P1.T3. Financial Markets & Products Robert Mcdonald, Derivatives Markets, 3Rd Edition Bionic Turtle FRM Study Notes Reading 20

Licensed to at [email protected]. Downloaded November 28, 2016.
The information provided in this document is intended solely for you. Please do not freely distribute.
P1.T3. Financial Markets & Products
Robert McDonald, Derivatives Markets, 3rd Edition
Bionic Turtle FRM Study Notes

Reading 20
By David Harper, CFA FRM CIPM
www.bionicturtle.com
McDonald, Chapter 6: Commodity Forwards and Futures

DEFINE COMMODITY TERMINOLOGY SUCH AS STORAGE COSTS, CARRY MARKETS, LEASE RATE,
AND CONVENIENCE YIELD. ................................................................................................... 3
EXPLAIN THE BASIC EQUILIBRIUM FORMULA FOR PRICING COMMODITY FORWARDS. ................. 4
DESCRIBE AN ARBITRAGE TRANSACTION IN COMMODITY FORWARDS, AND COMPUTE THE
POTENTIAL ARBITRAGE PROFIT............................................................................................. 5
DEFINE THE LEASE RATE AND EXPLAIN HOW IT DETERMINES THE NO‐ARBITRAGE VALUES FOR
COMMODITY FORWARDS AND FUTURES. ............................................................................... 7
DEFINE CARRY MARKETS, AND EXPLAIN THE IMPACT OF STORAGE COSTS AND CONVENIENCE
YIELDS HAVE ON COMMODITY FORWARD PRICES AND NO-ARBITRAGE BOUNDS. COMPUTE THE
FORWARD PRICE OF A COMMODITY WITH STORAGE COSTS. .................................................... 8
COMPARE THE LEASE RATE WITH THE CONVENIENCE YIELD ................................................. 10
IDENTIFY FACTORS THAT IMPACT GOLD, CORN, ELECTRICITY, NATURAL GAS, AND OIL FORWARD
PRICES. ............................................................................................................................ 11
DEFINE AND COMPUTE A COMMODITY SPREAD .................................................................... 13
EXPLAIN HOW BASIS RISK CAN OCCUR WHEN HEDGING COMMODITY PRICE EXPOSURE ........... 13
EVALUATE THE DIFFERENCES BETWEEN A STRIP HEDGE AND A STACK HEDGE AND EXPLAIN HOW
THESE DIFFERENCES IMPACT RISK MANAGEMENT ................................................................ 14
DESCRIBE EXAMPLES OF CROSS-HEDGING, SPECIFICALLY THE PROCESS OF HEDGING JET FUEL
WITH CRUDE OIL AND USING WEATHER DERIVATIVES. ........................................................... 15
EXPLAIN HOW TO CREATE A SYNTHETIC COMMODITY POSITION AND USE IT TO EXPLAIN THE
RELATIONSHIP BETWEEN THE FORWARD PRICE AND THE EXPECTED FUTURE SPOT PRICE ....... 16
CHAPTER SUMMARY ......................................................................................................... 18
2
McDonald, Chapter 6: Commodity Forwards and Futures

Define commodity terminology such as storage costs; carry markets, lease rate, and
convenience yield.
Explain the basic equilibrium formula for pricing commodity forwards.
Describe an arbitrage transaction in commodity forwards, and compute the potential

arbitrage profit.
Define the lease rate and explain how it determines the no-arbitrage values for
commodity forwards and Futures.
Define carry markets, and explain the impact storage costs and convenience yields
have on commodity forward prices and no-arbitrage bounds.
Compute the forward price of a commodity with storage costs.
Compare the lease rate with the convenience yield.
Identify factors that impact gold, corn, electricity, natural gas, and oil forward prices.
Define and compute a commodity spread.
Explain how basis risk can occur when hedging commodity price exposure.
Evaluate the differences between a strip hedge and a stack hedge and explain how
these differences impact risk management.
Describe examples of cross-hedging, specifically the process of hedging jet fuel with
crude oil and using weather derivatives.
Explain how to create a synthetic commodity position and use it to explain the
relationship between the forward price and the expected future spot price.
Define commodity terminology such as storage costs, carry

