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Chapter 51 CHAPTER 5 Agricultural, Energy and Metallurgical Futures Contracts This chapter explores futures contracts on physical commodities, those written.

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Presentation on theme: "Chapter 51 CHAPTER 5 Agricultural, Energy and Metallurgical Futures Contracts This chapter explores futures contracts on physical commodities, those written."— Presentation transcript:

1 Chapter 51 CHAPTER 5 Agricultural, Energy and Metallurgical Futures Contracts This chapter explores futures contracts on physical commodities, those written on agricultural, energy and metallurgical commodities. This chapter is organized into the following sections: 1. Commodity characteristics that interfere with the Cost- of-Carry Model. A.Commodity Supply and Storability B.Commodity Seasonal Production C.Commodity Seasonal Consumption D.Commodity Poor Storability 2. Spread A.Intra-commodity Spreads B.Inter-commodities Spreads 3. Hedging

2 Chapter 52 Commodity Characteristics Recall: the Cost-of-Carry Model implies a range of permissible prices. These prices are defined by the cash- and-carry and reverse cash-and-carry arbitrage strategies. Applying the cash-and-carry arbitrage strategy assumes that the physical good or commodity can be stored from one day to the next. Applying the reserve cash-and-carry arbitrage depends upon short selling. Some goods have a convenience yield, which stems from the usefulness of having them in inventory.

3 Chapter 53 Commodity Characteristics Recall: the relationships between cash and futures prices depend upon: –Storage characteristics of the commodity –Supplies of the commodity –Production and consumption cycle for the commodity –Ease of short selling the commodity –Transaction costs In the following section, we begin by discussing how the supply and storability move the market to or away from full carry. Then, we provide examples of commodities that are at full carry and commodities that are not at full carry.

4 Chapter 54 Commodity Characteristics Supply and Storability Insert Figure 5.1 here

5 Chapter 55 Commodity Characteristics Supply and Storability Table 5.1 presents the various features of the commodities and the expected price behavior.

6 Chapter 56 Commodity Characteristics SUMMARY If a good has excellent storage characteristics and a large supply relative to consumption, we expect markets for the good to approximate full carry (e.g., gold). Commodities with good storability may at some point, depart from full carry, due to fluctuation in production (grains during harvesting time) or fluctuations in consumption (gasoline during summer time). Commodities with poor storability can depart substantially from full carry (e.g., livestock).

7 Chapter 57 Full Carry Markets Precious Metals Figure 5.2 shows gold prices for the JUN and DEC futures contracts. Highly storable commodities with a large supply relative to annual consumption should behave according to the Cost- of-Carry Model. For precious metals, both the cash-and-carry and reverse cash-and-carry arbitrage strategies are potentially effective because short selling is fairly accessible for precious metals like gold. Recall: the carrying costs consist of storage, insurance, transportation, and financing charges. Insert Figure 5.2 here

8 Chapter 58 Full Carry Markets Precious Metals If gold is a full carry market, the following relationship should hold: where d > n Applying this equation to our present example implies: DEC gold futures = JUN gold futures (1 + C) Dividing both sides of the above equation by the right-hand side and subtracting 1, we have: Any time this equation equals something other than zero, an arbitrage opportunity is possible.

9 Chapter 59 A Full Carry Example: Gold Assume that the prices in Table 5.2 are present in the market and assume that the financing cost is the T-bill rate for the June-December period. All other transaction costs are ignored. We would like to know if the market is at full carry.

10 Chapter 510 A Full Carry Example: Gold While this value is close to zero indicating that the market is near full carry, the trader with a total carrying cost equal to the T-bill rate could make a profit from a cash-and-carry strategy. $ $ ( ) = $.36/ ounce

11 Chapter 511 A Full Carry Example: Gold If the T-bill rate is What is the repo rate? The futures contract is for ½ year, so to compare this rate to the T-bill rate, we must annualize it as follows: The difference between the T-bill rate and the repo rate is: = Thus, if a traders financing cost is below %, She/he could engage in a cash-and-carry strategy. This analysis demonstrates that gold market was very close to full carry on that day.

