Fintech Chapter 11: Commodities

Commodity Futures Buy/Sell for future delivery Agriculture Rice in China 6,000 years ago Now electronic/HFT/asset diversification Every major financial center Chicago Board of Trade (CBOT) 1848

U.S. Commodity Exchanges Chicago Board Options Exchange Chicago Board of Trade Chicago Mercantile Exchange COMEX ICE Futures Kansas City Board of Trade Minneapolis Grain Exchange North American Derivatives Exchange New York Mercantile Exchange New York Board of Trade

Regulation CFTC Dodd Frank Act SEF Exchanges FINRA/NFA

Commodity Markets Energy Agricultural Precious Metals Base Metals Crude Oil Gasoline Heating Oil/Gasoil Natural Gas Electricity Agricultural Corn Soybeans Wheat Coffee Sugar Cocoa Orange Juice Cattle Hogs Precious Metals Gold Silver Platinum Palladium Base Metals Copper Aluminum

Exchange: Trading Conventions, Terminology Crude Oil Minimum price change $0.01 Contract size 1,000 bbls Expiry months: F,G,H,J,K,M,N,Q,U,V,X, and Z E.g. WTI crude oil for June 2020: CLM20 Opening and closing range/prices Number of months/quarters/years to be listed for trading Daily trading limits

Exchange: Rules and Requirements Daily trading limits Severe volatility: closing and reopening rules Restrictions on position size Set margin rules Deliveries Liquidations Daily market reports: Open and closing prices Daily high and low Trading volume Open interest Rulebook: participation/capitalization/trading/enforcement…

Market Participants Hedgers Portfolio Managers Individual Traders Proprietary Trading Firms Hedge Funds Market Makers

Hedging Example: Farmers and Corn Farmer must purchase supplies well in advance of selling crop At risk to drop in price of crop ( supplies are fixed price, crop selling price is floating) In April, futures price for Dec wheat is $4 $4 is profitable for farmer, so buy supplies, sell Dec futures, locking in sale price and profit. When crop harvested in the fall, farmer sells wheat in cash market, buys back futures Assume cash market price moves penny for penny with futures (“basis” is difference between cash and futures, assume its constant over the time period) If futures price (and cash price) drops to $3.50, farmer gains $0.50 on futures ($4 sale, $3.50 buy back) just offsetting 0.50 loss in cash If futures price (and cash price) rises, farmer loses $0.50 on futures, but gains offsetting $0.50 in cash.

Hedging Example: Airlines and Jet Fuel Jet fuel major variable expense for airlines Example: lock in jet fuel purchase price In December, Sing Jet Kero price for June is $64 bbl Trader wants to lock in price for 100,000 bbls Buys 100 June swaps of 1,000 bbls each at $64 In June, trader sells swaps, buys cash jet fuel If price has risen to $74, trader gains $10 on the swap, which just offsets $10 rise in cash price. Net purchase price is $64: $74 paid in cash market, less $10 gained on swaps If price falls to $54, trader loses $10 on the swap. Net purchase price is still $64: Cash price has fallen to $54, but $10 gained on swap transacti0n.

Commodities as an Asset Class Portfolio diversification lowers risk Construct a commodity index with no or negative correlation with equities S&P GSCI 2004: $36 billion 2008: $240 billion

S&P GSCI Reference Percentage Dollar Weight 2016 and 2017

Commodities ETF ETF: Exposure to commodity prices Tax advantages Liquidity Convenience Low costs Over 150 different ETFs focused on one or a basket of commodities

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