Commodity Trading and Derivatives: Definitions and Concepts, Quizzes of Finance

Download Commodity Trading and Derivatives: Definitions and Concepts and more Quizzes Finance in PDF only on Docsity! TERM 1 Supply DEFINITION 1 production of the commodity and inventory. Includes the reserves of a commodity that have not yet been recovered. TERM 2 Demand DEFINITION 2 is the strong need or desire for a commodity. "Demand is generally inelastic to prices, given the indispensable nature of the good. TERM 3 Commodity SPOT Markets DEFINITION 3 Aka Cash or Physical marketsWhere supply (sellers) and demand (buyers) come together in a geographical location and transact. The physical commodity transfers from one owner to another at an agreed upon price immediately. This provides a spot price (index) in which many derivatives are financially settled.EVERY COMMODITY is trade on the SPOT TERM 4 Commodity Forwards DEFINITION 4 A contract between two counter parties, buyer and seller, whereby the seller agrees to deliver to the buyer the physical commodity at a known price (at time of the transaction) at a known future date, at a known location.*More flexible than a futures contract* TERM 5 Commodity Futures DEFINITION 5 A contract between two counter parties, buyer and seller, whereby the seller agrees to deliver the physical commodity to the buyer at a known price, known future date, known location .Cleared on a regulated exchange, whereby the exchange clearinghouse is the counter party until assignmentRegulated very specifically!Credit and Performance Risk are effectively eliminated! Unlike a Forward contract TERM 6 Commodity Options DEFINITION 6 Physical and Financial..The right/obligation to buy/sell the underlying at a future date at a known price TERM 7 Commodity Markets DEFINITION 7 Have evolved from local to global with increased ability to transport and store the commodityCommodities have become an asset class of their own. Entities invest in commodities for diversification and for returns.Commodities are natural hedges against inflation, and perform very differently than equities. TERM 8 Commodity Markets are EVOLVING and Changing DEFINITION 8 - Political upheavals- Economic Mutation- De-regulation and Regulation- Emerging Markets/Countries (ex. China's boom and now its bust!) TERM 9 Phases of the Physical Execution of a Trade DEFINITION 9 1) Oil is Produced from petroleum reserves underground2) Oil is transported from well to harbor storage via pipeline, rail, truck3) Oil is loaded onto a tanker for storage or transportation4) Oil is shipped, if economical, oil may be stored on tankers offshore5) Oil is placed in harbor storage or moved into pipeline or truck/train6) Oil is used in manufacturing/refining/consumption or Placed in Storage TERM 10 Bill of Lading DEFINITION 10 Is the document that reps the ownership of the good (commodity). It bears the label "shipped" or "to be shipped" TERM 21 Spot Trading Contracts DEFINITION 21 - Commercial contract- Flexible; grade, location, pricing, etc.- Can be very illiquid and discontinuous- Allows for the transfer of goods in the conditions suiting the demand- Many types of Risk: Credit, Delivery/Quality TERM 22 Forward Contracts DEFINITION 22 - OTC; Bilateral Agreement- Flexible; grade, location, pricing, etc.- Replace spot markets on many occasions (especially when the commodity can't be stored - electricity)- Flexibility regarding the optimal transfer of goods (supply and demand)- Many types of Risk: Credit, Delivery/Quality, Transportation TERM 23 Swap Contracts DEFINITION 23 - OTC; Bilateral agreements- Purely financial contract- No physical commodity changes hands- Flexible; references grade, pricing- Tend to be very liquid markets- Risks: Primarily Credit Risk if not cleared through CCP- Margining in Place if cleared TERM 24 Futures Contracts DEFINITION 24 - Standardized; Regulated Contract- Non-flexible; Grade, pricing, delivery location - all nown and fixed- The futures position will become a physical contract if the position is not liquidated prior to expiry- Price transparency- Central Clearing through Clearinghouses ensures performance and mitigates credit risk- Tend to be very liquid markets- Risk: limited to "extraordinary" e.g. Hurricane Katrina and the NG Henry Hub Contract- Margining in Place; Marked to Market Daily TERM 25 Derivative DEFINITION 25 Futures, Forwards, Swaps, and OptionsA financial instrument whose return is derived from the return on another instrument (underlying asset) such as a stock, bond, currency, interest rate, commodity. TERM 26 Advantages of Derivatives DEFINITION 26 - Lower transaction costs relative to spot transactions- Greater liquidity; function of lower the lower capital requirements- Allow investors to sell short more easily since they don't have to borrow the underlying- Lower Credit and performance risk TERM 27 Why use derivatives? DEFINITION 27 Arbitrage opportunitiesSpeculation opportunitiesRisk management/Hedging opportunities TERM 28 Who are the players? DEFINITION 28 ArbitrageursSpeculatorsHedgers TERM 29 Arbitrage DEFINITION 29 Use derivatives by taking offsetting positions in two or more instruments to lock in a risk-less profit.Ex: Buying sport crude oil, storing oil, and selling a forward/futures to lock in arbitrage profit if the forward/future is overvalued. TERM 30 Speculation DEFINITION 30 Use derivatives to bet on the future direction of a market variable (price, volatility, etc.) TERM 31 Hedging DEFINITION 31 Use derivatives to reduce risk that they face from future movements in a market variable. TERM 32 Convergence DEFINITION 32 An expiring futures contract should be equal to a spot transaction at the delivery point at expiryBuyers and Sellers will arbitrage anytime the futures is below/above the spot, and the futures price will converge to the spot when this happens TERM 33 Position Limits DEFINITION 33 Set specifically by each exchange for each product.Position limits are imposed to prevent undue influence on the market and to ensure performance