Commodity Futures Basics

A farmer will have corn to sell in September and has to decide today how many acres to plant. A cereal company will need that corn and has to print a price on a box. Neither wants to bet the business on what corn does over the summer, and both would happily agree a price now. The problem is finding each other, trusting each other, and agreeing on whose corn counts as corn.

A futures contract solves all three at once by standardising everything except the price. The exchange fixes the quantity (5,000 bushels), the grade, the delivery location and the delivery month, so any contract is interchangeable with any other. That fungibility is what creates a liquid market, and a clearing house steps between every buyer and seller so nobody has to assess anybody's credit.

Because the contracts are interchangeable, hardly anyone ever delivers. The farmer closes his short by buying back a contract before expiry and sells his actual corn to the local elevator; the two prices move together, so the hedge did its job without a single truck being routed by the exchange.

Worked example: margin and the daily cash flow

Corn futures cover 5,000 bushels and are quoted in cents per bushel. You buy one contract at 450, that is $4.50 a bushel.

1. Notional value. $5{,}000 \times 4.50 = 22{,}500$, so you control $22,500 of corn.
2. Cash required. Initial margin is about $1,500. That is 15 to 1 leverage, and it is a deposit you get back, not a cost.
3. That evening. Corn settles at 440. You are down $5{,}000 \times 0.10 = 500$, and $500 is removed from your account that night. Your balance is $1,000.
4. The margin call. Maintenance margin is $1,100. Having dropped below it, you must wire enough to restore the full $1,500, today, or the broker closes you out.

Two lessons live in that arithmetic. Futures have no premium and no up-front cost, so the leverage is enormous. And unrealised losses are not unrealised — they are debited nightly, which is why futures traders can be right about a price and still be stopped out on the way there.

Basis, and why it has to converge

The basis is the spot price minus the futures price. It can be positive or negative during the contract's life, but on the last delivery day the futures contract is a claim on the physical commodity, so the two prices must meet. If a September contract traded well below September spot, you could buy the contract, take delivery and sell the goods for an immediate profit. Arbitrage forces convergence.

That convergence is what makes hedging work, and its imperfection is what makes hedging imperfect. A Kansas elevator hedging with a Chicago contract still carries the risk that the Kansas-minus-Chicago gap moves — basis risk, the residue left after the big price risk has been removed.

The shape of the curve

Where does the futures price come from? For anything storable, from the cost of holding it. Buy the commodity today, borrow the money, pay for the tank, and you have manufactured a future delivery yourself. So

$$F = S \times (1 + rT) + \text{storage} - \text{convenience yield}$$

In words: today's price, plus the interest on the cash tied up, plus the cost of the warehouse, minus whatever benefit you get from physically having the goods on hand. That last term, the convenience yield, is the reason a refinery will pay up for barrels it can process this week.

Worked example: pricing six-month crude

Spot WTI is $78.00 a barrel, financing costs 5.0 percent a year and storage runs $0.40 a barrel a month.

$$F = 78.00 \times (1 + 0.05 \times 0.5) + 6 \times 0.40 = 79.95 + 2.40 = 82.35$$

So a fair six-month future is $82.35, about 5.6 percent above spot — contango, and every cent of it is carrying cost rather than optimism. If the six-month instead traded at $74.00, no arbitrage would be available, because you cannot easily borrow and short physical crude. The $8.35 shortfall is the market's implied convenience yield: an annualised 21 percent for the privilege of holding real barrels, which only happens when inventories are tight.

Now the sting for investors. Suppose the front month is $78.00 and the second month $78.70. A long futures position must be rolled before expiry, selling the cheap contract and buying the dear one, giving up 70 cents each time. Repeat monthly and roll yield alone costs roughly 10 percent a year, before crude has moved at all.

Key terms

• Contract specification — the fixed quantity, grade, delivery point and month.
• Initial / maintenance margin — the deposit to open, and the floor that triggers a call.
• Mark to market — the nightly cash settlement of gains and losses.
• Basis — spot minus futures; converges to zero at delivery.
• Contango / backwardation — futures above or below spot.
• Convenience yield — the benefit of physically holding the commodity.
• Roll yield — the gain or loss from replacing an expiring contract with a later one.