markets, lease rate, and convenience yield.
Storage Costs
Investment assets such as securities do not have any physical storage costs associated with
them, however assets that are both investment assets and consumption assets, such as
gold and silver do have a storage cost associated with them, such as the cost of storing the
commodity in a vault. Consumption assets in general do have storage costs associated with
them, e.g. one can think of the cost of storing corn in a silo. Moreover, certain consumption
assets such as, e.g. coal deteriorate over time, so there is a real cost to not utilizing it
immediately.
Carry Markets
Above, we mentioned that there is no physical storage cost for pure investment assets. One
does however; “store” financial assets although it might only be stored electronically in an
exchange’s database. The old adage, “time is money,” is nevertheless true: the owner of a
3
forward or a Futures contract expects to be compensated for this time-value of money. Thus
investment assets are always compensated for their “storage cost,” which is reflected in a
higher price for the asset. This phenomenon – that the forward or Futures price reflect the
costs of storage is called a carry market. Analogously, markets for consumption
commodities, such as e.g. corn, where the owner incurs storage costs are also carry
markets. Electricity, on the other hand, which cannot be easily stored, is not a carry market.
Later in this chapter we will explore the financial implications of storage costs and carry
markets on the forward and Futures price.
Lease rate
The lease rate is to commodities what the dividend is to financial assets: it is the rate
received by the owner of a consumption asset from the investor for borrowing the asset.
Lease rate payment is clearly a benefit to the owner of the asset. Accordingly, it has the
effect of lowering forward price. To see this, just imagine that the forward price was not
impacted by the lease rate. The owner of the commodity could exploit this by leasing his
commodity to a short seller, and turn around in the market and sell the forward at the higher
price, thus earning a risk-free payment equal to the present value of the lease rate.
“It is important to be clear about the reason a lease payment is required for a
commodity and not for a financial asset” (McDonald)
Convenience yield
Convenience yield also affect the pricing relation for a forward or a Futures contract. Think of
a commodity, such as oil, where the owner of the oil can derive immediate benefits by using
it in, e.g. production. This certainly has some value, and in fact, it serves to reduce the cost
of storing the oil. The forward price will thus decrease in the case when there is a
convenience yield.
Explain the basic equilibrium formula for pricing commodity

forwards.
The forward price is equal to the expected spot price in the future, but discounted to the
present.
F0,T  E0 (ST )e(r  )T
E0 (ST ) Spot price of S at time T, as expected at time 0

F0,T Forward price
r Risk-free rate
 Discount rate for commodity S
The discount rate is a function of the risk premium on the commodity: the risk premium is the
difference between the discount rate on the commodity and the riskless rate.
4
Describe an arbitrage transaction in commodity forwards, and

compute the potential arbitrage profit
If the forward price is too high, say $0.21, we can buy a pencil and sell it forward:
Cash and Carry

Spot $0.20
Forward $0.21
Cash Flows
Transaction Time 0 Time 1
Short forward @ $0.20 0 $0.010
Buy pencil $0.20 ($0.20) $0.200
Lend pencil @ 10% 0 $0.021
Borrow @ 10% $0.200 ($0.221)
$0.010
Consider the following example. The spot price is $10 and the implied forward price is about
$10.30 (i.e., the forward price implied by the cost of carry model). If the observed forward
price is $10.30, then both arbitrage attempts (at right) produce no profit.
McDonald Commodity Forwards

Spot (S0) $10.00 Cash-and-carry arbitrage
Riskless (r) 4% Cash Flows
Time 1.0 Transaction Time 0 Time T
Short forward @ F0 0 ($0.208)
Commodity discount rate 6% Buy commodity ($9.90) $10.513
expected growth rate (g) 5% Borrow @ riskless rate $9.900 ($10.305)
Lease rate 1% $0.0000
Exp. future spot price $10.5127

