Commodities Concepts
We will cover following topics
Introduction
Before delving into the intricacies of commodity forwards and futures, it’s essential to establish a strong understanding of the fundamental concepts and factors that shape the commodity markets. In this chapter, we will explore key concepts such as storage costs, carry markets, lease rates, and convenience yields. Moreover, we will delve into the factors that wield influence over prices within diverse commodity sectors, including agricultural products, metals, energy resources, and even weather derivatives.
Storage Costs
Commodities, unlike financial assets, often involve physical goods that require storage. Storage costs refer to the expenses associated with holding these goods until they are ready for consumption or sale. These costs encompass warehousing fees, insurance, handling, and even depreciation due to spoilage. For instance, storing perishable goods like agricultural produce involves constant monitoring and refrigeration, incurring additional costs that impact the commodity’s overall value.
Carry Markets and Lease Rate
A carry market is characterized by a price structure where the futures price for a commodity is higher than the expected spot price at the contract’s maturity. The difference between these two prices is referred to as the “carry.” This phenomenon indicates that holding the commodity incurs carrying costs, leading to the higher futures price. The lease rate plays a pivotal role in this context, representing the compensation a holder receives for leasing their commodity or forgoing its consumption. A higher lease rate often corresponds to a more pronounced carry market.
Convenience Yield
Convenience yield refers to the additional benefit or yield gained from holding a physical commodity rather than a futures contract. It arises due to the advantages of having immediate access to the physical good, especially during times of supply disruptions or unforeseen market events. For instance, in the oil market, having direct access to crude oil reserves enables a producer to react swiftly to supply shortages, enhancing the convenience yield of holding physical oil.
Conclusion
By grasping the intricacies of storage costs, carry markets, lease rates, and convenience yields, and understanding the diverse factors that shape commodity prices across various sectors, we gain a comprehensive foundation for comprehending the dynamics of commodity forwards and futures. These concepts set the stage for a deeper exploration of pricing models, risk management, and the strategic utilization of derivatives in commodity trading. In the following chapters, we will build upon this knowledge to further illuminate the complexities of the commodity market landscape.