3.2 Commodities Flashcards
Julian Simon’s argument on director commodity returns. And reasoning for the argument
That prices for commodities decrease over time if inflation adjusted. Because of technology improvement.
Futures curve is in contango when?
How does it reflect in the prices?
Term structure is positive => Curve is upward sloping
Current prices are lower than futures prices
Futures curve is in backwardation when?
How does it reflect in the prices?
Term structure is negative. Curve of the slope structure is downward sloping
Current prices are higher than futures prices
What is a calendar spread?
Difference between futures/forward contracts prices on same asset but with different settlement date
What is a long calendar spread
Buy longer term option +
selling shorter term option
What is a short calendar spread?
Sell longer term option +
Buy shorter term option
In futures valuation, what does:
r, c, y stand for?
r = risk free rate
c = storage cost
y = convenience yield
Steps in calculating a calendar spread
1) find the values of the futures (the long and short part)
2) if there is a change (storage costs increase, etc) => calculate the NEW futures price (for both the short & long part)
3) subtract the NEW (both the long and short part) from the INITIAL price of futures (of the long and short part)
4) subtract from the LONG option value the SHORT option value
All else equal, which of the following will result in a lower futures price?
I. An economy-wide decrease in the borrowing rate.
Il.Storage technology improvements lower spoilage rates.
III. Inclement weather halts production, leading to a higher spot price.
IV. A marked increase in storage capacity, resulting in lower storage costs.
1,2,4
What is cost of carry?
Costs of owning a security/physical commodity.
Usually: risk free interest rate + storage costs.
What is the S&P GSCI? What does it consist of?
Benchmark for commodity investments.
24 physical Commodities: energy, metals, livestock, agriculture.
70% is energy.
What is the BCOM (type)? What does it consist of (number of commodities, sectors, limits)?
Bloomberg Commodity Index, market-LIQUIDITY WEIGHTED long only index.
23 commodities in 6 sectors: energy, grain, metals (precious and industrial), livestock, softs.
Upper limit of individual commodity of 15% and lower limit 2%
Upper limit of 33% on weight of each commodity sector
What is a liquidity weighted index?
The index is weighted based on trading activity
4 sources of futures returns:
1) Excess return - return from changes in futures prices. Percentage change in futures contract
2) Spot return - change in spot price
3) Collateral yield (return) - risk free rate
4) Roll return (yield) - return on a futures position resulting from a change in contract basis
What is convergence
The movement of futures price toward spot price as the delivery date approaches
What is the basis of a futures/forward contract?
Basis = Spot price - Futures price (most common)
OR
Basis = Futures price - Spot price
I.e. difference between sport and futures price
Formula for Return on a Fully collateralized futures position:
R = collateral yield + spot return + Roll Return
OR
R = collateral yield + excess return
What is perfectly elastic and inelastic supply? How does it impact convenience yields?
Perfectly Elastic supply = quantity demand can be immediately supplied without changes in market price. Convenience yield is low.
Inelastic supply = quantity supplied changes slowly in response to market prices. The convenience yield is high.
What is inelastic demand? Impact on the convenience yield?
The demand does not change significantly in relation to changes in price.
Convenience yield is low.
What is a fully collateralized position in a futures contact?
Unleveraged position, the cash needed to settle the contract is posted in form of short term risk free bonds (t bills)
3 primary sources of basis risk?
1) carry costs are different from the costs implied by basis => basis does not reflect actual carrying costs => indicates informational inefficiency in the pricing of the futures contract
2) convenience yield from the spot position differs from its storage cost
3) basis changes
What is normal backwardation?
Forward price is believed to be less than EXPECTED spot price at EXPIRATION
What is Normal Contango?
Forward price is expected to exceed expected spot price at expiration.
What is Hotelling’s theory?
Prices of exhaustible commodities SHOULD INCREASE by the prevailing NOMINAL INTEREST RATE. Perhaps with a risk premium.
