Short Explanation- Behavioural Economics

Behavioural Economics Definition

Behavioural Economics is a part of economics that happens to be a blend of what the users know about human psychology and what they know about economics and with this concept, it becomes easier for users to simplify decision-making mechanisms and construct economic models that can be easily understood.

Short Explanation

Ever heard about Robert Shiller, Dan Ariely, and Daniel Kahneman? These are probably the three most popular names in the field of Behavioural Economics and Finance. Life is about decisions and both finance and economics make us think deeper. Ultimately the subject of Behavioural Economics helps us understand why so-called “rational people” like us make decisions the way we do. At first, you might think this is a theoretical subject which is boring as theory subjects in general – remember your school days? In fact, its underpinnings come from mathematical constructs that are rooted in advanced subjects like probability theory. This article is sure to have quite some calculations and numbers not just because I don’t want to make it theoretical, but make you understand your decisions with examples. Personally, this is one of my favourite subjects and is rooted in philosophy and math – what better combination can you think of!.

Simple Example of Behavioural Economics

Ever bargained at a shop? Well, Indians are considered to have a fascination for bargaining in general at least – sort of stereotyping it. If you don’t like the word, go with ‘negotiation’. You may or may not be good at it but it doesn’t change the fact about bargaining. Worse, some even bargain against MRP on the sticker and get the better of everything due to their superior skills. Why do people do so? Simply because you feel that the item is worth lesser than is actually being quoted by the seller for whatever purpose it is! This is not even because the seller wants to make a bigger profit from it.

This is probably a simple yet deep concept in behavioural economics just as an example. So let’s look at some areas we might touch upon in daily life and how it is related to behavioural economics.

Utilitarianism in Behavioural Economics

In simple words, people purchase and make use of things that add the maximum utility to them or the maximum benefit. You would choose 2 apples and 1 orange over 1 apple and 1 orange if it gives you the maximum benefit. But of course, at some point, you stop looking just at benefits added – 100 apples and 100 oranges are not likely to give you the greatest benefit unless you are sure to sell many of them at a higher price. In a way, the underlying theory is that money is a great equalizer and money can buy happiness.

At the same time, when costs are involved in doing an activity, one compares the benefit to the cost and chooses the point where the difference is the highest. It is also true that what we perceive to be of maximum utility is what any rational person would do – assumed to be rational decision making.

Risk-taking and Prospective Outcomes

This deals with how a situation is put up for us to deal with. It depends on the way the subject is conveyed. You can look at a situation in terms of gains or in terms of losses:

You have $100 to shell out. There are stocks of companies which I recommend to you both of them worth $100. I present you with two alternatives and you are forced to choose one of them:

1. Company A’s stock will surely pay you back $20 as dividend
2. You have a 20% chance of making $100 on the stock increasing and an 80% chance of making nothing ($0 since the stock won’t move) if you want to go with Company B’s stock

Assuming I give you the above information with certainty and that the choices are mutually exclusive, which would you choose? Seems pretty easy you’d choose Company A’s stock because it guarantees $20 right! Company B looks suicidal in nature. But statistically and mathematically, the expected return you would get is the same $20 ([20% x 100] + [80% x 0]).

Thus B looks equally good as A isn’t it! You may still not be convinced and can argue by saying that A gives the same outcome with certainty while B doesn’t. So, you would go with the least risky alternative provided.

How about the same question with the following alternatives (not the two presented earlier).

1. Company A’s stock will surely lose $80
2. You have an 80% chance of losing $100 on the stock dropping and a 20% chance of losing nothing ($0 since the stock won’t move) if you want to go with Company B’s stock

You’d choose Bright? It gives you an effect of losing less although it is quite risky by nature. Though you aren’t gaining anything you would not like to lose money – you dislike losses.

The situation involving gains (former example) gave you a sense of risk aversion and the latter, that of loss aversion. The outcomes of both mathematically give the same results! You could conclude that robots without human intelligence would’ve tossed a coin and chosen whatever the outcome would’ve been – indifferent between both. Humans make “smarter” choices!!

