Chapter 14: Understand the Uses of Commodity Derivatives

The main purpose of evolution of commodity derivatives market was price discovery amongst buyers and sellers as well as price risk management for users of commodity as a raw material. As you know from earlier chapters, there are three types of participants in the commodity derivatives market. They are traders, hedgers and arbitrageurs.

Let us deep dive into different uses of commodity derivatives.

Hedging

It is a price risk management tool adopted by actual users such as processors, miners, exporters, importers, manufacturers, etc.

Hedging means taking a position in the derivatives market that is the opposite of position in the physical market with an objective of reducing or limiting risks associated with price changes. Generally, there are two types of hedgers, namely commodity users and commodity producers.

Long hedge and short hedge strategies using Futures

Hedger transfers price risks to other parties by taking a Futures position opposite to their physical market exposure in the underlying commodity. By hedging, the hedger, to a large extent, minimises or even eliminates the possibility of loss from a price change of the commodity. At the same time, they also eliminate the possibility of a gain from price change.

Long hedge

The hedger does not hold the underlying commodity in case of a long hedge, but they will need to acquire it in the future. By purchasing or going long in Futures contracts, they can lock in the price they pay in the future.

Example: A jeweller needs to buy 1 kg of gold at the end of May. He has two options. 1) Buy 1 kg from the Spot market and store it in his vault. With this trade, he is investing an amount equivalent to 1 kg and bearing storage costs and 2) Take a position in the Futures market to avoid deploying huge investment and bearing storage costs.

Assume, the jeweller decides to take a position in the Futures market. Let us see how he is able to fix his purchase price to Rs. 51,700 at the end of May from hedging irrespective of price fluctuations.

Scenario 1: If prices were to rise

Net purchase price on 30 May: Gold Spot price on 30 May – Profit from gold Future

= Rs. 51700 (51900 - 200)

Scenario 2: If prices were to fall

Net purchase price on 30 May: Gold Spot price on 30 May + Loss from gold Future

Net purchase Price: Rs. 51700 (51300 + 400)

The loss in one leg of transaction will be offset by the profit in the second leg of the transaction while purchase price remains constant.

Short hedge

Short hedge works for market participants who produce the commodity and are concerned with price fall, which may erode their profit margin.

Example: A ginner is holding a huge stock of cotton. He is concerned with a fall in the price of cotton, which will reduce his profit margin. To protect himself from falling cotton prices, the ginner takes a short hedge in the Futures market. Let us see how the ginner protects himself from price fall and is able to sell his produce at Rs. 42,700 irrespective of market price at the end of April.

Scenario 1: If prices were to rise

Net sell price on 30 April: Cotton Spot price on 30 April – Loss from cotton Future

Net sell price: Rs. 42700 (43000 - 300)

Scenario 2: If prices were to fall

Net sell price on 30 April: Cotton Spot price on 30 April + Profit from cotton Future

Net sell price: Rs. 42700 (42000 + 700)

In the above examples, you can see that the buy/sell price remains the same irrespective of market movement. This is the benefit of hedging, where you can fix your buy/sell price in advance.

Hedge ratio

You have learnt about long hedge and short hedge with examples. Now, you might be wondering how much quantity needs to be hedged to cover physical market exposure. Should it be equal or lower or higher quantity?

For this question, the answer lies in calculating the hedge ratio.

What is hedge ratio?

Hedge ratio indicates the number of lots/contracts that the hedger is required to buy or sell in the Futures market to cover their risk exposure in the physical/Spot market. It helps to neutralise the volatility difference between Spot and Futures. Hedge ratio is calculated as under:

Hedge ratio = Coefficient of correlation between Spot and Futures price * (standard deviation of change in Spot price/standard deviation of change in Futures price)

Example: A silver trader needs 100 kgs of silver to make silverware and sell them after a month’s time. But he is afraid of a fall in silver prices after one month. He then enters short hedge. Let us calculate the quantity to be hedged to cover the risk of 100 kgs of silver using the following information.

