UNIVERSIT PARIS I PANTHON-SORBONNE

MASTER MMMEF Parcours Finance

Ramzi MAALOUF
PARTICULARITIES of the COMMODITIES MARKET
Rsum
Ce rapport de stage prsente une vue globale du march des matires premires. Limportance
de ce march na pas cess daugmenter ces dernires annes. En effet, lanne 2008 tait une
anne trs intressante, durant laquelle le march a t tmoin dune envole des prix du
ptrole, de lor, du cuivre, et des produits agricoles.
La premire partie du document introduit le march et met laccent sur la courbe forward.
Ensuite, elle se concentre sur la convenience yield , une notion particulire au monde des
commos. La deuxime partie labore le sujet des options et volatilits early expiry , qui est
aussi un concept spcifique au monde des commos. La troisime partie dcrit une mthode
utilise pour extraire la corrlation implicite entre deux sous-jacents partir dune option
basket. La dernire partie souligne limportance des options binaires dans le march des
commos et limpact qua le smile des volatilits sur les prix de ces options.

Rapport de stage prsent le

LUNDI 15 SEPTEMBRE a 16H45

Jury
Guillaume FOUCHERES
Natixis
Commodity Derivatives

Lieu du Stage
Natixis
47, Quai d'Austerlitz
75013 Paris
France

BICH Philippe
Universit Paris 1

Particularities of the Commodities Market

Table of Contents
1

Futures contracts in commodity markets............................................................................ 3

1.1
Different commodity asset classes ............................................................................. 3
1.2
Popularity of futures contracts in commodity markets .............................................. 3
1.3
Convenience yield ...................................................................................................... 4
1.4
Comparing futures and forwards................................................................................ 5
1.5
Shapes of the forward curve....................................................................................... 6
1.5.1
Contago .............................................................................................................. 7
1.5.2
Backwardation.................................................................................................... 8
1.5.3
Impact of the shape of forward curves on option prices .................................... 9
Early Expiry Options........................................................................................................ 10
2.1
Implied Volatilities................................................................................................... 10
2.2
Early expiry options: problem description ............................................................... 12
2.3
Methodology ............................................................................................................ 14
2.4
Numerical example................................................................................................... 15
Options on Baskets ........................................................................................................... 17
3.1
Pricing options on baskets........................................................................................ 17
3.2
Moment matching..................................................................................................... 18
3.3
Determining implied correlation .............................................................................. 20
Digital options .................................................................................................................. 21
4.1
Popularity of digital options ..................................................................................... 21
4.2
Volatilitys impact on the price of a digital option .................................................. 23
4.3
Smiles impact on the price of a digital option ........................................................ 25
References ........................................................................................................................ 27

Particularities of the Commodities Market

1 Futures contracts in commodity markets

1.1 Different commodity asset classes
The different commodity asset classes are the precious metals (gold, silver, platinum and
palladium), the base metals (copper, nickel, and aluminum), the energy commodities (crude
oil, natural gas ), the agricultural products , also called soft commodities, (wheat, soybean,
coffee ), the CO2 emissions permits and credits, and last but not least, electricity.

1.2 Popularity of futures contracts in commodity markets

The main players in commodity markets are:
1- producers and consumers looking at hedging the commoditys price risk
2- arbitragers looking for a riskless and profitable trading strategy in commodity markets
3- investors and speculators looking for an exposure to commodity price moves
In contrast to the equity market, the typical underlying for commodity derivative products is
not the spot or physical commodity, but rather the futures contract on the desired commodity.
For example, in equity markets, a typical call option on a Microsoft share has the share itself
as underlying. In commodity markets on the other hand, a typical call option on Brent has the
Brent futures contract as underlying.
Thanks to the arbitragers (the 2nd class of players in commodity markets), the price of the
futures contract converges to the spot price at the futures maturity. Thus, the payoff of a
European derivative product on a spot commodity is equivalent to a similar product on the
commoditys futures contract. Mathematically,
We denote :
ftT

: The price at t of the futures contract maturing at T

St

: The spot price at t of the commodity

Assuming No Arbitrage Opportunities (N.O.A.) :

fTT ST
So, comparing a european spot call option to a european futures call option
(with both options having a maturity T), we have :
 r .dt

( ST  K )  ( fTT  K )  (Q e 0 . ( ST  K ) 

( where Q is the risk neutral probability)

T

 r .dt

(Q e 0 . ( fTT  K ) 

Particularities of the Commodities Market

So, theoretically, both call options are worth the same. This can be generalized to all types of
European payoffs. Thus, given the premiums are identical (almost identical in practice),
people tend to choose the most liquid asset as underlying. Consequently, in equity markets,
stocks are preferred. In commodity markets however, futures are preferred for the following
reasons:
1- they avoid all risks associated with spot trading, namely transportation, storage, and
counterparty risk
2- their prices are readily available on exchanges, unlike spot prices which can only be
known by contacting a number of dealers
3- futures and futures options are generally traded on the same exchange, facilitating
hedging and speculation and reducing arbitrage

1.3 Convenience yield

In equity markets, the absence of arbitrage defines a strict relation between forward and spot
prices. Note that I have purposefully used the term forward instead of futures because I do not
want to consider daily margin calls.

