34 (AI) - Commodities and Derivatives

Question 1

What are the six major commodity sectors?

Answer 1

1. Energy - Crude oil, natural gas, and refined petroleum products.
2. Industrial metals - Aluminum, nickel, zinc, lead, tin, iron, and copper.
3. Grains - Wheat, corn, soybeans, and rice.
4. Livestock - Hogs, sheep, cattle, and poultry.
5. Precious metals - Gold, silver, and platinum.
6. Softs (cash crops) - Coffee, sugar, cocoa, and cotton.

Question 2

Which commodity sector is the largest by market value?

Answer 2

Energy (crude oil, natural gas, and refined products)

Question 3

Describe the key differences between crude oil and natural gas?

Answer 3

Crude oil needs to be refined into usable products such as gasoline, heating oil, and jet fuel. However, crude oil can be shipped and stored in its natural form.

Natural gas can be used by customers in its natural form but it needs to be liquefied to be shipped overseas.

Question 4

What are industrial and precious metals most sensitive to?

Answer 4

Business cycles. These commodities can be stored for long periods but are very sensitive to business cycles. Industrial metals are particularly sensitive to GDP growth as well.

Question 5

What are grains and softs most sensitive to?

Answer 5

Weather.

Question 6

What is livestock supply most sensitive to?

Answer 6

The price of feed grains.

Question 7

How is the valuation of commodities different than the valuation of traditional asset classes?

Answer 7

Unlike stocks and bonds, commodities are physical assets, have no cash flows, and may incur storage or transportation costs.

Financial assets (e.g. stocks and bonds) are valued by calculating the present value of their expected future cash flows. Since commodities produce no earnings or cash flows, the current spot price of a commodity can be viewed as the discounted value of the expected selling price at some future date.

Storage costs of commodities can also lead to forward prices that are higher the further the forward settlement date is in the future.

Question 8

What are energy commodities most sensitive to?

Answer 8

Many things including global economic growth, economic cycles, improvement in the efficiency of alternative sources of energy, and politics/regulation.

Question 9

What is an informed investor in commodity markets?

Answer 9

Investors who have information about the commodity they trade.

Question 10

Who are the major participants in commodity futures markets?

Answer 10

1. Hedgers
2. Speculators
3. Arbitrageurs
   4, Exchanges
4. Analysts
5. Regulators

Question 11

What is a hedger in commodity markets?

Answer 11

An Informed investor in a certain commodity because they either produce or use the commodity.

Question 12

What is a speculator in commodity markets?

Answer 12

An investor that attempts to profit from having better information or a better ability to process information about a commodity and make a trade. They could be an informed investor based on this.

Some speculators profit from providing liquidity to the futures markets.

Question 13

What is an arbitrageur in commodity markets?

Answer 13

A person in the business of buying, selling, and storing the physical commodities when the difference between spot and future prices is too large based on the actual cost of storing the commodity.

Question 14

Who is the major regulator of commodity markets in the USA?

Answer 14

Commodities Futures Trading Commission (CFTC)

Question 15

What is basis?

Answer 15

The difference between the spot price and the futures price for a commodity.

Question 16

What is a calendar spread?

Answer 16

The difference between futures prices for contracts with different expiration dates.

Question 17

Explain the difference between a commodity market in contango vs. a commodity market in backwardation.
What is the impact of such markets on basis and calendar spreads?

Answer 17

Contango: Spot Price < Future Price (Basis and calendar spread are positive)

Backwardation: Spot Price > Futures Price (Basis and calendar spread are negative)

Question 18

What is the relationship between spot and future prices?

Answer 18

Futures prices converge to spot prices over the term of the futures contract.

Thus, when a market is in contango, there is a negative return to a long futures contract. Conversely, when a market is in backwardation, there is a positive return to a long futures contract.

Question 19

What is the Insurance Theory?

Answer 19

Theory that futures contract buyers are compensated with returns for providing protection against price risk to futures contract sellers (i.e. the producers). This implies that backwardation is a normal condition and spot prices should be greater than future prices.

Question 20

What is the Hedging Pressure Hypothesis?

Answer 20

An expansion of the Insurance theory that includes long hedgers as well as short hedgers. This theory suggests the below:

Backwardation = Short hedgers dominate the market
Contango = Long hedgers dominate the market.

Question 21

What is the Theory of Storage?

Answer 21

Theory that states that spot and futures prices are related through storage costs and convenience yield.