Implied forward price $10.3045 Reverse cash-and-carry arbitrage
Cash Flows
Observed forward price $10.3045 Transaction Time 0 Time T
Implied lease rate 1.00% Long forward @ F0 0 $0.208
Short commodity $9.90 ($10.513)
Lend @ riskless rate $9.900 $10.305
$0.0000
5
Now instead assume the forward price is $10, such that the forward is “cheap” relative to its
(cost-of-carry) model price of $10.30. Now, the reverse cash-and-carry arbitrage is
profitable. If the forward is “cheap” then the trade is:
 Buy the cheap thing: go long the forward
 Sell the expensive (in a relative sense thing): short the commodity and lend the short
proceeds

Time Transaction Time 0 Time T
1.0
Short forward @ F0 0 ($0.513)
Comm disc rate (alpha) 6% Buy commodity ($9.90) $10.513
Lease rate 1% ($0.3045)

Cash Flows
Long forward @
Implied lease rate 4.00% 0 $0.513
F0
$0.3045
Now assume the observed forward price is “trading rich” at $11.00; i.e., higher than the
model implied price of $10.30. Now the cash-and carry arbitrage is profitable:
 Buy the cheap thing: borrow to buy the commodity on the (cash) spot market
 Sell the expensive: short the forward

Time 1.0 Transaction Time 0 Time T
Short forward @ F0 0 $0.487
Comm disc rate (alpha) 6% Buy commodity ($9.90) $10.513
Lease rate 1% $0.6955

Cash
Flows Flows
Implied lease rate -5.53% Long forward @ F0 0 ($0.487)
($0.6955)
6
Define the lease rate and explain how it determines the no‐arbitrage
values for commodity forwards and Futures.
If the lease rate is given by , then the forward price is given by:
F0,T  S 0 e( r  )T
The lease rate formula may look familiar. In an earlier section, we saw that the value of a
( )
stock index Futures contract was given by = where (q) equals the dividend
yield rate. That’s because the lease payment is essentially a dividend.
The lease rate = commodity discount rate – growth rate:
   g
The lease rate is economically like a dividend yield.
Contango and Backwardation
Contango refers to an upward-sloping forward curve, which must be the case if the lease
rate is less than the risk-free rate.
Backwardation refers to a downward-sloping forward curve, which must be the case if the
lease rate is greater than the risk-free rate.
7
Define carry markets, and explain the impact of storage costs and
convenience yields have on commodity forward prices and no-
arbitrage bounds. Compute the forward price of a commodity with
storage costs.
Define carry markets
A commodity that is stored is in a carry market. Storage is carry. Storage permits

consumption throughout the year
F0,T  S0e(r  c)T

Explain the impact storage costs and convenience yields have on commodity forward
prices and no‐arbitrage bounds
Carry is the cost of storage (a.k.a., holding cost). In an earlier section, we saw the “cost-of-
carry” model, as given by:
( r u y )T
0 F S e
0
This model says that the forward price is a function of the spot price, compounded forward
as a function of three variables: the riskless rate (r), the carry cost (u) and the convenience
yield (y).
We can use the same equation if we insert lambda () for the carry cost and (c) is used for
the convenience yield. Under that notation, the cost-of-carry model is still:
F0  S0e(r  c)T
These two cost-of-carry formulas (one, really) are the master formulas because the others
are subsets of these. Memorize this dynamic! Start with exponential function. It compounds
the spot rate to the forward rate. The “base case” is to compound the spot rate by the
riskless rate (spot  er).
To expand on the exponential function, ask whether there are benefits or costs to holding the
asset. Costs get added to the risk-free rate (because you’d pay less today for that!) and
benefits reduce the risk-free rate. So, if it’s a dividend paid on the stock, that’s a benefit and
you’ve got (r-q) instead of (r). If it’s a storage cost, that’s a cost, so you’ve got (r+u) instead
of (r) and so on. If it’s a storage costs (+u) but also convenience (-y), then we have (r+u-y).
8
Explain the impact storage costs and convenience yields have on no-arbitrage price
bounds
Given convenience yield (c) and storage costs (λ), the no-arbitrage price range is given by:
S0e(r  c)T  F0,T  S0e(r  )T
9
Compare the lease rate with the convenience yield

