DRM Commodity

Models of Futures Prices - Cost-of-Carry Model
Cost-of-Carry Model
The common way to value a futures contract is by using the Cost-of-Carry
Model. The Cost-of-Carry Model says that the futures price should depend upon
two things:
The current spot price.
The cost of carrying or storing the underlying good from now until the futures
contract matures.
Assumptions:
There are no transaction costs or margin requirements.
There are no restrictions on short selling.
Investors can borrow and lend at the same rate of interest.
In the next section, we will explore two arbitrage strategies that are associated
with the Cost-and-Carry Model:
Cash-and-carry arbitrage
Reserve cash-and-carry arbitrage
DRM_Commodity_Futures
Cash-and-Carry Arbitrage
A cash-and-carry arbitrage occurs when a trader borrows
money, buys the goods today for cash and carries the
goods to the expiration of the futures contract. Then,
delivers the commodity against a futures contract and
pays off the loan.
Any profit from this strategy would be an arbitrage profit.
0
1. Borrow money
2. Sell futures contract
3. Buy commodity
4. Deliver the commodity

against the futures contract
5. Recover money & payoff
loan
Cost-of-Carry Model
The Cost-of-Carry Model can be expressed as:
F 0, t S 0(1 C0, t )
Where:
S0
F0,t
=
=
the current spot price

the current futures price for delivery of
the product at time t.
C0,t =
the percentage cost required to store (or carry) the commodity
from today until time t.
The cost of carrying or storing includes:
1. Storage costs
2. Insurance costs
3. Transportation costs
4. Financing costs
In the following section, we will examine the cost-of-carry
rules.
Cost-of-Carry Rule
The futures price must be less than or equal to the spot price of the commodity
plus the carrying charges necessary to carry the spot commodity forward to
delivery.
F 0, t S 0(1 C 0, t )
Cash-and-Carry Gold Arbitrage Transactions

Prices for the Analysis:
Spot price of gold
Future price of gold (for delivery in one year)
Interest rate
Transaction
t=0
$400
$450
10%
Cash Flow
Borrow $400 for one year at 10%.

Buy 1 ounce of gold in the spot market for $400.
Sell a futures contract for $450 for delivery of
one ounce in one year.
+$400
- 400
0
Total Cash Flow
t=1
Remove the gold from storage.

Deliver the ounce of gold against the futures
contract.
Repay loan, including interest.
$0
$0
+450
-440
Total Cash Flow
+$10
Reverse Cash-and-Carry Arbitrage

A reverse cash-and-carry arbitrage occurs when a trader sells short a physical
asset. The trader purchases a futures contract, which will be used to honor the
short sale commitment. Then the trader lends the proceeds at an established
rate of interest. In the future, the trader accepts delivery against the futures
contract and uses the commodity received to cover the short position.
Any profit from this strategy would be an arbitrage profit.
0
1. Sell short the commodity

2. Lend money received
from short sale
3. Buy futures contract
4. Accept delivery from futures

contract
5. Use commodity received
to cover the short sale
Reverse Cash-and-Carry Arbitrage-Numerical Example

The futures price must be equal to or greater than the spot price of the
commodity plus the carrying charges necessary to carry the spot commodity
forward to delivery. F 0, t S 0(1 C 0, t )
Reverse Cash-and-Carry Gold Arbitrage Transactions
Prices for the Analysis
Spot price of gold
Future price of gold (for delivery in one year)
Interest rate
Transaction
t=0
$420
$450
10%
Cash Flow
Sell 1 ounce of gold short.

Lend the $420 for one year at 10%.
Buy 1 ounce of gold futures for delivery in 1
year.
+$420
- 420
0
Total Cash Flow
t=1
Collect proceeds from the loan ($420 x 1.1).

