GLOBAL COMMODITIES EXCHANGES

London Metal Exchange (LME)

The iconic London Metal Exchange, popularly referred to as ‘LME,’ is the world’s largest futures exchange market established in 1877, when Great Britain was at the peak of its glory. With half the world under the British Empire, London had become the epicenter of commodity trades of all kinds. Shortly the industrial revolution further spurred the growth of markets for metals like copper, tin, and aluminum. The ‘three month contract’ which is now considered as the standard period for a future, was actually borne out of the time frame that took copper to be shipped from Chile to UK. The opening of Suez Canal in 1869 similarly reduced the time for shipment of tin to arrive from Malaya to 3 months, which gave rise to the ‘3 month contract’ now in vogue.

LME was acquired in 2012 by Hong Kong Exchanges & Clearing Limited and a new custom clearing house was designed and introduced to bring technology into the global metal trade platform.

Today, LME sets the standards for operating in the commodity metals market within the framework of corporate governance – LME has an operational committee for each of the metal traded, like an ‘aluminum’ committee for aluminum, a ‘molybdenum’ committee for molybdenum, and so on. LME also has an elaborate ‘Ring Disciplinary’ committee and an appeal mechanism for both traders and members in place. 

The LME price discovery mechanism works in all the three ways – 

a) Open out-cry – the trading floor on the LME that is also called as the ‘Ring’, where the prices are determined on the traditional out-cry (verbal) method, 

b) LME Select – the electronic trading platform, and, 

c) Inter-office telephone market system. 

Thus, the LME is active for trading 24 hours a day. There is a common misconception that precious metals like gold are traded on the LME, but they aren’t. The LME specializes in ferrous and non ferrous metals, whereas gold and silver are traded on the OTC managed by London Bullion Market. 

Eurex Exchange 

Eurex is the largest European futures and options market, established in Germany. One of the foremost exchanges to usher in electronic trading, its trading platform T7 is considered to be the best in the world. Eurex is constantly pushing itself to explore new areas and product classes, for example, they have introduced a factor index based futures that allow investors to trade six individual risk factors in futures format. The six factors are - size, value, carry, momentum, low risk and quality, and is a dynamic attempt to allocate to alternative sources of beta in an attempt to deliver equity-like returns with low correlation. 

Chicago Mercantile Exchange (CME) Group 

Chicago Mercantile Exchange & Chicago Board of Trade (CME) is the US based largest futures and options platform for trading. Established in 1898, CME offers the entire bouquet of trades based on ferrous, non-ferrous metals, precious metals, and even on weather and real-estate. The acquisition of New York Mercantile Exchange (NYMEX) by the CME group in 2007 catapulted it to the number one status in US. The platform also allows for agri-based commodity contracts like Class IV milk, Class III milk, Feeder Cattle etc. CME has developed ‘SPAN’ (‘Standard Portfolio Analysis of Risk’) which is standardized software to calculate margin requirements for futures, which has been adopted by many agencies as benchmark software across the globe.

Students are advised to supplement this chapter with the topic of Commodity Derivative from the Study Material of Strategic Financial Management Paper.

TEST YOUR KNOWLEDGE

Theoretical Questions

1. Explain how Commodity Derivatives are different from Financial Derivatives.

2. Which is standardized software to calculate margin requirements for futures developed by CME adopted by many agencies as benchmark software across the globe.

Practical Questions 1.

A company is long on 10 MT of copper @ ` 474 per kg (spot) and intends to remain so for the ensuing quarter. The standard deviation of changes of its spot and future prices are 4% and 6% respectively, having correlation coefficient of 0.75.

What is its hedge ratio? What is the amount of the copper future it should short to achieve a perfect hedge?

Answers to Theoretical Questions

1. Please refer paragraph 4.1

2. Please refer paragraph 5.3

Answers to the Practical Questions 1.

The optional hedge ratio to minimize the variance of Hedger’s position is given by:

H= r sS

sF

Where

σS= Standard deviation of ΔS σF=Standard deviation of ΔF

ρ= coefficient of correlation between ΔS and ΔF H= Hedge Ratio

ΔS = change in Spot price.

ΔF= change in Future price.

Accordingly

H = 0.75 x 0.04 

0.06 

= 0.5 

No. of contract to be short = 10 x 0.5 = 5 Amount = 5000 x ` 474 = ` 23,70,000