12 Chapter 512 Departure from Full Carry: Gold Figure 5.2 shows how gold and other precious metals behave in similar fashion. INSERT FIGURE 5.3 HERE

13 Chapter 513 Departure From Full Carry: Silver If prices decline, the results of the full carry market equation may be above zero. This is said to be above full carry. If the market is above full carry, cash-and-carry arbitrage strategies become attractive. Assuming short selling is possible and that no convenience value exists: Borrow money. Sell a futures contract. Buy the commodity. Deliver the commodity against the futures contract. Recover the money and payoff loan.

14 Chapter 514 Departure from Full Carry: Silver If prices rise, the results of the full carry market equation may fall below zero. This is said to be below full carry. If the market is below full carry, reverse cash-and-carry arbitrage strategies become attractive. Assuming short selling is possible and that no convenience value exists: Sell short the commodity. Lend money received from short sale. Buy a futures contract. Accept delivery of futures contract. Use commodity received to cover short sale.

15 Chapter 515 Product Profile: The NYMEX Silver Futures

16 Chapter 516 Departure from Full Carry: The Hunts Silver Manipulation Case In January 1980, the Hunt Manipulation was at its peak and silver hit its all-time record price of $50/ounce. Traders with no convenience value, delivered silver to benefit from the quasi-arbitrage opportunities. On Thursday, March 27,1980, the silver manipulation ended, the market crashed, and the silver market quickly returned to almost full carry again. Figure 5.4 shows the silver market from October 1, 1979 through June 30, 1980.

17 Chapter 517 Departure from Full Carry: Silver Insert figure 5.4 here

18 Chapter 518 Commodities with Seasonal Production In this section, we examine commodities that are produced seasonally. To facilitate the discussion assume: –Consumption of the commodity is steady. –Long-term inventory is constant. –Production will equal consumption. –Commodity stores well (e.g., wheat, corn, oats, barley, soy products). –Prices exhibit seasonal trends due to harvesting patterns. Wheat is used to illustrate the seasonal characteristics of commodities.

19 Chapter 519 Inventories and Price Patterns Insert Figure 5.5a Here Insert Figure 5.5b hereInsert Figure 5.5c here

20 Chapter 520 Inventories and Price Patterns: Basis A fluctuating basis is often interpreted as a sign of high risk and unstable prices. However in this example, due to our assumptions, there is no risk. This shows that the basis may fluctuate radically even under conditions of certainty. It is important to separate fluctuations in the basis into the expected and unexpected components. Insert Figure 5.6

21 Chapter 521 CBOTs Wheat Futures Profile

22 Chapter 522 Wheat and Wheat Futures Although, wheat does not fit our model perfectly. The seasonal factor and the availability of wheat in the US is very strong. Figures 5.7 shows that wheat prices tend to be high during winter and low during summer.

23 Chapter 523 Seasonal Character of Cash Wheat Prices Insert figure 5.7 here

24 Chapter 524 Wheat and Wheat Futures Table 5.3 shows the average stock of wheat in the US by month from 1969 to Notice the low inventory for June, and the high level for August and September.

25 Chapter 525 Wheat and Wheat Futures Based on Table 5.3, high supply should cause a drop in price (other factors held constant). Table 5.4 shows the seasonal character of cash wheat prices. Results confirm the view that cash prices should be high when inventories are low and low when inventories are high.

26 Chapter 526 Wheat and Wheat Futures The large number of highs and lows in these months reflects the large forecasting errors in futures prices when the expiration is distant. There is no tendency for high prices to occur in one month and low prices to cluster in some other time period. Thus, cash prices can be seasonal, while futures prices for the same commodity are not.

27 Chapter 527 Wheat and Wheat Futures Table 5.6 presents a portion of Telsers classic study of wheat and cotton futures. Telser concluded futures data offer no evidence to contradict the simple hypothesis that the futures price is an unbiased estimate of the expected spot price.

28 Chapter 528 Wheat and the Cost-of-Carry Model Given the characteristics of wheat, we expect wheat price relationships to differ substantially from the full carry behavior of gold. First, wheat production is seasonal. Even if the harvest were known well in advance, wheat would still be abundant after harvest and scarce later. Second, the harvest is not known in advance, so shortages or surpluses of wheat can develop. In general, we would not expect wheat to behave as a full carry market in all circumstances.