Accept delivery on the futures contract.
Use gold from futures delivery to repay short
sale.
$0
+$462
-450
0
Total Cash Flow +$12
Arbitrage Strategies
Transactions for Arbitrage Strategies
Market
Cash-and-Carry
Reverse Cash-and-Carry
Debt
Borrow funds
Lend short sale proceeds
Physical
Buy asset and store; deliver

against futures
Sell asset short; secure

proceeds from short sale
Futures
Sell futures
Buy futures; accept delivery;

return physical asset to honor
short sale commitment
Models of Futures Prices -Spreads

Spread
A spread is the difference in price between two futures contracts on the same
commodity for two different maturity dates:
Spread F 0, t k F 0, t
Where
F0,t = The current futures price for delivery of the
product at time t
This might be the price of a futures contract on wheat for delivery in 3
months.
F0,t+k = The current futures price for delivery of the
product at time t +k.
This might be the price of a futures contract for wheat for delivery in 6
months.
Spread relationships are important to speculators.
Spreads-Numerical Example
Suppose that the price of a futures contract on
wheat for delivery in 3 months is $3.25 per bushel.
Suppose further that the price of a futures contract
on wheat for delivery in 6 months is $3.30/bushel.
What is the spread?
Spread F 0, t k F 0, t
Spread $3.30 $3.25 $0.05
Agricultural, Energy and Metallurgical

Futures Contracts
This chapter explores futures contracts on physical commodities, those
written on agricultural, energy and metallurgical commodities. This chapter
is organized into the following sections:
Commodity characteristics that interfere with the Costof-Carry Model.
A. Commodity Supply and Storability
B. Commodity Seasonal Production
C. Commodity Seasonal Consumption
D. Commodity Poor Storability
1. Spread
A. Intra-commodity Spreads
B. Inter-commodities Spreads
2. Hedging
10
Commodity Characteristics
Recall: the Cost-of-Carry Model implies a range of permissible
prices. These prices are defined by the cash-and-carry and
reverse cash-and-carry arbitrage strategies.
Applying the cash-and-carry arbitrage strategy assumes that the
physical good or commodity can be stored from one day to the
next.
Applying the reserve cash-and-carry arbitrage depends upon short
selling.
Some goods have a convenience yield, which stems from the
usefulness of having them in inventory.
11
Commodity Characteristics
Recall: the relationships between cash and futures prices depend
upon:
Storage characteristics of the commodity
Supplies of the commodity
Production and consumption cycle for the commodity
Ease of short selling the commodity
Transaction costs
In the following section, we begin by discussing how the supply and
storability move the market to or away from full carry. Then, we
provide examples of commodities that are at full carry and
commodities that are not at full carry.
12
Commodity Characteristics Supply and Storability

Storage and Stock Characteristics and Price Behavior
Example Commodities
Relative Stocks
Storability
High
High
Precious metalsCexpect general

conformance to full carry.
Good
Production cycle causes

fluctuations in stocks
Grains and oilseedsCexpect departures from full carry.
Good
Consumption cycle causes

fluctuations in stocks
Energy productsCexpect departures from full carry.
Poor
Low, largely due to poor

storability
LivestockCexpect frequent departures from full carry.
13
Commodity Characteristics-SUMMARY
If a good has excellent storage characteristics and a large
supply relative to consumption, we expect markets for the
good to approximate full carry (e.g., gold).
Commodities with good storability may at some point,
depart from full carry, due to fluctuation in production
(grains during harvesting time) or fluctuations in
consumption (gasoline during summer time).
Commodities with poor storability can depart substantially
from full carry (e.g., livestock).
14
Full Carry Markets Precious Metals

Highly storable commodities with a large supply relative to annual
consumption should behave according to the Cost-of-Carry
Model.
For precious metals, both the cash-and-carry and reverse cashand-carry arbitrage strategies are potentially effective because
short selling is fairly accessible for precious metals like gold.
Recall: the carrying costs consist of storage, insurance,
transportation, and financing charges
15
Full Carry Markets Precious Metals

If gold is a full carry market, the following relationship should
hold
F 0, d F 0, n(1 C)
where d > n
Applying this equation to our present example implies:
DEC gold futures = JUN gold futures (1 + C)
Dividing both sides of the above equation by the right-hand
side and subtracting 1, we have:
DEC gold futures

-1 = 0
JUN gold future (1 + C )
Any time this equation equals something other than zero,
an arbitrage opportunity is possible.
16
A Full Carry Example: Gold