If we are given the forward price, we only need to re-arrange the above formula to solve for
the implicit lease rate. We re-arrange as follows:
F0,T
F0,T  S0 e(r  )T   e(r  )T 
S0
F  1 F 
ln  0,T   (r   )T  l n  0,T   (r   ) 
 S0  T  S0 
1 F 
  r  l n  0,T 
T  S0 
For example, assume the spot price, , is $9.8 and the forward price in six months (T=0.5)
is $10 , . . Given further a risk-free rate of 6%, the implicit lease rate is about 2%:
1  F0,T  1  10 
 r l n   6%  l n  2%
T  S0  0.5  9.8 
Both are benefits of ownership, however; convenience yield is hard to quantify in practice.
The observed lease rate , depends on both storage costs , and the convenience yield c.
This implies a no-arbitrage region (zone) rather than a specific price point estimate.
S0 e(r   c )T  F0  S 0 e(r   )T
You may not need to memorize this formula if the derivation is natural
F0,T  S0 e(r  )T
1  F0,T 
 r ln 
S 
T 
10
Identify factors that impact gold, corn, electricity, natural gas, and
oil forward prices.
Gold is durable with low storage costs. The forward price tends to be a gradually increasing
function of maturity; this implies a lease rate. Exposure to gold can be achieved by
ownership or (indirectly) by a long position in gold Futures.
If you own physical gold directly: you forgo a “lease rate” but you also bear storage costs.
If instead you have a synthetically long position in gold: you have no storage costs, but you
are exposed to credit risk. The text says that synthetic exposure is preferable, assuming you
ignore credit (counterparty) risks.
Gold futures
$1,010
$1,000
$990
$980
$970
$960
$950
$940
$930
Jun/09
Aug/09
Jun/10
Aug/10
Jun/11
Aug/11
Dec/09
Feb/10
Dec/10
Feb/11
Dec/11
Oct/09
Apr/10
Oct/10
Apr/11
Oct/11
Corn is seasonal. In theory, the price should rise between harvests (rises to reward storage)
due to storage costs. In reality, the price varies year to year.
Corn
500
490
480
470
460
450
440
430
420
Nov-09
Mar-10
Nov-10
Mar-11
Nov-11
Jul-09
Sep-09
Jul-10
Sep-10
Jul-11
Sep-11
Jan-10
May-10
Jan-11
May-11
11
Natural gas is largely impacted by seasonality and storage costs. Gas is (i) expensive to
transport overseas, (ii) costly to store, (iii) exposed to seasonal demand with a characteristic
peak in the winter. While corn is seasonally produced and constantly demanded; gas is
constantly produced and seasonally demanded.
Natural Gas
8.50
8.00
7.50
7.00
6.50
6.00
5.50
5.00
Jul/09
Jul/10
Jul/11
Jul/12
Jul/13
Jul/14
Oct/09
Oct/10
Oct/11
Oct/12
Oct/13
Apr/10
Apr/11
Apr/12
Apr/13
Apr/14
Jan/10
Jan/11
Jan/12
Jan/13
Jan/14
Oil is less expensive than gas to transport and easier to store. Historically crude oil forward
(Futures) curve was in backwardation…
Crude Oil
118
116
114
112
110
108
106
104
102
100
Jun Oct Feb Jun Oct Feb Jun Oct Feb Jun Oct Feb Jun Oct
08 08 09 09 09 10 10 10 11 11 11 12 12 12
But, for example in June 2009, oil Futures switched to contango:
12
Crude oil
June 2009
90
85
80
75
70
65
60
55
50
Jul/09 Jan/10 Jul/10 Jan/11 Jul/11 Jan/12 Jul/12 Jan/13 Jul/13
Define and compute a commodity spread