Standard deviation of change in silver Spot price = 1.17

Standard deviation of change in silver Futures price = 0.62

Coefficient of correlation between Spot and Futures = 0.90

Hedge ratio = (1.17/0.62) * 0.90 = 1.70

Optimal quantity to be hedged: 100 * 1.70 = 170 kgs of silver Futures

Silver contract is of 30 kgs. Hence, the number of lots to be hedged are 170/30 = 5.67 contracts (Rounding off to 6 contracts)

Speculation/Trading

Speculation is the practise of trading in order to profit quickly from price changes. It covers the purchase and sale (short sale) of securities, commodities, and other financial assets. Speculators never use the item for physical purposes because their goal is to benefit quickly from price fluctuations.

Each of the financial markets get two types of speculators or traders. They are long speculators and short speculators.

Long speculators or traders are those market participants who buy securities expecting the price to rise while short speculators or traders sell securities in anticipation of a fall in the price of securities.

Arbitrage

You may have come across price differences for the same commodity in two different shops or markets and may have thought: Why can’t I buy from the market where it is quoted lower and sell in the market or shop where it is quoted high? If you are thinking or doing so, it is called arbitrage.

Arbitrage is the process of buying and selling simultaneously in two different markets to profit from price differences in those two markets. There are mainly two types of arbitrages, namely Cash-and-carry and Reverse cash-and-carry arbitrage.

Cash-and-carry arbitrage

Cash-and-carry arbitrage refers to the simultaneous purchase of a physical commodity using borrowed funds and the sale of a Futures contract. When the contract expires, the tangible commodity is delivered. This opportunity comes when the commodity's Futures price exceeds the sum of the Spot price and the cost of carrying it until the expiration date.

For example, assume you find an arbitrage opportunity in silver, and will be initiating arbitrage trading as follows.

Buy 30 kgs silver at the rate of Rs. 65,000 per kg by borrowing Rs. 19,50,000 at the rate of 10% per annum for two months and simultaneously sell 30 kgs silver Futures contract at the rate of Rs. 67,000 per kg and hold the position for two months. You will be closing out the position on the contract expiry date when the Spot and Futures price converge by providing delivery of 30 kgs silver that you purchased two months ago on the exchange platform. This transaction yields a profit of Rs. 60,000 {(Rs. 67000 – Rs. 65000) * 30} and returning the borrowed money of Rs. 19,50,000 along with interest of Rs. 32,500 (1950000*0.1*2/12) and earning an arbitrage benefit of Rs. 27,500.

Reverse cash-and-carry arbitrage

Those with asset holdings can take advantage of the reverse cash-and-carry arbitrage opportunity. When the commodity's Futures price is less than the Spot price + cost of carry, an arbitrage opportunity arises. It is initiated by lending funds obtained from selling a commodity on the Spot market and simultaneously purchasing Futures. The asset will be purchased at the end of the contract period once funds are realised, and interest income will be included in the final income calculations.

Example: As an arbitrageur, you will sell 30 kgs silver in the Spot market at Rs. 60,500 per kg and simultaneously buy silver Futures at Rs. 60,000 per kg. You will be investing the sale proceeds of Rs. 18,15,000 at the rate of 10% per annum for two months. You close the Futures position on the contract expiry date, when the Spot and Futures prices converge by accepting delivery of the silver. You earn a profit of Rs. 15,000 [(60500 - 60000) *30] on this position. You earn an interest of Rs. 30,250 on an investment of Rs. 18,15,000. Your arbitrage profit is Rs. 45,250 (Rs. 30250 + Rs. 15000) after purchasing 30 kgs physical silver at the price of Rs. 60,000 per kg.

Summary

• Three principal users of commodity derivatives are traders (speculators), hedgers and arbitrageurs.
• Traders bring liquidity to the market through their buying and selling; hedgers mitigate their price risk by taking an opposite position of their physical market exposure and arbitrageurs takes advantage of price differences in two different markets for the same commodity.
• Speculators trade with the sole intention of making profit from price changes in commodities.
• Consumers of commodities always take a long hedge while producers of the commodity take short hedge.
• For hedgers, optimal number of contracts to be hedged will be calculated using hedge ratio, which is derived by multiplication of correlation coefficient with standard deviation of Spot price divided by standard deviation of Futures price.
• There are mainly two types of arbitrages, namely cash-and-carry and reverse cash-and-carry arbitrage.

In the next chapter, you will learn about non-directional trading strategies, which are very useful in all types of market situations.