While almost all retail structured products are linked to equities, those linked to commodities or commodity indexes have been slow to be introduced to retail investors. In many markets, commodities are a natural alternative. Over the long term, the prices of commodities can be expected to increase as they provide a natural hedge against inflation, and typically they also have low correlations with equities, making them an excellent diversification tool in any portfolio. But perhaps most importantly, they represent a straightforward investment story for retail investors, who often hear about rising commodity prices, particularly oil and gas.
Commodity based structured products are very different from other products based on different asset classes; a fact that becomes quickly apparent when investigating the pricing or hedging of these instruments. Furthermore, ‘commodity based' can mean two things: products that are based on a physical commodity, and products that are based on a commodity index. This month we will look at the link to the spot prices of physical commodities.
The main difference between commodities and equities comes down to the construction of the forward curve for pricing. The forward curve for any asset is the market implied level of the spot value at future points in time. Usually it is not directly connected to any market consensus about where the asset price is heading, but arises out of pricing data and is therefore used as the basis for constructing a hedge. For equities (indexes or stocks), the forward curve is constructed by the risk free interest rate minus any dividend yield over a given maturity. This is because there is an easy way to replicate an equity future: simply buy the index or stock, pay interest on the borrowing and receive dividends that are due. The net carry is given by the excess (if any) of interest rates over dividend yields. The interest rate can be locked in from the interest rate yield curve, and while dividends are not entirely fixed, there is generally known and expected behaviour when studying forward equity prices. The implied volatility equity levels are derived from option prices, so with the forward and volatility curve we can price any equity option and thus construct the building blocks for the structured product.