Bounded Rationality in Behavioural Economics

This is a seriously interesting topic! As the words say, we assume humans make rational decisions. But these decisions are made given certain constraints. This is why some make decisions that differ from others. Why would you choose a Starbucks coffee versus one from Barista or an Ariel versus a Tide detergent? The first one may depend on the taste – and argument accepted. The second? Both might clean equally well. You may choose one over the other just at random since you’re indifferent or because one of them may not be available in the shop. These reasons aside, you might have more information, a different experience, a feel of after-sales support, quick and perfect feedback, etc. about one brand versus another. Thus decisions made like these are relative to the environment in which we are put and in which these products came.

At the same time, it is not the smartest assumption that humans decide rationally. Dan Ariely wrote a book titled “Predictably Irrational.” He gives a simple example that goes somewhat like this. Chocolate which is given free is more attractive relative to chocolate that costs $0.20 than chocolate given for $0.01 which costs $0.21 – disproportionate attraction. The price difference in both cases is the same at $0.20. Guess what, some of us may go ahead with the free chocolate even if the difference in the second case was higher. Price is generally considered an indicator of quality but we still make such choices.

Money and Time

Money has some value associated with it. This leads to the concept of present values, future values, and discounts. A dollar today is worth more than the same dollar tomorrow since interest is added to the value of the dollar. Tomorrow also depends on how far tomorrow is from today. If interest rates are at 10% p.a. and doesn’t change, $100 today will be preferred over the same amount one day from now and given choices between receiving $100 one day from now versus one year from now, you know for sure what you would want.

The Gut Feel

This one would test you! If a bat and ball cost $1.10 and the bat costs $1 greater than the ball, how much would the ball cost? $0.10 is sadly not the right answer. If the ball did cost $0.10, then the bat should cost $1.10 to be $1 more than the ball whereas it is currently only $0.9 more than the ball. The bat doesn’t cost $1 but $1 more than the ball.

Let the cost of the ball and the bat be ‘x’ and ‘x+1’

So, x + x + 1 = 1.10

• 2x = 0.10
• x = 0.05

The ball would cost $0.05 and the bat would cost $1.05.

Don’t worry if you got it wrong. Around 50% of the students at Harvard got the answer wrong if you would like to keep Harvard as your benchmark to keep you sane for longer. We might even tend to make such decisions in real life!

The outcome of the above test was meant to study how people respond to situations. Those who gave the answer as $0.10 tended to be more intuitive by nature while those who answered it as $0.05 were more analytical by nature. This could even reflect in our purchasing behaviour and daily life, be it cornflakes vs muesli debate or anything else.

Salient Goods and Salience

What is salience? It’s a form of behaviour where the most recent information or knowledge got stays longer in our memory due to which we remember them more often than older information and influence our decisions and actions. Here is an example.

Just as in many other countries, the major indicator of inflation in India is the CPI. CPI inflation is determined by taking surveys from individuals and households. It is believed that people mention during the survey that their measure of inflation is very high. When asked why they say that it is the price of ‘Pulses’ that they buy which makes them feel so since the price of pulses has been going up continually. They do not factor in how overall inflation reduction has led them to have greater personal disposable income. Here, pulses are salient goods since it was probably the last thing they bought and is a commodity they keep buying where they can clearly gauge the rise in price. There are different degrees of salience that are observed and several studies have gone deep into this.

Status Quo in Behavioural Economics

There are times we aren’t willing to change our mindset. This may be due to past experiences or just due to the way we actually are. Even without trying a sizzler or a taco, we think that pizzas are the best food item. We might not even listen to a connoisseur and fail to adapt to change. Only if the incentive to change our behaviour is so strong will we be willing to change – status quo bias.

The Ego Factor and being consistent

Whether you like it or not, you just have to accept this. Yeah, it is quite spiritual in a subject but just cannot be ignored. We as humans tend to think positively of ourselves as people. This carries further into an adamant nature to change or listen merging into ego problems. Your junior might make a better suggestion than a superior, but the fact that he’s a junior doesn’t allow the superior to admit that he made a better suggestion. When this is pushed a bit further, the superior ensures that he consistently behaves in such a way. The big risk, of course, is that the decision made by the superior due to his consistency of living up to his ego/image may blow up and cause a deeply negative impact overall.

