Commodity Derivatives Research Articles

Valuation of commodity derivatives with an unobservable convenience yield

This paper extends the existing literature on commodity derivatives to account for an unobservable stochastic convenience yield. Investors operate in an economy with incomplete information. In contrast to other incomplete information models, analytical formulas for forward and futures prices, as well as for European options on forward and futures contracts are obtained. These formulas reveal the important role played by the initial values of the estimator of the convenience yield and of the estimation error respectively when valuing commodity derivatives. We estimate Schwartz׳s [11] model and the incomplete information model based on the discrete-time Kalman filtering method. For futures prices, the latter seems to perform better than the former. Moreover, Schwartz׳s model provides higher option prices than the incomplete information model. The most important differences are obtained for higher futures prices and for longer options maturities.

Analytic Formulas for Options in the Schwartz 97 Multifactor Framework with Added Regime Shifts

We consider the Schwartz 97 two and three factor models, which have been considered as benchmarks for pricing commodity derivatives in the last two decades. In order to take account of sudden regime shifts in commodity prices, we superimpose a regime shifting structure onto this framework. Using methodology developed by Duan et. al. (2002) and Swishchuk (2008) we are able to obtain within the resulting models closed form expressions for the values of European call options written on the commodity. Using data from the Gold, Copper and Corn markets, we find that the added regime shifting feature leads to a significant improvement in fit.

Commodity derivatives pricing with cointegration and stochastic covariances

Empirically, cointegration and stochastic covariances, including stochastic volatilities, are statistically significant for commodity prices and energy products. To capture such market phenomena, we develop a continuous-time dynamics of cointegrated assets with a stochastic covariance matrix and derive the joint characteristic function of asset returns in closed-form. The proposed model offers an endogenous explanation for the stochastic mean-reverting convenience yield. The time series of spot and futures prices of WTI crude oil and gasoline shows cointegration relationship under both physical and risk-neutral measures. The proposed model also allows us to fit the observed term structure of futures prices and calibrate the market-implied cointegration relationship. We apply it to value options on a single commodity and on multiple commodities.

The investigation of destabilization effect in India’s agriculture commodity futures market

Purpose– This paper aims to examine the destabilization effect in the case of India’s agricultural commodity market for the sample period of 01 January 2009 to 31 May 2013.Design/methodology/approach– The daily data of eight agricultural commodities traded on the National Commodity & Derivatives Exchange, viz., barley, castor seed, chana (chickpea), chilli, potato, pepper, refined soya and soybean, have been used in this study. At the first stage of the empirical analysis, the study estimates the time-varying spot market volatility by using the exponential generalized autoregressive conditional heteroscedasticity model and applies three different high and band-pass filters, viz., the two-sided linear band-pass filter by Hodrick and Prescott (1997), the fixed-length symmetric band-pass filter by Baxter and King (1999) and the asymmetric band-pass filter by Christiano and Fitzgerald (2003), to calculate the unexpected liquidity of sample commodities. At the second stage of the empirical analysis, the study applies linear Granger causality and recently developed non-linear causality given by Diks and Panchenko (2006) to examine the cause and effect between time-varying volatility of spot market and futures market liquidity of sample commodities.Findings– The linear and non-linear causality results suggest the destabilizing effect of commodity futures on the underlying spot market for chana, chilli and pepper. The empirical findings are in contrast with the recommendations of Abhijit Sen’s committee and provide important direction for further policy research.Research limitations/implications– The study has a limitation in that it is based on the daily data. The use of intra-day data would have been more suitable for such type of analysis.Practical implications– The study has strong policy implications from a financial policy perspective, as there is already disagreement among researchers and policy makers with regard to the functioning of commodity derivatives markets in India. There have been many occasions when commodity market regulators have to undertake decisions of suspension of trading of many commodities. The study also provides new directions of policy research with regards to the restructuring of the commodity derivatives market in India.Social implications– The findings of this study may further help the regulators and policy makers to undertake decisions about how to provide an alternative platform for farmers to sell their agricultural produce more efficiently. This will certainly have some impact on the socioeconomic set-up of the country, as India is primarily an agriculture-dominated country.Originality/value– So far not many studies have investigated the destabilization hypothesis in the case of emerging markets. This study is a novel attempt to fill the gap. In the case of emerging markets and especially in the case of India’s commodity derivatives market, this is the first study that examines the destabilization hypothesis in the case of India by applying new methods of high and band-pass filters and non-linear causality.