If we denote :
FtT

: The price at t of the forward contract maturing at T

B (t , T ) : The price at t of the zero coupon bond maturing at T

St
then N.A.O gives : FtT
B(t , T )
This is not true for commodity forward contracts due to the following reasons:
12345-

the difficulty of short selling some spot commodities

the illiquidity of some spot commodities
the transportation costs
the storage costs
the benefits obtained by the ownership of the physical commodity

What is true however is that :

FtT d

S t . e c (T  t )
B(t , T )

where c is the storage cost of the commodity, expressed as a proportion

of the spot price

The other inequality does not hold because of the reasons mentioned above, namely points 1 and 5.
Therfore, to get the equality, we introduce a new parameter b, which represents the benefit from
holding the physical commodity rather than its corresponding futures or forward contract.
FtT

S t . e ( c  b ) .(T  t )
B(t , T )

S t . e  y .(T t )
B(t , T )

Particularities of the Commodities Market

The convenience yield y, combined both the storage cost and the physical benefit of holding
the commodity.
Note that for simplicity, the convenience yield is taken to be constant. A more general case
will follow.

1.4 Comparing futures and forwards

In the finance world, futures and forwards are used interchangeably. Theoretically however,
they are not equivalent.
To compare the two, we first look at the spots differential equation, after we introduced the
convenience yield parameter:
dSt
St

(rt  y )dt  V t .dWt

assuming a constant convenience yield for simplicity

ST S t e

 y .(T  t ) 

rs .ds
t

1
V 2 s .ds  V s .dWs
2t
t

Since the futures price is a martingale under Q, the risk neutral probability, we have :
rs .ds

. ( e t

ft

( { f } ( {ST } St e
Q
t

T
T

Q
t

 y .(T  t )

Q
t

1
V 2 s .ds  V s .dW s
2

Assuming the stochastic interest rate is independent of the brownian motion filtration, we get :
rs .ds
rs .ds  1 V 2 s .ds  V s .dWs

Q 2t
t
Q t
 y .(T  t )
t
St e
. ( e
. (t e

St e
.(t e

(since the 2nd expextation is that of an exponential martingale)

T

ft

 y .(T  t )

Q
t

On the other hand, since the forward price is a martingale under QT, the forward neutral probability,
we have :
FtT (QtT {FTT } (QtT {ST }

Particularities of the Commodities Market

By a change of probability, we have :

 rs .ds

.ST
(Qt e t

 y .(T  t )

1
QT
Q

. ( t St . e
(t {ST }
B(t , T )
B(t , T )

Ft

1
V 2 s . ds  V s .dW s
2

 1 V 2 s .ds  V s .dWs
 y .(T  t )
1
St . e
2
t
. St . e  y .(T  t ) . (Qt e t

B(t , T )
B (t , T )

rs .ds
1

Q t
So, comparing futures to forwards reduces to comparing (t e
.
to

B(t , T )

Using Jensen' s inequality and the fact that f(x) 1/x is a convex function of x, we have :
rs .ds

(Qt e t

1
1
( T
t
T
 rs .ds
 rs .ds

Q
e t
(t e t

Q
t

1
B (t , T )

We conclude that f tT t FtT .

T

In the case where the interest rates are deterministic, we have : B (t , T ) e

Consequently, f t T

 rs . ds
t

FtT .

This is not a surprising result, because under deterministic interest rates, the two probability
measures Q and QT are equivalent.
Since in the commodities markets, the interest rates are not the main source of uncertainty,
they are considered to be deterministic. Thus, futures and forwards are used interchangeably.
This is what I will be assuming for the rest of the document.

1.5 Shapes of the forward curve

We can see that in contrast to equity markets where the entire forward curve can be
determined from the spot price, a commoditys forward curve is directly read from the market.
Different futures contracts for the same commodity are considered as distinct (though
correlated) underlying assets.

Particularities of the Commodities Market

Consequently, in practice, we work backwards from the forward curve to deduce the implied
convenience yield. Some forward curves may be complex enough requiring a non-constant
convenience yield to explain their shape.