29 Chapter 529 Wheat Versus Gold: The Cost-of-Carry Model Insert Figure 5.2 JUL and DEC Gold Futures Prices Insert Figure 5.8 Here JUL and DEC Wheat Futures Prices

30 Chapter 530 Wheat Versus. Gold: The Cost-of-Carry Model Insert Figure 5.9 here Deviations from Full Carry for Wheat

31 Chapter 531 Wheat Versus Gold: The Cost-of-Carry Model

32 Chapter 532 Wheat Versus Gold: The Cost-of-Carry Model Summary: Wheat cash prices are seasonal, due to fluctuating supply and surprises about the harvest. The spread between two futures maturities can vary in a systematic way, due to seasonal factors. Storage, insurance, and transportation costs, as well as the financing cost should be evaluated to determined if a market is at full carry.

33 Chapter 533 Commodities with Seasonal Consumption In this section, we examine commodities that show seasonal consumption. Particular attention will be given to crude oil. Seasonal consumption patterns can produce fluctuating stocks of some commodities. This can create shortages and give a convenience value to these commodities. Oil and related products provide an example of a good with fairly steady production, but highly seasonal demand (e.g., gasoline during summer, heating oil during winter). Crude oil futures sometimes are at full carry, while at other times, crude oil can have a substantial convenience yield or the market can even be in backwardation. Table 5.7 shows crude oil prices with virtually every possible price pattern.

34 Chapter 534 Crude Oil Futures Prices

35 Chapter 535 Commodities with Poor Storability In this section, we examine commodities that show poor storability. Particular attention will be given to livestock. Livestock is an example of a commodity with poor storability. Example: Live cattle must have an average weight between 1,050 and 1,200 pounds at delivery. If cattle are held too long, they cannot be delivered in fulfillment of the contract. Difficult storage conditions loosen the no-arbitrage connection between futures contracts with different expirations.

36 Chapter 536 Feeder Cattle and Live Cattle The CME trades contracts on feeder cattle and live cattle. The decision to slaughter feeder cattle, or to carry forward for delivery as live cattle, depends on the spread between to feeder cattle and live cattle futures contracts and the cost of feeding. I PHASE: CALF Conception to weaning II PHASE: FEEDER CATTLE Feeding 1 yr Weight Lbs Grow More YesNo III PHASE: LIVE CATTLE Weight Lbs TRADE Feeder Cattle

37 Chapter 537 Live Cattle Futures Prices Figures 5.10 and 5.11 show that there is little chance live cattle adhere to the cash-and carry structure. Insert figure 5.10 here

38 Chapter 538 Commodities with Poor Storability Live Stock Insert figure 5.11 here We conclude that the Cost-of-Carry Model does not apply very well to cattle. Prices fluctuate from above to below full carry.

39 Chapter 539 Spreads In this section, we examine spreads: 1. Intra-commodity spreads. Every intra-commodity spread must have at least two contracts (one short/one long). A. Bull Spread A bull spread is an intra-commodity spread designed to profit if the price of the underlying commodity rises. B. Bear Spread A bear spread is an intra-commodity spread designed to profit if the price of the underlying commodity falls. 2. Inter-commodity spreads. Every inter-commodity spread must have at least two contracts in two different, but related commodities A. Soybeans complex B. Energy complex C. Livestock

40 Chapter 540 Intra-Commodity Spreads Recall: the Cost-of-Carry Model for a full carry market with perfect markets. d > n Recall further: changes in spreads and changes in prices for full and non-full carry markets behaves as follows: In full carry markets, if the commodity price rises, the distant futures price rises more than the nearby futures price. In non-full carry markets, if the commodity price rises, the nearby futures price rises more than the distant futures price. Table 5.9 lists commodities that follow each type of relationship.