. Assume that the prices in Table 5.2 are present in the market and
assume that the financing cost is the T-bill rate for the June-December
period. All other transaction costs are ignored. We would like to know if
the market is at full carry.
Data
JUN futures price
DEC futures price
TBbill rate (Jun-December)
HalfByear factor, (1 + C), for Jun-December
$426.00
442.60
7.7719%
1.038132
17
A Full Carry Example: Gold
18
Commodities with Seasonal Production

In this section, we examine commodities that are produced
seasonally. To facilitate the discussion assume:
Consumption of the commodity is steady.
Long-term inventory is constant.
Production will equal consumption.
Commodity stores well (e.g., wheat, corn, oats, barley, soy
products).
Prices exhibit seasonal trends due to harvesting patterns.
Wheat is used to illustrate the seasonal characteristics of
commodities.
19
Wheat and Wheat Futures

WHEAT ASSUMPTIONS
Good stored well.
REALITY OF WHEAT
It store well, but not forever. Practically,
wheat can be stored for about 5 years or
longer.
Prices exhibit seasonal trends due There are various harvest times which
to harvesting patterns.
brings wheat almost continually to the
market (winter wheat, spring wheat, and
wheat harvest overseas (e.g. Argentina)
wheat prices tend to be high during winter and low during summer.
20
Wheat and Wheat Futures

Below table presents a portion of Telsers classic study of wheat
and cotton futures. Telser concluded futures data offer no
evidence to contradict the simple hypothesis that the futures
price is an unbiased estimate of the expected spot price.
Telser's Wheat Futures Results, 1927-1941 and 1946-1954
Number of
Months
Futures Rose
Number of
Months
Futures Fell
Years of Falling Cash Prices
19
42
Years of Stable Cash Prices
45
56
Years of Rising Cash Prices
52
32
Total
116 (47.15%)
130 (52.85%)
21
Wheat and the Cost-of-Carry Model

Given the characteristics of wheat, we expect wheat price
relationships to differ substantially from the full carry behavior of gold.
First, wheat production is seasonal. Even if the harvest were known
well in advance, wheat would still be abundant after harvest and
scarce later.
Second, the harvest is not known in advance, so shortages or
surpluses of wheat can develop.
In general, we would not expect wheat to behave as a full carry market
in all circumstances.
22
Wheat Versus Gold: The Cost-of-Carry Model

WHEAT
Deviations from full carry are much
larger (4 times larger for wheat).
GOLD
Deviation from full carry are minimal.
Stronger trend to deviate from full

carry (first below full carry, and later
above full carry).
Almost always at full carry.
Distant futures exceeded the nearby

futures plus financing cost.
Distant futures never exceeded the

nearby futures plus financing cost.
Storage, insurance and transportation Financing cost is a significant carrying

are more significant carrying costs).
cost.
23
Wheat Versus Gold: The Cost-of-Carry Model

Summary:
Wheat cash prices are seasonal, due to fluctuating
supply and surprises about the harvest.
The spread between two futures maturities can
vary in a systematic way, due to seasonal factors.
Storage, insurance, and transportation costs, as
well as the financing cost should be evaluated to
determined if a market is at full carry.
24
Commodities with Seasonal Consumption

Seasonal consumption patterns can produce fluctuating stocks of some
commodities. This can create shortages and give a convenience value to these
commodities.
Oil and related products provide an example of a good with fairly steady
production, but highly seasonal demand (e.g., gasoline during summer, heating
oil during winter).
Crude oil futures sometimes are at full carry, while at other times, crude oil can
have a substantial convenience yield or the market can even be in
backwardation.
25
Commodities with Poor Storability

Livestock is an example of a commodity with poor storability.
Example:
Live cattle must have an average weight between 1,050 and 1,200
pounds at delivery. If cattle are held too long, they cannot be
delivered in fulfillment of the contract.
Difficult storage conditions loosen the no-arbitrage connection

between futures contracts with different expirations.
26
Feeder Cattle and Live Cattle