The graph shows the price per barrel on the y-axis and the maturity of the futures contract on the x-axis

So, a deterministic function of time will do the trick.

The generalized formula becomes:
T

ys .ds
St .e t
B (t , T )


FtT

Once the convenience yield is deduced from the available market quotes, it can be used to
determine the prices of futures that are not quoted on the exchanges.
The most common shapes of forward curves in the commodities markets are the next
subsections.

1.5.1 Contago
If we assume for simplicity that the interest rates and convenience yield are constants,
Contago is the case where (r y) > 0.
Usually, it is the case where the current world inventories for the commodity in question are
relaxed, and the common feeling in the market is the fear of a possible supply crunch in the
future, stimulating the buying of long dated futures. We therefore see the long dated end of
the curve higher than the short dated one.

Particularities of the Commodities Market

Below is an example of contago:

The graph shows the price per barrel on the y-axis and the maturity of the futures contract on the x-axis

1.5.2 Backwardation
The forward curve is in backwardation when (r-y) < 0.
Usually, this is the case where the current world inventories are tight, and consumers prefer to
buying now what they will be using in the near future, fearing that inventories will keep on
decreasing. We therefore see the short dated end of the curve higher than the long dated one.
Below is an example of backwardation:

The graph shows the price per barrel on the y-axis and the maturity of the futures contract on the x-axis

Particularities of the Commodities Market

It is worth noting that although it occurs very rarely, a forward curve may change from
backwardation to contago (or vice versa). This was the case for the Brent and WTI crude oil
futures during May and June 2008. Indeed, consumers feared that oil fields and reserves will
soon be depleted because of the massive demand of emerging countries like China and India.
This pushed the forward curves from contago to backwardation.

1.5.3 Impact of the shape of forward curves on option prices

Speculators, consumers and producers usually buy at the money options. For them, the
important reference is the spot commodity price. However, they usually buy options on the
futures contract with maturity closest to that of the option. These are called standard options
(More on standard options later)
B&S formula for a call option on a future gives us:

C0

B ( 0 , T ) { f 0T . N ( d 1)  K N ( d 2 ) }

with
ln(
d1

f 0T
1 2
)  V basket
T
K
2
V T

d2

d1  V

and V being the futures volatility .

Moreover, because of the absence of arbitrage, the sport price is generally closest to the
futures price with the shortest maturity, called the first nearby. This explains the results shown
in the table below

Shape of forward
Curve
Contango

Backwardation

Future Compared to strike

Call premium

ATM means
K S0 | f 0 first Nearby  f 0T
So, the option is actually ITM
ATM means
K S 0 | f 0 first Nearby ! f 0T
So, the option is actually OTM

Expensive

Cheap

Table 1-1

Obviously, the opposite is true for a put option.

As a conclusion, backwardation is suitable when investors have a bullish view, and contango
is suitable when they have a bearish view, since in these mentioned cases, the premium they
pay is cheap.

Particularities of the Commodities Market

2 Early Expiry Options

2.1 Implied Volatilities
Since the probability distribution of underlying assets is not lognormal as assumed in the B&S
world, a volatility smile (or skew) exists in the market for a given option maturity. This gives
the implied volatility for each strike. The implied volatility is the volatility that the market
uses to price options for given strikes. They are thus obtained by taking the option premium
from the market and inversing the B&S formula numerically.
Below is an example of a volatility smile:
35.0%
30.0%
25.0%
20.0%
15.0%
10.0%
5.0%

156

150

145

139

134

128

123

117

112

106

101

95

89.

84

78.

73

67.

62

56.

51

45.

40

0.0%

The graph shows the volatility smile of WTI crude oil options with 2 years to maturity. On the x-axis, we
have the strikes. On the y-axis, we have the implied volatilities.

If we consider several maturities, we obtain what is called a volatility surface. In order to have
consistent smiles, we should normalize the strikes by dividing them by the futures price. We
obtain what is called a moneyness ratio.
An example of a volatility surface is shown below:

10

Particularities of the Commodities Market

50.00%

40.00%

30.00%

Implied Vol
20.00%
735
553
370
337
309
279
251
Maturity
219
188
160

10.00%

0.00%
45%

60%

75%

127
90%

Moneyness

105%

120%

97
135%

The graph shows the volatility surface of Brent Crude Oil. The maturity is in days.

