Life in the commodity markets is based on many forms of arbitrage or relative pricing. Arbitrage determines price in the context of other prices. Of course, arbitrage tells us something about commodity price relative to other market and not completely about valuation. Relative value arbitrage will tell you about prices differences but not true value; nevertheless, relative value is often the process engaged by most fundamental commodity traders.
As an aside:
Stephen Ross's words that "All it takes to turn a parrot into a learned financial economist is just one word - arbitrage".
Larry Summers pointed out in his wonderful parody of financial economics "Traditional finance is more concerned with checking that two 8oz bottles of ketchup is close to the price of one 16oz bottle, than in understanding the price of the 16oz bottle".
We identify a number of arbitrages that exist through commodities. We will explain and provide examples of types that can be traded or exploited in the futures markets. This does not include all of the combination that may exist in the cash market, but this set provides a robust number of examples of arbitrage.
As an aside:
Stephen Ross's words that "All it takes to turn a parrot into a learned financial economist is just one word - arbitrage".
Larry Summers pointed out in his wonderful parody of financial economics "Traditional finance is more concerned with checking that two 8oz bottles of ketchup is close to the price of one 16oz bottle, than in understanding the price of the 16oz bottle".
We identify a number of arbitrages that exist through commodities. We will explain and provide examples of types that can be traded or exploited in the futures markets. This does not include all of the combination that may exist in the cash market, but this set provides a robust number of examples of arbitrage.
Quality arbitrage - the relative price of different grades or quality within futures markets. In the cash market, quality or grade is priced as premium or discount versus a standard grade which will be the futures contract traded. Still, there are quality arbitrages across futures. The driver of quality arbitrage will be a shortage or oversupply of the grade of commodity.
Agricultural markets:
In the case of wheat, there are a number of futures contracts which do not represent the same grade. If there is a shortage, there will be a greater premium for high protein wheat which is used for human consumption. Hence, KC - Chicago spreads will widen when inventories are low or stock to use is low. Kansas city wheat versus Chicago wheat will be an arbitrage based on protein content of the wheat. Kansas City versus Minneapolis or Chicago will also based on type of wheat priced. LIFFE Millers wheat versus Chicago wheat are different grades, (additionally a location difference).
There are differences in coffee quality between Robusta and Arabica. Arabica coffee represent higher quality beans while Robusta beans will be almost like a shrub row crop and not as flavorful. If incomes increase, there will be a higher demand for Arabica beans.
Metals:
There is little quality difference in the industrial and precious metals futures markets between the London and New York markets. However, the specs for each contract are slightly different.
Energy:
There are grade differences between brent and WTI but the main differences are locational; nevertheless, WTI will be a light sweet crude while oil coming from most parts of the Middle East will be more sour and heavier.
Locational or geographical arbitrage -
Locational differences are associated with delivery points but more importantly, they can be associated with production or growing locations. Delivery points and contract trade locations means there is not a perfect arbitrage and currency differences can lead to risk unrelated to the underlying commodity.
Agricultural markets:
There are dual NY versus London contracts in coffee, cocoa, and sugar. The delivery differences will be one of the main drivers of arbitrage.
There are locational differences in wheat contracts. There are other futures which are not liquid which can represent locational differences.
Metals:
There are differences in New York and London contracts for most industrial metals. There is also an arbitrage between NYC, London, and Shanghai in copper.
Energy:
The main difference is Brent versus WTI which is a locational difference. The locational differences allows for supply imbalances to drive spread differentials. There will be locational arbitrage between NY and London contracts.
Basis trading is strong between locations in natural gas.
The main difference is Brent versus WTI which is a locational difference. The locational differences allows for supply imbalances to drive spread differentials. There will be locational arbitrage between NY and London contracts.
Basis trading is strong between locations in natural gas.
Product arbitrage - There is strong arbitrage link between the raw material input and the products that come from a commodity. This a key driver of pricing because inputs cannot rise above a level that will make transformation uneconomical.
Agricultural markets: To name a few.
Corn/ethanol - The transformation of corn into ethanol and DDG's.
Soybean crush -The transformation of soybeans into meal and oil
sugar/ethanol - The transformation of sugar into ethanol
cocoa grind - The grinding of cocoa into butter and powder.
Feeder to live cattle.
The use of corn to feed hogs which is the switch to protein.
Feeder to live cattle.
The use of corn to feed hogs which is the switch to protein.
Live cattle to products
Energy:
Oil to refined products. Crack spreads.
Oil to refined products. Crack spreads.
Substitute arbitrage - The use of one product over another based on price
Agricultural markets:
Switch between corn, wheat and soybean meal as feed. There is also substitution of what will be grown. In the Midwest, there will be switching between corn and soybeans.
Switch between corn, wheat and soybean meal as feed. There is also substitution of what will be grown. In the Midwest, there will be switching between corn and soybeans.
If there is a commodity, there is a relative price arbitrage.
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