41 Chapter 541 Bull and Bear Intra-commodity Spreads

42 Chapter 542 Inter-Commodity Spread Relationships In this section, the spread relationships between the following related commodities will be explored: 1. Soy complex 2. The energy market (oil) 3. The livestock market ( feeder cattle and live cattle)

43 Chapter 543 Soybeans Futures Market

44 Chapter 544 Soybeans and The Crush Soybeans must be crushed to yield edible soymeal and soyoil. A 60-pound bushel of soybeans produces approximately: 48 lbs. of soymeal 11 lbs. of soyoil 1 lbs. of waste Crush Margin The crush margin is the difference in value between a bushel of soybeans and the resulting meal and oil. One soybeans contract ( 5000 bushels) produces approximately: 120 tons of soymeal or 1.2 soymeal contracts 55,000 pounds of oil or 92% of a soyoil contract 10 contracts 5,000 bushels 2,400,000 lbs. of meal + 550,000 lbs. of oil 12 contracts of meal + 9 contracts of oil

45 Chapter 545 Soybeans and Crush Spreads In normal conditions, the value of the meal plus the oil must exceed the value of the soybeans. If this were not the case, there would be no incentive to process the soybeans. Thus, we expect the crush margin to be positive. The following crush and reverse crush information along with Table 5.11 will be used to illustrate soybean crush spreads.

46 Chapter 546 Soybeans and Crush Spreads Assume that today, August 4, a speculator believes that the crush margin is too small. That is, the speculator believes that by buying beans and selling the combined meal and oil positions, he/she will make a profit. Table 5.12 details the transactions the speculator enters to take advantage of his/her beliefs.

47 Chapter 547 Soybeans and Crush Spreads Bean prices actually fell resulting in a net loss of $27,733.

48 Chapter 548 Soybeans and Crush Spreads Now the speculator believes that the prices will continue to fall, so the speculator enter the market again with the transactions as shown in Table Bean prices rise causing the speculator another net loss of $13,013.

49 Chapter 549 Oil and the Crack

50 Chapter 550 Oil and the Crack Crude oil must be refined into other products (e.g., gasoline, heating oil, or propane). Cracking Cracking is the process of refining crude oil. The same crude oil can produce a variety of products depending on the techniques used to crack it. A barrel of oil can only produce a certain amount of total product. The mix is variable, but the total output is a zero- sum game. Cracking patterns are largely governed by the season of the year (more gasoline will be produce during summer, and more heating oil during winter). Crack Spread The price relationship between crude oil and its refined products.

51 Chapter 551 Oil and the Crack There are several kinds of crack spreads, including: 1. Crude oil/heating oil crack spread 1 barrel crude oil 1 barrel gasoline 2. Crude oil/gasoline crack spread 1 barrel crude oil 1 barrel heating oil 3. Other Combination based on multiple units of crude oil 2 barrels crude oil 1 barrel gasoline 1 barrel heating oil Buy a Crack Spread The trader buys the refined product and sells the crude. Sell a Crack Spread (Reverse Crack Spread) The trader sells the refined product and buys the corresponding crude. The most popular crack spreads are the 1:1 spreads between crude and heating oil or crude and gasoline.

52 Chapter 552 Oil and Crack Spreads Table 5.14 shows the contract specifications for crude oil, heating oil and gasoline. 1 barrel = 42 gallons Figures 5.12 shows the prices of July crude oil and heating oil futures in dollars per gallon and 5.13 illustrates the spread.

53 Chapter 553 Oil and Crack Spreads Insert Figure 5.12 here JUL Crude and Heating Oil Futures Insert Figure 5.13 Here Spread between JUL Heating and Crude Oil Futures

54 Chapter 554 Oil and Crack Spreads Assume that today, March 16; a trade has gathered the information from Table The trader believes that the $.0616 crude oil/ heating oil crack is not sustainable ($.4569-$.5185= $.0616). The trader thinks that the justifiable refining spread is only $.04 per gallon. Therefore, the trader expects the spread to narrow and thus decides to enter into a reverse crack spread (sell heating oil and buy crude oil). Table 5.16 shows the transactions the trader enters into in order to take advantage of her/his beliefs.

55 Chapter 555 Oil and Crack Spreads The traders assessment was correct and thus he/she made a profit.

56 Chapter 556 Oil and Crack Spreads The trader now believes that the spread will widen, and that heating oil will now rise in price relative to crude. Therefore, she decides to place a crack spread (crack spread consists of buying the refined product and selling crude). Table 5.17 shows the traders transactions. Notice that the traders overall profit depends only on the crack spread, not on the direction of oil prices in general.

