Alternate Investment Markets

Module 5
Commodities

Dr. Ketan Mulchandani, FRM, FMVA, FIII

Associate Professor
Anil Surendra Modi School of Commerce
NMIMS Deemed to be University
Mumbai
Commodities
 Commodities
 Commodity is a physical good attributable to a tradable natural resource
and supplied without substantial differentiation by the general public.
 Spot Market
 Future Market
 Risk Management
 Price Discovery
 Liquidity
 Standardization
 Margin requirement
 Forward Market
 Customization
 Counterparty risk
 Illiquidity
 No margin
 Commodities’ value derives from their use as consumables or as inputs to
producing goods and services.

 Fundamental analysis of commodities relies on analysing supply and demand

for each product and estimating the reaction to the inevitable shocks to their
equilibrium or underlying direction.
 Direct Announcement
 Component Analysis
 Timing Consideration
 Money flow
 Life cycle of Commodities

The life cycle of commodities varies

considerably depending on the economic,
technical, and structural (i.e., industry, value
chain) profile of each commodity and the
sector.
Energy
Industrial/Precious Metals
 Valuation of Commodities

Commodities are typically tangible items with an intrinsic (but

variable) economic value (e.g., a nugget of gold, a pile of coal,
a bushel of corn).

They do not generate future cash flows beyond what can be

realised through their purchase and sale.
 Future Market Participants

Commodity Hedgers
Long Hedge
Short Hedge

Commodity Trader and Investors

Informed Traders
Liquidity Providers
Arbitragers
Commodity Exchanges
Commodity Market Analyst
Commodity Regulators
 Commodity Spot and Future Pricing

 The spot price is simply the current price to deliver a physical commodity to a
specific location or purchase it and transport it away from a designated location

 A futures price is a price agreed on to deliver or receive a commodity's defined

quantity (often quality) at a future date.

 The difference between spot and futures prices is generally called the basis

 Backwardation
 Contango
 Convergence

 Either cash or physical delivery settles commodity futures.

 THEORIES OF FUTURES RETURNS

Insurance theory
Hedging Pressure Hypothesis
 Theory of Storage

This theory, originally postulated by Kaldor (1939), focuses on

how the level of commodity inventories helps shape
commodity futures price curves.

Futures price = Spot price of the physical commodity + Direct

storage costs (such as rent and insurance) − Convenience yield.
 Commodity Futures
Cost of Carry
 According to the cost-of-carry model, the futures price of a commodity
depends on the spot price of a commodity and the cost of carrying the
commodity from the date of spot price to the date of delivery of the futures
contract.

 Cost of storage, insurance, transportation, financing, and other costs

associated with carrying the commodity until a future date constitutes the
cost-of-carry.
 The cost-of-carry model can be expressed as:
F=S+C
where:
F: Futures Price
S: Spot Price
C: Cost of carrying
 Fair Value of a Futures Contract

Question 1
Spot price: Rs 2,500
Period: 90 days
Interest rate: 6% per annum
Storage cost: 1% per annum

Calculate the Fair Value of the commodity after 90 days.

Question 2
The cost of 10 grams of gold in the spot market
is Rs 50,000, and the cost of financing is 12 per
cent per annum, compounded monthly (i.e., m =
12). The fair value of a 4- month futures contract
will be:
 The fair value of a futures price with
continuous/daily compounding can be
expressed as:
Question 3
if the cost of 10 grams of gold in the spot market
is Rs 50,000 and the cost of financing is 12% per
annum (continuously compounded), the fair
value of a 4-month futures contract will be:
 Convenience Yield
 Convenience yield indicates the benefit of owning a commodity rather than buying a
futures contract on that commodity. Convenience yield can be generated because of
the benefit of ownership of a physical asset. This is one of the differentiating
features between financial and commodity derivatives.

 Producers may face losses if they do not always have enough inventory for
uninterrupted production. Therefore, a commodity’s convenience yield is the benefit
in rupee terms that a user realises for carrying sufficient stock of physical goods
over and above his immediate needs. Sometimes, due to supply bottlenecks in the
market, holding of an underlying commodity may become more profitable than
owning the futures contract due to its relative scarcity versus huge demand.