Conclusion

There’s quite some material covered and a lot of examples to support each kind of behaviour and is not an exhaustive list, but a mere introduction into what you may encounter. The essence is that humans think they are rational while making choices. We think that a decision made by us was the smartest that could be. We have a predisposition to think that we are smart and make smart choices but do not realize that there could’ve been smarter and better decisions that we could make. Well, it is not so much due to our ego that we behave in such ways, but based on our behavioural tendencies rooted from past experiences, a pool of choices, limited thinking, etc.

The more difficult part is that even if we think and try to alter our decisions from now on, there is no guarantee that we will make the best decision. What is good enough is to be aware of this constantly when we make decisions because it will not only make us appreciate behavioural economics better but may also be a better reflection about ourselves in the future. This can even help reduce the number of arguments we have outside and at home on a deeper angle. Think about it!

A Detailed Understanding of Macroeconomics.......

What is Macroeconomics? | Top Terms in Macroeconomics

This is probably the more fascinating subject among the two branches of economics – micro and macroeconomics. This contains the global picture, a bird’s eye view and to me, has a lot more interesting aspects to think about. I would choose macro over microeconomics any day. So what’s with macroeconomics?

• What is Macroeconomics?
• Grossly Important – GDP and GNI
• Schools of Economic Thought
• Consumption (C); Investment (I); Government Spending (G) and; Net Exports (X-M)
• The Nation’s Accounts – Balance of Payments (BoP)
• Conclusion

What is Macroeconomics?

Macroeconomics is a ‘top-down’ approach and is in a way, a helicopter view of the economy as a whole. It aims at studying those aspects and phenomena which are important to the national economy and world economy at large. To mention a few of them are the country’s GDP (Gross Domestic Product) growth; inflation and inflation expectations; the government’s spending, receipts, and borrowings (fiscal policies); unemployment rates; monetary policy, etc. (also have a look at Fiscal vs Monetary Policy)

These can help understand the state of the economy, formulate policies at an influential level and conduct macroeconomic research.

John Maynard Keynes is widely regarded as a pioneer in macroeconomics. In fact, it is almost as if macroeconomics owes a lot to him. His understanding of macroeconomics so to speak was influenced by the Great Depression of the late 1920s. In the late 1930s when the Great Depression was nearing its end, Keynes came up with a piece of seminal research, ‘The General Theory of Employment, Interest and Money’ which focused on observing the depression and formulating the field of macroeconomics – the work and its offshoots are considered as Keynesian economics.

Another great macroeconomist and a Nobel Laureate, Milton Friedman also did a study on the Great Depression and debated the earlier premise Keynes – this piece and its offshoots form part of Monetary economics,

While Keynes explained the Great Depression through aggregate demand, expenditure, levels of income, government financing and rates of unemployment, Friedman explained the event through monetary stances – higher interest rates, contractionary monetary policy, a banking crisis and disinflation to deflation.

When we study macroeconomics, we must familiarize ourselves with certain ubiquitous terms and more importantly, what they mean. Once we appreciate the theory, we get a sound understanding of the global events that affect everyday life. So let’s get to it!

Top Terms in Macroeconomics

#1 – Gross Domestic Product (GDP)

This is the value in terms of money, of all the goods and services that are produced domestically (within the nation). Why is this important? The country’s actual worth is determined by its ability to produce domestically – that it makes use of the resources available within it to make widgets that people are willing to spend for. Thus it measures the level of economic activity in the country.

#2 – Gross National Product (GNP) aka Gross National Income (GNI)

This too measures the level of economic activity in a country and is very similar to GDP. The difference is that another component known as ‘Net Factor Income from Abroad’ (NFIA) is added to the value of GDP.

