1. Fundamentals of Commodities and Derivatives
Teaching rewrite of commodity-market fundamentals. Original wording; prices are illustrative (gold around USD 1,400 is a teaching number, not today’s market). Not investment advice.
Introduction
“What are commodities?” sounds simple. Mostly they are unprocessed or semi-processed goods that are consumed or processed and resold — crude oil, copper, wheat. But the definition leaks: freight and carbon emissions are traded like commodities without being goods at all.
| Group | Examples |
|---|---|
| Energy | Crude oil and refined products (WTI, Brent, gasoline); power and natural gas; natural gas liquids (propane, butane); coal |
| Industrial (base) metals | Copper, aluminium |
| Precious metals | Gold, silver |
| Agricultural | Grains; softs (coffee, cocoa, sugar); livestock |
| Specialty | Forest products (pulp, recovered paper); carbon emissions; weather; freight |
This lesson covers:
- The physical vs financial market and its main participants
- Price discovery: exchanges and price reporting agencies (PRAs)
- Traded vs non-traded commodities — the iron ore story
- The four core derivatives: forwards, futures, swaps, options
- Exotic options: binary, barrier, spread, and average rate
1.1 Market overview
flowchart TB
subgraph Financial market
HF[Hedge funds<br/>view-driven strategies]
II[Institutional investors<br/>strategic exposure]
CB[Commercial banks<br/>financing, risk mgmt, physical assets]
FX[Futures exchange<br/>benchmark price, risk mgmt, source of supply]
end
subgraph Physical market
P[Producers] -->|commercial contracts| R[Refiners / processors] -->|commercial contracts| C[Consumers]
TH[Trading houses<br/>own assets, trade physical, risk mgmt]
end
FX --- P
FX --- C
TH --- P
TH --- C
CB --- TH
Think of crude oil. Producers extract it, refiners turn it into gasoline and diesel, consumers buy the products. Trading houses move and store it; banks finance it; investors and hedge funds take price exposure; the futures exchange provides the benchmark price.
Five features shape every commodity market:
| Feature | Meaning | Crude oil example |
|---|---|---|
| Not homogeneous | “Crude oil” means many grades with different chemistry — 150+ traded types | Light sweet vs heavy sour |
| Must be transformed | Commodities become consumer goods only after processing | Crude → refinery → gasoline |
| Benchmarks | Non-identical grades are priced relative to an agreed reference | A grade priced at “Brent futures + USD 1.20” |
| Transport | Production and consumption happen in different places; the mode varies | Pipeline/rail in the US, tankers in Europe/Asia |
| Storage | Production and consumption happen at different times; inventories bridge the gap | Tank farms, floating storage |
1.2 Market participants
Derivatives let each participant avoid, retain, transfer, reduce, or increase risk — matching different risk profiles with each other.
Physical participants
| Participant | Main price risk |
|---|---|
| Producers (miners, oil companies, farmers) | Falling prices |
| Consumers (airlines, manufacturers, food companies) | Rising prices |
| Refiners, processors, utilities | Margins — output price minus input cost (e.g. gasoline minus crude) |
They also face credit risk (customers not paying), logistics risk, quality/sourcing risk, and financing needs.
Price reporting agencies (PRAs)
Where no liquid futures market exists, how do you know a fair price? PRAs (e.g. Platts, Argus) publish price assessments: they collect transactions, bids, and offers and apply a methodology — partly judgement — to determine a price for a defined grade, location, and timing. IOSCO’s 2012 principles govern how PRAs should do this. Assessments are used to settle physical supply contracts and cash-settled derivatives.
Investment banks
Business models vary. A full-service bank trades derivatives and physical commodities; others offer derivatives only.
| Sector | Problem | Bank solution |
|---|---|---|
| Crude and products | Inventory ties up working capital | Bank owns the inventory |
| Natural gas | Cold snaps raise demand but pipelines are constrained | Bank invests in pipelines or storage |
| Base metals | Consumers want better payment terms | Bank finances the logistics chain or intermediates |
Commodity trading houses
Traditionally they bought from producers and sold to consumers. Many now own and operate mines, refineries, storage, ships, and terminals (Glencore — merged with Xstrata in 2013 — is a well-known example). Around 2013, trading houses handled well over 15 million barrels of oil a day, about half of world grain and soybean flows, and in some niches (zinc, coffee) a few firms dominated.