=
Should grow at a risk adjusted nominal rate
What should the expected spot price be according to Hotelling’s theory?
Expected spot price = FV of current spot compounded at a nominal risk-less rate + risk premium
4 ways of getting exposure (invest in) to commodities (apart from futures)
1) physical ownership
2) equity related commodity investments
3) ETFs
4) Commodity linked notes (CLNs)
What are CLNs?
Commodity linked notes. They are intermediate debt instruments.
Values of which at MATURITY are linked to performance of underlying commodity/basked of commodities.
AKA Commodity Backed Notes
Pros / cons of CLNs?
Pros:
1) investors dont need to rollover the futures contracts.
2) provide exposure through a debt instrument, which benefits funds that cant invest in futures
Cons:
1) CLNs contain issuing firm’s default risk
2) commodity producing CLN issuers can better match their assets and liabilities
2 types of CLNs
1) principally protected - CLN holders will get the guaranteed face value of the note at maturity + coupon.
2) non principally protected - no guarantee of face value of note. The face value and/or coupon payments are linked to the underlying security’s value => the investor shares in the upside or down side.
CLNs vs Bond (plain vanilla) coupon/face value payments.
CLN coupon payments are usually lower because of ability to potentially earn more because of price fluctuations.
Face value can also change in CLN. As it is tied to the commodity’s value.
Which option does a CLN have imbedded and why?
Call option. Because is the price increases the holders of principal protected CLNs also get more. If the price decreases they get the face value + coupon.
When does the CLN payout the increase in the commodity’s value?
If the value of commodity increase past a certain level
=
higher than strike price.
What is included in the principal repayment?
Principal + appreciation (if there is an increase above strike)
What is the difference between normal backwardation and backwardation?
Normal = difference in futures price and expected future spot price
Regular = difference in futures price and current spot price
Drawbacks of commodity related equity investments
1) companies usually hedge their commodity exposure
2) commodity equities are exposed to 2 betas: commodity & equity market (which is not good for equity market diversification)
3) companies are exposed to several idiosyncratic risks
What is an ETN? How does it work? What are the risk?
Exchange traded note.
A bank issues a bond like debt instrument that pays out returns on a portfolio it is linked to (i.e. which portfolio the note tracks). There a no coupons, only payment based on return of a tracked portfolio at maturity.
Credit risk of issuing bank.
When is CLNs coupon rate the lowest?
When it is the closest to being in the money
Slope and shape of forward curve is driven by?
Carrying costs
In a perfect market, slope of forward curve for financial forward contract is driven by?
Interest rates & Dividends
In a perfect and informationally efficient market, contango and backwardation occur to prevent what?
Arbitrage opportunities if forward curve is flat, when r≠q (risk free rate ≠ dividend yield)
When is market upward sloping (in contango)?
When risk free rate > dividend yield
When is the market downward sloping (in backwardation)?
When the risk free rate < dividend yield
3 issues that hinder arbitrage activity that insures relationship between carrying costs and shape of forward curve?
1) different storage costs
2) different convenience yields
3) difficulty in short selling commodities
What happens to basis at maturity? Why?
Basis = 0, because at maturity the forward price always converges to spot price
In informationally efficient market, if you are short forward and long the spot, what it your expected return?
Cost of carry
Description of Thomson Reuters Core Commodity CRB Index
Designed to reflect importance of each commodity to world development
19 physical commodities
Tier weighted
Tier 1 commodities = 33%, Tier 2 = 42%, Tier 3 = 20%, Tier 4 = 5%
4 reasons for a negative relationship between commodity and stock/bond prices (financial assets)
1) price determined by different factors:
Commodity: supply/demand, FA: PV of future cashflows
2) Different correlation between prices & inflation: Commodity increases with inflation, FA: decreases
3) Different performance at different parts of the business cycle
4) Effect of prices on earnings (FA)
In a CAPM based perfect market, what is the optimal weight to allocate to a specific commodity?
