FX & Commodity
Markets

What this week covers

Markets are not interchangeable. FX is driven by interest rate differentials and central bank policy. Commodities have storage costs, seasonal patterns, and convenience yields that shape their term structures. This week walks through the core mechanics of both asset classes, how prices are determined, and where AlgoGators finds edges. Next week covers fixed income and equity factors.

FX markets

Core mechanics

FX spot rates are determined by supply and demand for each currency. The forward rate (price locked in today for delivery in the future) incorporates the spot rate plus the cost of carry — primarily the interest rate differential between the two currencies.

Covered Interest Parity: The relationship between spot, forward, and interest rates.

\[ F = S \cdot \frac{1 + r_d}{1 + r_f} \]

Where F = forward rate, S = spot rate, r_d = domestic interest rate, r_f = foreign interest rate.

If you borrow low-yield currency and lend high-yield currency, you're paid the interest differential. This is the carry trade — and it's structurally persistent because the interest differential reflects real economic differences.

What drives FX rates

• Interest rate differentials: Higher rates attract capital. A currency with higher rates should trade at a forward discount (future depreciation) to equalize returns. (This is interest parity.)
• Inflation: Purchasing power parity: currencies with higher inflation should depreciate. Long-term anchor on spot rates.
• Current account flows: A country with a trade surplus (exports > imports) accumulates foreign currency. Currencies strengthen on current account surpluses.
• Central bank intervention: Dramatic moves come from policy shifts. ECB rate hikes in 2022–2023 drove EUR appreciation.

The edge: Uncovered Interest Parity failure

Theory says: if interest rates in Country A are 3% and in Country B are 1%, the currency of B should depreciate by roughly 2% per year to equalize returns. This is covered interest parity.

But uncovered interest parity (the weaker version: speculators fully arbitrage the forward market) fails empirically. The high-yield currency often appreciates, not depreciates. Carry trades (borrow low, lend high) have been profitable for decades. This is a structural edge — hedgers need to pay speculators a risk premium to take on currency risk.

Key FX instruments

Commodity futures

Core mechanics

Commodity futures have a term structure (different prices for different delivery months). The shape of this term structure — whether it slopes upward (contango) or downward (backwardation) — tells you something important about supply and demand.

Cost of carry

The fair value of a commodity forward is determined by storage costs and convenience yield:

\[ F = S \cdot e^{(r + u - c)T} \]

Where u = cost of storage, c = convenience yield (benefits of holding physical commodity), r = interest rate, T = time to maturity.

Roll yield: A strategy that is long front-month futures and rolls into the next contract before expiry. In backwardation (front > back), rolling captures positive yield. In contango (front < back), rolling costs money.

What drives commodity prices

• Supply and demand: Weather, production, geopolitical shocks. Real, physical constraint.
• Inventory levels: High inventory signals low convenience yield (storage is easy). Low inventory signals high convenience yield (supply is tight).
• Seasonality: Crop cycles are predictable. Planting, growing, harvest seasons drive seasonal price swings.
• Speculation vs. hedging: Hedgers (producers, consumers) are net long or short based on their physical needs. Speculators take the other side. When speculators become crowded long, prices often reverse.

The edge: Roll yield and seasonality

Both are structural. Roll yield is determined by physical costs (storage, convenience). Seasonality is driven by harvest cycles. These don't change just because traders learn about them. AlgoGators operates in both — roll yield strategies are core to the commodity book, and satellite weather data gives us a seasonal signal advantage.

Commodity contract mechanics

Chart: Term structure shapes

Commodity futures term structures. Corn (orange) in backwardation: front-month contracts at a premium. This signals supply tightness and produces positive roll yield. Wheat (blue) in contango: forward prices are higher. Rolling these contracts will lose money.

Common mistakes