HÉLYETTE GEMAN is Director of the Commodity Finance Centre at Birkbeck, University of London and Research Professor at Johns Hopkins University. She is a graduate of Ecole Normale Supérieure in Mathematics, holds a Masters degree in Theoretical Physics and a PhD in Probability from the University Pierre et Marie Curie; and a PhD in Finance from the University Paris Sorbonne.

Professor Geman has published more than 130 papers in top international finance, insurance and energy economics Journals, became in 1993 a Member of Honour of the French Society of Actuaries for her work on Catastrophic risk; received in 1994 the first Prize of the Merrill Lynch awards for her research on Asian and complex options; was named in 2004 in the Hall of Fame of Energy Risk. She has been a scientific advisor to major financial institutions, energy and mining companies and commodity houses for the last 21 years, covering the spectrum of interest rates, crude oil and natural gas, metals and agricultural, including water, fertilizers and land.

Her book Insurance and Weather Derivatives was published in 1999 by RISK Publications; her book entitled Commodities and Commodity Derivatives: Energy, Metals and Agriculturals published by Wiley Finance in 2005 has become the reference in industry and Master programmes worldwide.

Prof Geman counts among her PhD students Nassim Taleb. She is presently on the Board of a green energy company and an active participant in a 'precision farming' project involving 12,500 farmers in East Africa.

Acknowledgments xiii

About the Author xv

Preamble xvii

1 Physical and Financial Agricultural Markets 1

1.1 Agriculture and the Beginning of Human Sedentarization 1

1.1.1 Some recent numbers 2

1.1.2 The growing role of Africa 2

1.2 The Outlook of Agricultural Commodities Markets 3

1.2.1 Recent mergers and acquisitions 3

1.2.2 ‘Trading places’: from the abcd to the now 4

1.2.3 The physical markets 9

1.2.4 The global flows of commodities 10

1.2.5 Back to the future: a new age for barter 11

1.2.6 The sources of information in agricultural commodity markets 12

1.3 History of Commodity Futures and Spot Markets 12

1.3.1 The actors in financial markets 12

1.3.2 The actors in agricultural commodity exchanges 13

1.3.3 The growth of Futures markets exchanges and the recent mergers 14

1.3.4 Futures markets and price volatility 15

1.3.5 The role of indexes in the creation of efficient commodity spot markets 16

1.3.6 Commodities and numéraire 17

1.4 Shipping and Freight 17

1.4.1 International trade 18

1.4.2 Price formation in freight markets 18

2 Agricultural Commodity Spot Markets 25

2.1 Introduction 25

2.2 Price Formation in Agricultural Commodity Markets 25

2.3 Volatility in Agricultural Markets 27

2.3.1 Volatility of the price level versus return in agricultural commodity markets 32

2.3.2 Which factors drive volatility? 36

2.3.3 Conclusion 38

3 Futures Exchanges – Future and Forward Prices – Theory of Storage – The Forward Curve 39

3.1 Major Commodity Exchanges 39

3.2 Forward Contracts 41

3.3 Futures Contracts 43

3.3.1 Definition 43

3.3.2 Exchange of Futures for physicals (efp) 44

3.4 Relationship between Forward and Futures Prices 45

3.5 Example of a Future Spread 47

3.6 Inventory and Theory of Storage 47

3.6.1 Spot and Futures prices volatilities 49

3.6.2 Development of the theory of storage: inventory and prices 51

3.7 The Benefits of Forward Curves 52

3.7.1 Trading strategies around forward curves 52

3.7.2 Example of a seasonality-based Futures spread 53

3.7.3 From linear to convex payoffs 54

3.8 Stochastic Modeling of the Forward Curve 55

4 Plain Vanilla Options on Commodity Spot and Forward Prices. The Bachelier–Black–Scholes Formula, the Merton Formula, the Black Formula 59