The CME trades contracts on feeder cattle and live cattle.
The decision to slaughter feeder cattle, or to carry forward for delivery as live
cattle, depends on the spread between to feeder cattle and live cattle futures
contracts and the cost of feeding.
I PHASE: CALF
Conception to weaning
II PHASE: FEEDER
CATTLE
Feeding 1 yr
Weight 600-800 Lbs
No
TRADE
Feeder Cattle
Yes
Grow
More
III PHASE: LIVE

CATTLE
Weight 1050-1200 Lbs
27
Spreads
1. Intra-commodity spreads.
Every intra-commodity spread must have at least two contracts (one
short/one long).
A. Bull Spread
A bull spread is an intra-commodity spread designed to
profit if the price of the underlying commodity rises.
B. Bear Spread
A bear spread is an intra-commodity spread designed to
profit if the price of the underlying commodity falls.
2. Inter-commodity spreads.
Every inter-commodity spread must have at least two contracts in two
different, but related commodities
A. Soybeans complex
B. Energy complex
C. Livestock
28
Intra-Commodity Spreads
Recall further: changes in spreads and changes in prices
for full and non-full carry markets behaves as follows:
F0,d F0,n 1 c
d>n
In full carry markets, if the commodity price rises, the distant

futures price rises more than the nearby futures price.
In non-full carry markets, if the commodity price rises, the nearby
futures price rises more than the distant futures price.
29
Bull and Bear Intra-commodity Spreads

Bull and Bear IntraBCommodity Spreads
Bull Spread
Bear Spread
Commodities
Short nearby
Long distant
Long nearby
Short distant
Full Carry Markets

Gold, silver, platinum, palladium,
financials
Long nearby
Short distant
Short nearby
Long distant
Non-Full Carry Markets

Cocoa, copper, wheat, corn, oats,
orange juice, plywood, pork bellies,
soybeans, soymeal, soyoil, sugar
30
Inter-Commodity Spread Relationships

In this section, the spread relationships between the
following related commodities will be explored:
1. Soy complex
2. The energy market (oil)
3. The livestock market (feeder cattle and live cattle)
31
Soybeans Futures Market

Soy Contract Quantities
Contract
Quantity per Contract
Method of Price Quotation
Soybeans
5,000 bushels
$ per bushel
Soymeal
100 tons
$ per ton
60,000 pounds
cents per lb.
Soyoil
Soybeans must be crushed to yield edible soymeal and soyoil. A 60-pound bushel of soybeans
produces approximately:
48 lbs. of soymeal
11 lbs. of soyoil
1 lbs. of waste
Crush Margin
The crush margin is the difference in value between a bushel of soybeans and the resulting
meal and oil.
One soybeans contract ( 5000 bushels) produces approximately:
120 tons of soymeal or 1.2 soymeal contracts
55,000 pounds of oil or 92% of a soyoil contract
10 contracts X 5,000 bushels 2,400,000 lbs. of meal + 550,000 lbs. of oil
12 contracts of meal + 9 contracts of oil
32
Soybeans and Crush Spreads

In normal conditions, the value of the meal plus the oil must exceed the value of
the soybeans. If this were not the case, there would be no incentive to process
the soybeans. Thus, we expect the crush margin to be positive.
Crush and Reverse Crush Soybean Spreads
Crush spread
Reverse crush
spread
Long soybeans of one expiration; short

soymeal and soyoil for the next expiration.
Short soybeans of one expiration; long
soymeal and soyoil for the next expiration.
Assume that today, August 4, a speculator believes that the crush margin is too
small. That is, the speculator believes that by buying beans and selling the combined
meal and oil positions, he/she will make a profit.
Soy Futures Prices
August 4
JUL Beans ($ per
bushel)
SEP Meal ($ per ton)
SEP Oil ($ per lb.)
November 14
December 19
8.6600
7.8525
8.1700
232.5000
232.0000
232.0000
0.2665
0.2442
0.2495
33

A Soybean Crush Speculation
Futures Market
Date
August 4
Buy 10 JUL bean contracts at $8.66 per bushel

Sell 12 SEP meal contracts at $232.50 per ton
Sell 9 SEP oil contracts at $.2665 per lb.
November 14
Sell 10 JUL bean contracts at $7.8525 per bushel

