The History of a Pricing Pyramid

Long before there were futures, options, or any derivatives at all, there was always an active market for trading physical commodities. Producers of metals, agricultural staples, energy, soft commodities, and many other raw materials sold their output to consumers. The advent of organized markets gave way to the birth of a way for both producers and consumers to hedge price risk. As producers do not always want to sell at times or prices when consumers wish to buy, these markets expanded to include other participants. As prices move around due to supply and demand factors, speculators and investors appeared on the scene. Brokers, market makers, and arbitrageurs began facilitating business between all market participants.

Forward Trading

Physical trading, or cash trading, gave way to forward trading. Forwards allowed some market participants to hedge price risk for production or consumption. They also allowed others to speculate or invest in the future direction of prices. Forwards are a derivative, their value derived from the price of the underlying physical staple or commodity.

In a classic forward transaction, the buyer and seller transact with one another, each assuming the performance risk of the other. However, the liquidity in forward transactions was limited as contracts were very specific in terms of quantities traded, qualities of the various raw materials as well as other terms. Parties to each contract on a case-by-case basis negotiated these terms. Forward markets reflected price action in the physical markets.

Commodity Markets

As years went by commodity markets evolved. What followed was the concept of organized markets and futures contracts. The idea was to standardize terms to facilitate the ease of trading. Futures contracts first appeared on the scene in the 1730s in Japan. The Dojima Rice Exchange met the needs of samurai who received rice for their services and after a series of bad harvests needed to convert the rice to currency. The Chicago Board of Trade (CBOT) listed the first standardized futures contract in grain markets in the mid-1860s. Futures contracts have become popular derivative instruments in markets all over the world.

The first option was traded back in the year 332 B.C. when Thales of Miletus bought the rights to an olive harvest. During tulip mania in 1636, options traded to facilitate speculation in soaring tulip prices. From 1700-1733 these derivatives, put and call options, began trading in London; however, they were banned due to excess speculation from 1733-1860. In the late 1800s, over-the-counter options began trading in the U.S., and in the 1970s options on futures became popular on futures exchanges.

Options are the right but not the obligation to buy or sell (call or put option) at a specified price (strike price) for a specified period of time (expiration date). Options are another level of derivative product—in the world of commodities; all derivatives reflect action in the underlying price of the commodity that it represents.

The first swap was traded in 1981 when IBM and the World Bank entered into a swap agreement on interest rates. A swap is the exchange of a fixed price for a floating price on an underlying instrument. In commodities, most swaps are energy-related. Swaps and swaptions (options on swaps) are derivatives that have come under new and increased regulations in the U.S. since the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.

Exchange Traded Funds

Exchange-traded funds (ETFs) and exchange-traded notes (ETNs) began trading in the U.S. beginning in 1989. These instruments traded on equity exchanges allow market participants to trade vehicles that reflect the price of many assets, including commodities. Therefore, both ETF and ETN products derive from the prices of physical commodities themselves and are derivatives.

When it comes to derivatives in commodities, think of the ever-increasing universe of different types of these instruments (forwards, futures, options, swaps, and ETF/ETN products) as a pyramid of related market vehicles with the physical commodity at the top affecting all of these products designed to reflect price action of the source, the physical.