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Commodity derivatives for Financial Planning MCOM sem 1 Delhi University

Commodity derivatives for Financial Planning MCOM sem 1 Delhi University

Commodity derivatives markets have been in existence for centuries, driven by the efforts of commodities producers, users and investors to manage their business and financial risks.Commodity derivatives for Financial Planning MCOM sem 1 Delhi University.

Commodity derivatives for Financial Planning MCOM sem 1 Delhi University

Producers want to manage their exposure to changes in the prices they receive for their commodities. They are mostly focused on achieving the same effect as fixed prices on contracts to sell their produce. A silver producer, for example, wants to hedge its losses from a fall in the price of silver for its current silver inventory. Cattle ranchers want to hedge their exposure to changes in the price of cattle.  Food companies need to hedge the risk of price changes in green coffee, cocoa beans, cereals, milk and other commodities they sell.

End-users want and need to hedge the prices at which they can purchase commodities. A hospital system might want to fix the price at which it purchases electricity for air conditioning during the summer.  An airline wants to lock in the price of the jet fuel it needs to purchase in order to satisfy the peak in seasonal demand for travel.

At the same time, investors and financial intermediaries can either buy or sell commodities through the use of derivatives.  They put capital that is essential to facilitating the business of the producer and of the end-user.  They stand ready to transact with these market participants; without them, producers and end-users could not hedge their risks. Commodity derivatives for Financial Planning MCOM sem 1 Delhi University.

Today, the commodity derivatives market is global, and includes both exchange-traded and over-the-counter (OTC) derivatives contracts.  It consists of a wide range of segments:  agriculture, base metals, coal, commodity index products, crude oil, emissions, freight, gas, oil products, plastics products, power, precious metals and weather.

Commodity derivatives for Financial Planning MCOM sem 1 Delhi University

Thousands of companies of all shapes and sizes, in all industries and in all regions use commodity derivatives.  Manufacturers, energy companies, farmers, agriculture and food companies, IT companies – these and other types of firms make up the global commodity derivatives markets. They all contribute to the supply of needed commodities for ever-rising earth’s population. In this respect, the first half of the 21st century is a critical moment. The world’s population is expected to reach 9 billion in 2050, creating ever-increasing demands on limited resources and providing a challenge for industrial producers, market intermediaries, policy makers, governments and international organizations. Commodity derivatives for Financial Planning MCOM sem 1 Delhi University.

This leads to concerns about price increases and volatility, as Nobel Prize-winning economist Paul Krugman pointed out in a recent editorial, saying that volatility exists in our markets because we live in a “finite world” where there is not, at any given moment in time, an inexhaustible supply of oil, wheat, milk or other physical commodities to meet the global demand for such products. Simply put, prices are higher because the demand for a product around the globe is greater than the supply.

In a nutshell, fundamental factors will significantly put pressure on production, transportation, storage and delivery of commodities.

Closer to the financial sphere, some government agencies, academics and researchers have also pointed out the important of the linkage between all actors in the commodity derivatives markets:

The Deputy Governor of the Bank of Canada stated,

“…the financial system is linked with the commodities markets. Here, I mean the intricate web of global markets in which commodities are bought and sold, prices determined, and the producers and end-users of commodities hedge against unexpected movements in those prices. These markets are very important in determining the returns that Canadian producers earn for their output, as well as the risks they face.”

A US Foreign Affairs Report highlighted that

“In order to help consumers and companies deal with unpredictable oil prices, the United States should encourage more hedging through the financial markets. This idea may trouble those who blame speculators for price swings, but careful studies by the U.S. Energy Information Administration and the U.S. Commodity Futures Trading Commission have found that medium-term and long-term price shifts are primarily a function of changes in global supply and demand. Policymakers should help facilitate more hedging by encouraging the development of well-regulated financial markets: the point is to relieve those who are exposed to price risks today—from motorists to airlines and other oil-intensive industries—and transfer those risks to speculators, who are more willing and better able to bear them.” Commodity derivatives for Financial Planning MCOM sem 1 Delhi University.

And an EDHEC-Risk Institute Paper noted that

“We conclude by noting that modern commodity futures markets are the result of 160 years of trial-and-error efforts. We recommend that European Union policymakers consider studying market practices globally and then adopt what is demonstrably best practice, rather than invent new untested regulations.”

Derivatives Between Two Parties

For example, commodity derivatives are used by farmers and millers to provide a degree of “insurance.” The farmer enters the contract to lock in an acceptable price for the commodity, and the miller enters the contract to lock in a guaranteed supply of the commodity. Although both the farmer and the miller have reduced risk by hedging, both remain exposed to the risks that prices will change. For example, while the farmer locks in a specified price for the commodity, prices could rise (due to, for instance, reduced supply because of weather-related events) and the farmer will end up losing any additional income that could have been earned. Likewise, prices for the commodity could drop and the miller will have to pay more for the commodity than he otherwise would have. Commodity derivatives for Financial Planning MCOM sem 1 Delhi University.

Using a basic example, let’s assume that in April 2017 the farmer enters a futures contract with a miller to sell 5,000 bushels of wheat at $4.404 per bushel in July. At expiry date in July 2017, if the market price of wheat falls to $4.350, the miller has to buy at the contract price of $4.404 which is much higher than the market price of $4.350. Instead of paying 4.350 x 5000 = $21,750, he’ll pay 4.404 x 5000 = $22,020. Lucky farmer gets to sell at a higher price than what the market is offering.

Derivatives are used for speculating and hedging purposes. Speculators seek to profit from changing prices in the underlying asset, index, or security. For example, a trader may attempt to profit from an anticipated drop in an index’s price by selling (or going “short”) the related futures contract. Derivatives used as a hedge allow the risks associated with the underlying asset’s price to be transferred between the parties involved in the contract. Commodity derivatives for Financial Planning MCOM sem 1 Delhi University.

A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, index, or security. Common underlying instruments include: bonds, commodities, currencies, interest rates, market indexes, and stocks. (For more on derivatives, also check out Derivatives 101.)

Futures contracts, forward contracts, options, swaps, and warrants are common derivatives. A futures contract, for example, is a derivative because its value is affected by the performance of the underlying contract. Similarly, a stock option is a derivative because its value is “derived” from that of the underlying stock. Commodity derivatives for Financial Planning MCOM sem 1 Delhi University.

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