Handbook of Finance: Valuation, Financial Modeling, and Quantitative Tools

Chapter 50. The Pricing and Economics of Commodity Futures

MARK J. P. ANSON, PhD, JD, CFA, CAIA, CPA

President and Executive Director of Nuveen Investment Services

Abstract: While stocks and bonds are valued based on the discounted present value of future cash flows, commodity futures prices demonstrate different pricing dynamics because they do not provide a claim on future cash flows; they provide a claim on a physical asset. Commodity futures prices are tied mathematically to the current price of physical commodities in the cash markets. In addition, futures prices are dependent upon the risk aversion of buyers and sellers of physical commodities. Depending on whether the buyer or seller is more risk averse and, therefore, more willing to hedge their commodity price exposure, commodity futures prices can exhibit an upward or downward sloping yield curve.

Keywords: commodity futures, commodity prices, spot prices, convenience yield, lease rates, normal backwardation, backwardation, contango market

Capital assets such as stocks and bonds can be valued on the basis of the net present value of expected future cash flows. Expected cash flows and discount rates are a prime ingredient to determine the value of capital assets. Conversely, commodities do not provide a claim on an ongoing stream of revenue in the same fashion as stocks and bonds, with the exception of precious metals such as gold, silver, and platinum which can be lent out at a market lease rate. Consequently, they cannot ...