A physical market – also called a “spot market” – is a market where commodities are effectively exchanged: the seller delivers them and the buyer takes delivery of them. The transaction is carried out at a price that is called the spot price or the physical price. Commodity derivative markets make it possible to negotiate standardized financial instruments (FIs; futures contracts and options contracts) and over the counter (OTC) FIs (deferred contracts, swaps and options). The price of these FIs depends on the physical price of the commodity; the commodity is said to underlie or support the FI. The FIs constructed with reference to an underlying asset are called derivatives as their price is derived from the price that develops on the physical market. This relationship, however, is neither clear-cut nor simple. It is not clear-cut as the physical price does influence the derivative; however, in return, the price of the FI has an impact on the physical markets. The relation between the two prices is complex and has proven to be very difficult to model. We will return to this question several times when analyzing various pricing models for derivatives.
2.1. A financial instrument is a security or a contract that generates a series of financial flows
Before stating the specificities of commodity derivatives, we will define the characteristics that are common to all FIs. In legal terms, “financial instruments ...