Overview
Similar to other asset classes, commodities have derivatives that are actively traded. The derivative markets provide a way for both the producers and consumers of commodities to hedge their exposure. Probably the most common derivative used for this purpose it the commodity future or forward.
Plain vanilla derivatives such as calls and puts are also commonly traded.
Commodity derivatives are priced using the same framework that is common for equities. Just as with equities, commodity prices are usually modelled as geometric brownian motions. The mathematics for valuing commodity derivatives mostly just carries over from the equity case, However, there are some subtleties.
Commodity Yield
Commodities are typically thought to a yield associated with holding them. in the first place, holding a commodity incurs storage costs. (that is, a negative yield) Storage costs can generally be assumed to be proportional to the amount of commodity.
In addition, there is generally thought to be a benefit to holding the commodity, known as the convenience yield. The convenience yield is modelled 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 modelled 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.