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Name the influences on the prices of agricultural, metal and energy commodities and of weather derivatives.

FRM® Part I · Financial Markets and Products · Commodity Forwards and Futures · FRM1.FM.11.c

The idea

Agricultural prices respond to weather, planting and harvest cycles, yields, stock levels relative to use, and policy such as biofuel mandates and trade rules. Low inventories magnify supply shocks. Industrial metals such as copper follow global industrial and construction demand, mine output and disruptions, and recycling. Precious metals also react to inflation, real rates and the dollar. Energy prices depend on producer decisions, geopolitics, inventories, refining and pipeline capacity, and seasonal demand. Electricity cannot be stored, so prices spike locally. Weather derivatives pay on an index such as heating degree days (HDD), summed over a period. On each day, HDD = max(65 − average temperature, 0). Temperature is in Fahrenheit. The underlying cannot be traded or stored, so there is no replication pricing. Know the drivers by commodity group.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which set of factors most directly influences agricultural commodity prices?

  1. Ore grades, smelting capacity and industrial output.Why not: These affect metals, not crops.
  2. Refinery capacity, pipeline constraints and OPEC production quotas.Why not: These influence energy markets, particularly crude oil and products.
  3. Weather, crop yields, planting and harvest cycles, and inventory levels. - correct
  4. Heating degree days and electric load forecasts only.Why not: Weather matters, but through growing conditions and yields; degree days drive energy demand and weather derivatives.

Crops depend on weather and the harvest cycle, with stock levels relative to use determining price sensitivity to shocks. Metals and energy have different driver sets.

A harder one

Which pairing of commodity and primary price driver is correct?

  1. Copper: crop yields in producing regions; natural gas: global construction demand.Why not: Mixes the drivers; crop yields affect agricultural prices, and construction affects metals.
  2. Wheat: refinery outages; electricity: harvest timing.Why not: Applies energy drivers to a crop and a crop driver to electricity.
  3. Gold: heating degree days; corn: central bank gold reserves.Why not: Swaps the drivers entirely; weather indexes and reserves have no such link.
  4. Copper: global construction and industrial demand; natural gas: weather-driven heating demand and storage levels. - correct

Industrial metals follow industrial activity and mine supply; natural gas follows weather and storage. Matching drivers by commodity group is the core of the outcome.

The hardest tier

A heating degree day option pays USD 20 for every HDD above a strike of 40 HDD accumulated over a five-day window. The daily average temperatures are 58, 62, 66, 50 and 45 degrees Fahrenheit, base 65. The payoff to the option holder is:

  1. USD 80Why not: Allows the 66-degree day to subtract one HDD instead of flooring that day at zero.
  2. USD 900Why not: Ignores the strike and pays on all accumulated HDD.
  3. USD 100 - correct
  4. USD 0Why not: Uses cooling degree days, which are almost zero over this cold window, instead of heating degree days.

Daily HDD = [7, 3, 0, 15, 20], total 45. Payoff = (45 - 40) x 20 = USD 100. The 66-degree day contributes zero, not minus one.

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