The volatility matrix corresponding to the above surface is shown below:

Maturity in
days
97
127
160
188
219
251
279
309
337
370
553
735

45%

60%

49.59%
48.10%
47.69%
46.15%
44.93%
44.02%
41.75%
41.91%
39.04%
38.84%
39.17%
37.49%

47.52%
45.63%
45.00%
43.83%
42.90%
42.12%
40.12%
39.92%
37.85%
37.50%
38.07%
36.80%

75%

Moneyness
90%

44.15%
39.31%
43.69%
39.07%
42.40%
38.03%
41.53%
37.35%
40.68%
36.67%
39.99%
36.16%
38.04%
34.92%
37.58%
34.47%
36.18%
33.72%
35.84%
33.47%
35.94%
32.80%
34.53%
31.44%
Table 2-1

105%

120%

135%

34.92%
34.79%
34.31%
33.84%
33.35%
32.95%
32.48%
32.07%
31.81%
31.59%
30.32%
29.05%

33.35%
33.17%
32.68%
32.26%
31.81%
31.35%
31.38%
30.96%
30.85%
30.66%
28.86%
27.56%

34.18%
33.60%
32.76%
32.19%
31.64%
31.05%
31.17%
30.69%
30.56%
30.35%
28.25%
26.89%

11

Particularities of the Commodities Market

2.2 Early expiry options: problem description

As mentioned in section 1.4.3, market participants tend to buy or sell standard options. A
standard option is an option whose underlying is the futures contract which matures slightly
after the expiry of the option. To clarify matters, we denote:

Tnfuture
Tnoption

the maturity of the nth futures contract listed on the exchange

the maturity of the standard option on the nth futures contract described above

Note that the standard options are listed on the same exchange as their corresponding futures
contract, and they obviously mature a few days earlier than the futures contract maturity

option < T future ). The reason for that is to avoid physical delivery of the commodity if
n

( Tn

the option is exercised at maturity.

Since for the nth future, standard options with several strikes are listed on the exchange and
are generally liquid products, a volatility smile can be implied for that future. We call this
smile the standard volatility smile of future n.
So, for every futures contract (distinguished from other contracts by its maturity), a standard
volatility smile can be implied from the market. The result is a standard volatility matrix for
the commodity in question.

Standard volatility matrix

Future

Future 1
Future 2

Futures
Maturity

Options maturity
(in days)

T1future
T future
2

Moneyness
80%

90%

ATM

110%

120%

T1option = 6

49.12%

43.80%

37.84%

34.71%

36.32%

T2option = 35

45.59%

41.38%

37.56%

35.28%

35.09%

= 66

44.47%

40.62%

37.09%

34.93%

34.29%

T3future
T future

T4option = 97

42.86%

39.31%

36.10%

34.09%

33.35%

T5option = 127

42.45%

39.07%

35.97%

33.98%

33.17%

Future 6

T5future
T future

T6option = 160

41.09%

38.03%

35.34%

33.56%

32.68%

Future 7

T7future

40.23%

37.35%

34.83%

33.14%

32.26%

Future 3
Future 4
Future 5

option
3

option
7

= 188

Table 2-2

Sometimes, however, participants may be interested in buying or selling options on futures

contract with longer dated maturities. To be more specific, they are interested in options

12

Particularities of the Commodities Market

expiring much earlier than their underlying futures contract, hence the name early expiry
options.
As an example, the WTI crude oil options with maturities beyond 1 year are only listed for the
maturity months of June and December. So, if the current month is July 2008, and a consumer
wants to hedge against an increase in price of oil in September 2009, he/she will not find the
appropriate call option in the exchange. He/she must buy an Over the Counter early maturity
option. In order to price that option, we need to know the early expiry implied volatility.
So, the problem at hand is the following:
Given a standard volatility matrix (in moneyness format) of future contracts on a certain
commodity, we need to generate an array of early volatility matrices (one early volatility
matrix per future).
Now the question is:
Given the standard volatility matrix shown in the table above, we need to find the volatility of

option on the future n as underlying, for all k smaller than n. In

k

the option with maturity T

other words, the problem is the one of generating, for each future, the following early
volatility matrix:
Early volatility matrix of future 5
Future

Futures
Maturity

Options maturity
(in days)

T1option = 6
Future 5

T5future

option
2
option
3

Moneyness
80%

90%

ATM

110%

120%

= 35

= 66

T4option = 97

42.45%

39.07%

35.97%

33.98%

33.17%

option
5

= 127

Table 2-3

13

Particularities of the Commodities Market

2.3 Methodology
To tackle this problem, we take two main assumptions:
Assumption 1: For a given commodity, ATM instantaneous volatility is stationary
By stationary, we mean that the instantaneous volatility does not depend on time but rather on
the distance to maturity.
Let T2 ! T1

If we denote :
the instantaneous implied volatility of option with maturity T1
V 1 (t )
at time t,  t [0, T1 ]
the instantaneous implied volatility of option with maturity T2
V 2 (t )
at time t,  t [0, T2 ]
then assumption 1 gives :
E{V 2 (T2  T1  t )}

