Commodities

Overview

Commodity Derivatives

For the purposes of pricing derivatives, commodity prices are usually modeled as geometric brownian motions , the same as for equities. That means that the frameworks for pricing commodity deriivatives is the same as that for equities. However, commodities have a cost and a yield associated with holding them. That is, when one owns a commodity (not a commodity derivative), one typically has to pay stoarge costs proportional to the amount of commodity held. This is cost to holding the commodity.

In addition, there is generally thought to be a benefit to holding the commodity, known as the convenience yield. The convenience yield is modeled as a monetary benefit that accrues to the holder of the commodity. In real life, the yield is theorectical, that is, one does not typically receive actual payments for holding a commodity, however, it is known that market players often prefer to have physical possession of commodities, even if they dont plan to utilize those commodities for some time. That is, there is a utility to holding the commodity.

The net effect of the storage costs and convenience yield associated with a commodity is that commodity derivatives are modeled just like equity derivatives, for equities that pay dividends. In this case, the appropriate yield that is used in place of the dividend yield is the convenience yield minus the storage costs.