Financial Markets for Commodities

Agricultural, energy or mineral commodities are traded internationally in two market categories: physical markets and financial markets. More specifically, on the financial markets, contracts are negotiated, the price of which depends on the price of a commodity. These contracts are called derivatives (futures, options contracts, swaps).

This book presents, on the one hand, the characteristics of these derivatives and the markets on which they are traded and, on the other hand, those transactions that typically combine an action on the physical market and a transaction on the corresponding financial market.

The understanding of commodity financial markets mainly relies on the resources of economic analysis, especially the financial economy, because the use of this discipline is essential to understanding the major operations that are conducted daily by the operators of these markets: traders, producers, processors, financiers.

Preface xi
Joël PRIOLON

Introduction xiii
Joël PRIOLON

Chapter 1 General Observations on the Physical Trading of Commodities 1
Joël PRIOLON

1.1 The standardization of commodities and commercial contracts 1

1.2 Price volatility of commodities 3

1.2.1 Elasticity 5

1.2.2 King’s law 6

1.3 Important actors in the trading of agricultural commodities 8

1.3.1 Enterprises trading in agricultural commodities 8

1.3.2 Business banks 10

1.3.3 States and the trading of agricultural commodities 10

1.4 Physical markets and financial markets 11

Chapter 2 The Financial Commodity Markets 13
Joël PRIOLON

2.1 A financial instrument is a security or a contract that generates a series of financial flows 13

2.2 Physical markets and derivative financial markets 15

2.2.1 Physical commodity markets 15

2.2.2 Organized financial markets of commodities 16

2.3 Large financial operations 19

2.3.1 Arbitrage 19

2.3.2 Speculation on price increases 20

2.3.3 Hedging 22

2.3.4 Physical transactions and financial transactions 23

Chapter 3 Futures Contracts and Forward Contracts 25
Joël PRIOLON

3.1 Futures markets in 2013 and 2014 26

3.2 Derivative markets in 2016 27

3.3 An overview of futures contracts 27

3.3.1 Notations 27

3.3.2 Gains and losses at the maturity of an elementary operation 29

3.3.3 Closing a position before maturity 32

3.4 Arbitrage operations and conditions for no arbitrage 32

3.4.1 An elementary example of arbitrage through replication 33

3.4.2 A formal definition of NA 34

3.5 Hedging operations 35

3.5.1 An elementary example of hedging 36

3.5.2 A model for an optimal hedge 40

3.6 Speculation 42

3.6.1 Speculation and hedging, a model for the optimal position 42

3.7 Forward contracts 45

3.8 The pricing of futures and forwards 46

3.8.1 The bases of the Black model 46

3.8.2 The dynamic of futures prices 50

3.9 Commodity swaps 52

3.9.1 Definition and example 52

3.9.2 Pricing a swap 54

Chapter 4 The Storage and Term Structure of Commodity Futures Prices 55
Christophe GOUEL

4.1 Essential concepts 56

4.1.1 Uncertainty, spreads and future markets 56

4.2 Normal backwardation 58

4.2.1 The diversity of hedgers on futures markets 59

4.2.2 The empirical scope of the normal backwardation theory 62

4.3 The theory of storage 62

4.3.1 Some fundamental concepts 62

4.3.2 The theory of storage with occasional stockouts 63

4.3.3 Spread and storage 65

4.3.4 The concept of convenience yield 69

4.4 Futures markets and price volatility 70

4.4.1 Hedging and volatility 71

4.4.2 Futures markets and information 71

4.5 Conclusion 72

Chapter 5 Options Markets 73
Christophe DOURSAT and Joël PRIOLON

5.1 The fundamental concepts 73

5.1.1 Characteristics of options and a glossary 74

5.1.2 The life of an options contract on an exchange 75

5.1.3 The risk of gain and the risk of loss on elementary strategies  78

5.2 The determinants of the value of an option, the pricing of options  81

5.2.1 The general principle behind the pricing of options 82

5.2.2 Pricing options and choosing a model 83

5.3 Models for estimating the value of an option 84

5.3.1 The one-period CRR pricing model 84

5.3.2 The BS model 87

5.3.3 The origin of the BS model, the Arrow–Debreu model and the concept of the complete market 88

5.3.4 Four propositions 89

5.4 An example of a commodity option traded on an exchange 91

5.5 Conclusion 92

Chapter 6 A Selective Review of Classic Literature in Economics  95
Joël PRIOLON

6.1 Holbrook Working 96

6.1.1 Definitions 96

6.1.2 Hedging possibilities in Kansas city in 1951–1952 97

6.1.3 Reinterpreting hedging 100

6.1.4 Price fluctuations 100

6.1.5 Other work related to Working’s model 101

6.2 Leland L Johnson 104

6.2.1 The model 104

6.2.2 A graphical interpretation of the model 106

6.3 Jerome L Stein: cash price and future price 109

6.3.1 The choice of hedging or not hedging stocks 109

6.3.2 The supply of and demand for stocks and balance on the physical market 111

6.3.3 Supply and demand of futures contracts and equilibrium on the financial market 113

6.3.4 Simultaneous equilibrium on the spot and futures markets 114

6.4 Conclusion 115

Chapter 7 A Very Selective Review of Modern Literature in Economics 117
Joël PRIOLON

7.1 The price dynamics for cash prices and future prices – a theoretical approach 117

7.1.1 The first case: there is no futures market 118

7.1.2 Second case: a futures market is opened 124

7.2 Market failure: the basis does not always cancel itself out at maturity  125

7.2.1 The model 125

7.3 An example of the destabilizing effect of optional hedging 129

7.3.1 Delta-hedging 129

7.3.2 An elementary example 130

7.3.3 Intuition 131

7.3.4 Graphical analysis of delta-hedging 131

7.4 Conclusion 133

Chapter 8 Questions Surrounding Regulation 135
Joël PRIOLON

8.1 Dilemmas surrounding regulation 135

8.1.1 Organized financial markets are governed by strict regulations on the judicial level 136

8.1.2 Physical markets have very little regulation 136

8.2 A broad overview of the evolution of regulation 136

8.2.1 Regulation within the framework of the European Union 137

8.2.2 Regulation in the United States 138

8.2.3 The role of the IOSCO 139

8.3 High-frequency trading: a burning question 140

8.3.1 Algorithmic trading 140

8.3.2 High-frequency trading 141

8.3.3 HFT and the risk of manipulation of the market 143

8.4 Conclusion 144

Appendix  145

References  157

List of Authors 159

Index  161

Joël Priolon is Associate Professor at AgroParisTech. He has a PhD in economics and his research and teaching focus on financial markets, including commodity markets.