Buy 12 SEP meal contracts at $232 per ton
Buy 9 SEP oil contracts at $.2442 per lb.
Profit/Loss:
Beans: 10 X 5,000 X (- $8.66 + $7.8525) = - $40,375
Meal: 12 X 100 X ($232.50 - $232) = $600
Oil: 9 X 60,000 X ($.2665 - .2442) = $12,042
Total Loss: - $27,733
Bean prices actually fell resulting in a net loss of $27,733.
34

Now the speculator believes that the prices will continue to fall, so the speculator
enter the market again with the transactions as shown in below table:
A Soybean Reverse Crush Speculation
Date
Futures Market
November 14
Sell 10 JUL bean contracts at $7.8525 per bushel

Buy 12 SEP meal contracts at $232 per ton
Buy 9 SEP oil contracts at $.2442 per lb.
December 12
Buy 10 JUL bean contracts at $8.17 per bushel

Sell 12 SEP meal contracts at $232 per ton
Sell 9 SEP oil contracts at $.2495 per lb.
Profit/Loss:
Beans: 10 X 5,000 X ($7.8525 - 8.17) = - $15,875
Meal: 12 X 100 X ($232 - $232) = 0
Oil: 9 X 60,000 X (-$.2442 + .2495) = $2,862
Total Loss: - $13,013
Bean prices rise causing the speculator another net loss of $13,013.
35
Oil and the Crack

.
Product Profile: The NYMEX=s Light, Sweet Crude Oil Futures
Contract Size: 1,000 U.S. barrels (42,000 gallons).

Deliverable Grades: Specific domestic crudes with 0.42% sulfur by weight or less, not less
than 37API gravity nor more than 42API gravity. The following domestic crude streams are
deliverable: West Texas Intermediate, Low Sweet Mix, New Mexican Sweet, North Texas
Sweet, Oklahoma Sweet, South Texas Sweet.Specific foreign crudes of not less than 34API
nor more than 42API. The following foreign streams are deliverable: U.K. Brent and Forties,
and Norwegian Oseberg Blend, for which the seller shall receive a 304-per-barrel discount
below the final settlement price; Nigerian Bonny Light and Colombian Cusiana are delivered
at 154 premiums; and Nigerian Qua Iboe is delivered at a 54 premium.
Tick Size: One cent per barrel ($10 per contract)
Price Quote: U.S. dollars and cents per barrel.
Contract Months: Thirty consecutive months plus long-dated futures initially listed 36, 48, 60,
72, and 84 months prior to delivery.
Expiration and final Settlement: Last trading day is the third 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 third business day prior to the business day
preceding the 25th calendar day. Delivery at Cushing, Oklahoma at any pipeline or storage
facility with pipeline access to TEPPCO, Cushing storage, or Equilon Pipeline Co., by in-tank
transfer, in-line transfer, book-out, or inter-facility transfer Deliveries are permitted over the
course of the month and must be initiated on or after the first calendar day and completed by
the last calendar day of the delivery month.
Trading Hours: Open outcry trading is conducted from 10:00 AM until 2:30 PM. After-hours
futures trading is conducted via the NYMEX ACCESS7 internet-based trading platform
beginning at 3:15 PM on Mondays through Thursdays and concluding at 9:30 AM the
following day. On Sundays, the session begins at 7:00 PM.
Daily Price Limit: $10.00 per barrel ($10,000 per contract) for all months. If any contract is
traded, bid, or offered at the limit for five minutes, trading is halted for five minutes. When
trading resumes, the limit is expanded by $10.00 per barrel in either direction. If another halt
were triggered, the market would continue to be expanded by $10.00 per barrel in either
direction after each successive five-minute trading halt. There will be no maximum price
fluctuation limits during any one trading session.
36
Oil and the Crack

Crude oil must be refined into other products (e.g., gasoline, heating oil, or
propane).
Cracking
Cracking is the process of refining crude oil. The same crude oil can produce a
variety of products depending on the techniques used to crack it.
A barrel of oil can only produce a certain amount of total product. The mix is
variable, but the total output is a zero-sum game.
Cracking patterns are largely governed by the season of the year (more gasoline
will be produce during summer, and more heating oil during winter).
Crack Spread
The price relationship between crude oil and its refined products.
37
Oil and the Crack