 Factoring in the above information, the futures price equation we mentioned earlier
can be updated as below:

F=S+C-Y
 where:
 F: Futures Price
 S: Spot Price
 C: Cost of carrying
 Y: Convenience Yield
 Arbitrage

Spot versus Futures Arbitrage

Cash and Carry arbitrage
Reverse Cash and Carry Arbitrage
 Spot versus Futures Arbitrage

Assume that the spot price of gold in June is

Rs.50, 000 per 10 grams and the cost of carry
for one month is Rs.700 per 10 grams, i.e., the
fair futures price is Rs.50,700 per 10 grams.
However, the July gold futures are trading at
Rs.51, 200 per 10 grams.
 Cash and Carry arbitrage

In May, 1 kg of silver spot price was Rs.

50,000 per Kg. The interest rate prevailing in
the market is 10% for lending and borrowing.
July future contracts trade at Rs. 51,500 per
Kg. Mr. X wants to exploit the arbitrage
opportunity if any is available. As an
investment advisor, find out the same for your
client Mr. X
 Reverse Cash and Carry Arbitrage

1st May 2022, 1 kg of silver spot price was Rs. 40,500

per Kg. The interest rate prevailing in the market is
10% for lending and borrowing. June future contracts
trade at Rs. 40,600 per Kg (Expiry last day of the
month). Mr X wants to exploit the arbitrage
opportunity if any is available. As an investment
advisor, find out the same for your client Mr. X
 COMPONENTS OF FUTURES RETURNS
The total return on commodity futures is traditionally broken into
three components:
The price return (or spot yield),
The roll return (or roll yield), and
The collateral return (or collateral yield).
 Price return = (Current price − Previous price)/Previous price.
 Roll return = [(Near-term futures contract closing price − Farther-term
futures contract closing price)/Near-term futures contract closing price] ×
Percentage of the position in the futures contract being rolled.
 The collateral return is the yield (e.g., interest rate) for the bonds or cash
used to maintain the investor’s futures position(s). The minimum amount of
funds is called the initial margin. If an investor has less cash than the
exchange requires to maintain the position, the broker who acts as custodian
will require more funds (a margin call) or close the position (buying to
cover a short position or selling to eliminate a long position). Collateral thus
acts as insurance for the exchange that the investor can pay for losses.
An investor has realized a 5% price return on a
commodity futures contract position and a 2.5% roll
return after all her contracts were rolled forward. She
had held this position for one year with collateral
equal to 100% of the position at a risk-free rate of 2%
per year. Her total return on this position (annualized
excluding leverage) was:
An investor has a $10,000 position in long futures
contracts (for a hypothetical commodity) that he wants
to roll forward. The current contracts, which are close to
expiration, are valued at $4.00 per contract, whereas the
longer-term contract he wants to roll into is valued at
$2.50 per contract. What are the transactions— in terms
of buying and selling new contracts—he needs to
execute to maintain his current exposure?
 Commodity Swaps

A commodity swap is a legal contract involving the exchange

of payments over multiple dates as determined by specified
reference prices or indexes relating to commodities.

The instrument provides risk management and transfer while

eliminating the need to set up and manage multiple futures
contracts.

Swaps also provide a degree of customization not possible with

standardized futures contracts
 Total Return Swaps
TRS, the change in the index level will be equal to the returns
generated by the change in the price of each future contract
that makes up the index plus a return based on interest earned
on any cash collateral posted on the purchase of the futures
contracts that make up the index.

If the index level increases, the swap buyer receives payment
net of the fee paid to the seller; if the index level decreases
between two valuation dates, the swap seller receives payment
(plus the fee charged to the buyer).
A portfolio manager enters into a $100 million
(notional) total return commodity swap to obtain a
long position in commodity exposure. The position is
reset monthly against a broad-based commodity
index. At the end of the first month, the index is up
3%, and at the end of the second month, the index
declines 2%. What are two payments that would occur
between the portfolio manager and the swap dealer on
the other side of the swap transaction?
 Variance Swap
Variance swaps of commodities are similar in concept to
variance swaps of equities in that there is a variance buyer
and a variance seller.
Two parties agree to periodically exchange payments based
on the proportional difference between an observed/actual
variance in the price levels of a commodity (over
consecutive periods), and some fixed amount of variance
established at the outset of the contract.
If this difference is positive, the variance swap buyer
receives a payment; if it is negative, the seller receives
payment. The variance differences (observed versus fixed)
are often capped to limit upside and losses.
 Volatility Swaps
Assume that an institutional trader wants a volatility swap on the 
S&P 500 index. The contract will expire in twelve months and has a
notional value of $1 million. Currently, the implied volatility is 12%.
This is set as the strike for the contract.
In twelve month's time, volatility is 16%. This is the realized
volatility. There is a 4% difference, or $40,000 ($1 million x 4%).
The seller of the volatility swap pays the swap buyer $40,000,
assuming the seller is holding the fixed leg and the buyer the
floating leg.
If volatility dropped to 10%, the buyer would pay the seller $20,000
($1 million x 2%).
This is a simplified example. Since volatility swaps are 
over-the-counter instruments (OTC) they can be constructed in
different ways. Some alternatives may be to annualize the rates or
calculate the difference in volatility in terms of daily changes.
 Factors Affecting Global Commodities Markets

