Commodity Derivatives: Markets and Applications

1

An Introduction to Derivative Products

SYNOPSIS The purpose of this chapter is to outline the main features of derivatives and provide a description of the main ways in which they are priced and valued.

 

This chapter is divided into two distinct sections that cover:

• The key features of the derivative “building block” products

• The principles of how each of the products is priced and valued.

The coverage is not particularly mathematical in style, although numerical examples are included where it helps to illustrate the key principles.

In the first section the fundamental concepts of the main derivative products are considered. The products covered include:

• Futures

• Forwards

• Swaps

• Options (mostly “vanilla” with some “exotic” coverage)

In the second section the focus is on the pricing of derivatives. The approach considers that all of the building block markets are linked through mathematical relationships and describes how the price of one product can be derived from another.

One of the unique elements of pricing commodity derivatives is the existence of the convenience yield, which is explained in conjunction with the concepts of contango and backwardation.

Two extra themes are developed in the pricing section that are relevant to other parts of the book. The first is a discussion on put-call parity, which will help the reader to understand how some structures are created. This idea is then developed to outline the potential sources of value in risk management solutions. ...