There are several kinds of crack spreads, including:
1.
Crude oil/heating oil crack spread

1 barrel crude oil
2.
1 barrel gasoline
Crude oil/gasoline crack spread

1 barrel crude oil
3.
1 barrel heating oil
Other Combination based on multiple units of crude oil

2 barrels crude oil
1 barrel gasoline
1 barrel heating oil
Buy a Crack Spread

The trader buys the refined product and sells the crude.
Sell a Crack Spread (Reverse Crack Spread)

The trader sells the refined product and buys the corresponding crude.
The most popular crack spreads are the 1:1 spreads between crude and heating oil
or crude and gasoline.
38
Oil and Crack Spreads

Below table shows the contract specifications for crude oil, heating oil and gasoline.
Energy Complex Futures Contract Specifications

Commodity
Contract Quantity
Price Quotations
1,000 barrels
$ per barrel
West Texas Intermediate
Heating Oil
42,000 gallons
$ per gallon
No. 2
Gasoline
42,000 gallons
$ per gallon
Unleaded
Crude Oil
Grade
1 barrel = 42 gallons
Assume that today, March 16; a trade has gathered the information from below table. The trader believes
that the $.0616 crude oil/ heating oil crack is not sustainable ($.4569-$.5185= $.0616). The trader thinks that
the justifiable refining spread is only $.04 per gallon. Therefore, the trader expects the spread to narrow and
thus decides to enter into a reverse crack spread (sell heating oil and buy crude oil).
Energy Complex Futures Prices

Crude Oil
($ per gal.)
Heating Oil
($ per gal.)
Crack
Heating Oil B Crude Oil
March 16
.4569
.5185
.0616
June 8
.5017
.5628
.0611
June 3
.4700
.5419
.0719
Date
39

Below table shows the transactions the trader enters into in order to take
advantage of her/his beliefs.
A Reverse Crack Speculation
Date
Futures Market
March 16
Sell 1 JUL heating oil contract at $.5185 per gallon.

Buy 1 JUL crude oil contract at $.4569 per gallon.
June 8
Buy 1 JUL heating oil contract at $.5628 per gallon.

Sell 1 JUL crude oil contract at $.5017 per gallon.
Profit/Loss:
Heating Oil: 1 X 42,000 X ($.5185 - .5628) = -$1,860.60
Crude Oil: 1 X 42,000 X ($.5017 - .4569) = $1881.60
Total Gain: $21
The traders assessment was correct and thus he/she made a profit.
40

The trader now believes that the spread will widen, and that heating oil will now
rise in price relative to crude. Therefore, she decides to place a crack spread
(crack spread consists of buying the refined product and selling crude). Below
table shows the traders transactions.
A Crack Speculation
Date
Futures Market
June 8
Buy 10 JUL heating oil contracts at $.5628 per gallon

Sell 10 JUL crude oil contracts at $.5017 per gallon
June 3
Sell 10 JUL heating oil contracts at $.5419 per gallon

Buy 10 JUL crude oil contracts at $.4700 per gallon
Profit/Loss:
Crude Oil: 10 X 42,000 X ($.5017 - .4700) = $13,314.00
Heating Oil: 10 X 42,000 X ($.5419 - .5628) = - $8,778.00
Total Gain: $4,536
Notice that the traders overall profit depends only on the crack spread, not on
the direction of oil prices in general.
41
Feeder Cattle and Live Cattle

Product Profile: The CME=s Live Cattle Futures
Contract Size: 40,000 pounds of 55% choice, 45% select grade live steers
Tick Size: .025 cents per pound ($10.00/contract)

Price Quote: Cents per pound
Contract Months: February, April, June, August, October and December..
Expiration and final Settlement: The last trading day is the last business day of the contract
month. Physical delivery required.
Trading Hours: Open outcry: 9:05 a.m. - 1:00 p.m. Central Time, Monday-Friday.Electronic:
9:05 p.m. - 1:00 a.m. Central Time, Monday.-Friday.
Daily Price Limit: 30 cents per pound ($1,200/contract) above or below the previous day's
settlement price.
42
The Cattle Crush: Feeder Cattle and Live Cattle