Mother Nature

Supply and Demand

Storage Levels and Transportation Constraints

Geopolitics

Market Information

Seasonality
Regulatory Structure of Commodities Market

The main objective of commodity market regulation is to

maintain and promote the fairness, efficiency, transparency and
growth of commodity markets and to protect the interests of
the various stakeholders of the commodity market and to
reduce systemic risks and ensure financial stability.
The three-tiered regulatory framework for commodity markets
comprises
 Government of India,

 Securities and Exchange Board of India (SEBI) and

 Exchanges.
The Central Government formulates the broad policy
regarding the recognition of commodity exchanges
and the list of commodities permitted for
futures/forward trading.
The subject of the forward market is under the Union
List in Schedule VII of the Constitution of India,
whereas the spot market trade in commodities,
particularly agriculture commodities, are the subjects
within the jurisdiction of States.
Securities and Exchange Board of India (SEBI) regulates
commodity derivatives markets.
After the Forward Contracts (Regulation) Act, 1952
(FCRA) was repealed by the Government with effect from
September 28, 2015, Securities Contracts Regulation)
(Stock Exchanges and Clearing Corporations) Regulations,
2012 (SECC Regulations) and SEBI (Stock Brokers)
Regulations, 1992 are made applicable to the commodities
derivatives exchanges and their trading members.
SEBI has also created a separate Commodity Derivatives Market
Regulation Department (CDMRD) to regulate the commodity
derivatives segment.
 supervising the functioning and operations of the commodity derivatives
segment
In order to integrate the two markets at the intermediary’s
level, SEBI has issued a circular on ‘Integration of broking
activities in Equity Markets and Commodity Derivatives
Markets under single entity’ in September 2017.
The next step was integration of trading at the exchange level.
For this SEBI has amended the Securities Contracts
(Regulation) (Stock Exchanges and Clearing Corporation)
Regulations, 2012 (SECC Regulations) and permitted trading
of commodity derivatives and other segments of securities
markets on single exchange with effect from October 1, 2018.
Securities Contract (Regulations) Act 1956

 Granting recognition to stock exchanges

 Corporatization and demutualisation of stock exchanges
 The power of the Central Government to call for periodical returns from
stock exchanges
 The power of SEBI to make or amend bye-laws of recognized stock
exchanges
 The power of the Central Government (exercisable by SEBI also) to
supersede the governing body of a recognized stock exchange
 The power to suspend the business of recognised stock exchanges
 The power to prohibit undesirable speculation
 SEBI Act 1992
Regulating the business in stock exchanges and any other securities
markets.
Registering and regulating the working of stock brokers
Promoting and regulating self-regulatory organisations.
Prohibiting fraudulent and unfair trade practices.
Calling for information from, undertaking inspection, conducting
inquiries and audits of the stock exchanges, mutual funds and other
persons associated with the securities market and intermediaries
and self–regulatory organisations in the securities market.
Performing such functions and exercising according to Securities
Contracts
(Regulation) Act, 1956, as may be delegated to it by the Central
Government.
 Other Regulatory Norms to Encourage Commodity
Derivatives Markets

SEBI wide powers conferred to it under the above regulations

also created rules and regulations relating to other
intermediaries about their participation in commodity markets.
Under SEBI’s Listing Obligations and Disclosure Regulations,
SEBI mandated listed companies to provide details about
commodity risk management policies, commodity risk
exposures and the extent to which these are hedged in
domestic and international markets.
RBI also advised banks to advise their borrower clients to
hedge their commodity exposures if the lending is against
collaterals of commodities. SEBI-wide