Question 22

What is the convenience yield?

Answer 22

The benefits of having a physical inventory of a certain commodity.

Question 23

What are the three components of total return for a fully collateralized commodity futures contract?

Answer 23

1. Collateral return
2. Price return
3. Roll return

Question 24

Collateral Return

Answer 24

The yield/interest rate of return of securities (typically T-bills) the investor deposits as collateral for establishing a futures position.

Question 25

Price Return (AKA Spot Yield)

Answer 25

The return generated from the change in the spot price of a futures position.

Price Return = (Current Price - Previous Price) / Previous Price

Question 26

Roll Return (AKA Roll Yield)

Answer 26

The return generated from closing out expiring contracts and reestablishing the position in longer-dated contracts.

Roll Return = (Price of expiring futures contracts - price of new futures contract) / price of expiring futures contract

Question 27

What is the roll return in contango vs. backwardation?

Answer 27

Contango = Negative roll return. Because the longer-dated contracts are more expensive (higher prices) than the expiring contracts.

Backwardation = Positive roll return. Because the longer-dated contracts are cheaper (lower prices) than the expiring contracts.

Question 28

How are swaps used in commodities markets? What are swaps?

Answer 28

Swaps allow investors to increase or decrease exposure to commodities.

They are customized instruments created and sold by dealers, who take on the risk of their swap exposure or hedge their exposure by entering into an offsetting swap contract or by holding the physical commodity.

Question 29

Total Return Swap

Answer 29

The buyer of the swap receives periodic/variable payments from the seller based on the change in price of a commodity plus the return on the collateral, in return for a series of fixed payments.

The seller of the swap receives a series of fixed payments from the buyer.

Question 30

Excess Return Swamp

Answer 30

The buyer of the swap receives periodic/variable payments from the seller based on the difference between the commodity price and a benchmark value.

The seller of the swap receives a series of fixed payments from the buyer.

Question 31

Basis Swap

Answer 31

The buyer of the swap receives periodic/variable payments from the seller based on the difference between the prices of two different commodities.

The seller of the swamp receives a series of fixed payments from the buyer.

Question 32

Commodity Volatility Swap

Answer 32

The buyer of the swap receives periodic/variable payments from the seller based on the volatility of a commodity’s price.

The seller of the swamp receives a series of fixed payments from the buyer.

Question 33

How can a commodity index be most useful to investors?

Answer 33

An index should be investable, in that an investor should be able to replicate the index with available liquid futures contracts.

Question 34

What are the four major factors in why commodity indices will difffer?

Answer 34

1. Commodities included in the index
2. Weighting of the commodities in the index
3. The method of rolling contracts over as they near expiration (passive or active)
4. The method of rebalancing portfolio weights.

Question 35

How does the rebalancing of portfolio weights of commodities impact an index returns?

Answer 35

Frequent rebalancing - Decrease returns in trending markets and increase returns in choppy/mean-reverting markets.

Infrequent rebalancing - Increase returns in trending markets and decrease returns in choppy/mean-reverting markets.

Question 36

What is the life cycle of a commodity?

Answer 36

The time it takes to produce, transport, store, and process a commodity.

Question 37

What is the life cycle of crude oil?

Answer 37

Drilling a well and extracting and then transporting the oil. The oil is then stored for only a short period before being refined into products that will be transported to consumers.

Question 38

What is the life cycle of natural gas?

Answer 38

Similar to oil, natural gas is extracted by drilling a well into the earth. However, natural gas requires little processing after it is extracted and is typically transported to consumers by pipeline. Natural gas can also be cooled to liquid form (LNG) and transported on ships.

Question 39

What is the life cycle of metals?

Answer 39

Metals are produced by mining and smelting ore into products that consumers need. Such a process requires producers to construct large-scale fixed plants and equipment. Most metals can be stored long-term.

Question 40

What is the life cycle of livestock?

Answer 40

Production cycles vary depending on the size of the animal (e.g. chickens are ready in weeks while cows are ready in years, etc.) There is a significant seasonal component. Meat can also be frozen for shipment and storage.

Question 41

What is the life cycle of grains?

Answer 41

Very seasonal, however, grains can be stored after harvest. Growing seasons are opposite in the northern and southern hemispheres.

Question 42

What is the life cycle of softs?

Answer 42

Softs are produced in warm climates and have production cycles and storage needs that vary by product.