Price risk management in the copper market using commodity derivatives and options strategies

Metals price risk management is a key issue related to financial risk in metal markets because of uncertainty of commodity price fluctuation, exchange rate, interest rate changes and huge price risk either to metals’ producers or consumers. Thus, it has been taken into account by all participants in metal markets including metals’ producers, consumers, merchants, banks, investment funds, speculators, traders and so on. Managing price risk provides stable income for both metals’ producers and consumers, so it increases the chance that a firm will invest in attractive projects. The purpose of this research is to evaluate risk management strategies in the copper market. The main tools and strategies of price risk management are hedging and other derivatives such as futures contracts, swaps and options contracts. Hedging is a transaction designed to reduce or eliminate price risk. Derivatives are financial instruments, whose returns are derived from other financial instruments and they are commonly used for managing financial risks. Although derivatives have been around in some form for centuries, their growth has accelerated rapidly during the last 20 years. Nowadays, they are widely used by financial institutions, corporations, professional investors, and individuals. This project is focused on the over-the-counter (OTC) market and its products such as exotic options, particularly Asian options. The first part of the project is a description of basic derivatives and risk management strategies. In addition, this part discusses basic concepts of spot and futures (forward) markets, benefits and costs of risk management and risks and rewards of positions in the derivative markets. The second part considers valuations of commodity derivatives. In this part, the options pricing model DerivaGem is applied to Asian call and put options on London Metal Exchange (LME) copper because it is important to understand how Asian options are valued and to compare theoretical values of the options with their market observed values. Predicting future trends of copper prices is important and would be essential to manage market price risk successfully. Therefore, the third part is a discussion about econometric commodity models. Based on this literature review, the fourth part of the project reports the construction and testing of an econometric model designed to forecast the monthly average price of copper on the LME. More specifically, this part aims at showing how LME copper prices can be explained by means of a simultaneous equation structural model (two-stage least squares regression) connecting supply and demand variables. A simultaneous econometric model for the copper industry is built: {█(Q_t^D=e^((-5.0485))∙P_((t-1))^((-0.1868) )∙〖GDP〗_t^((1.7151) )∙e^((0.0158)∙〖IP〗_t ) @Q_t^S=e^((-3.0785))∙P_((t-1))^((0.5960))∙T_t^((0.1408))∙P_(OIL(t))^((-0.1559))∙〖USDI〗_t^((1.2432))∙〖LIBOR〗_((t-6))^((-0.0561))@Q_t^D=Q_t^S )┤ P_((t-1))^CU=e^((-2.5165))∙〖GDP〗_t^((2.1910))∙e^((0.0202)∙〖IP〗_t )∙T_t^((-0.1799))∙P_(OIL(t))^((0.1991))∙〖USDI〗_t^((-1.5881))∙〖LIBOR〗_((t-6))^((0.0717) Where, Q_t^D and Q_t^Sare world demand for and supply of copper at time t respectively. P(t-1) is the lagged price of copper, which is the focus of the analysis in this part. GDPt is world gross domestic product at time t, which represents aggregate economic activity. In addition, industrial production should be considered here, so the global industrial production growth that is noted as IPt is included in the model. Tt is the time variable, which is a useful proxy for technological change. A proxy variable for the cost of energy in producing copper is the price of oil at time t, which is noted as POIL(t ) . USDIt is the U.S. dollar index variable at time t, which is an important variable for explaining the copper supply and copper prices. At last, LIBOR(t-6) is the 6-month lagged 1-year London Inter bank offering rate of interest. Although, the model can be applicable for different base metals' industries, the omitted exogenous variables such as the price of substitute or a combined variable related to the price of substitutes have not been considered in this study. Based on this econometric model and using a Monte-Carlo simulation analysis, the probabilities that the monthly average copper prices in 2006 and 2007 will be greater than specific strike price of an option are defined. The final part evaluates risk management strategies including options strategies, metal swaps and simple options in relation to the simulation results. The basic options strategies such as bull spreads, bear spreads and butterfly spreads, which are created by using both call and put options in 2006 and 2007 are evaluated. Consequently, each risk management strategy in 2006 and 2007 is analyzed based on the day of data and the price prediction model. As a result, applications stemming from this project include valuing Asian options, developing a copper price prediction model, forecasting and planning, and decision making for price risk management in the copper market.

Open top chambers and infrared lamps : a comparison of heating efficacy and CO₂/CH₄ dynamics in a Lake Superior coastal peatland

Experimental warming provides a method to determine how an ecosystem will respond to increased temperatures. Northern peatland ecosystems, sensitive to changing climates, provide an excellent setting for experimental warming. Storing great quantities of carbon, northern peatlands play a critical role in regulating global temperatures. Two of the most common methods of experimental warming include open top chambers (OTCs) and infrared (IR) lamps. These warming systems have been used in many ecosystems throughout the world, yet their efficacy to create a warmer environment is variable and has not been widely studied. To date, there has not been a direct, experimentally controlled comparison of OTCs and IR lamps. As a result, a factorial study was implemented to compare the warming efficacy of OTCs and IR lamps and to examine the resulting carbon dioxide (CO2) and methane (CH4) flux rates in a Lake Superior peatland. IR lamps warmed the ecosystem on average by 1-2 #°C, with the majority of warming occurring during nighttime hours. OTC's did not provide any long-term warming above control plots, which is contrary to similar OTC studies at high latitudes. By investigating diurnal heating patterns and micrometeorological variables, we were able to conclude that OTCs were not achieving strong daytime heating peaks and were often cooler than control plots during nighttime hours. Temperate day-length, cloudy and humid conditions, and latent heat loss were factors that inhibited OTC warming. There were no changes in CO2 flux between warming treatments in lawn plots. Gross ecosystem production was significantly greater in IR lamp-hummock plots, while ecosystem respiration was not affected. CH4 flux was not significantly affected by warming treatment. Minimal daytime heating differences, high ambient temperatures, decay resistant substrate, as well as other factors suppressed significant gas flux responses from warming treatments.

Warming alters photosynthetic rates of sub-boreal peatland vegetation

Boreal peatlands are important in the global carbon cycle. Despite covering only 3% of the global land area, peatlands store approximately one third of all soil carbon. Temperature is one of the major drivers in peatland carbon cycling as it affects both plant production and CO2 fluxes from soils. However, it is relatively unknown how boreal peatland plant photosynthesis is affected by higher temperatures. Therefore, we measured plant photosynthetic rates under two different warming treatments in a poor fen in Northern Michigan. Eighteen plots were established that were divided into three treatments: control, open-top chamber (OTC) warming and infrared (IR) lamp warming. Previous work at this site has shown that there was a significant increase in canopy and peat temperature with IR warming (5°C and 1.4°C respectively), while the OTC’s had mixed overall warming. Plots were divided equally into lawns and hummocks. We measured mid-day carbon dioxide (CO2) uptake on sedges (Carex utriculata), shrubs (Chamaedaphne calyculata) and Sphagnum mosses. Sphagnum moss net primary production (NPP) was also measured with cranked wires and compared with CO2 uptake. Our results indicate that there was no significant difference in sedge CO2 uptake, while shrub CO2 uptake significantly decreased with warming. A significant increase occurred in Sphagnum moss gross ecosystem production (GEP), ecosystem respiration (ER) and net ecosystem exchange (NEE). Contrary to the positive CO2 exchange of Sphagnum, overall NPP decreased significantly in hummocks with both warming treatments. The results of the study indicate that temperature partly limits the photosynthetic capacity of plants in sub-boreal peatlands, but not all species respond similarly to higher temperatures.