Growth drivers: the post-2000 emerging-market boom, buying physical assets, exploiting arbitrage along their own supply chains, and earlier industry consolidation.
Hedge funds
Pooled, actively managed vehicles open to a limited investor group, aiming for returns in any market — often view-driven. (Amaranth’s 2006 collapse after losing billions in US natural gas is the classic warning.)
“Real money” accounts
Investors that can’t borrow to leverage — pension funds, insurers — plus banks selling commodity investment products to retail clients. Mainly investment motivations.
Checkpoint 1: markets and participants
Checkpoint — sections 1.1 and 1.2
1 / 5Which risk does an oil refiner mainly face?
Pick an answer to see if you are right.
1.3 Traded vs non-traded commodities: the iron ore story
Iron ore (with steel, the world’s second-largest commodity bloc by value) had no meaningful spot market before ~2003:
- Annual benchmark era — Japanese and Korean steelmakers bought from Brazilian and Australian miners on annual fixed-price bilateral contracts (April–March).
- Demand shock — China’s demand outgrew what the traditional system supplied; Indian suppliers responded quickly with one-off deals → a spot market emerged.
- Price reporting — PRAs began publishing daily assessments for a standard grade (62% Fe fines).
- Contract stress — in the 2008–09 crisis spot fell below the annual price; some buyers defaulted on fixed-price contracts to buy cheaper spot.
- Derivatives — exchange-cleared iron ore swaps came first, then OTC swaps and futures (e.g. SGX, Dalian), forming a forward curve.
Why benchmarks matter for “tradability”:
- A standard reference based on actual activity, understood by all
- Contracts reference a transparent, representative, publicly determined price
- Other grades trade as differentials — 58% Fe below the benchmark, 65% above (also reflecting origin and availability)
- A benchmark enables derivatives for hedging
In gold, spot means delivery on trade date + 2 business days, like financial markets. In crude oil, “spot” usually means near-term physical delivery, often priced off futures.
Worked example: pricing off a benchmark
Benchmark 62% Fe = USD 110/t. A 58% grade trades at a USD 12 discount; a 65% grade at a USD 8 premium.
| Grade | Price |
|---|---|
| 58% Fe | 110 − 12 = USD 98/t |
| 62% Fe (benchmark) | USD 110/t |
| 65% Fe | 110 + 8 = USD 118/t |
If the benchmark rises to USD 120, the differentials (if unchanged) move every grade by +10.
1.4 Forward contracts
A forward fixes today the price for delivery at a future date. It is negotiated bilaterally (over-the-counter, OTC).
- Gold for spot settles in two days; gold for delivery in one month is a forward.
- A forward is a commitment: you can’t walk away because the spot price moved.
- Both parties can agree to terminate early at a “break” amount reflecting current value (mark-to-market, or the exit price in an arm’s-length deal).
- A floating forward commits to buy/sell at a future date, with the price set by formula at delivery (e.g. the average of daily spot prices in the prior month).
Worked example: forward commitment
You bought 100 oz of gold forward at USD 1,430/oz. At delivery spot is USD 1,420.
You must still pay 1,430: economic loss = (1,420 − 1,430) × 100 = −USD 1,000. Had spot been 1,450, the gain would be +USD 2,000.