The cattle crush depends upon the price of cattle today, the expected price of cattle in the future,
and the price of grain necessary to feed the cattle to a larger future size.
A popular cross-exchange spread occurs between corn contracts on the CBOT and cattle
contracts on the CME.
The cattle crush spread can be established by holding a long position in corn futures while
simultaneously establishing a short position in live cattle.
A reverse cattle crush involves buying two live cattle contracts for each corn contract the trader is
short.
Example
The owner of the newborn calf sells two futures contracts for the calf:
One contract for delivery as a feeder in 12 months.
One contract for delivery against the live cattle contract in 18 months.
The owner has the following options:
Deliver the calf against the feeder contract, and offset the live cattle contract.
Offset the feeder contract, maintain the live cattle contract, and deliver the 18 month steer
against the live cattle contract.
The owners potential profitability is largely a function of the cost of corn.
If feed prices rise, the profitability of feeding is reduced. Thus, spread between the cash price of
feeder cattle and the futures price for live cattle will narrow as corn prices rise.
43
Corn and Live Cattle Future Prices

Assume that today, May 22, we, a cattle feeder, have gathered the information from the
below table. We have 65 steers and anticipate that the steers will be on feedlot rations for
sixth months in order to produce slaughter weight cattle. We know that one corn contract
will feed the steers underlying 2 live cattle contracts to slaughter weight. We calculate our
current spread to be $739.46 per steer. We fear that the cattle crush spread may narrow,
and wish to lock in the current spread. The ratio of corn contracts to live cattle contracts is
1:2.
Corn and Live Cattle Futures Prices
May 22
DEC Corn
DEC Live Cattle
November 22
Contract Size
Method of
Quotation
2.675
2.80
5,000 bu.
$ per
bushel
76.800
76.00
40,000 lbs
per pound
The current spread is calculated as follows:

Value of two cattle contracts:
2(40,000)(.7680) = $61,440 or 945.23 per steer
Value of one corn contract:
1(5,000)(2.675) = $13,375 or $205.77 per steer
The spread is the difference between the value of the cattle contracts and the cost of corn.
44
The Cattle Crush Spread Position

Below table shows the transactions we enter in order to lock in our current spread.
A Cattle Crush Spread Position
Date
Futures Market
May 22
Buy 1 DEC corn contract at $2.675 per bushel

Sell 2 DEC live cattle contracts at 76.80 cents per pound
November 22
Sell 1 DEC corn contract at $2.80 per bushel

Buy 2 DEC live cattle contracts at 76.00 cents per pound
Profit/Loss:
Corn: 5,000 X (-$2.675 + $2.80) = $625
Live Cattle: 2 X 40,000 X ($.7680-$.7600) = $640
Total Gain: $1,265
our cattle crush produce a $1,265 gain.
45
Reverse Cattle Crush Spread Position

Now assume that you believe that the corn/cattle spread will widen. Therefore, to
take advantage of your belief, you establish a reverse cattle crush spread.
Below table shows the results of a reverse cattle crush using the prices displayed in
the earlier table.
A Reverse Cattle Crush Spread Position
Date
Futures Market
May 22
Sell 1 DEC corn contract at $2.675 per bushel

Buy 2 DEC live cattle contracts at 76.80 cents per pound
November 22
Buy 1 DEC corn contract at $2.80 per bushel

Sell 2 DEC live cattle contracts at 76.00 cents per pound
Profit/Loss:
Corn: 5,000 X ($2.675 - $2.80) = -$625
Live Cattle: 2 X 40,000 X (-$.7680 + $.7600) = -$640
Total Gain: -$1,265
We miscalculated. As the spread narrowed, our reverse cattle crush position in

the futures market lost $1,265.
46
Hedging
In this section we explores more hedging strategies particular to:
Energy markets
Agricultural markets
Metallurgical markets
We consider hedging different grades of oil.
There are different kinds of crude oil originating around the world. The following
table illustrates six types of oil.
Types of Oil
Designation
WTI
Brent
ANS
Forcados
Dubai
Urals
Description
West Texas IntermediateBMidland
North Sea oil
Alaskan North Slope oil
Nigerian oil
Arab light oil
Soviet oil
47
Hedging Worldwide Crude Oil

