Third Generation Commodity Indexes, Alternative Investment Analyst Review
• NYMEX, Guide to Energy Heding, http://www.kisfutures.com/GuideEnergyHedging_NYMEX.pdf
• Understanding the CFTC COT Report, https://bit.ly/2UuQvx3
• #Perret, Guillaume (2008) Coaltrans, Coal Trading and Risk Management Training Cource
• Picard Angst (2016) Commodities as an asset class
• Risk Metrics, JPMorgan/Reuters, Technical Document, 1996
• Rogers, Jim (2005). Hot Commodities, 2005
• Societe Generale, 2018, Commodity Market Analysis and Outlook, https://goo.gl/Kk1WHU
• Till, Hilary, (2003). The Design of a Commodity Futures Trading Program
• Till, Hillary (2018), Deducing Petroleum-Complex Fundamentals, https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3110900
• Traders‘ 04.2019 – Erfolgreiches Trading mit COT-Daten
• Trafigura, 2018a, Commodities Demystified, 2nd edition, https://goo.gl/Rq9Qnv
• Trafigura, 2018b, Corporate Brochure, https://www.trafigura.com/media/364955/2018-trafigura-corporate-brochure.pdf
• https://www.trafigura.com/how-physical-arbitrage-works/

Thank you for attending the class
„Commodity Portfolio Management“. Good
luck in your final examination!
Sheikh Zayed Road, Dubai
Foto: Schlesinger 2007

Commodity Portfolio Management

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