Factor Income is the income received from the four factors of production namely: Land, Labour, Capital, and Entrepreneurship. This factor income can be received from abroad by utilizing the factors of production and remitting incomes, paid abroad by having foreign companies utilizing the factors of production in your country or both. Netting both of them (factor income received minus factor income paid) we get NFIA.

Thus GNP is also a measure of a nation’s economic activity but GDP is more often used for different reasons.

GNP = GDP + NFIA

Demand and Supply in Macroeconomics

Where beauty lies in the eyes of the beholder

In general, there are considered to be two schools of economic thought: ‘demand-side’ and ‘supply-side’. This is very widely debated and economists generally fall into one of these categories. This is even more visible when it comes to macroeconomics than microeconomics. Here, demand and supply mean a broad range of things since both of them are aggregate by nature.

Demand-side economics which Keynes advocates try to impact real GDP by increasing aggregate demand. Measures like improving income/wage levels, stable unemployment, government spending to boost the spending abilities of the people, industry and corporate investment in capital goods and other factors.

Supply-side economics tries to impact real GDP by increasing aggregate supply. Measures like adjusting tax rates, deregulation, infrastructure support, benefitting educational levels, privatization and a number of others form part of supply-side economics.

Broadly speaking, GDP and thus GNP can be said to comprise the following four fundamental components of the aggregate demand side of economics.

Consumption (C); Investment (I); Government Spending (G) and; Net Exports (X-M)

Private consumption of goods and services forms part of Consumption (C) which is how much households expend to purchase final goods and services and not intermediate ones. Examples of final goods and services are cars, refrigerators, milk purchased by households and they’re like. Intermediate goods are those which can be used for further production or can be resold. Examples include the milk shop purchasing the milk which we consider as a final good etc. The curd we buy from the shop is a final good unless the milk made by us using the curd is meant to be sold. Thus they are distinguished based on their use and not based on the product itself.

Investments (I) include purchases of machinery, equipment, capital-intensive purchases, households’ spending on homes, etc. Buying shares of companies doesn’t form part of the above mentioned ‘investment’ nor do change hands of assets which we already have with us.

Government Spending (G) as the name suggests talks about public spending which shows itself in different forms like expenditures on the defence sector; building roads, public schools, and hospitals, etc. Although the government does spend on unemployment benefits etc. in some countries like the US these don’t count in the calculation of aggregate demand for GDP.

Net Exports (X-M) is Exports (X) minus imports (M). There’s no need for an explanation for that! Net Exports are similar to Balance of Trade (BoT) but a subtle point to note is that balance of trade includes exports and imports only of goods (goods are also known as ‘visible items’ in macroeconomics while services are known as ‘invisible items’). In the modern age, services are increasingly forming a major part of one’s economy. Have a look at how many IT companies are already there, the apps you use and whatnot.

Thus, GDP consists of all the above components. I am sure you would allow me to write it as:

GDP (Y) = C + I + G + (X-M)

Macroeconomic – Balance of Payments (BoP)

We looked at the Balance of Trade a while ago. A country also maintains its Balance of Payments (BoP). BoP is simply an overall record of the receipts and payments of a country with the other countries. Typically transactions made by consumers, corporates and the governments of one country with the others’ are recorded.

There are two types of accounts that every nation has. The ‘Current Account’ and ‘Capital Account.’ Let’s have a look at what they are:

Current Account

The Current Account (CA) of a country is a record of the monetary value of its exports and imports (goods, services, and unilateral transfers) and forms part of the BoT. When the exports are greater than its imports, its current account records a surplus and when exports are lesser than its imports, it records a deficit – quite obvious! These are generally short-term transactions. The US, UK, India and a majority of the countries in the world run a current account deficit. Japan and Germany are a few examples of nations running a current account surplus.

Just to put this in an equation’s perspective,

CA = Net Exports of goods and services + Net unilateral transfers + NFIA

Capital Account

This is a record of the monetary value of purchases of foreign assets and liabilities like sovereign debt, investments made by and into the country, corporate debt from abroad, etc. although I wouldn’t like to elaborate too much on this, the talk about Foreign Direct Investment (FDI) and Foreign Portfolio Investment (FPI) into countries and the building up of FX Reserves (like buying US government debt and thus, dollars) to stabilize a country’s currency falls into the capital account.