57 Chapter 557 Feeder Cattle and Live Cattle Insert Figure 5.14 here A Time Line for Cattle Production

58 Chapter 558 The Cattle Crush The cattle crush depends upon the price of cattle today, the expected price of cattle in the future, and the price of grain necessary to feed the cattle to a larger future size. A popular cross-exchange spread occurs between corn contracts on the CBOT and cattle contracts on the CME. The cattle crush spread can be established by holding a long position in corn futures while simultaneously establishing a short position in live cattle. A reverse cattle crush involves buying two live cattle contracts for each corn contract the trader is short.

59 Chapter 559 Feeder Cattle and Live Cattle Example The owner of the newborn calf sells two futures contracts for the calf : –One contract for delivery as a feeder in 12 months. –One contract for delivery against the live cattle contract in 18 months. The owner has the following options: –Deliver the calf against the feeder contract, and offset the live cattle contract. –Offset the feeder contract, maintain the live cattle contract, and deliver the 18 month steer against the live cattle contract. The owners potential profitability is largely a function of the cost of corn. If feed prices rise, the profitability of feeding is reduced. Thus, spread between the cash price of feeder cattle and the futures price for live cattle will narrow as corn prices rise.

60 Chapter 560 Corn and Live Cattle Future Prices Assume that today, May 22, you, a cattle feeder, have gathered the information from Table You have 65 steers and anticipate that the steers will be on feedlot rations for sixth months in order to produce slaughter weight cattle. You know that one corn contract will feed the steers underlying 2 live cattle contracts to slaughter weight. You calculate your current spread to be $ per steer. You fear that the cattle crush spread may narrow, and wish to lock in the current spread. The ratio of corn contracts to live cattle contracts is 1:2.

61 Chapter 561 Corn and Live Cattle Future Prices The current spread is calculated as follows: Value of two cattle contracts: 2(40,000)(.7680) = $61,440 or per steer Value of one corn contract: 1(5,000)(2.675) = $13,375 or $ per steer The spread is the difference between the value of the cattle contracts and the cost of corn.

62 Chapter 562 The Cattle Crush Spread Position Table 5.19 shows the transactions you enter in order to lock in your current spread. Your cattle crush produce a $1,265 gain.

63 Chapter 563 Reverse Cattle Crush Spread Position Now assume that you believe that the corn/cattle spread will widen. Therefore, to take advantage of your belief, you establish a reverse cattle crush spread. Table 5.20 shows the results of a reverse cattle crush using the prices displayed in Table You miscalculated. As the spread narrowed, your reverse cattle crush position in the futures market lost $1,265.

64 Chapter 564 Hedging Chapter 4 explored hedging and basic hedging strategies. This section explores more complicated strategies particular to: –Energy markets –Agricultural markets –Metallurgical markets We consider hedging different grades of oil. Two highly publicized cases of improperly implemented hedges will also be explored.

65 Chapter 565 Hedging Worldwide Crude Oil There are different kinds of crude oil originating around the world. The following table illustrates six types of oil.

66 Chapter 566 Hedging Worldwide Crude Oil Recall that the easiest way to compute the risk- minimizing hedge ratio, number of futures contracts to hold for a given positions in a commodity, is by estimating the following regression: From the previous regression: β = The risk-minimizing hedge ratio Α = A measure of hedging effectiveness Where The closer to 1, the better the chance that the hedge will work.

67 Chapter 567 Hedging Worldwide Crude Oil Table 5.21 reports the volatility of the weekly price changes for the different oils and the results from two hedging strategies. Finding a futures contract that closely matches the spot commodity is important and will generally improve the hedge considerably. Second, for cross-hedges, the naive 1:1 hedging approach may be markedly inferior to using a risk- minimizing hedge ratio.

68 Chapter 568 Improperly Implemented Hedges Two highly publicized cases of improperly implemented hedges were: The Hedge-To Arrive (HAT) Fiasco Agricultural commodities The Metallgesellschaft Hedging Fiasco Energy Products

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