DERIVATIVES MARKET

UNIT IV
COMMODITY FUTURES PRICING AND
APPLICATIONS
• Commodity futures are contracts to buy or sell a commodity
at a set price in the future. The price depends on the current
price of the commodity, interest rates, time to delivery, and
storage costs.
• Pricing
• Spot price: The current price of the commodity
• Interest rates: Affect the price of the contract
• Time to delivery: The longer it takes to deliver the commodity,
the more the price may change
• Storage costs: The cost of storing the commodity affects the
price
Applications
Hedging
Businesses use futures to protect against price changes. For example, a
farmer might sell wheat futures before harvest to protect against price
fluctuations.
Speculation
Investors may trade futures to profit from price changes. They may not
own the commodity when it’s due, avoiding the need to deal with the
physical commodity.
Arbitrage
• Traders may profit from price differences between related assets in
different markets.
PRICING OF FUTURES
The price of a futures contract is calculated using a
formula that considers the spot price of the underlying
asset, interest rates, dividends, and time.
Formula
Futures price = Spot price * (1 + rf – d)
In this formula, rf is the risk-free rate and d is the dividend
The risk-free rate is the interest rate that can be earned in
a normal year
• The number of days to expiration is represented by X
Factors affecting price
The price of a futures contract can increase or decrease
based on the price of the underlying asset
Other factors that affect the price include interest rates,
dividends, and carrying costs
The difference between the futures price and the spot
price is called the spread
• The spread is largest at the beginning of the series and
narrows as the settlement date approaches
COST OF CARRY
Cost of carry (CoC) is the total cost of holding a position in the market
until a futures contract expires. It’s the difference between the spot price
and futures price of a stock or index.
What does CoC include?
Interest on long holdings
Local short rates
Insurance and storage charges
Inventory pricing
Yield of convenience
Overnight funding charges
• Interest payments on margin accounts
FUTURES SPOT CONVERGENCE
• Futures spot convergence is the process by which the price of
a futures contract moves closer to the spot price of the
underlying asset. This happens as the contract’s expiration
date approaches
• Benefits of convergence
• It reduces the risk of big losses for traders.
• It helps investors profit from trading contracts.
• It helps farmers plan their work because they know they have
a buyer and their earnings are set.
• It helps buyers plan their cash flow because they know what
they'll pay.
PRICE RELATIONSHIPS
• Different types of derivatives have different pricing
mechanisms. A derivative is simply a financial contract
with a value that is based on some underlying asset
(e.g. the price of a stock, bond, or commodity). The
most common derivative types are futures contracts,
forward contracts, options and swaps.
• Futures contracts are standardized financial contracts
that allow holders to buy or sell an underlying asset or
commodity at a certain price in the future, which is
locked in today. Therefore, the futures contract’s value
is based on the commodity’s cash price.
• Options are also common derivative contracts. Options give
the buyer the right, but not the obligation, to buy or sell a set
amount of the underlying asset at a pre-determined price,
known as the strike price, before the contract expires.
• Swaps are derivative instruments that represent an
agreement between two parties to exchange a series of cash
flows over a specific period of time. Swaps offer great
flexibility in designing and structuring contracts based on
mutual agreement. This flexibility generates many swap
variations, with each serving a specific purpose. For instance,
one party may swap a fixed cash flow to receive a variables
cash flow that fluctuates as interest rates change.
FUTURES OF HEDGING
• Futures contracts, agreements to buy or sell assets at a future date
for a predetermined price, are often used for hedging purposes. This
is because they allow investors to lock in prices and take offsetting
positions, effectively securing against the unpredictability of market
movements. Whether the goal is to safeguard stocks, bonds, or
commodities, futures provide a way to manage financial exposure
and mitigate risk.
SPECULATION
• Speculation in the derivatives market is the act of using
derivatives to profit from price fluctuations in the underlying
asset. It’s a high-risk activity that involves buying and
selling assets in the expectation of making a quick profit.
• Speculators buy and sell derivatives based on their
expectations of how the price of an underlying asset will
move
• They may use derivatives to bet on whether a stock is
overvalued or undervalued
• They may use derivatives to take advantage of market
volatility
 ARBITRAGEUR
• Arbitrageurs in the derivatives market are traders who exploit price
differences between markets to make a profit. They are market
participants who help ensure fair prices across markets.
• Buy low, sell high: Arbitrageurs buy an asset in one market and sell it
in another market at a higher price.
• Take advantage of inefficiencies: Arbitrageurs exploit temporary price
inefficiencies in the market.
Volatility arbitrage
Compares the prices of options and underlying securities to exploit differences in volatility
Dividend arbitrage
• Involves buying put options and an equal amount of underlying stock before the ex-
dividend date
• Merger arbitrage
• Involves taking advantage of price differences between a target company's stock price
and the offer price from an acquiring company
• Convertible arbitrage
• Involves holding a long position in convertible securities while shorting the underlying
stock
OPTION PRICING
Intrinsic Value (Calls)
• A call option is in-the-money when the underlying security's price is
higher than the strike price.
• Intrinsic Value (Puts)
A put option is in-the-money if the underlying security's price is less
than the strike price. Only in-the-money options have intrinsic value. It
represents the difference between the current price of the underlying
security and the option's exercise price, or strike price.
Time Value
• Time value is any premium in excess of intrinsic value before
expiration. Time value is often explained as the amount an investor is
willing to pay for an option above its intrinsic value. This amount
reflects hope that the option’s value increases before expiration due to
a favorable change in the underlying security’s price. The longer the
amount of time available for market conditions to work to an
investor's benefit, the greater the time value.
 OPTIONS FOR HEDGING
• A hedge refers to an investment that helps mitigate the risk of the existing position. The gains
from one investment offset the losses from another, thus mitigating the risk. A hedge may not help
generate significant returns, but it can help limit losses or bring the investment to break even.
• Options are financial instruments that give the holder the right but not the obligation to purchase
or sell a security at a predetermined price on a specific date. There are two primary types of
options contracts:
• Call option: A call option gives the buyer the right but not the obligation to buy a security at a
predetermined price on a specific date. The value of the call option rises with an increase in the
value of the underlying asset and vice versa.
• Put option: A put option gives the buyer the right but not the obligation to sell a security at a
predetermined price on a specific date. The value of the put option increases with a fall in the
value of the underlying asset and vice versa.
• Several options hedging strategies make use of both call and put options. Hedging strategies can
be used to hedge an investment in equities, indices, commodities, or currencies.
 SPECULATION AND ARBITRAGE
Feature Arbitrage Speculation

Objective Exploit price discrepancies for a risk-free profit. Predict market trends and capitalize on anticipated price
movements, taking calculated risks.

Profit Guaranteed (assuming successful execution). Potential, subject to market fluctuations.

Risk Limited risk, relies on identified market High risk, relies on predicting market trends, potential
inefficiencies. for significant losses.

Timeframe Short-term, exploiting fleeting price differences. Can be short or long-term, depending on the speculator's
outlook.

Market Involves simultaneous buying and selling of the May involve trading in one or multiple markets, based
Activity same asset in different markets, often at the same on the speculator's analysis of potential future price
time. movements.