E{V 1 (t )} and E{V 2 (T2  T1  t )}

2

E{V 1 (t )}
2

If we denote :
6 Tn
Ti , Tj

the average ATM volatility on the period [Ti, Tj] of the option whose standard
maturity is Tn

then assumption 1 gives :

T2

(6 TT 22  T 1, T 1 ) 2 .T 1

2
V 2 (t ) dt }

E{

T 2 T 1
T1

E{ V 1 (t ) dt}
2

T2

E{V 2 (t )} dt
2

T 2 T1

T1

E{V

2
1

(t )} dt

(6 T0,1T 1 ) 2 .T 1

T2
T 2  T 1, T 1

T1
0, T 1

In words, this means that seen from today, the volatility during the last month of the life of an
option is the same as the volatility of an option that expires in one month. Obviously, this
interpretation applies to all durations other than one month.
Visually,

14

Particularities of the Commodities Market

.
Same average ATM volatility
for the specified duration (T1)
T1

T1

T2

T1

T2

Same average ATM volatility

for the specified duration (T2)

T3

Assumption 2: For a given futures contract, the standard volatility smile is replicated in its
early volatility smiles. The reason for that is that traders believe it is the best estimate for the
early volatility smiles. They assume market participants will keep the same skewed
probability distribution for the underlying, independent of the options maturity.
Therefore, the methodology to generate an array of early volatility matrices is the following:
For future n, we first start by computing the ATM early volatilities based on assumption 1.
Then, we compute early ITM and OTM volatilities based on the previously computed early
ATM volatilities and assumption 2.

2.4 Numerical example

The following example better illustrates the algorithm. Suppose our standard volatility matrix
is the one shown in table 2-2. Suppose, moreover, that we want to fill the early volatility
matrix of future 5, shown in table 2-3.
Note that the last row is exactly the 5th row of standard volatilities given in the standard
volatility matrix. The remaining volatilities are to be calculated. We show in details the
calculation of the shaded volatilities
We first calculate the 66days early ATM volatility
According to the notation described in the previous section, the first volatility in question is:
127
0 , 66
We know that:
2
(127
0 ,127 ) u127

2
(127
0 , 66 ) u 66

2
(127
66 ,127 ) u 61

(1)

15

Particularities of the Commodities Market

61
By assumption 1, we have: 127
66 ,127 = 0 , 61
2
Formula (1) thus becomes: (127
0 ,127 ) u127

2
(127

0 , 66 ) u 66

2
( 61
0 , 61 ) u 61

Moreover, from the standard volatility matrix, we can directly read the following volatilities:

127
0,127 35.97%
66
0,66 37.09%
35
0,35 37.56%
35
Thus, by linear interpolat ion between th e couples (66 , 66
0,66 ) and (35 , 0,35 )
we find : 61
0,61 37.16%

So , 127
0,66

2
61 2
( 127
0,127 ) u127  ( 0,61 ) u 61
34.83%
66

Standard volatility given by the market

66

Early Volatility
(Unknown)

127

Volatility determined by interpolating standard

volatilities given by the market
(After assuming ATM volatilities are stationary)

Figure 1- Illustrating the assumption of stationary ATM volatilities

We now calculate the 66days early 80% volatility (the second volatility in question),
denoted by 80%
early
80%
80%
early
Standard
By assumption 2, we have:
(2)
ATM

ATM
early
Standard

16

Particularities of the Commodities Market

The right hand side of the equation can directly be read from the standard volatility matrix.
ATM , on the other hand, is calculated in the previous step
early
We therefore have:

42.45
80% 34.83u
%
early
35.97

41.10%

In the same fashion, the rest of the early volatility matrix is computed. The result is shown in
the table below.

Early volatility matrix of future 5

Future

Futures
Maturity

Options maturity
(in days)

T1option = 6
Future 5

T5future

option
2
option
3

Moneyness
80%

90%

ATM

110%

120%

41.84%

38.51%

35.45%

33.49%

32.70%

= 35

41.54%

38.24%

35.21%

33.26%

32.47%

= 66

41.10%

37.83%

34.83%

32.90%

32.12%

T4option = 97

41.83%

38.50%

35.45%

33.48%

32.69%

42.45%

39.07%

35.97%

33.98%

33.17%

option
5

= 127

Table 2-4

3 Options on Baskets
3.1 Pricing options on baskets
Options on a basket of underlying assets are very common in commodity markets. We can
imagine a consumer who uses both natural gas (Nat Gas) and crude oil (WTI) for the
manufacturing of his goods. This consumer would be interested in buying a basket call option
to hedge an increase in price rather than buying 2 separate call options, since it is cheaper to
do so. Certainly, this reduction in cost results from a weaker protection, since the basket call
option is only profitable when the average price exceeds the strike.
Mathematically, if we denote
Ft1,T

