Pricing Commodity: Fundamental Analysis

4. Pricing Commodities

Price discovery is done through two popular methods:

1. The Fundamental analysis is concerned with basic supply and demand information, such as, weather patterns, carryover supplies, relevant policies of the Government and agricultural reports.

• Fundamental analysis is a means of analyzing commodities and trying to predict where the prices of commodities should be trading and what they will do in the future. The main basis for fundamental analysis is supply and demand.

• Supply and demand is a very simple equation, but it gets more complicated when you try to forecast prices in the future. Commodities trade in cycles. Sometimes supplies will be tight and prices will be high. Other times, we just have too much of

The best example of a commodity that fulfills these criteria and conforms to the cost of carry model is gold. The available worldwide inventory of gold is large, it can be stored almost anywhere with little risk of spoilage or damage, and its supply and demand flows are not seasonal or disruptive. Such factors make it easy for arbitrageurs to keep the price of gold in futures in line. For the same reasons, financial futures, including those on U.S. treasury issues, foreign exchange and the S&P 500, also conform closely to the cost of carry

In particular, models based on Black-Scholes assume that the underlying volatility is constant over the life of the derivative, and unaffected by the changes in the price level of the underlying security. However, these models cannot explain long-observed features of the implied volatility surface such as volatility smile and skew, which indicate that implied volatility does tend to vary with respect to strike price and expiry. By assuming that the volatility of the underlying price is a stochastic process rather than a constant, it becomes possible to model derivatives more accurately

• Mean revertion

The mean reversion is the theory suggesting that prices and returns eventually move back towards the mean or average. This mean or average can be the historical average of the price or return or another relevant average such as the growth in the economy or the average return of an industry.

• Wiener process

The Wiener process is a continuous-time stochastic process named in honor of Norbert Wiener. It is often called standard Brownian motion, after Robert