1.5 Futures
A future gives the same economic result as a forward — price certainty — but is traded on an exchange (e.g. CME Group) with standardised terms.
| Feature (CME gold futures) | Specification |
|---|---|
| Trading unit | 100 troy ounces |
| Price quote | USD and cents per troy ounce |
| Minimum tick | USD 0.10/oz = USD 10 per contract |
| Settlement | Physical delivery |
| Quality | 100 oz (±5%) refined gold, fineness ≥ 0.995, one bar or three 1 kg bars, stamped by an exchange-approved refiner |
| Margin | Required on open positions |
| Forward (OTC) | Future (exchange) | |
|---|---|---|
| Terms | Negotiated | Standardised size, dates, quality |
| Counterparty | The other party | The exchange clearing house |
| Margin | Traditionally none; now often collateralised too | Initial margin (roughly ~5% of value as a rule of thumb) + daily variation margin |
| Exit | Agree a break with the counterparty | Trade out on the exchange |
About 95% of futures are closed out before expiry — most users want risk management, not delivery.
Worked example: margin
Buy 1 gold future at USD 1,425 → contract value 1,425 × 100 = USD 142,500.
- Initial margin ≈ 5% × 142,500 ≈ USD 7,125 (illustrative)
- Next day settlement price 1,410 → variation margin = (1,410 − 1,425) × 100 = −USD 1,500 paid
- Ticks: a move from 1,425.00 to 1,425.30 = 3 ticks × USD 10 = USD 30
Checkpoint 2: benchmarks, forwards, futures
Checkpoint — sections 1.3 to 1.5
1 / 5What turned iron ore into a traded commodity?
Pick an answer to see if you are right.
1.6 Swaps
In a swap, two parties exchange cash flows based on different price indices — usually fixed vs floating. A notional quantity sizes the flows but is not exchanged.
| Market | Typical swap |
|---|---|
| Gold | Pay fixed lease rate vs receive floating lease rate |
| Base metals | Pay fixed aluminium price vs receive average price of the near-dated future |
| Oil | Pay fixed WTI vs receive average of near-dated WTI futures |
Features:
- Usually spot-starting (effective two days after trade); can be forward-starting.
- Settlement periods negotiable (1–12 months); flows net.
- Commodity swaps typically use an average floating price — because the physical exposure is usually priced on an average.
- In base metals a “swap” can simply be a single-period, cash-settled forward.
Who does what
A consumer buying oil monthly at market prices fears rising prices → pays fixed, receives floating. The bank on the other side now has the consumer’s original exposure and hedges with an offsetting swap — earning the bid-offer spread.
| From the market maker’s quote | Bid | Offer |
|---|---|---|
| Fixed leg | Market maker pays fixed | Market maker receives fixed |
| Floating leg | Receives floating | Pays floating |
| Jargon | “Buy”, long | “Sell”, short |
Convention: the buyer receives floating and pays a single fixed price. To avoid confusion, say explicitly who pays fixed and who receives fixed.
Worked example: a consumer’s swap
An airline swaps 10,000 bbl/month: pays fixed USD 75, receives the monthly average WTI.
| Month average | Airline receives (floating − fixed) × 10,000 | Physical purchase cost | Net cost per bbl |
|---|---|---|---|
| USD 80 | +5 × 10,000 = +USD 50,000 | 80 | 75 |
| USD 70 | −5 × 10,000 = −USD 50,000 | 70 | 75 |
The swap locks the effective price at USD 75 either way.
1.7 Options
A forward locks the buyer in — good if prices rise, bad if they fall. An option gives the right, but not the obligation, to buy or sell at an agreed price.
| Term | Meaning |
|---|---|
| Call | Right to buy |
| Put | Right to sell |
| Strike (exercise price) | Agreed trade price |
| Premium | Price paid by the buyer (usually upfront; quoted in the underlying’s units, e.g. USD/oz) |
| European / American / Bermudan | Exercise only at maturity / any time / on set dates |
| Physical vs cash settlement | Deliver the commodity, or pay the difference |
Cash-settled payoffs at expiry:
Call = MAX(underlying − strike, 0) Put = MAX(strike − underlying, 0)
Moneyness (for a call)
| Spot | Strike | Status |
|---|---|---|
| 1,425 | 1,400 | In-the-money (ITM) — strike better than market |
| 1,425 | 1,430 | Out-of-the-money (OTM) |
| 1,425 | 1,425 | At-the-money (ATM) |
Profit profiles at expiry
| Position | Gains when | Max loss | Max gain |
|---|---|---|---|
| Buy call | Price rises above strike + premium | Premium | Unlimited |
| Sell call | Price stays below strike | Unlimited | Premium |
| Buy put | Price falls below strike − premium | Premium | Strike − premium |
| Sell put | Price stays above strike | Strike − premium | Premium |
The seller’s profile is always the mirror of the buyer’s.