: the price at t of the futures contract 1 maturing at T

Ft 2,T

: the price at t of the futures contract 2 maturing at T

1
t

: spot price at t of underlying 1

2
t

: spot price at t of underlying 2

17

Particularities of the Commodities Market

Note that if the spot price is not readily available or accessible in the market, it is replaced
by the first nearby.
That is, we replace Sti by Ft i , first nearby in all what follows. This is the case for a lot of commodities,
like crude oil and natural gas.
Let us define the process :

A European call option on an equally weighted basket of underlying assets 1 and 2 has the
following payoff at maturity T :

Yt

1 Ft1,T Ft 2,T

 2
S0
2 S01

Payoff

(YT  K ) 

For an ATM call, we set K 100%

Using Jensen' s inequality and the fact that the price of a call option is a convex function of
the spot price, we can see that :

Callt (Yt ) d

1
2

1,T
Callt Ft 1
S

F 2 ,T

 Callt t 2
S0

The two most common ways of pricing basket options are:

1. Monte Carlo
2. Moment Matching
I will not address the first method since it is pretty straight forward. The next section will
describe the 2nd method.

3.2 Moment matching

We know that (under specific conditions), the product of 2 lognormal stochastic process is a
lognormal stochastic process. Their sum however is not. Empirical studies have shown that it
can be approximated as such without loosing a lot of accuracy when calculating the price of
vanilla options. The advantage is the speed of calculation compared to Monte Carlo.
So, if we assume Yt is a lognormal stochastic process, then B&S can be applied to determine
the value of a call on an equally weighted basket.

18

Particularities of the Commodities Market

In fact, B&S gives:

C0basket B(0, T ){ E0Q [YT ]. N (d1)  K . N (d 2) }
with

d1

E Q [Y ] 1 2
ln 0 T  V basket
T
K% 2
d2
V basket T

d1 V basket T

So, the two unknowns in the above equations are E0Q [YT ] and V basket .
Let :
M 1 E0Q [YT ]

1 F01,T F02,T
(
 2 ) Y0
2 S01
S0

( This is because the futures price is a martingale uner Q)

Now that we found the first unknown, let us try to find the second, V basket :
To do so, we have to pass by an intermediate step:
Let :
M 2 E0Q [YT2 ]

1
4

E0 Q { Ft1,T . Ft 2,T } E0 Q { ( Ft1,T ) 2 } E0 Q { ( Ft 2,T ) 2 }

2.




S 01 .S 02
( S 01 ) 2
( S 02 ) 2

But since the futures price is an exponential martingale under Q, and assuming V is deterministic,
we have :
Q

E0 { ( Ft1,T ) 2 }

1,T 2
0

2
To
o
1 T 2

 V 1 s .ds  V 1s .d W s

2
Q
0
0
. E0 e

F  . e
1,T 2
0

E0 { ( Ft 2,T ) 2 }

2 Vo1s .d Wo s

Q 0
E0 e

 V 2 s .ds
0

F  . e
1,T 2
0

V 1 s .ds
2

2
To
o

1 T 2
 V 2 s . ds  V 2 s .d W s

2
Q
0
. E0 e 0

F 
2 ,T
0

F  . e
2 ,T 2
0

 V 2 s .ds
0

2 Vo 2 s .d Wo s

Q 0
E0 e

F  . e
2 ,T 2
0

V 2 s .ds
2

19

Particularities of the Commodities Market

1,T

E0 { Ft . Ft

2 ,T

1,T
0

2 ,T
0

F .F

.e

1
V 1 2 s .ds
2

1
V 1 2 s . ds
2

.e

F01,T . F02,T .e
1,T
0

2 ,T
0

F .F

1
V 1 2 s .ds
2

T o o
V 1 V 2 .ds

.e 0

(Vo1s
Q 0
.E0 e

.e

1
V 1 2 s .ds
2

.e

 V 2 s ).d W s

o
1 o

V 1 s  V 2 s .ds
2

1,T
0

2 ,T
0

F .F

U V 1 V 2 .ds
.e 0

If we further assume for simplicity that V is constant, we get :

M 2 E0Q [YT2 ]

2
2
F 1,T
1
F 2 ,T
F 1,T . F 2,T
{ ( 0 1 ) 2 . e V 1 T  ( 0 2 ) 2 . eV 2 T  2. 0 1 02 . e U V 1 V 2 T
S0
4
S0
S0 .S0

(1)

Now that we found M2, we have to find a relation between M2 and V basket .
For any exponential martingale, and for Yt in particular, we have:
1

YT

Y0 .e

2
V basket

2
.T
V basket .W T  V basket

M
1
. ln 22
T
M1

M2

Y0 . e  V basket .T . E 0 {e
2

2.V basket .W T

} M 1 . e V basket .T
2

( 2)

Now that we found all the parameters we need, B&S formula can readily be applied.

