Introduction
Commodities market has experienced significant turbulence in recent times, possible returns and diversification benefits offered by commodities have attracted some investor interest. Derivatives have an important role to play in encouraging a further activity on this market, and this requires wide availability of pricing tools to improve price transparency and investor confidence. However, in contrast to other markets, there is an absence of such pricing tools for commodity derivatives due to their inherent complexities and this is the impetus behind the idea of development of a Commodity Price Engine described in this post.
Situation
Recent fluctuations in demand for raw materials is expected to continue for some time. High volatility in commodities market has led to certain growth in the derivatives market as commodity producers and consumers sought ways to hedge against adverse price movements.
When used for hedging purposes, futures contracts remove the risk of unexpected losses by providing price certainty, but for the same reason they also preclude the possibility of profiting from favourable price movements. As participants become more sophisticated, they naturally turn to options and other derivatives that allow them to obtain more flexible hedges and speculative positions.
At present, participants in the commodity derivatives market comprises primarily of large producers and consumers of raw materials, who have little choice but to use derivatives, usually over-the-counter (OTC), to hedge their positions, and large financial institutions that have the capacity to acquire necessary pricing tools to service this demand. But as regulators push more of these “standard” OTC derivatives onto exchanges to ensure greater transparency and competition, the derivatives market will attract broader class of investors attempting to take advantage of the benefits offered by commodities.
Complication
Although some commodity derivatives are already listed on exchanges and many others are traded over-the-counter, investors interested in entering this market are confronted with issues such as limited liquidity, poor quality of market data, and the absence of accurate pricing tools. These contribute towards the lack of transparency in the way commodity derivatives are valued, which adds to the perception of risks associated with these derivatives.
Liquidity and the quality of market data can only improve with greater activity in these derivatives, and for this to occur there must be more transparency and confidence in the way prices are determined.
Unfortunately, commodity derivatives have inherent complexities that require more advanced pricing tools than those used for derivatives in other markets. Although such tools do exist, their availability is limited to large financial institutions, and are included only in high-end commercial financial software. In order for the derivatives market to flourish, investors need a better understanding of the salient features of commodity derivatives and, more importantly, require access to quantitative tools for independent valuation of these derivatives with higher degree of confidence.
Solution
Commodity Price Engine could implement advanced pricing models for commodity derivatives and deliver these through platforms including the web, smartphones, and tablets. Salient properties of commodity derivatives and observed volatility skews in the market would be fully incorporated into the models to provide accurate valuation and flexible delivery platforms would ensure that these tools are available anywhere with access to the internet.
For reliability and scalability Commodity Price Engine could be deployed on a cloud computing infrastructure and be accompanied by a distributed data server that cleans and smoothes market data. The former ensures that intensive pricing calculations are available even on devices with limited computing power, while the latter eliminates, for most users, the non-trivial task of obtaining reliable market data.
In order to handle large number of concurrent user sessions, Commodity Price Engine could be enhanced with grid computing capabilities to ensure valuation requests receive faster responses even for complex derivatives and large portfolios. These features would enable small to medium sized market participants to independently value and monitor their derivative portfolios with confidence.
Conclusion
Higher returns and diversification benefits of commodities provide attractive trading opportunities and market participants seeking more tailored solutions for their requirements are naturally led to derivatives. With regulators pushing to move standard OTC derivatives onto exchanges, the demand for derivatives have a good chance to increase. A necessary catalyst to transform this increasing interest into growth in market activity is accessible quantitative tools that help bring transparency to this market, and this is precisely the role that Commodity Price Engine may play.