4.1 Introduction 59

4.2 Classical Strategies involving European Calls and Puts 62

4.2.1 Straddle 62

4.2.2 Strangle 62

4.2.3 Call spread or vertical call spread 63

4.2.4 Butterfly spread 64

4.3 Put–Call Parity for a Non-dividend Paying Stock 64

4.4 Valuation of European Calls: the Bachelier–Black–Scholes Formula and the Greeks 66

4.4.1 Consequences of the Black–Scholes formula 70

4.4.2 The Greeks 71

4.5 The Merton (1973) Formula for Dividend-paying Stocks 75

4.6 Options on Commodity Spot Prices 77

4.7 Options on Commodity Futures: the Black (1976) Formula 78

4.8 Monte-Carlo Simulations for Option Pricing 79

4.8.1 The founding result 79

4.8.2 Monte-Carlo methods for plain vanilla options on non-dividend paying stocks 80

4.8.3 Monte-Carlo methods for plain vanilla options on the spot commodity 82

4.9 Implied Volatility, Smile, and Skew in Equity Option Markets 83

4.10 Volatility Smile in Agricultural Commodity Markets 86

4.10.1 W here is the liquidity in agricultural commodity option markets? 86

4.10.2 Extracting the implied volatility from options on commodity Futures 86

5 Commodity Swaps, Swaptions, Accumulators, Forward-Start, and Asian Options 89

5.1 Swaps and Swaptions 89

5.2 Accumulators 92

5.3 Forward-Start Options (or Calendar Spread Options on the Spot Price) 93

5.4 Asian Options as Key Instruments in Commodity Markets 95

5.4.1 Approximation of the arithmetic average by a geometric average 96

5.4.2 Approximation of the distribution of the arithmetic average by a log-normal distribution 97

5.4.3 Monte-Carlo simulations for Asian options valuation 98

5.4.4 Exact results (Geman and Yor, 1993) 100

5.5 Trading the Shape of the Forward Curve through Floating-strike Asian Options 102

6 Exchange, Spread, and Quanto Options in Commodity Markets 103

6.1 Exchange Options 103

6.2 Commodity Spread Options and Their Importance in Commodity Markets 105

6.3 Commodity Quanto Options 109

7 Grain Cereals: Corn, Wheat, Soybean, Rice, and Sorghum 113

7.1 Introduction 113

7.2 Corn 113

7.3 Wheat 118

7.3.1 W heat trading 119

7.3.2 Global wheat 119

7.3.3 The wheat supply chain 120

7.4 Soybeans 123

7.5 Rice 126

7.6 Sorghum 129

8 Sugar, Cocoa, Coffee, and Tea 133

8.1 Sugar 133

8.1.1 Links of sugar with other commodities 134

8.1.2 Sugar trading 135

8.1.3 The European Union 136

8.1.4 Special relations of the eu with other countries 136

8.1.5 The United States 136

8.1.6 Special relations of the usa with other countries 137

8.1.7 Brazil 137

8.1.8 China 138

8.1.9 India 138

8.1.10 Thailand 139

8.1.11 Australia 139

8.1.12 Guatemala and Cuba 139

8.1.13 Sugar cane in Mauritius 140

8.2 Cocoa 140

8.3 Coffee 146

8.4 Tea 149

9 Cotton, Timber and Wood, Pulp and Paper, Wool 153

9.1 Cotton 153

9.2 Lumber and Wood 156

9.3 Pulp and Paper 158

9.3.1 Pulp NBSK and BHKP indexes 159

9.3.2 Pulp US NBSK index 160

9.3.3 Pulp BHKP China 160

9.3.4 Pulp NBSK China 161

9.3.5 When bank notes go plastic 161

9.4 Wool and Cashmere 162

9.4.1 Cashmere 163

9.4.2 From the Kashmir Goat to high quality yarns 164

10 Orange Juice, Livestock, Dairy, and Fishery 165

10.1 Orange Juice 165

10.2 Livestock 166

10.2.1 Livestock markets 167

10.2.2 Cattle 168

10.2.3 Hogs 169

10.2.4 Pork bellies 169

10.2.5 The US live cattle contract specifications 170

10.2.6 Australia 171

10.2.7 The USA 171

10.3 Dairy 172

10.4 Fish Markets 173

10.5 Poultry and Eggs 174