ELECTRICITY FUTURES PRICE MODELING WITH LÉVY TERM STRUCTURE MODELS

In this paper, we generalize the approach of Hinz & Wilhelm (2006), Pricing flow commodity derivatives using fixed income market techniques. International Journal of Theoretical and Applied Finance 9, 1299–1321, replacing in the dynamics of the asset prices the Brownian motion by a more general Lévy process, also taking into account the occurrence of spikes. In particular, we reduce the modeling of an electricity futures market to the modeling of a Lévy bond market with an additional risky asset. This allows to employ well established techniques from interest rate term structure modeling. We then examine Markovianity of the induced electricity spot price, an important property when it comes to option pricing. We show that the considered method combined with the Fourier transform techniques provides semi analytic pricing formulas for European electricity options. Finally, we consider the pricing of path dependent derivatives such as electricity swing options.

Крупнейшие мировые банки на рынке нефтяных деривативов

The article examines recent developments in the global market for crude oil futures contracts. Amid persistently high trading volume of futures contracts for Brent and WTI global oil benchmarks structure of the market has recently changed profoundly. Share of non-commercial investors who are not directly linked to physical oil operations and are often considered speculators in the trade turnover of futures contracts for WTI at the NYMEX exchange has exceeded 50%. Financial investors play a prominent role in price discovery process for crude oil. However, world leading commercial banks that used to be the major participants in crude oil futures market and were also actively engaged into physical oil trading operations presently are forced to adjust their strategies responding to the regulatory reforms unleashed in the USA and European Union after the global financial crisis of 2008/2009. Provisions of Dodd-Frank Act in the USA and similar regulations in the European Union member countries aim to limit banks’ involvement in commodity derivatives market exclusively to hedging activities referred to swap transactions between banks and their clients. New tighter regulation substantially increases costs of commodity derivatives’ business for commercial banks. Also, the current US legislation prohibits banks from proprietary trading with derivatives instruments. These legislative innovations could substantially reduce banks’ profits. The largest global commercial banks have already reduced their physical commodity trading activities. The author concludes that while it is still unclear how significant the retreat of banks from crude oil derivatives market will be, the established mechanism of oil price setting is unlikely to change dramatically as new players from the financial sector are entering the market, replacing commercial banks.

Indian Commodity Derivatives Market & Economic Growth: A Perspective

When all the major asset classes saw a downturn post-financial crisis of 2008,only commodity derivatives exhibited a stable performance. This strengthens the argument that commodity markets hold prospects for strong economic growth, particularly for developing nations. This paper endeavours to review literature to find evidence in support of the underlying link between financial markets and economic growth. Also, a review of the extant literature pertaining to Indian commodity market has been done. A survey of empirical investigation shows a number of cases of inefficiency in the markets that needs to be checked. Further, the paper discusses a theoretical model that strives to help in achieving the super ordinate goal of economic growth through development of efficient commodity market. The model presses upon four key areas for growth that collectively aids in accelerating the pace of Gross Domestic Product (GDP) growth. However, this requires addressing the challenges blocking the efficient functioning of commodity markets, which have also been highlighted.

Diversifying Portfolios of U.S. Stocks with Crude Oil and Natural Gas: A Regime-Dependent Optimization with Several Risk Measures

Energy markets are strategic to governments and economic development. Several commodities compete as substitutable energy sources and energy diversifiers. Such competition reduces the energy vulnerability of countries as well as portfolios’ risk exposure. Vulnerability results mainly from price trends and fluctuations, following supply and demand shocks. Such energy price uncertainty attracts many market participants in the energy commodity markets. First, energy producers and consumers hedge adverse price changes with energy derivatives. Second, financial market participants use commodities and commodity derivatives to diversify their conventional portfolios. For that reason, we consider the joint dependence between the United States (U.S.) natural gas, crude oil and stock markets. We use Gatfaoui’s (2015) time varying multivariate copula analysis and related variance regimes. Such approach handles structural changes in asset prices. In this light, we draw implications for portfolio optimization, when investors diversify their stock portfolios with natural gas and crude oil assets. We minimize the portfolio’s variance, semi-variance and tail risk, in the presence and the absence of constraints on the portfolio’s expected return and/or U.S. stock investment. The return constraint reduces the performance of the optimal portfolio. Moreover, the regime-specific portfolio optimization helps implement an enhanced active management strategy over the whole sample period. Under a return constraint, the semi-variance optimal portfolio offers the best risk-return tradeoff, whereas the tail-risk optimal portfolio offers the best tradeoff in the absence of a return constraint.

