University of Hong Kong Trading Workshop

1. University of Hong Kong Trading Workshop Class 8 Commodities Workshop David Lo

2. Agenda • 1.What is Commodity ? .CRB? • 2. Correlation between commodities & other markets • 3. Spot, Forward/Futures and Options Strategy on Commodities

3. 1. What is Commodity ? Commodities can be classified as follow : 1. Metals 2. Grains & Oilseeds 3. Meals, Livestock 4. Fibres & Timber • Softs & Tropicals • Energy

4. Example : Metals

5. Over the last couple of years, CRB Price Index (a global benchmark for measuring commodity price movement) moves up by 34% in a year. • The price of commodities as diverse as crude gold, silver and oil make a series of new highs. This seminar will give you an overview of the current commodities market and their related derivative products, e.g. Gold/Oil futures and options, with the pricing models.

6. Commodities outperform other markets • With the current subprime crisis, commodities are outperforming equities and bonds markets. • Emerging markets still drive the demand for resources, no matter precious metals or agricultural products.... • 26/Mar/2008 • Gold =943.60 up 43% in a year • Silver = 18.00 up 35% • Crude Oil =102.40 up 63% • Rice = 19.36 up 99% • Corn = 550 up 41%

7. Rebasing Performance – Past 1 Year (.DJI .HSI Gold Silver Crude Rice Corn)

8. First Energy, metals and now agriculture……. • •Commodities and energy markets were seen as alternative assets investment in subprime crisis • •Cyclical play on global growth • •Trade on dollar weakness • •Hedge against inflation • •Way of leveraging Chinese and Indian growth, gold & silver demand, agricultural products... • •Estimated $170 billion from institutional investment have gone into Commodities in 2007 * • Source: * Jefferies

9. What is CRB Index? • Reuters/Jefferies CRB Excess Return Index • <.CRB> <0#.RJCRB>

10. History of CRB Index • The history of the Reuters/Jefferies-CRB Index dates back to 1957, when the Commodity Research Bureau constructed an index comprised of 28 commodities that made its inaugural appearance in the 1958 CRB Commodity Year Book. • Since then, as commodity markets have evolved, the Index has undergone periodic updates to remain a leading benchmark for the performance of commodities as an asset class. • The Index was renamed the Reuters/Jefferies-CRB Index in 2005 when it underwent its tenth and most recent revision - as the collaborative effort of Reuters, the global information company, and Jefferies Financial Products, LLC - to maintain its continued accurate representation of modern commodity markets.

11. Weighting in .CRB

12. 1.5.4 Constituents of, example, <.CRB> Index <RJCRB01> & <RJCRB02> give information about the constituents. <0#.RJCRB> shows all the constituents & pricing of each component.

13. .CRB - Constituents

14. Correlation between Commodities vs. other markets

15. U.S. Dollar Index <=USD> 71.50 (27Mar2008) • A measure of the value of the U.S. dollar relative to majority of its most significant trading partners. This index is similar to other trade-weighted indexes, which also use the exchange rates from the same major currencies. • Currently, this index is calculated by factoring in the exchange rates of six major world currencies: the euro, Japanese yen, Canadian dollar, British pound, Swedish krona and Swiss franc. This index started in 1973 with a base of 100 and is relative to this base. This means that a value of 120 would suggest that the U.S. dollar experienced a 20% increase in value over the time period. • It is possible to incorporate futures or options strategies on the USDX. These financial products currently trade on the New York Board Of Trade.

16. Fed Discount Rate <USDISC=> 2.50% (27MAR2008)

17. .CRB =USD USDISC= .DJI

18. Correlation Matrix Model .DJI .SPX .FTSE .GDAXI .N225 .HSI .HSCE .SSEC .BSESN .TWII (Stock Markets : 1Jan06 – 3Mar08)

19. Correlation : .CRB vs. Dollar Index, Discount Rate, Dow Jones Index, Hang Seng Index Period : 01Jan2006 – 03Mar2008

20. Correlation : .CRB vs. Dollar Index, Discount Rate, Dow Jones Index, Hang Seng Index Period : 01Jan2007 – 03Mar2008

21. Correlation between Commodities vs. • Dollar Index/Interest Rate/Stock Markets Spot, Forwards/Futures & Options Strategy

