Commodity Derivative Settlement

Commodity Derivative Settlement

In this video, Emma explains us the two settlement mechanisms for commodity derivatives, "physical-settlement" and "cash-settlement".  She also examines how well the price of a commonly traded commodity derivative, the commodity forward, converges to the price of the underlying commodity under each settlement mechanism.
Overview

Commodity derivatives can either be physically-settled or cash- (or financially-) settled. The concept of price convergence is explained. Physically-settled contracts generally exhibit the best price convergence. Cash-settled contracts use an index to calculate the final cash settlement amount and will only exhibit good price convergence to the underlying commodity if the index closely tracks the underlying market. Forward contracts are defined and used to demonstrate price convergence.

Key learning objectives:

  • Describe the main features of a forward contract.

  • What is price convergence?

  • Explain why the prices of physically-settled contracts converge to the price of the underlying commodity.

  • Why can price convergence be weaker for cash-settled contracts?

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