Systemic risk in the energy sector—Is there need for financial regulation?

The credit crisis points at serious systemic risks in Over The Counter derivative trading. This has resulted in new financial regulation, covering both the financial sector and non-financial sectors. The actual extent to which non-financial companies trading on OTC markets contribute to systemic risk has hardly been the subject of research. This paper investigates the need for financial regulation in the energy sector, which shows a high use of OTC derivatives, by modeling systemic risk measured by the expected fraction of additional failing firms (EAF). Contagion risk within the energy sector and from the energy sector towards the banking sector is compared with that in other non-financial sectors. This paper adds to existing systemic risk literature by specifically looking at financial interdependence between a non-financial sector showing a high usage of OTC commodity derivatives and the banking sector, while contributing to the discussion on energy sector regulation with technical systemic risk analysis. Results indicate that contagion risk from the energy towards the banking sector is not relatively high compared to other non-financial sectors. Our results provide a first indication to question the need for generalized regulation of OTC derivative transactions, as recently introduced by the European Market Infrastructure Regulation (EMIR).

Commodity derivative valuation under a factor model with time-varying market prices of risk

It is well known that market prices of risk play an important role in commodity derivative valuation. There is an extensive literature showing that market prices of risk vary through time. Based on these results, a factor model, with two long- and short-term factors, with market prices of risk depending on these underlying asset factors is proposed and estimated, using data from crude oil, heating oil, unleaded gasoline and natural gas futures prices traded at NYMEX. The valuation results obtained with an extensive sample of commodity American options traded at NYMEX show that this model with time-varying market prices of risk outperforms standard models with constant market prices of risk.

Market efficiency in Indian soybean futures markets

Purpose – The National commodity exchanges were established in India in the year 2003-2004 to perform the functions of price discovery and price risk management in the economy. The derivatives market can perform these functions properly only if they are efficient and unbiased. So, there is a need to properly evaluate these aspects of the Indian commodity derivatives market. The purpose of this paper is to test the market efficiency and unbiasedness of the Indian soybean futures markets. Design/methodology/approach – The paper uses cointegration and a QARCH-M-ECM-based framework to test the market efficiency and unbiasedness in the soybean futures contract traded in the National Commodity Derivatives Exchange (NCDEX). The cointegration test is used to test the long-run unbiasedness and market efficiency of the contract, while the QARCH-M-ECM model is used to test the short-run market efficiency and unbiasedness of the contract by allowing for a time-varying risk premium. The price data is also tested for presence of structural breaks using a Zivot and Andrews unit root test. Findings – The soybean contract is unbiased in the long run, but there are short-run market inefficiencies and also a presence of a time-varying risk premium. Though the weak form of market efficiency is rejected in the short run, the semi-strong market efficiency is not rejected based on the forecasts. Originality/value – This is the first paper to consider time-varying risk premium while performing the tests of market efficiency and unbiasedness on Indian commodity markets.

Role of Indian Commodity Derivatives Market in Hedging Price Risk: Estimation of Constant and Dynamic Hedge Ratio, and Hedging Effectiveness