Recall that the easiest way to compute the risk-minimizing hedge ratio, number of
futures contracts to hold for a given positions in a commodity, is by estimating the
following regression:
( St 1 St ) ( Ft 1 Ft ) t
From the above regression:
= The risk-minimizing hedge ratio
= A measure of hedging effectiveness
Where
0 R2 1
The closer to 1, the better the chance that the hedge will work.
48
Hedging Worldwide Crude Oil

Below table reports the volatility of the weekly price changes for the
different oils and the results from two hedging strategies.
Results for Crude Oil Hedging
Oil
Weekly
($ per barrel)
R2
1:1 Hedge
RiskBMinimizing
Hedge Ratio
R2 Risk
Min. Hedge
WTI
.8407
.8462
.9991
.8462
Brent
.8238
.5779
.8272
.6042
ANS
.8433
.8284
.9961
.8285
Forcados
.7500
.5010
.7351
.5758
Dubai
.7049
.2959
.6227
.4676
Urals
.6699
.2553
.5956
.4738
Source: Gordon Gemmill, AHedging Crude Oil: How Many Markets Are Needed
in the World?@
The Review of Futures Markets, 7, 1988, pp. 556B571.
Finding a futures contract that closely matches the spot commodity is important
and will generally improve the hedge considerably.
Second, for cross-hedges, the naive 1:1 hedging approach may be markedly
inferior to using a risk-minimizing hedge ratio.
49

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Models of Futures Prices - Cost-of-Carry Model

4. Deliver the commodity

the current spot price

Cash-and-Carry Gold Arbitrage Transactions

Borrow $400 for one year at 10%.

Remove the gold from storage.

Reverse Cash-and-Carry Arbitrage

1. Sell short the commodity

4. Accept delivery from futures

Reverse Cash-and-Carry Arbitrage-Numerical Example

Sell 1 ounce of gold short.

Collect proceeds from the loan ($420 x 1.1).

Lend short sale proceeds

Buy asset and store; deliver

Sell asset short; secure

Buy futures; accept delivery;

Models of Futures Prices -Spreads

Agricultural, Energy and Metallurgical

Commodity Characteristics Supply and Storability

Precious metalsCexpect general

Production cycle causes

Grains and oilseedsCexpect departures from full carry.

Consumption cycle causes

Energy productsCexpect departures from full carry.

Low, largely due to poor

LivestockCexpect frequent departures from full carry.

Full Carry Markets Precious Metals

Full Carry Markets Precious Metals

DEC gold futures

A Full Carry Example: Gold

A Full Carry Example: Gold

Commodities with Seasonal Production

Wheat and Wheat Futures

Wheat and Wheat Futures

Years of Falling Cash Prices

Years of Stable Cash Prices

Years of Rising Cash Prices

Wheat and the Cost-of-Carry Model

Wheat Versus Gold: The Cost-of-Carry Model

Stronger trend to deviate from full

Almost always at full carry.

Distant futures exceeded the nearby

Distant futures never exceeded the

Storage, insurance and transportation Financing cost is a significant carrying

Wheat Versus Gold: The Cost-of-Carry Model

Commodities with Seasonal Consumption

Commodities with Poor Storability

Difficult storage conditions loosen the no-arbitrage connection

Feeder Cattle and Live Cattle

III PHASE: LIVE

In full carry markets, if the commodity price rises, the distant

Bull and Bear Intra-commodity Spreads

Full Carry Markets

Non-Full Carry Markets

Inter-Commodity Spread Relationships

Soybeans Futures Market

Quantity per Contract

Method of Price Quotation

cents per lb.

Soybeans and Crush Spreads

Long soybeans of one expiration; short

Soybeans and Crush Spreads

Buy 10 JUL bean contracts at $8.66 per bushel

Sell 10 JUL bean contracts at $7.8525 per bushel