Master Study Guide: Commodity Futures (Chapter II, Part 2)
This section completes the analysis of Commodity Futures, focusing on pay-offs, contract specifications, margins, delivery systems, and trading strategies.
1. Futures Pay-off Profiles
A pay-off refers to the net profit or loss from a trade. At contract expiration, the pay-off depends on the spot price of the underlying asset at expiry and the initial trade price.
Long Position (Buyer)
The buyer has a legal obligation to purchase the asset and expects prices to rise.
- Formula: Pay-off = Spot Price at Expiry - Futures Entry Price
- Profit: Spot Price > Futures Entry Price
- Loss: Spot Price < Futures Entry Price
Short Position (Seller)
The seller has a legal obligation to deliver the asset and expects prices to fall.
- Formula: Pay-off = Futures Entry Price - Spot Price at Expiry
- Profit: Spot Price < Futures Entry Price
- Loss: Spot Price > Futures Entry Price
2. Trading Parameters & Contract Specifications
Standardized specifications ensure contract integrity and liquidity.
- Tick Size & Value: The tick size is the minimum price movement.
- Formula: Tick Value = (Lot size / Quotation factor) * Tick size
- Daily Price Limits (DPL): Also called circuit filters, these set the maximum daily price fluctuation range based on the contract's base price on day one.
- Settlement Prices: The Daily Settlement Price (DSP) is used for daily mark-to-market calculations. The Final Settlement Price (FSP) is used for delivery default penalties.
3. Clearing, Margining, & Risk Management
The Clearing Corporation (CCP) guarantees settlement, eliminating counterparty default risk.
- SPAN Margin: Standard Portfolio Analysis of Risk is a scenario-based methodology estimating liquidation risk.
- Initial & Extreme Loss Margin (ELM): Initial margin is an upfront deposit. ELM covers risks outside standard VaR models.
- Mark-to-Market (MTM) Margin: Adjusted daily based on price movements; gains are credited and losses debited.
- Tender/Delivery Period Margin: Additional margins collected during delivery periods to protect against default.
4. Delivery & Settlement Mechanics
Under exchange rules, contracts enter the delivery period in their expiry month.
- Compulsory Delivery: Both parties must execute physical delivery of the commodity upon contract expiry.
- Both Options to Deliver: Physical delivery occurs only if both parties agree; otherwise, it is cash-settled at the Due Date Rate (DDR).
- Seller's Option: The seller decides whether to deliver. If exercised, the marked buyer must accept delivery or pay a penalty.
- Staggered Delivery: The seller can initiate delivery on any day during the last 10 days before expiry, and the exchange randomly assigns a buyer.
5. Strategic Trading Applications
Hedging
Mitigates spot price risk by taking an opposite position in futures.
- Long Hedge: Locking in a purchase price for future delivery. Long hedgers benefit from a weakening basis (futures rise relative to spot).
- Short Hedge: Locking in a selling price for finished goods or harvested crops. Short hedgers benefit from a strengthening basis (spot rises relative to futures).
- Hedge Ratio: Hedge Ratio = coefficient of correlation between spot and futures price * (standard deviation of change in spot price / standard deviation of change in futures price)
Speculation
Trading to profit from price movements without physical usage. Long speculators buy first; short speculators sell first.
Arbitrage
Simultaneously buying and selling to capture riskless profits from price differentials.
- Cash-and-Carry: Borrowing funds to buy physical inventory and simultaneously shorting futures.
- Reverse Cash-and-Carry: Selling physical inventory and buying futures when futures price < spot + cost of carry.
Spread Trading
Trading the price difference between two futures contracts.
- Intra-commodity (Calendar) Spread: Positions in different months of the same commodity (e.g., buying near-month, selling far-month).
- Inter-commodity Spread: Long and short positions in different but economically related commodities.
- Note: Spreads require lower margin requirements because spread prices are less volatile than outright prices.