This  paper  examines  hedging  effectiveness  of  four  agricultural  (soybean,  corn,  castor seed and guar seed) and seven non-agricultural (gold, silver, aluminium, copper, zinc, crude oil  and,  natural  gas)  futures  contracts  traded  in  India,  using  VECM  and  CCC-MGARCH model to estimate constant hedge ratio and dynamic hedge ratios, respectively. We ind that agricultural  futures  contracts  provide  higher  hedging  effectiveness  (30-70%)  as  compared to  non-agricultural  futures  (20%).  In  the  more  recent  period,  the  hedging  effectiveness  of Indian futures markets has increased. When hedging effectiveness of non-agricultural Indian futures  contracts  with  the  world  spot  markets  (NYMEX  and  LME)  is  analyzed,  hedging effectiveness  increases  dramatically  which  indicates  the  fact  that  Indian  futures  contracts are more effective for hedging exposures to global prices. Other reasons of lower hedging effectiveness  of  Indian  futures  contracts  may  be  low  awareness  of  futures  markets  among participants,  high  transaction  costs  in  the  futures  markets,  policy  restrictions,  inadequate contract design, or high transaction costs in the spot market. These are, of course, expected birth pays for a nascent futures markets in an emerging economy. ");} // --> activate javascript

A drift‐free simulation method for pricing commodity derivatives

Having in view the pricing of commodity derivatives in Libor Market Model (LMM) setting, we first analyze the set of basic rates we need to formulate the model by using the spanning tree concept taken from graph theory. Next, we present an efficient procedure for Monte Carlo simulation of the dynamics of the rates associated to LMM, avoiding the presence of the rates dependent drifts (drift‐free simulation) and the presence of negative deflated bond prices and negative forward rates. The method is based upon a new parameterization of the martingales introduced by Glasserman and Zhao and it is extended to a Cross‐Market Model for commodities. Finally, a particular example of commodity derivative (spread option) pricing problem is considered. Copyright © 2014 John Wiley & Sons, Ltd.

Regulatory Capture, Civil Society & Global Finance in Derivative Regulation: An Analysis of Commodity Derivative Regulation in Europe

The paper analyses the divergent outcomes of post-crisis derivative regulation in Europe. In the aftermath of the financial crisis, most regulatory issues only represent incremental changes of existing practices and incentives, tweaking rather than reforming the financial system and, mostly, these regulations have been captured by the financial industry. A few regulations however seem to have greater impacts on the functioning of financial markets. The regulation of commodity derivatives through MiFID II is an example of such a fundamental change. Adopting a modified version of the institutional supply and demand (ISD) framework, this paper analyses the regulatory processes of these MiFID II and the occurrence of regulatory capture. This paper argues that meaningful regulatory change in commodity derivative regulation was primarily achieved through the lobbying of civil society groups (CSOs) that were able to prevent the regulation being captured by capitalising on the normative aspects of commodity trading and forming alliances with economically powerful actors. As against to more complex and technical regulations, CSOs were able to raise public awareness on the topic of food speculation and its negative impacts and capitalise on this development. Backed by the economically powerful agriculture industry and discursively connecting commodity derivatives with food speculation, CSOs were able to create pressure on elected officials to adapt more stringent regulations. Methodologically, process tracing is used to compare the influence of civil society and business interests in the regulatory process on derivatives.

Economic spillovers between related derivatives markets: The case of commodity and freight markets

Extant literature investigates volatility spillovers between spot markets of the same asset class or between derivatives and their underlying spot markets. This paper investigates economic spillovers between the freight and commodity derivatives markets. The economic relationship tested links the derivative price of the commodity transported with the derivative price on the freight rate. High frequency data on commodities are synchronised with freight data and freight rates of different vessels are matched with portfolios (baskets) of commodities that these vessels carry. The investigation of various types of commodities transported under different types of freight contracts reveal that in most cases new information appears first in the returns and volatilities of the commodities futures markets, before it is spilled over into the freight derivatives markets. Thus, agricultural commodity futures informationally lead the freight markets. The results can help improve the understanding of the information transmission mechanisms between freight and commodity markets.

Systemic Risk in Commodity Markets: What Do Trees Tell Us About Crises?

We examine the impact, on commodity derivative markets, of two financial crises: the Subprime crisis and the bankruptcy of Lehman Brothers. These crises are external for commodity markets: they appeared in the financial sphere. Still, because now commodity markets are highly integrated, between themselves and with other financial markets, such events could have had an impact. In order to fully comprehend this possible impact, we examine prices fluctuations in three dimensions: the observation time, the space dimension – the same underlying asset can be traded simultaneously in two different places – and the maturity of the transactions. We first focus on the efficiency of the shocks propagation: does it improve during crises? Then we concentrate on the paths of shocks propagation: are they modified? How? Finally we focus on the centrality of the prices system: does it change? Does it increase?