If we can take a long position in one commodity that is an input (e.g., oil) into another
commodity that is an output (e.g., gas or heating oil), then we can take a short position in the
output commodity and the difference is the commodity spread.
Assume oil is $2 per gallon, gasoline is $2.10 per gallon and heating oil is $2.50 per gallon.
If we take a long position in 2 gallons of gasoline and one gallon of heating oil, plus a short
position in three gallons of oil, the commodity spread =
(2 long gasoline  $2.10) + (1 long heating oil  $2.50) – (3 oil  $2) = +$0.70
Explain how basis risk can occur when hedging commodity price
exposure
The basis is the difference between the price of the Futures contract and the spot price of
the underlying asset. Basis risk is the risk (to the hedger) created by the uncertainty in the
basis.
The Futures contract often does not track exactly with the underlying commodity; i.e., the
correlation is imperfect. Factors that can give rise to basis risk include:
 Mismatch between grade of underlying and contract

 Storage costs
 Transportation costs
Basis = Spot Price Hedged Asset – Futures Price Futures Contract = S0 – F0
The basis converges to zero over time, as the spot price converges toward the future price.
When the spot price increases by more than the Futures price, the basis increases and this
is said to be a “strengthening of the basis” (and when unexpected, this strengthening is
favorable for a short hedge and unfavorable for a long hedge).
When the Futures price increases by more than the spot price, the basis declines and this is
said to be a “weakening of the basis” (and when unexpected, this weakening is favorable for
a long hedge and unfavorable for a short hedge).
13
Evaluate the differences between a strip hedge and a stack hedge

and explain how these differences impact risk management
A strip hedge is when we hedge a stream of obligations by offsetting each individual
obligation with a Futures contract that matches the maturity and quantity of the obligation.
For example, if a producer must deliver X number of commodities per month, then the strip
hedge entails entering into a Futures contract for X commodities, to be delivered in one
month; plus a Futures contract for X commodities to be delivered in two months. The strip
hedger matches a series of Futures to the obligations.
A stack hedge is front-loaded: the hedger enters into a large future with a single maturity. In
this case, our hedger would take a long position in a near-term Futures contract for 12X
commodities (i.e., a year’s worth). The stack hedge may have lower transaction costs but it
entails speculation (implicit or deliberate) on the forward curve: if the forward curve gets
steeper, the stack hedger may lose. On the other hand, if the forward curve flattens, then the
stack hedger gains because he/she has locked in the commodity at a relatively lower price.
Oil producer to deliver 10K barrels per month
Strip hedge: contract for each obligation
Stack hedge: Single maturity, “stack and roll.”
14
Describe examples of cross-hedging, specifically the process of

hedging jet fuel with crude oil and using weather derivatives.
Jet fuel Futures do not exist in the United States, but firms sometimes hedge jet fuel with
crude oil Futures and/or Futures for related petroleum products. In order to cross-hedge, we
need to understand the relationship between crude oil and jet fuel prices. If we own a
quantity of jet fuel and hedge by holding (H) crude oil Futures contracts, our mark-to-market
profit depends on the change in the jet fuel price and the change in the Futures price:
[P(t) - P(t-1)] + H[F(t) – F(t-1), where P(t) is the price of jet fuel and F(t) the crude oil Futures
price. We can estimate (H) by regressing the change in the jet fuel price (denominated in
cents per gallon) on the change in the crude Futures price (denominated in dollar per barrel).
Weather derivatives give another example of cross hedging. Weather as a business risk can
be difficult to hedge. For example, weather can affect both the prices of energy products and
the amount of energy consumed. If a winter is colder than average, homeowners and
businesses will consume extra electricity, heating oil, and natural gas, and the prices of
these products will tend to be high as well. Conversely, during a warm winter, energy prices
and quantities will be low. While it is possible to use Futures markets to hedge prices of
commodities such as natural gas, hedging the quantity is more difficult. There are many
other examples of weather risk: ski resorts are harmed by warm winters, soft drink
manufacturers are harmed by a cold spring, summer, or fall, and makers of lawn sprinklers
are harmed by wet summers. In all of these cases, firms could hedge their risk using
weather derivatives—contracts that make payments based upon realized characteristics of
weather—to cross-hedge their specific risk.
The payoffs for weather derivatives are based on weather-related measurements. For
example:
The degree-day index Futures contract trades on the Chicago Mercantile Exchange. A
heating degree-day is the maximum of zero and the difference between the average daily
temperature and 65 degrees Fahrenheit. A cooling degree-day is the maximum of the
difference between the average daily temperature and 65 degrees Fahrenheit, and zero.
Sixty-five degrees is a moderate temperature. At higher temperatures, air conditioners may
be used, while at lower temperatures, heating may be used. A monthly degree-day index is
constructed by adding the daily degree-days over the month. The Futures contract then
settles based on the cumulative heating or cooling degree-days (the two are separate
contracts) over the course of a month. The size of the contract is $100 times the degree-day
index. As of September 2004, degree-day index contracts were available for over 20 cities in
the United States, Europe, and Japan. There are also puts and calls on these Futures.
15
Explain how to create a synthetic commodity position and use it to