Cap A/C = Net FDI + Net FPI + Net of other Portfolio flows (debt flows etc.) + change in reserves

If you are familiar with accounts, this is like a company’s balance sheet which has an assets and liabilities side where both should tally and the difference be zero.

BoP = CA + Cap A/C

• The above should be equal to zero.
• If CA > Cap A/C the country faces a Current Account Surplus or a Capital Account Deficit
• If CA < Cap A/C the country faces a Current Account Deficit or a Capital Account Surplus

Conclusion

Guess you got familiar with some basic understanding of macroeconomics from the above stuff. Take the financial newspaper or financial magazines of your country be it the Financial Times, Wall Street Journal, The Economic Times, The Economist or; take books written by economists like Dr.Nouriel Roubini, Dr Raghuram Rajan and many others, I am pretty sure you will find at least one article or page making a mention about any or all of the above concepts.

A Detailed Understanding of Commodity Derivatives Market....

Commodity Derivatives Definition

Commodity Derivatives are the commodity futures and commodity swaps that use the price and volatility of price in underlying as the base to change in prices of the derivatives so as to amplify, hedge, or invert the way in which an investor can use them to act on the underlying commodities.

In economics, a commodity is a marketable item produced to satisfy wants or needs. The commodity is generally Fungible (Fungibility is the property of a good or commodity whose individual units are capable of being substituted in place of one another). For example, since one ounce of pure gold is equivalent to any other ounce of pure gold, gold is fungible. Other fungible goods are Crude oil, steel, iron ore, currencies, precious metals, alloy, and non-alloy metals.

In this article, we are going to discuss commodity derivatives including Commodity Forwards, Commodity, Futures, and Commodity Options.

• Commodity Trade
• Example of Commodity Derivative instrument
• Commodity Spot contract & how to calculate the return
• Commodity Forward contracts
• How Forward Price of Commodity is determined?
• Commodity Futures contracts
• Commodity Options contracts

Commodity Trade

A commodity market is a market that trades in the primary economic sector rather than manufactured products.  Soft commodities are agricultural products such as Wheat, coffee, sugar, and cocoa. Hard commodities are mined products such as gold and oil. Futures contracts are the oldest way of investing in commodities. Futures are secured by physical assets. Commodity market can include physical trading in derivatives using spot prices, forwards, futures, and options on futures. Collectively all these are called Derivatives.

Example of Commodity Derivative instrument

There is a concert of Coldplay happening in an auditorium in Mumbai next week. Mr X is a very big fan of Coldplay and he went to the ticket counter but unfortunately, all the tickets have been sold out. He was very disappointed. Only seven days left for the concert but he is trying all possible ways including the black market where prices were more than the actual cost of a ticket. Luckily his friend is the son of an influential politician of the city and his friend has given a letter from that politician to organizers recommending one ticket to Mr.X at the actual price. He is happy now. So still 6 days are left for the concert. However, in the black market, tickets are available at a higher price than the actual price.

So, in this example, the letter of that influential politician is an underlying asset and the value of the letter is the difference between the “Actual price of the ticket” and “Ticket price in the black market”

Day	Actual price (a)	Price in the black market (b)	Value of underlying instrument(Letter of Politician)[(a)-(b)]
Day- 1	500	600	100
Day- 2		700	200
Day-3		800	300
Day-4		900	400
Day-5		1000	500
Day-6(Day of the concert)		0	0

n this example, the derivative contract is the compulsion of the organizers to provide tickets at a normal price based on the letter of the politician. A derivative is the letter of the politician, Value of derivative is the difference of actual and price in the black market. The value of an underlying instrument becomes zero on the due date/honouring of the contract.

I hope you now understand what the derivative contract is. Commodity contract is being traded-in both spot and derivative (Futures/options/swaps) now let us understand how to calculate the returns from various commodity contracts in both spot and derivative trade.