22. Crude Oil & Gold • Spot : WTC- & XAU= Period :1986-2008

23. The consumer years: 1986 - 2006 • 1986 Price collapse $32 => $10 • 1987 OPEC stop setting prices • 1990 Iraq invasion of Kuwait $20 => $40 => $20 • 1998 Price collapse $20 => $10 • 1999 Price recovery $10 => $30 • 2003 Iraq war. Price surge, high volatility $25 => $45 • 2004 Terrorism, world demand outstrips OPEC supply $50+ • 2005 Hurricanes in the Gulf Coast $50 =>$70 • 2006 Nuclear threat plus increasing demand $70+ • Features • Trading taken over by large oil companies, trading houses and investment banks. • Free market with high volatility • Price management instruments are developed

24. Crude oil markets • Physical Nigerian, Iranian, • Russian Urals, Columbian etc • Forwards BFO (Brent, Forties, Oseberg), • Dubai • Derivatives Futures NYMEX Crude Oil • Swaps WTI, Dubai......

25. Price value units • Oil supply, shipping, refining & trading expressed in US dollars • Crude oils: Worldwide $ per barrel • Products: Europe $ per metric ton USA cents per American gallon (but No.6 oil in $ / bbl) Singapore $ per barrel (but fuel oil in $/mt) Arab Gulf $ per barrel (but naphtha & fuel oil in $/mt)

26. Measurement and conversion • Volume measured in barrels, gallons, cubic metres, litres • 1 barrell = 42 American gallons • Weight measured in metric tons (1000 kilograms) • Typical conversion factors bbls/metric ton • Nigerian Bonny Light 7.5 • Arabian Heavy 7.1 • Naphtha 9.0 • Gasoline 8.6 • Jet / kerosene 7.9 • No.2 fuel / diesel 7.5 • No.6 fuel / fuel oil 6.4

27. Differences between Forward & Futures

28. Example : Crude Oil future contract <CLc1> • A standard contract for purchase and sale of a standard quantity and quality of oil • Oil to be traded for delivery in a specified future month at specified locations • A standard number of months will always be available for trading and the last day of trading for each contract month will be defined • All trading takes place under the rules of a regulated futures exchange

29. Crude Oil Future – New York Mercantile Exchange (NYMEX)

30. Example :Crude Oil JUN08 Future CLM8

31. Relationships between Cash and Futures Prices Cash prices are the prices for which the commodity is sold at the various market locations. The Futures price represents the current market opinion of what the commodity will be worth at some time in the future.

32. Relationships between Cash and Futures Prices Under normal circumstances of adequate supply, the price of the physical commodity for future delivery will be approximately equal to the present cash price, plus the amount it costs to carry or store the commodity from the present to the month of delivery. Futures = Spot + basis These costs, known as carrying charges, determine the normal premium of futures over cash. carrying charges (cost of carry) + time - Futures price Cash price

33. On Contango As a result, one would ordinarily expect to see an upward trend to the prices of distant contract months. Such a market condition is known as contango and is typical of many futures markets.

34. On Contango

35. Gold Future – Commodity Exchange (COMEX)

36. On Backwardation The opposite of contango is backwardation, a market condition where the nearby month trades at a higher price relative to the outer months. Such a price relationship usually indicates a tightness of supply; a market can also be in backwardation when seasonal factors predominate.

37. 2.6 Rules and Codes for Futures & Options

38. Example :Gold APR08 Future GCJ8

39. Measures of futures markets • Open Interest • The number of open or outstanding contracts for which there has not yet been an offsetting sale or purchase • Volume • The number of contracts which change hands during a given period of time

40. Future Option List Model –Comex Gold Jun Future

41. Premium Received Strategy : Buy 2 C(980)+ Sell 1 P(940)+ Sell 1P(920) = $490 (received) {(-31.1X2 + 38.2 + 28.9)X100}

42. Payout Profile

43. 3D Payout Profile

44. Market News :Nymex Oil ends above $107..... >Strangle Option Trading Source: Reuters

45. Future Option List Model –Nymex Light Crude May Future Implied Volatility

46. Strangle • An options strategy where the investor holds a position in both a call and put with different strike prices but with the same maturity and underlying asset. This option strategy is profitable only if there are large movements in the price of the underlying asset. This is a good strategy if you think there will be a large price movement in the near future but are unsure of which way that price movement will be.   The strategy involves buying an out-of-the-money call and an out-of-the-money put option. A strangle is generally less expensive than a straddle as the contracts are purchased out of the money.

47. Buy 1 May P(100) + Buy 1 May C(106) Nymex Crude Future= $5200 (paid) (2.85+2.35)X1000

48. Strangle Payout Profile

49. 3D Payout Profile on Strangle Strategy

50. What-if Analysis : 102.3 > 110 May106 Call Premium? 2.350 => 6.394