explain the relationship between the forward price and the
expected future spot price
E0 (ST ) Spot price of S at time T, as expected at time 0

F0,T Forward price
r Risk-free rate
 Discount rate for commodity S
Consider the following investment strategy: enter into a long forward contract plus a zero
coupon bond that pays F(0,T) at time T. Since the forward contract is costless, the cost of
this investment strategy at time 0 is just the cost of the bond: the discounted price of the face
value of the bond = EXP[(-r)(T)]*F(0,T). Again, the idea is to lend at the risk-free rate in order
to receive back, at future time T, the exact amount need to meet the long forward obligation.
At time T, this strategy (long forward on the commodity plus invest in zero coupon bond) has
the same payoff as the future spot price. By using the forward, the unfunded position is
synthetic but otherwise equivalent to buying the commodity on the cash market:
ST  F0,T  F0,T  F0,T  ST
Here is the key step: we equate the price paid for the synthetic strategy (i.e., the amount we
need to invest at the riskless rate in order to receive future proceeds to meet the long
forward obligation) with the price we should be willing to pay for the commodity today. That
price is the expected future spot price, discounted to today using the discount rate (α):
erT F0,T  E0 (ST )eT

Then we solve for the forward price:
F0,T  erT E0 (ST )eT

And end up with the essential formula that links the forward price to the expected future spot
price:
F0,T  E0 (ST )e(r  )T
16
And, as McDonald says, the forward price [F0] is a biased estimate of expected spot price
[E(St)], where the bias is due to the risk premium on the commodity (risk premium = α – r).
Explain the effect non‐storability has on electricity prices
Because electricity cannot (mostly) be stored, the forward market provides “invaluable price
discovery.” Price changes largely reflect, “[consensus] changes in the expected future spot
price.
Typical pattern of electricity prices