Commodity Spot contract & how to calculate the return

A spot contract is a contract of buying or selling a commodity/security/currency for settlement on the same day or maybe two business days after the trade date. The settlement price is called a spot price.

In the case of non-perishable goods

In the case of nonperishable goods like gold, metals, etc, spot prices imply a market expectation of future price movements. Theoretically, the difference between spot and forward should be equal to finance charges plus any earnings due to the holder of security (Like dividend).

For example: On a company stock the difference between the spot and forward is usually the dividends payable by the company minus the interest payable on the purchase price.  In practicality, the expected future performance of the company and the business/economic environment in which a company operates also causes differences between spot and futures.

In the case of perishable/soft commodities:

In the case of perishable commodity, the cost of storage is higher than the expected future price of a commodity (For ex: TradeINR prefer to sell tomatoes now rather than waiting for 3 more months to get a good price as a cost of storage of tomato is more than the price they yield by storing the same). So in this case, the spot prices reflect current supply and demand, not future movements. There spot prices for perishables are more volatile.

For example, Tomatoes are cheap in July and will be expensive in January, you can’t buy them in July and take delivery in January since they will spoil before you can take advantage of January’s high prices. The July price will reflect tomato supply and demand in July. The forward price for January will reflect the market’s expectations of supply and demand in January. July tomatoes are effectively a different commodity from January tomatoes.

Commodity Forward contracts 

A forward contract is simply a contract between two parties to buy or to sell an asset at a specified future time at a price agreed today.

For example, A trader in October 2019 agrees to deliver 10 tons of steel for INR 30,000 per ton on January 2020 which is currently trading at INR 29,000 per ton.  In this case, trade is assured because he got a buyer at an acceptable price and a buyer because knowing the cost of steel in advance reduces uncertainty in planning. In this case, if the actual price on January 2020 is INR 35,000 per ton, the buyer would be benefitted from INR 5,000 (INR 35000-INR 30,000). On the other hand, if the price of steel becomes INR 26,000 per ton then the trader would be benefitted by INR 4,000 (INR 30,000- INR 26000)

The problem arises if one party fails to perform. The trader may fail to sell if the prices of steel go very high like for example INR 40,000 in January 2020, in that case, he may not be able to sell at INR 31,000. On the other hand, if the buyer goes bankrupt or if the price of steel in January 2020 goes down to INR 20,000 there is an incentive to default. In other words, whichever way the price moves, both the buyer and seller have an incentive to default.

How Commodity Forward Price is determined?

Before going determined how to calculate Forward price let me explain the concept of forwarding spot parity

The “forward spot parity” provides the link between the spot and forward markets for the underlying forward contract.  For example, if the price of steel in the spot market is INR 30,000/tonne and the price of steel in the forward market is definitely not the same. Then why is the difference???

The difference is due to many factors. Let me generalize the same in simple terms.

1. A major factor of difference is storage cost from today to till the date of a forward contract, It generally takes some cost to store & insure the steel, Let us take 2% p. a cost is the cost of storage & insurance of steel
2. Interest cost, for example, is 10% p.a

Therefore parity implies

Forward(f) = Spot(s) * Cost of storage * Interest cost

So in this case 3 months forward will be INR 30,000+ (INR 30,000*2%*10%)*3/12= INR 30,900

But INR 30,900 may not be actual forward after three months. It may be less or more. This is due to the following factors INR.

1. Market expectations of commodity due to variations in demand and supply (If the market feels commodity may go up and traders are bullish about commodity, then forward prices are higher than forwarding parity price, whereas, if the market feels that prices may go down then forward prices may be lesser) The expectations are mainly dependent on demand-supply factors INR.