Worked example: call and put
Gold call, strike 1,400, premium 20:
| Spot at expiry | Payoff | Profit |
|---|---|---|
| 1,380 | 0 | −20 |
| 1,420 | 20 | 0 (breakeven = 1,400 + 20) |
| 1,460 | 60 | +40 |
Gold put, strike 1,400, premium 15, spot at expiry 1,350: payoff 50, profit +35. Breakeven = 1,400 − 15 = 1,385.
Four uses of options
- Directional view — e.g. buy a call instead of physical gold (less outlay) or a future (limited downside).
- Volatility trading — options carry implied volatility, an asset class in its own right.
- Hedging — profiles in between full protection and full participation.
- Outperformance — e.g. a holder of gold sells options to earn premium above money-market rates.
Checkpoint 3: swaps and options
Checkpoint — sections 1.6 and 1.7
1 / 6A producer fears falling prices. Which swap position hedges it?
Pick an answer to see if you are right.
1.8 Exotic options
Exotics have payoffs that differ from plain (“vanilla”) European/American options. Four building blocks appear in many structures.
Binary (digital) options
A bet-like option: if it finishes in the money, the buyer receives a fixed amount, regardless of how far in the money. The strike is often (confusingly) called the barrier.
Example: digital call on gold, trigger 1,450, pays USD 10,000 if gold settles above 1,450 — whether at 1,451 or 1,600.
Barrier options
Vanilla options that knock in (come into existence) or knock out (are cancelled) if spot touches a barrier/trigger.
| Barrier in the out-of-the-money region | Barrier in the in-the-money region | |
|---|---|---|
| Name | Standard barrier | Reverse barrier |
| Call examples | Down-and-in, down-and-out | Up-and-in, up-and-out |
| Put examples | Up-and-in, up-and-out | Down-and-in, down-and-out |
Example (spot 1,425, call strike 1,430, 3 months):
| Barrier option | Trigger | Effect |
|---|---|---|
| Down-and-in call (standard) | 1,420 | Call is granted only if spot falls to 1,420 or lower |
| Down-and-out call (standard) | 1,420 | Call is cancelled if spot falls to 1,420 or lower |
| Up-and-in call (reverse) | 1,435 | Call is granted if spot rises to 1,435 |
| Up-and-out call (reverse) | 1,435 | Call is cancelled if spot rises to 1,435 — just as it was paying off |
Barriers are cheaper than vanillas because the buyer accepts the chance of having no option.
Spread options
Pay off on the difference between two prices relative to a strike:
Call = MAX(price₁ − price₂ − strike, 0) Put = MAX(strike − price₁ + price₂, 0)
Common in commodities for:
- Input vs output — e.g. gasoline minus crude (a crack spread)
- Location — the same commodity at two delivery points
- Time — the same future for two delivery months (a calendar spread)
Valuation needs the correlation between the two prices. For a call on the spread, negative correlation makes a wide spread more likely → higher premium; high positive correlation → lower premium.
Worked example: crack-spread call, strike USD 15/bbl. At expiry gasoline = USD 95, crude = USD 75 → spread 20 → payoff = 20 − 15 = USD 5/bbl.
Average rate options (“avros”)
Probably the most common commodity option: the payoff uses the average price over a period before maturity.
Call = MAX(average − strike, 0) Put = MAX(strike − average, 0)
They match physical contracts priced on averages, avoiding a cash-flow mismatch between the hedge and the commercial deal. Averaging dampens volatility, so avros are cheaper than equivalent vanillas — but they are not simply a “cheap” vanilla: the protection is different.
