Principles of Commodity Economics and Finance

by Ahn

ISBN: 9780262038379 | Copyright 2019

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A rigorous but practical introduction to the economic, financial, and political principles underlying commodity markets.

Commodities have become one of the fastest growing asset classes of the last decade and the object of increasing attention from investors, scholars, and policy makers. Yet existing treatments of the topic are either too theoretical, ignoring practical realities, or largely narrative and nonrigorous. This book bridges the gap, striking a balance between theory and practice. It offers a solid foundation in the economic, financial, and political principles underlying commodities markets. The book, which grows out of courses taught by the author at Columbia and Johns Hopkins, can be used by graduate students in economics, finance, and public policy, or as a conceptual reference for practitioners.

After an introduction to basic concepts and a review of the various types of commodities—energy, metals, agricultural products—the book delves into the economic and financial dynamics of commodity markets, with a particular focus on energy. The text covers fundamental demand and supply for resources, the mechanics behind commodity financial markets, and how they motivate investment decisions around both physical and financial portfolio exposure to commodities, and the evolving political and regulatory landscape for commodity markets. Additional special topics include geopolitics, financial regulation, and electricity markets. The book is divided into thematic modules that progress in complexity. Text boxes offer additional, related material and numerous charts and graphs provide further insight into important concepts.

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Contents (pg. v)
Preface (pg. vii)
Acknowledgments (pg. xi)
1 Introduction (pg. 1)
Definitions (pg. 1)
Fungibility (pg. 2)
Perfect Substitution and Globalization (pg. 3)
Types of Commodities (pg. 4)
Conclusion (pg. 14)
Module I: Fundamentals of Commodity Economics (pg. 15)
2 Fundamentals of Commodity Economics: Supply (pg. 17)
Hotelling’s Model: Optimal Production with a Nonrenewable Resource (pg. 17)
Relaxing Hotelling’s Assumptions (pg. 23)
Hubbert: The Geologist’s Approach (pg. 28)
Industry Cost Curves (pg. 34)
Toward a New Theory of Supply (pg. 36)
Mathematical Appendix A: Optimal Control Theory (pg. 37)
Mathematical Appendix B: Hubbert’s Logistical Model (pg. 41)
3 Fundamentals of Commodity Economics: Demand (pg. 43)
Distinguishing Demand Factors by Frequency (pg. 43)
Demand Factors by Type of User (pg. 45)
Nerlove’s Partial Adjustment Model (pg. 47)
Bringing Demand and Supply Together: Equilibrium in Theory and Practice (pg. 55)
Commodity Supercycles (pg. 57)
Conclusion (pg. 59)
Module II: Financial Markets for Commodities (pg. 61)
4 Fundamentals of Commodity Derivatives (pg. 63)
Introduction (pg. 63)
Spot Contracts and Forward (Futures) Contracts (pg. 63)
Types of Spot and Futures Market Behavior (pg. 64)
Who Is “the Market”? (pg. 67)
Risk Premia and Risk Neutrality (pg. 69)
Keynes-Hicks Theory of Hedging Pressure (pg. 71)
Working-Kaldor Theory of Storage (pg. 73)
Options (pg. 76)
Valuing Options (pg. 80)
Conclusion (pg. 86)
Appendix 4.1 Primer on Ito Calculus, the Black-Scholes-Merton Model, and Greeks (pg. 87)
5 Economics and Financial Activities behind Derivatives (pg. 95)
Hedging Commodity Risk: Motivations and Methods (pg. 96)
Speculation and the Economic Calculation Problem (pg. 102)
A Simple Model of Price Discovery (pg. 104)
Module III: Valuation and Portfolio Choice (pg. 109)
6 Real Optionality and Valuation (pg. 111)
A New Theory of Investment Valuation: Real Optionality (pg. 111)
A Simple Example (pg. 114)
A More Complex Example (pg. 115)
Real-World Examples (pg. 117)
7 Commodity Beta: Diversification and Inflation Protection (pg. 125)
Financialization of Commodities Markets (pg. 126)
Commodity Beta and Diversification (pg. 127)
Commodity Beta and Inflation Protection (pg. 131)
Expected versus Unexpected Inflation (pg. 135)
Commodity Beta (pg. 138)
8 Commodity Alpha: Risk Premia (pg. 139)
Risk Premia Revisited (pg. 139)
Conclusion (pg. 146)
Module IV: Other Topics (pg. 147)
9 Geopolitics and Commodities (pg. 149)
Resource Scarcity and Security (pg. 149)
Resource Nationalism and National Energy Companies (pg. 156)
Commodity Producer Cartels (pg. 160)
Energy Subsidies (pg. 163)
Pipeline Geopolitics (pg. 166)
10 Commodity Markets and Financial Regulation (pg. 169)
Commodity Market Regulation in the United States (pg. 171)
Physical Transparency (pg. 172)
Financial Transparency (pg. 175)
Real-Time Data Depository (pg. 178)
Centralized Clearing (pg. 179)
Capital and Margins Requirements (pg. 182)
Position Limits and Hedge Exemptions (pg. 183)
Conclusion (pg. 184)
11 Electricity Markets (pg. 185)
The Structure of Power Markets (pg. 186)
Traditional versus Deregulated Ownership Structures (pg. 188)
Electricity Demand and Supply: Load Duration, Price Dispatch, and Price Duration Curves (pg. 191)
Markets for Power Capacity (pg. 195)
Congestion Markets (pg. 199)
Smart Grids and the Future of Electricity Markets (pg. 200)
Index (pg. 203)

Daniel P. Ahn

Daniel P. Ahn is the Acting Chief Economist at the U.S. Department of State and a Professorial Lecturer at Johns Hopkins University Paul H. Nitze School of Advanced International Studies. He was previously the Chief Commodities Economist at Citibank in New York.

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