The % of the total value of an asset relative to the total value of all assets globally.
If gold = 1% of total value of global assets => investors should hold 1% of their portfolio in gold
What is Empirical evidence on long run commodity price changes?
They do not rise at the riskless nominal rate. Some have even declined
Why Keynes believed futures markets should be in normal backwardation?
1) because commodity producers have an incentive to fix their sales (enter futures now at a lower price)
2) commodity users generally buy at spot prices because of Liquidity preference theory
Description of a humped curve in a forward market?
Is in contango for shorter maturities and backwardation for longer maturity contracts.
This is typical for commodities.
Relationship of Commodities in imperfect market conditions? In practice
Commodities can serve as diversifiers with good returns
It is not obvious that market participants should hold any amount of commodities.
Therefore, the amounts of commodities are the amounts that provide the most risk adjusted returns
Relationship between UNEXPECTED inflation and commodities?
Commodities provide protection agains unexpected inflation because they react to supply/demand
A significant decline in supply of oil with have what effect on the returns of commodities and financial assets?
Commodities return will increase
Financial asset return will decrease, because commodities are often costs for financial assets
What is roll return?
Return on futures position resulting in change of basis (spot - futures)
What is excess return?
Return from changes in futures price (which is made up of spot return and change in basis)
Futures price formula in a cost of carry mode with simple interest rate
Futures price = Spot commodity price + Carry costs
A commodity futures index for which the face values of the underlying futures contracts are entirely collateralized by
Treasury bills is generally referred to as?
Unleveraged futures
The current spot price of gold is $107, the expected future spot price of gold is $108, and the current futures price of gold is $106. Which of the following is true of the environment for gold? Why?
Backwardation = futures price < spot
ALSO
Normal Backwardation = futures price < expected spot price at expiration
What is the state of the market for each of these:
A) F> St
B) F < E(S at time T)
C) F > E(S at time T)
D) F < St
A) contango
B) normal backwardation
C) Normal contango
D) backwardation
Major economic events usually have what affect on commodity returns?
Large positive commodity returns occur more often than large negative commodity returns
What is rolling up/down?
Rolling up: the price of futures rolls UP to converge with the Spot price = backwardation market
Rolling up: the price of futures rolls DOWN to converge with the Spot price. = Contango market
In informationally efficient market what is the relationship between absolute value of basis and absolute value of carrying costs?
They are equal
In informationally efficient market, roll yield of a financial futures contact is _______ to contract’s cost of carry
Equal
Excess return =
Difference in futures prices
3 issues regarding roll returns?
1) roll return is not generated when one position is closed and new is opened. (It is generated by calculating the difference between price when the forward was entered and closed)
2) roll return is positive in backwarded markets if carry costs and term structure dont change
3) position with positive roll return does not imply its total returns are superior
Roll return is usually positive for which futures contracts?
Futures contracts on financial assets with dividend yields that exceed risk free rate
What was the volatility, sharpe ratio, max drawdown, partial autocorrelation, max calendar-month loss for commodities VS global equities?
Volatility: moderately higher than GE
Sharpe ratio: negative vs positive for GE
Max drawdown: very large (significantly larger than GE)
Partial autocorrelation: moderately positive 1st order
Max calendar-month loss: around 30%, which is 1.5x higher than GE
What are the 2 types of options in an option based term structure model?
1) option to extract commodity
2) option to store inventory
What is asymmetry in volatility of commodity prices?
Prices are more volatile when there is a shortage => when prices are increasing.
This is because shortages are more of an issue that over supply
What is the conclusion from asymmetric volatility?
Holding a physical commodity is more preferable than long & short term contracts
Can
1) backwardation
2) normal backwardation
3) contango
4) normal contango
be observed?
1) yes
2) no
3) yes
4) no
Working curve definition
Describes positive relationship between slope of forward curve & current inventory levels.
What theory does the working curve describe?
Theory of storage: low inventory = downward slope, high inventory = upward sloping forward curve