24-hour period
70
60
50
40
30
20
10
0
12:00 PM
10:00 PM
11:00 PM
1:00 AM
2:00 AM
3:00 AM
4:00 AM
5:00 AM
6:00 AM
7:00 AM
8:00 AM
9:00 AM
1:00 PM
2:00 PM
3:00 PM
4:00 PM
5:00 PM
6:00 PM
7:00 PM
8:00 PM
9:00 PM
12:00 AM
10:00 AM
11:00 AM
17
Chapter Summary
This chapter re-visits several themes previously seen in Hull’s chapter 5 Determination of
Forward and Futures prices, thus a lot of the concepts should already be familiar. One
important thing to note is the difference in notation between Hull and McDonald, e.g. Hull
uses u for storage costs and y for convenience yield, whereas McDonald uses lambda and
c, respectively for the same. The underlying theory remains the same though.
What is new and important in this reading is how the theory is applied specifically to
commodities. One of the key concepts encountered is that of a carry market, that is, when
commodities are, e.g., stored, the forward or Futures price must reflect the fact that the
investor must bear both financing costs as well as storage cost (a so called cash-and-carry).
More succinctly, a commodity that is stored is in a carry market. Storage is carry.
In addition to our usual terms of the risk-free rate, storage costs the notion of a lease-rate
and convenience yield are introduced. The lease-rate can be thought of as the commodity
market equivalent of a financial dividend yield. In particular, the owner of a commodity
expects to be compensated in order to lend, e.g., a short seller the commodity. On the other
hand, the convenience yield reflects the fact that holders of a given commodity may derive
some benefit from having physical ownership over the commodity. Both the convenience
yield and lease rate are benefits to the owner, and thus will reduce the price of the forward.
One thing to note is that it can often be difficult to ascertain what the convenience yield for a
commodity is. This gives us arbitrage bounds for the forward price, where we effectively
solve for the lease rate, but the lease rate depends on both the storage cost and the
convenience yield. You should be comfortable with the derivation of the following inequality:
S0 e( r   c )T  F0  S0 e(r   )T
When taking, e.g., a long position in one commodity that is an input factor for another
commodity that is an [final] output, then we can take a short position in the output commodity
and the difference is the commodity spread.
As we saw in Hull’s chapter 3 on Hedging Strategies using Futures, the basis is the
difference between the price of the Futures contract and the spot price of the underlying
asset. Basis risk is the risk (to the hedger) created by the uncertainty in the basis. We
elaborated slightly on the concept (page 44).
The forward curves of various commodities exhibit patterns that are often idiosyncratic to
that commodity. We can often infer these factors from the forward curve and what we know
about the commodity. McDonald says, the forward price [F0] is a biased estimate of
expected spot price [E(St)], where the bias is due to the risk premium on the commodity (risk
premium = α – r).
Synthetic commodities can be constructed using default-free bonds and commodity Futures,
and will always be preferred over their physical equivalent, except for in a carry-market
where the investor will be indifferent between the two.
18

P1.T3. Financial Markets & Products Robert Mcdonald, Derivatives Markets, 3Rd Edition Bionic Turtle FRM Study Notes Reading 20

Uploaded by

Copyright:

Available Formats

P1.T3. Financial Markets & Products Robert Mcdonald, Derivatives Markets, 3Rd Edition Bionic Turtle FRM Study Notes Reading 20

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

P1.T3. Financial Markets & Products Robert Mcdonald, Derivatives Markets, 3Rd Edition Bionic Turtle FRM Study Notes Reading 20

Uploaded by

Copyright:

Available Formats

Licensed to at [email protected]. Downloaded November 28, 2016.

P1.T3. Financial Markets & Products

Robert McDonald, Derivatives Markets, 3rd Edition

Bionic Turtle FRM Study Notes

McDonald, Chapter 6: Commodity Forwards and Futures

McDonald, Chapter 6: Commodity Forwards and Futures

Explain the basic equilibrium formula for pricing commodity forwards.

Describe an arbitrage transaction in commodity forwards, and compute the potential

Compute the forward price of a commodity with storage costs.

Compare the lease rate with the convenience yield.

Define and compute a commodity spread.

Define commodity terminology such as storage costs, carry

Explain the basic equilibrium formula for pricing commodity

E0 (ST ) Spot price of S at time T, as expected at time 0

Describe an arbitrage transaction in commodity forwards, and

Cash and Carry

McDonald Commodity Forwards

Exp. future spot price $10.5127

McDonald Commodity Forwards

Exp. future spot price $10.5127

McDonald Commodity Forwards

Exp. future spot price $10.5127

The lease rate = commodity discount rate – growth rate:

Contango and Backwardation

A commodity that is stored is in a carry market. Storage is carry. Storage permits

F0,T  S0e(r  c)T

S0e(r  c)T  F0,T  S0e(r  )T

Compare the lease rate with the convenience yield

Define and compute a commodity spread

 Mismatch between grade of underlying and contract

Basis = Spot Price Hedged Asset – Futures Price Futures Contract = S0 – F0

Evaluate the differences between a strip hedge and a stack hedge

Describe examples of cross-hedging, specifically the process of

Explain how to create a synthetic commodity position and use it to

E0 (ST ) Spot price of S at time T, as expected at time 0

erT F0,T  E0 (ST )eT

F0,T  erT E0 (ST )eT

F0,T  E0 (ST )e(r  )T

Typical pattern of electricity prices

You might also like