Technical University Munich Commodities as an Asset Class - risklab

2.3 Trading Commodities
markets are futures contracts. They are the original vehicle to trade commodities.
Although the price of a futures contract depends on the current spot (cash)
price 41 of the underlying commodity, it represents on its side the underlying of other
derivatives like options, swaps and commodity linked bonds.
Many economists, including Alan Greenspan, stated that the financial derivatives
markets have significantly decreased the cost of doing business and thus have risen
the standard of living for everybody. A major step to this development was done in
the work of Merton Miller, Harry Markowitz and William Sharpe who won the 1990s
Novel Price in economics for recognizing and illustrating the value of derivatives in
business application. 42 Their theoretical conclusions found their way into practical
applications created by Fischer Black, Myron Scholes, Robert Shiller, Rudi Zagst
and many others.
Today many financial intermediaries, including domestic and international banks,
public and private pension funds, investment companies, mutual funds, hedge funds,
energy providers, asset and liability managers, mortgage companies, swap dealers,
and insurance companies, that face foreign exchange, energy, agricultural or environmental
exposure use financial markets to hedge or manage their price risk. For
instance, at the Chicago Mercantile Exchange (CME) more than one billion contracts
representing an underlying notional value of 640 trillion US dollar were traded
and cleared in 2005. 43
2.3.1.1 Forwards and Futures
A forward contract is a bilateral agreement where one party is going to buy an asset
at a today predefined time in the future for a fixed price. Hereby someone can be
long or short the contract depending on the fact whether he took the asset buyer
or seller position.
Forwards were originally developed to hedge commodity price
risk and are useful vehicles to look at future prices. As described in Section 2.2
commodity producers need to ensure future cash flows to be cost covering. First
applications of forwards go back in the 18th and 19th centuries. Potato growers in
the state of Maine (USA) started selling their crops at the time of planting in order to
finance the production process. Such arrangements became particularly important
41 For the feature of spot prices in commodity markets see the discussion in Section 5.1.1.
42 William Sharpe was rewarded for the Capital Asset Pricing Model, beta and relative risks, Harry
Markowitz for his theory of efficient portfolio selection and Merton Miller for his work on the
effect of a firm’s capital structure and dividend policy on market price.
43 Data source: Futures Industry Magazine Mar/Apr 2006, numbers include financial derivatives
(i.e. derivatives on interest rates or equities)
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