Worked example: strike USD 50. Monthly settlement prices in the averaging window: 48, 52, 56.
| Option | Reference price | Payoff |
|---|---|---|
| Vanilla call (final price) | 56 | USD 6 |
| Average rate call | (48 + 52 + 56) / 3 = 52 | USD 2 |
Illustrative premiums: a 6-month ATM crude call (strike 50, 30% vol) ≈ USD 4.20/bbl; averaging over the last 3 months ≈ USD 3.96/bbl.
Checkpoint 4: exotic options
Checkpoint — section 1.8
1 / 6A digital call pays USD 5,000 if gold settles above 1,500. Gold settles at 1,620. Payoff?
Pick an answer to see if you are right.
Rank: putting it together
Instruments and markets
1 / 2Rank the stages in a commodity becoming “traded”.
OrderDrag the handle to rearrange — top should be first.
- 1One-off spot transactions appear
- 2Bilateral fixed-price contracts only
- 3Futures and a forward curve develop
- 4Swaps reference the benchmark
- 5PRAs publish regular assessments of a benchmark grade
Drag items into the correct order (or use ↑↓), then check.
Check: fundamentals of commodities and derivatives
Fundamentals of commodities and derivatives
1 / 7Which item does NOT fit the classic “unprocessed good” definition but is traded like a commodity?
Pick an answer to see if you are right.
Calculate: numeric practice
Type the number (no units or currency symbols; use a minus sign for losses or payments). Commas are fine.
Formula sheet
| Instrument | Result |
|---|---|
| Forward (buyer) | (spot at delivery − forward price) × quantity |
| Future (long) variation margin | (today’s settlement − previous price) × contract size × contracts |
| Initial margin | price × contract size × contracts × margin % |
| Swap (pay fixed) | (floating average − fixed) × volume |
| Call / put payoff | MAX(S − K, 0) / MAX(K − S, 0); profit = payoff − premium |
| Breakeven | call: K + premium; put: K − premium |
| Spread call | MAX(P₁ − P₂ − K, 0) |
| Average rate call / put | MAX(avg − K, 0) / MAX(K − avg, 0) |
Calculate: commodity derivatives
1 / 12You bought 300 oz of gold forward at USD 1,445/oz. At delivery spot is USD 1,410. Economic profit in USD (negative for a loss)?
Enter a number (at most 2 decimal places).
Randomized practice
Each attempt draws new numbers.
Practice: forwards, futures, swaps, benchmarks
1 / 6The 62% Fe iron ore benchmark is USD 104/t. A 65% grade trades at a USD 13 premium. Its price in USD/t?
Enter a number (at most 0 decimal places).
Practice: options and exotics
1 / 6Average rate call, strike USD 49. Monthly prices in the averaging period: 55, 53, 61. Payoff per unit? Round to 2 decimals.
Enter a number (at most 2 decimal places).
Takeaways
- Commodities span energy, metals, agriculture, and specialty markets (freight, carbon, weather)
- They are heterogeneous, need transformation, transport, and storage — so benchmarks are central
- Producers fear falling prices, consumers rising prices, processors their margin
- PRAs and exchanges provide price discovery; iron ore shows how a benchmark creates a traded market
- Forward = OTC commitment; future = standardised, exchange-traded, margined
- Swap = fixed vs (often average) floating; say who pays fixed
- Option = right, not obligation; know call/put payoffs, moneyness, and buyer/seller profiles
- Exotics: binary (fixed payout), barrier (knock in/out), spread (two prices, correlation), average rate (most common, cheaper)
Further Reading
- Inventory optimization — physical stock decisions behind commodity storage
- Export–Import: international payments — FX forwards and options in trade
- International Business home
- Next: 2. Derivative valuation
- Sources: CME Group gold futures contract specification; IOSCO Principles for Oil Price Reporting Agencies (2012)
- Background: N. Schofield, Commodity Derivatives: Markets and Applications (Wiley) — used as a study outline