3.3 Determining implied correlation

Sometimes the problem faced by traders is inverted. This means, they observe in the market
(namely brokers, since basket options are not traded on exchanges), prices of products called
dispersions.
A dispersion product between WTI and Nat Gas is the difference between the price of the
separate calls and the price of a call on a basket.
In other words:
Dispersion = 0.5 x ( Call(WTI) + Call(Nat Gas) ) Call(basket)
The trader can easily price the separate calls. So, given the dispersion price, the price of the
call basket is determined.
Once the call basket premium is determined, the B&S formula can be numerically inverted to
find the implied basket volatility, V basket .

20

Particularities of the Commodities Market

2

2
T
1 F01,T F02,T V basket
1  2 e
Then, from equation (2) above, we find M 2 M .e

2 S
S0
0
After determining M 2 , we have everything we need to determine the implied correlation

2
1

V2

basket

from equation (1). Rearraging equation (1) gives us :

2
2
F 2, T
1 F 1,T
M 2  [ ( 0 1 ) 2 . e V 1 T  ( 0 2 ) 2 . eV 2 T ]
4
S0
S0
ln{
}
1, T
2,T
1 F0 . F0
2 S 01 .S 02
V1 V 2 T

In most cases, the implied correlation turns out to be different than the historical correlation,
just like implied and historical volatilities are different. Implied correlation is interpreted as
the correlation the market is using to price basket options.
From equations (1) and (2), we can see that M2 is an increasing function of U , and V basket is
an increasing function of M2. We also know that the call value is an increasing function of
volatility. This shows that the price of a call basket is monotonically increasing with U .
So, if the market is pricing a high implied correlation, it means there is a common sentiment
that both underlying assets are going to increase together. This creates a high demand on call
baskets for hedging purposes, pushing their price higher.
Once this implied correlation is determined, it can either be used to price other basket options,
or it can be used to build a correlation matrix, which is in turn used to price basket options on
more than 2 underlying assets.

4 Digital options
4.1 Popularity of digital options
A European digital (or binary) option with maturity T and strike K on an underlying futures
contract FTt, is the option whose payoff at T is 1^F T t K `.
T

Digital or binary options are very common in the commodities market. They are used in the
pricing of popular payoffs, like European barrier options (knock in and knock out options).
The reason for that popularity is that the option structure disregards the highly improbable
events with very large payoffs, reducing the premium for the client.
An example of such a payoff is shown below:

21

Particularities of the Commodities Market

Payoff

25

50

75

100

125

150

175

Percentage
Moneyness

We can see that the investor is protected against the rise in the price of the underlying up to
the level of 175%, after which a rebate of 25% of the nominal is paid. Since this event is
considered as highly unlikely, giving away this payoff is not much of a problem for the
investor, and will reduce the overall cost of the structured product.
On the other hand, if the price drops, the client is not exposed to the downside loss unless the
drop is bigger than 25%. In the latter case, the investor experiences a 100% participation loss,
which is capped at 50% of the nominal.
The above payoff is easily structured using vanilla and digital calls and puts.
In fact, if we denote
N
C(K)
P(K)
DC(K)
DP(K)

Nominal amount invested in the structure

Vanilla call option with strike K
Vanilla put option with strike K
Digital call option with strike K
Digital put option with strike K

Payoff = P(50%) P(75%) 0.25 x N x DP(75%) + C(100%) C(175%) 0.5 x N x

DC(175%)

22

Particularities of the Commodities Market

4.2 Volatilitys impact on the price of a digital option

Unlike vanilla call options, the price of a digital call is not an increasing function of volatility.
This can be explained intuitively.
In fact, two cases are to be considered.
Case 1: The digital call is in the money (ITM)
In this case, the intrinsic value of the call is 1, but the time value is negative, since with time,
we risk to fall back below the strike. So, when the option is ITM, we want the volatility to be
as low as possible, ideally 0, to remain above the strike. Traders say they are short volatility.
Case 2: The digital call is out of the money (OTM)
In this case, the answer is not very obvious. It depends on how close we are to the strike price.
If we are very far below, we are long volatility. If we are very close below, we are short
volatility. Some calculations have to be made to determine the exact level at which digital
calls Vega changes signs.
Briefly speaking, the digital call option behaves differently than vanilla call options when it
comes to volatility. The reason is that the Digitals upside potential is limited.
Lets study the above results mathematically.
 rt .dt

