By

Dhyani Mehta

Meaning commodity derivatives

COMMODITY DEFINED : Every kind of movable goods excluding

money and securities.
Commodities include:

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Metals (Bullion & Other Metals)

Agro Products
Perishable / Non Perishable
Consumable / Non Consumable

Meaning commodity derivatives

DERIVATIVES DEFINED : Contract (future/options) the value of

which is derived from underlying
assets
are called Derivatives.

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Derivatives are contract that

originated from the need to minimize
the risk.

Meaning commodity derivatives

Derivative contracts where underlying

assets are commodities which is :

PRECIOUS METALS (Gold, silver, platinum etc)

OTHER METALS (tin, copper, lead, steel, nickel etc)
AGRO PRODUCTS (coffee, wheat, pepper, cotton)
ENERGY PRODUCTS (crude oil, heating oil,natural gas)

then the derivative is known as a

commodity derivative.
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WHY ARE COMMODITY DERIVATIVES

REQUIRED ?

India is among the top-5 producers of the

commodities, in addition to being a major
consumer of bullion and energy products.
Agriculture contributes about 22% to the
GDP of the Indian economy.
It employees around 57% of the labor force
on a total of 163 million hectares of land.

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WHY ARE COMMODITY DERIVATIVES

REQUIRED ?

It is important to understand why commodity

derivatives are required and the role they
can play in risk management.
It is common knowledge that prices of
commodities,
metals, shares and currencies fluctuate over
time.
The possibility of adverse price changes in
future creates risk for business.
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2 IMPORTANT DERIVATIVES

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Commodity future contract

A futures contract is an agreement for buying or

selling a commodity for a predetermined delivery
price at a specific future time. Future contract can be
OTC or standardized contracts that are traded on
organized
futures
exchanges
that
ensure
performance of the contracts and thus remove the
default risk.
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EXAMPLE

Suppose a farmer is expecting a crop of wheat to be

ready in 2 months time, but is worried that the price
of wheat may decline in this period. In order to
minimize a risk ,he can enter to futures contract to
sell his crop in 2 months time at a price determined
now. This way he is able to hedge his risk arising from
a possible adverse change in the price of his
commodity.
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Commodity option contract

The commodity option holder has the right, but not

the obligation, to buy(or sell) a specific quantity of a
commodity at a specified price on or a before a
specified date.

The seller of the option writes the option in favors of

the buyer (holder) who pays a certain premium to the
seller as a price for the options.

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Commodity option contract

There are two types of commodity options a call

option gives the holder a right to buy a commodity
agreed price, while a put option gives the holder a
right to sell a commodity at an agreed price on or
before a specified date (called a expiry a date)
The option holder will exercise the option only if it is
beneficial to him, otherwise he will let the option
lapse.
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EXAMPLE

Suppose a farmer buys a put option to sell 100 quintals of

wheat at price of 25dollar per quintal and pays a premium of
0.5 dollar per quintal (or a total of 50 dollar). If the price of
wheat declines to 20 dollar before expiry, the farmer will
exercise his option to sell his wheat at the agreed price of
dollar 25 per quintal. However ,if the market price of wheat
increases to say 30 dollar per quintal it would be advantageous
for the farmer to sell it directly in the open market at the spot
price rather
then exercise his option to sell at 25 dollar
per quintal.
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Commodity Future
Pricing

One of the method for pricing the future

derivative is use of beta and Market return
rate and Risk free return rate.
For Example Beta of wheat is .117 and T-bill
rate is 5%. With your historical market risk
premium is about 8%. It the expected future
spot price of wheat after 6 month is $1.45.
Find out the Present Price of the wheats
future contract? How much will you pay?

Solution

Step 1: Find out the discount rate by CAPM

method.
RR= Rf+(Mr-Rf)
Rf=5% , =.117, (Mr-Rf)= 8%,
Placing the value we get the discount rate as 5.94%

Step 2: Find out the Present value of the future

price of wheat.
$1.45/(1+RR)^n=PV of Wheat
Which will be 1.45/(1.0594)^0.5
Thus PV of wheat is $1.409.

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