2. Arbitrage arguments:  When the commodity has plentiful supply then the prices can be very well dictated or influenced by Arbitrage arguments. Arbitrage is basically buying in one market and simultaneously selling in another, profiting from a temporary difference. This is considered a riskless profit for the investor/trader. For example, if the price of gold in Delhi is INR 30,000 per 10 grams and in Mumbai gold price is INR 35,000 then arbitrageur will purchase gold in Delhi and sell in Mumbai

3. Regulatory factors Government policies on commodities may be a major factor in determining prices. If the government levies taxes on imports of steel, then domestic steel prices will go up in both spot and forward markets

4. International markets: The prices of commodities in international markets to some extent influence commodity prices in spot and forward markets.

Now let us go into futures contracts…….

Commodity Futures contracts

What is a Futures contract?

On a simple sense futures and forwards are essentially the same except that Futures contract happens on a Futures exchanges, which act as a market place between buyers and sellers.

In the case of futures, a buyer of a contract is said to be a “long position holder” and a seller is “Short position holder”. In the case of futures, to avoid the risk of defaulting contract involves both parties lodging a certain percentage margin of the value of the contract with a mutually trusted third party. Generally, in gold futures trading, the margin varies between 2%-20% depending on the volatility of gold in the spot market.

How futures Price are determined?

The pricing of futures contracts are more or less the same as forwards as explained above

Futures Traders:

Futures traders are generally Hedgers or speculators. Hedge traders generally have an interest in the underlying asset and are willing to hedge the commodity/currency/stock for risk of price changes

For example, A steel manufacturer importing coal from Australia currently and in order to reduce the volatility of changes in prices he always hedges the coal purchases on a 3 monthly forward contract where he agrees with the seller on day one of the financial quarter to supply coal at defined price irrespective of price movements during the quarter. So in this case, the contract is forward/future and the buyer has an intention to buy the goods and no intention of making a profit from price changes.

Speculators

These one make a profit by predicting market moves and opening a derivative contract(Futures or forward) related to the commodity and while they have no practical use of the commodity or no intention to actually take or make delivery of the underlying asset.

Commodity Options contracts 

An option is a contract that gives the buyer (Who is the owner or holder of the option) a right, but not the obligation, to buy or sell an underlying asset at a specified strike price on a specified date, depending on the form of the option.

The strike price is nothing but a future expected price determined by both buyer and seller of the option of the underlying commodity or security. The strike price may be set by reference to spot price of underlying commodity or security on the date of purchase of an option or it may be fixed at a premium (More) or discount(Less)

Let’s say that on Oct 1, the stock price of Tata steel is INR 250 and the premium (cost) is INR 10 per share for a Dec Call the strike price is INR 300. The total price of the contract is INR 10 x 100 = INR 1,000. In reality, you’d also have to take commissions into account, but we’ll ignore them for this example.

Remember, a stock option contract is the option to buy 100 shares; that’s why you must multiply the contract by 100 to get the total price. The strike price of INR 300 means that the stock price must rise above INR 300 before the call option is worth anything; furthermore, because the contract is INR 10 per share, the break-even price would be INR 310(INR 300 + INR 10).

When the stock price is INR 250, it’s less than the INR 300 strike price, so the option is worthless. But don’t forget that you’ve paid INR 1000 for the option, so you are currently down by this amount.

In December if the stock price is INR 350. Subtract what you paid for the contract, and your profit is (INR 350- INR 310) x 100 = INR 4000. You could sell your options, which is called “closing your position,” and take your profits – unless, of course, you think the stock price will continue to rise.

On the other hand by the expiration date, if the stock price drops to INR 230. Because this is less than our INR 300 strike price and there is no time left, the option contract is worthless. We are now down to the original investment of INR 1000 (INR 10*100).

Valuation or pricing of an Options contract:

The value of an option can be derived using a variety of quantitative techniques. The most basic model is the Black Scholes model.

In general, standard option valuation models depend on the following factors.

1. The current market price of an underlying security
2. The strike price of the option (In relation to the current market price of the underlying commodity)
3. Cost of holding a position of the underlying security( Incl Interest/dividends)
4. Estimated future volatility of the underlying security price over the life of the option.
5. The time to expiration together with any restrictions on when exercise may occur.

I hope now you understand what are commodity derivatives (Forwards/Futures/Options) and pricing mechanisms.