DC 0 E 0Q e 0 .1^F T t K `
T

By changing to the forward neutral measure Q T , we get :

T

DC 0

B(0, T ) .E 0QT 1^F T t K `

FTT t K F0T .e

1
 V 2T  V .WT
2

B(0, T ). QT FTT t K

FT 1
ln 0  V 2T
K 2
K 1
t K V .WT t ln T  V 2T z t
V. T
F0 2

d2

where z ~ N(0,1)
So, DC 0

B(0, T ).QT ^z t d 2 ` B(0, T ). N (d 2 )

Now, we will study the first derivative of d2 with respect to volatility, which will directly give
us the behavior of the price since N(x) is an increasing function of x.

wd 2
wV

FT
ln 0
K
 2
V . T

1
T
2

23

Particularities of the Commodities Market

Case 1: The digital call is in the money (ITM)

FT
ln 0
K

wd
t 0 2  0
wV

So, the price of the digital call is always decreasing with volatility. (displays a -ve Vega)

ITM Digital Call Option (Moneyness = 150%)

1.2

Digital Call Price

0.8

0.6

0.4

0.2

145%

139%

133%

127%

121%

115%

109%

97%

103%

91%

85%

79%

73%

67%

61%

55%

49%

43%

37%

31%

25%

19%

7%

13%

1%

Volatilities

Case 2: The digital call is out of the money (OTM)

FT
ln 0
K

wd 2
 0 wV ! 0

wd 2  0
wV

FT
 ln 0
K
when V  2
T

otherwise

So, the price of the digital call is increasing with volatility. (+ve Vega) up to a certain point,
where more volatility will actually hinder the calls value.

24

Particularities of the Commodities Market

OTM Digital Call Option (Moneyness = 50%)

0.14
0.12

Digital Call Price

0.1
0.08
0.06
0.04
0.02

193%

185%

177%

169%

161%

153%

145%

137%

129%

121%

113%

97%

105%

-0.02

89%

81%

73%

65%

57%

49%

41%

33%

25%

9%

17%

1%

Volatilities

4.3 Smiles impact on the price of a digital option

Traders hedge digital call options by selling the replicating portfolio. The market standard is
to approximately replicate a digital call option with strike K by a vanilla call spread, centered
at K with a very small difference between the 2 strikes K1 and K2.
Payoff

K1 K

K2

Spot Price

25

Particularities of the Commodities Market

In practice, this replicating portfolio rarely has the same value as the formula for the price of a
digital call derived in the previous section. This difference is clearly seen when the volatility
smile is not flat.
Intuitively, when the volatility skew is upward sloping, the replicating portfolio consists of
buying a large number of calls with strike K1 and selling the same number of calls with strike
K2. Since C(K1) is priced with a volatility V1 a bit smaller than V2 ( which is used to price
C(K2) ), the replicating portfolio is worth less than the case where V1 = V2 (when the
volatility smile is flat). The opposite can be said when the volatility is downward sloping.
So, given the same parameters (Maturity, Strike, Volatility, and interest rates), and the
different volatility smiles shown below,
Volatilities
Smile 3

Smile 2
Smile 1

Strikes

We can say, DC(Smile 1) > DC(Smile 2) > DC(Smile 3)

To show this result mathematically:
DC S , K , V ( K ), T , r 

wC S , K , V K , T , r 
C S , K  H , V K  H , T , r 

H o0
2.H
wK
wC S , K , V , T , r 

dV K 
wC S , K , V , T , r 
.



dK
wK
wV
K 
V V K 








VV 
 Slope of volatility
lim

B ( 0 ,T ). N ( d 2 )

Vega of

Vanilla Call

First, we observe that when the smile is flat (B&S world), the slope is zero, and the equation
reduces to the formula obtained in the previous section.
Second, since the Vega of a vanilla call option is always positive, the price is only affected by
the sign of the slope parameter. In the case it is positive, the price decreases and vice versa.

26

smile

Particularities of the Commodities Market

5 References
1- Commodities and Commodity Derivatives: Modeling and Pricing for Agriculturals,
Metals, and Energy by Helyette ,Prof. Geman
2- Options, Futures and Other Derivatives, by John C. Hull
3- Commodity trade definitions and pricing, ECDA Analytics, Natixis
4- Interest Rate Models Theory and Practice, by Damiano Brigo Fabio Mercurio

27