3.1.6 Commodity Forwards and Futures

6. Commodity Forwards and Futures

6.1 Features of Commodities

6.1.1 Difference between Commodities and Financial Assets

Storage costs: can be quite substantial for commodities, including insurance for metals and special care for corn, natural gas, etc.
Transportation:the costs depend on their location.
Lease rate: a commodity held for investment purposes (e.g., gold or silver) can be borrowed for shorting.
Mean reverting: the prices of most commodities tend to get pulled back toward some central value.

6.1.2 Types of Commodities

Agricultural Commodities
Metals
Energy
Weather

6.1.3 Consumption and Investment Commodity

Most commodities are consumption assets. storage cost and convenience yield should be considered in pricing.

Some precious metals (like gold, silver or lesser extent platinum and palladium) are held for investment purposes. Lease rate should be considered in pricing.

6.2 Pricing Commodity Forwards

6.2.1 Lease Rate

The lease rate for an investment commodity is the interest rate charged to borrow the underlying asset.

Let $L/l$ be the lease rate pre year for maturity $T$ with annual/continuous compounding. The relationship between the forward price and the spot price is :

$$F=S(\frac{1+R}{1+L}{)}^T\text{or}F=S\times e^{(r-l)T}$$

This equation can produce an implied lease rate

$$L=(\frac{S}{F}{)}^{\frac{1}{T}}(1+R)-1\text{or}l=r-\frac{In(F/S)}{T}$$

6.2.2 Convenience Yield

The convenience yield measures the benefits to the asset holder of having it in their inventory as a protection against future shortages or delivery delays.

Let $U/u$ and $Y/y$ be the storage cost and convenience yield per year for maturity $T$ with annual/continuous compounding.

$$F=(S+U)(\frac{1+R}{1+Y}{)}^T\text{or}F=S\times e^{(r+u-y)T}$$

This equation can produce an implied convenience yield:

$$Y=(\frac{S+U}{F}{)}^{\frac{1}{T}}(1+R)-1\text{or}y=r+u-\frac{In(\frac{F}{S})}{T}$$

6.2.3 Cost of Carry

The cost of carry for an asset reflects the impact of (in the percentage form):

Storage cost ($u$), Financing cost ($r$), Income earned on the asset ($q$)

The cost of carry per year is:
$$(1+r)(1+u)/(1+q)-1\approx r+u-q$$

In the case of a financial asset, there are no storage costs.
In the case of a commodity, there is usually no income.