Future Trading in India and Commodity Price Risk Management: A Pragmatic Study

Commodity future markets in India are experiencing unparalleled growth and have attained critical economic significance in the last one decade. On the other hand, instability in commodity prices is becoming an issue of great concern not only for India, but all over the world impacting income, economic growth and a poor adversely. Ever-increasing demand and supply side constraints are adding to the upsurge in prices of metal and agricultural commodities, affecting manufacturers and consumers at the same time. Moreover, farmer participation in the market has been very poor. So the price risk management in commodity is not a cliche but a necessity for the development of future market. In an agriculture based economy like India, commodity derivatives are expected to play a pivotal role in the process of price discovery and risk management. The price discovery in futures markets would not be effective unless spot markets are regulated and integrated. The present paper aims to analyse the performance of futures trading in improvising commodity price risk management in India. The study employs co-integration technique to study the existence of long-term relationship between the spot and future prices of agricultural and metal commodities traded in Indian commodity exchanges. The study also explores the volatility aspect in spot and future prices to test the informational efficiency of the contracts and comment on their suitability for hedging activities. Based on the results, propositions would be made on the nature of speculative conditions and offer suggestions for improvement futures trading in commodities.

Future Trading in India and Commodity Price Risk Management: A Pragmatic Study

Commodity future markets in India are experiencing unparalleled growth and have attained critical economic significance in the last one decade. On the other hand, instability in commodity prices is becoming an issue of great concern not only for India, but all over the world impacting income, economic growth and a poor adversely. Ever-increasing demand and supply side constraints are adding to the upsurge in prices of metal and agricultural commodities, affecting manufacturers and consumers at the same time. Moreover, farmer participation in the market has been very poor. So the price risk management in commodity is not a cliché but a necessity for the development of future market. In an agriculture based economy like India, commodity derivatives are expected to play a pivotal role in the process of price discovery and risk management. The price discovery in futures markets would not be effective unless spot markets are regulated and integrated. The present paper aims to analyse the performance of futures trading in improvising commodity price risk management in India. The study employs co-integration technique to study the existence of long-term relationship between the spot and future prices of agricultural and metal commodities traded in Indian commodity exchanges. The study also explores the volatility aspect in spot and future prices to test the informational efficiency of the contracts and comment on their suitability for hedging activities. Based on the results, propositions would be made on the nature of speculative conditions and offer suggestions for improvement futures trading in commodities.

Los derivados financieros, su impacto en la seguridad alimentaria y los intentos de regulación

The consequences of the financial derivatives speculation on food commodities have been gradually clarified. The article emphasizes the excessive speculation and deregulation that took place after 2000, arguing that factors affecting supply and demand cannot explain alone the extreme price volatility and the price increases in food commodities since 2007. The financialization of agricultural markets prevents that farmers and traders can use the futures market as a hedge, and seriously harm consumers, especially in the poorer States. Adding to this, highly volatile agricultural prices lead to lower profits for farmers,, discourages investment, innovation and the pursuit of higher productivity in agriculture. The article explains the regulation of commodity derivatives markets that has taken place in the U.S. and the European Union, and the role of the G-20.

On the Possible Impact of Commodity Transaction Tax on India's Commodity Derivatives: An Empirical Study

In this paper, we empirically investigate the relationship between bid-ask spread, trading activity and intra-day volatility using futures data for five commodities for the sample period of 2006-2010. We have considered five commodities from four categories in our study viz., Gold from precious metals, Copper from basic metals, Crude oil from energy products, Cardamom and Refined Soya Oil from agricultural commodities. The empirical results suggest that there is negative relationship between bid-ask spread as measure of transaction cost and trading volume and positive relationship between bid-ask spread and intraday volatility. More specifically, while higher transaction cost shall decrease trading activity, they shall increase price volatility. The imposition of Commodity Transaction Tax (CTT) shall lead to greater distortions in market micro-structure as trading volumes are likely to become more fluctuating. CTT, however, may not significantly increase price volatility.