Introduction

This Chapter delves into the fundamental aspect of pricing commodity forwards, a critical concept in the realm of commodity markets. Commodity forwards serve as agreements between two parties to buy or sell a commodity at a predetermined price on a future date. Understanding how to price these contracts is crucial for effective risk management and strategic decision-making in commodity trading.

Understanding Forward Contracts

A forward contract is an agreement between two parties to exchange a specified quantity of a commodity at a predetermined price on a future date. The predetermined price is the forward price, which is set at the time of contract initiation. Forward contracts are traded over-the-counter (OTC) and are customizable to suit the needs of the parties involved.

Formula for Commodity Forward Pricing

Pricing a commodity forward involves determining the fair value of the contract considering factors such as the current spot price, the time to maturity, and any carrying costs. The formula for pricing a commodity forward is as follows:

$$\text{Forward Price} = \text{Spot Price} \times e^{(rt)}$$

Where:

• Spot Price is the current price of the commodity.
• $r$ is the risk-free interest rate.
• $t$ is the time to maturity in years.
• $e$ represents the mathematical constant approximately equal to 2.71828.

This formula captures the time value of money and reflects the expected appreciation of the commodity’s price over time. As the time to maturity increases, the forward price tends to rise, assuming other factors remain constant.

Example: Suppose a company wants to enter into a forward contract to purchase 1,000 barrels of crude oil three months from now. The current spot price of crude oil is $70 per barrel, and the risk-free interest rate is 5% per annum. Using the formula, we can calculate the forward price:

$$\text{Forward Price} = \text{USD 70} \times e^{(0.05 \times (3/12))} ≈ \text{USD 71.72 per barrel} $$

This forward price reflects the expected price of crude oil three months from now, accounting for the time value of money and the anticipated growth in the commodity’s value.