11 Rubber, Palm Oil, and Biofuels 177

11.1 Rubber 177

11.2 Palm Oil 180

11.2.1 The oil palm and palm oil 181

11.2.2 Markets 182

11.3 Ethanol, Biofuels, and Biomass 183

12 Land, Water, and Fertilizers 187

12.1 Land Types, Yields, and Erosion 187

12.1.1 Yield-at-risk 187

12.1.2 Land competition 188

12.1.3 Farmland in the USA 188

12.2 Fertilizers 189

12.2.1 Fertilizer markets 191

12.2.2 Fertilizer Index, corn, and wheat price trajectories over the period 1991 to 2011 193

12.2.3 Fertilizer producing companies and share price returns over the period 2004 to 2011 193

12.2.4 A factor model for the share returns of fertilizer firms 198

12.3 Water and its crucial Role in the World Economy 207

12.3.1 The case of Australia, China, and Saudi Arabia 208

12.3.2 The case of Brazil 208

12.3.3 Competition for electricity, water, and land 209

12.4 Projections for the Future of Agriculture 209

12.4.1 Farm insurance 210

12.4.2 Estimating long-term agricultural supply 210

12.4.3 Market concentration 211

12.4.4 Spare capacity 211

12.5 Subsidies and Export Bans 211

12.5.1 Subsidies 212

12.5.2 Export bans 212

12.6 Market-oriented Farming 212

12.6.1 Open wheat market takes root in Canada 213

12.6.2 Kansas City wheat Futures trading coming to an end after 157 years 213

12.6.3 China food needs 214

13 Infrastructure and Farming Management in the Digital Age 217

13.1 Introduction 217

13.2 Agricultural Infrastructure 218

13.2.1 Total factor productivity 218

13.2.2 Climate change 219

13.2.3 Irrigation and increased productivity 219

13.2.4 Trends in irrigation 219

13.2.5 Storage 220

13.2.6 Grain elevators 220

13.2.7 Soybean crushers 220

13.2.8 The Brave New World of Monsanto 221

13.2.9 Infrastructure in sub-Saharan Africa 221

13.2.10 Gabon: after black gold, green gold? 221

13.2.11 Agricultural Transformation Agenda (ATA) in Nigeria 222

13.2.12 Digital age on the farm: prescriptive planting 222

13.2.13 Sugar biofactory for ethanol in Brazil 224

13.2.14 After ethanol, railway, and natural gas 224

13.2.15 From iron ore mining to cattle farming in Australia 225

13.2.16 Robots for cow milking 225

13.2.17 Containers for agricultural commodities 226

13.2.18 Singapore as a hub for refrigeration containers 226

13.2.19 The trip of the banana 226

13.2.20 Energy, water, and infrastructure for DAP and agriculture in Saudi Arabia 227

13.3 Country Risk: the Example of Ukraine in 2014 227

13.4 Analyzing the Risks Involved in an International Wheat Tender Offer 228

13.5 Weather Risk and Weather Derivatives 229

14 Investing in Agricultural Commodities, Land, and Physical Assets 233

14.1 Purchase of Commodity Futures 233

14.2 Purchase of Commodity Options and Structured Products 235

14.3 Commodity Index Investing 236

14.3.1 Some prominent commodity indexes 236

14.3.2 How commodity indices are constructed 238

14.3.3 Commodity-linked bonds 239

14.4 Investing in Commodity-related Equities 239

14.5 Investing in Land 240

14.5.1 The US case 241

14.5.2 The world case 241

14.6 Acquisition of Infrastructure and Physical Assets 242

14.6.1 Valuation of a transformation plant using a real options approach 242

14.6.2 D CF approach to the valuation of a transformation plant 243

14.6.3 Valuation of a silo (or an aquifer, or any storage facility) 245

14.7 Conclusion 247

Glossary 248

References 252

Index 257

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