From the October 01, 2010 issue of Futures Magazine • Subscribe!

Steel futures: Ready for prime time?

On “Dueling metals” (below) the three series of daily prices are shown as ratios to their average price over the period Feb. 1 to Aug. 31, 2010. The higher volatility of steel futures (using only the Mediterranean contract) reflects the peak and decline shown in the “London steel” chart. Copper futures exhibit a smaller amount of volatility, although they match the steel price increase and subsequent decline through March and April, in timing if not in absolute gain in the price ratio. LME and New York copper futures stay closely related because of arbitrage between the two futures markets. Potential spread trades between the two markets were analyzed in “The New York -- London Connection” (January 2010).

Image


Crossing the pond

Looking to the future, the potential exists for an active futures market in steel on both sides of the Atlantic, similar to the current daily phasing of London copper futures into those traded in New York -- with predictable opportunities for arbitrage between the two markets. Trading two different steel products -- billet versus hot rolled coil -- should not present a large problem in comparative pricing.

Currently, we can structure a hypothetical simulated call option on LME steel futures. This requires the use of options on Nymex copper for construction of an option price curve and an assumption that the volatilities of the prices of LME steel futures and LME or Nymex copper futures are closely related.

The second requirement -- close relationship between the volatilities of LME steel futures and copper futures -- is supported by their ratios of daily prices to the five-month average price during May and June 2010. Whether increased futures trading in steel will help to eliminate volatility differences is unknown at this time, but for the purpose of the proposed option analysis, it is assumed they are equal.

“Modeling the price of steel” (below) contains two sections. The upper section shows calculation of a call option price curve for September 2010 Nymex copper futures on July 1, 2010. A regression equation based on an original set of 16 futures price-option price pairs resulted in the following equation coefficients:

A = - 2.6102

B = 8.2308

C = - 14.5758

Ln (W/E) = A + (B x Ln(S/E) + C x (Ln(S/E)^2)

Where:

W = option’s market price

S = future’s price

E = strike price

The predicted call price at each strike price is computed from the following equation:

Predicted call price = ((2.718281)^Ln(W/E)) x E

Image

<< Page 2 of 3 >>
Comments
comments powered by Disqus
Check out Futures Magazine - Polls on LockerDome on LockerDome