Functional Requirements for Commodity Price Engine

Introduction

Commodity Price Engine is a derivatives sales tool and potentially a trading application designed specifically for the commodities market covering energy, base metals and agricultural products. It provides server based pricing and sensitivities for structures consisting of forwards and options that incorporate volatility skew and is designed to be delivered via the web and as native mobile applica- tions. The implemented functionalities in the prototype are detailed below, along with market data requirements and planned extensions.

Supported Underlying Assets

Commodity Price Engine supports any asset with forward curves and implied volatility surfaces. This includes exchange traded products with sufficient liquidity and products for which the user is able to supply the forward curves and volatility surfaces. A planned extension for Commodity Price Engine would build required curves and surfaces to accommodate structures on illiquid underlying assets.

Supported Derivatives and Valuation

Pricing and sensitivities are available for forwards, bullet and Asian options, and structures consisting of any combination of forwards and options. The valuation model takes into account volatility skew and has been benchmarked against commercial software used in investment banks. Price and sensitivities can be converted to any currency and standard metric units.

4. Sales and Trading Features

Commodity Price Engine would allow addition of sales and trading margins, shifting of forward curves and volatility surfaces for what-if analysis, solving for break even strikes for structures, generation of term sheets, and graphing of forward curves and payoff diagrams. It also would accommodate back-dated pricing for available historical data.

5. Planned Extensions and Enhancements

Additional features that are planned for Commodity Price Engine include:
- Construction of illiquid forward curves and implied volatility surfaces.
- Calculation of credit value adjustment (CVA).
- Computation of value-at-risk (VaR).

6. Market Data Requirements

Commodity Price Engine assumes availability of the following market data:
- Yield curves for required currencies (it would be possible to bootstrap yield curves from cash, futures, OIS, swap, and single currency basis swap quotes).
- Forward curve and implied volatility surface (it is possible to build volatility surfaces from market quoted option prices) for required underlying assets.
- FX forward curve and volatility surface for required currency pairs.
- Implied survival probabilities for relevant entities if CVA calculation is required (it would be possible to compute the survival probabilities from yield curves and credit default swap (CDS) spread quotes).
- Historical data for above if VaR calculation is required.
Market data can be obtained from commercial data vendors such as Bloomberg or Reuters (commodities data from such market data sources as ze.com will need to be supplemented by interest rate, FX, and credit data).

7. Technology Architecture

Commodity Price Engine architecture consists of server and client side components. The server side manages market data and could be loosely coupled with a grid of quantitative pricing libraries. The client side is the Graphical User Interface (GUI) that communicates with the server via secure protocol and could be accessed from desktops or a variety of mobile devices. Pricing libraries could be placed on the client side if required.

8. Conclusion

Commodity Price Engine would be a sales and trading application designed for participants in the commodities market who traditionally relied on investment banks for pricing support due to limited access to suitable tools. It would have the capacity to become a full-scale trading platform if supplemented with modules for connecting to trade booking and counterparty portfolio management systems.