5. Commodities Flashcards
Spot Market
For immediate delivery
Forward Contract
Is a bilateral contract that obligates one party to buy and one party to sell a specific quantity of an asset, at a set price, on specific date in the future.
Futures Contract
Is a forward contract that is standardized and exchange-traded.
**Main difference between the two is that futures are traded in an active secondary market, are regulated, backed by a clearinghouse, and require daily settlement of gains and losses.
Regulated by CFTC
CFTC
Commodity Futures Trading Commission
Open Interest in Futures Market
- Number of outstanding contracts.
- A long position and a short position on the same contracts are counted as one contract towards open interest.
Commodity Swaps
Custom, privately negotiated packages of forward contracts that have a pre-specified prices (which may vary) and different expiration dates.
- OTC instruments with limited liquidity
Marking-to-market
Change in contact value is transferred in cash from the margin account of the counterparty with a loss in value to the margin account of the counterparty with a gain in value.
Initial Margin
- collateral that must be deposited in a futures account before trading takes place.
- generally, relatively low amount.
Maintenance Margin
Amount of margin that must be maintained in a futures account and is usually set at 75-80% of the initial margin.
Nearby Contract
Futures contract with the shortest time to expiration
Deferred Contract
Longer maturity futures contracts.
Term Structure of Forward Prices
- relationship between he forward prices and time.
- concerned with asset’s spot price,S, and it’s forward price, F(T), where T represents the time until the contract maturity in years.
Simple Forward Pricing Model
F(T) = S for all maturities, T
where,
F(T)= current forward price of a contract expiring at time T
S = spot price
For the above to hold true, following assumptions:
- no transaction costs
- risk free rate zero
- underlying assets can be borrowed at zero
- no div yield, convenience yield, storage costs
- underlying asset can be easily obtained
Contango
A price pattern where forward prices are above the spot price and converge to the spot price from above over time.
- Upward sloping forward curve
Backwardation
Instances in which forward prices are less than the current spot price
Cost of Carry
Measure of financial difference between holding a position in a spot market and hooding a position in a forward market.
Cash and Carry Arbitrage Strategy
At initiation of strategy:
- sell forward contract at F(T)
- borrow cash at risk free, for term of contract, T
- use borrowed funds to buy underlying asset
At contract expiration:
- deliver underlying asset, receive forward price F(T)
- repay interest and principal on the loan
Price of Future Contract > Price Implied
cash and carry arbitrage strategy
Reverse Cash and Carry Arbitrage Strategy
At initiation of strategy:
- buy forward contract at F(T)
- sell underlying asset short at current spot, S
- lend cash received from short at risk free, r
At contract expiration:
- collect loan proceeds, plus interest
- use collect loan proceeds to take delivery of asset at the forward price and cover the short- sale commitment
Forward Pricing Arbitrage Equation
F(T) = S x e^(rxT)
where:
F(T) = price of forward contract
S = spot price of the underlying asset
e = transcendental number used to calculate, ~2.718
r = risk free rate
T = time to maturity of the forward contract
Financial forward equation
F(T) = S x e^[(r-d)xT)]
where:
d= continuously compounded dividend or coupon rate
Financial Forward Pricing Relationships
- F(T) >S when r>d, resulting in an upward sloping forward curve (i.e. contango); slightly convex
- F(T) < S when r
Explanation of Why Forward Prices are Reduced when
r < d
- dividends and coupons cause the value of financial assets to decrease on the day of the distribution. Forward contracts with maturities after the distribution date must reflect the decline in value.
- Forward contracts only account for the present value of the market price at time T, not the PV of dividends or coupon rates, therefore the forward contract price must be less than the spot.
Convenience Yield
Reflects the return form holding the physical asset
Forward Pricing Relationship with Convenience Yield
F(T) = S x e^[(r+c-d-y) x T]
where:
F(T) = price of forward contract
S = spot price of the underlying asset
e = transcendental number used to calculate, ~2.718
r = risk free rate
c= storage costs
d= continuously compounded dividend or coupon rate
y = convenience yield
T = time to maturity of the forward contract
Perfectly Elastic Supply
mean that at any level of market demand for an asset (e.g., currencies) can instantly by supplied without limit or price impact.
Inelastic Supply
means that a change in supply to meet market demand requires large price changes or that supply quantities react slowly to price changes.
Key Points Regarding Term Structure of Forward Prices
- The slope and share of the term structure are driven by differences in the cost of carry.
- The slope and shape of the term structure are not related to returns earn on forward contracts.
Normal Backwardation
- Refers to a price pattern where the forward price is below the expected future spot price and converges to that price from below over time.
- thus, long forward contract is expected to earn positive return with no investment, and a short contract is expected to incur a loss.
Normal Contango
- Refers to a price pattern where the forward price is above the expected future spot price and converges to that price from above over time.
- thus, a short forward contract is expected to earn positive return with no investment, and a long forward contract is expected to incur a loss.
Possible Forward Market Term Structure Based on Future Expected Values
Backwardation- current forward price is less than the current spot price
Normal Backwardation - current forward price is less than the expected future spot price
Contango- current forward price is greater than the current spot price
Normal contango - current forward price is grater than the expected future spot price
Hedgers_ Normal Backwardation
Hedgers will tend to hold more short contracts than long contracts
Hedgers_Normal Contango
Hedgers are net long forward contracts rather than net short
Futures and Forwards as Beta Drivers
Investors who use futures as beta drivers are attempting to gain risk and return exposure of the underlying asset while minimizing the costs
Futures and Forwards as Alpha Drivers
Investors who use futures as alpha drivers look for violations of the law of one price in the futures market and engage in the appropriate arbitrage transactions.
Law of One Price
States that two assets with identical payoffs must have the same price.
Ex-Ante Alpha Strategy and Term Structure
Ex-ante alpha strategies attempt to profit speculation on the changes in the shape of the forward term structure, a belief based on the assumption that the term structure is informationally inefficient (i.e. pricing relationships incorrectly incorporate current information).
-Strategy: purchase underpriced forward contracts and sell overpriced forward contracts.
Basis in Terms of Forward Contract
- difference between the spot price and the price of the forward contract.
Basis = S - F(T)
where:
S= spot price of the underlying asset
F(T) = price of the forward contract
Calendar Spread
Ex-ante alpha strategy that combines a long forward position and a short forward position on the same underlying asset but with different expiration dates.
- implicit bet on the shape of the forward term structure and an attempt to earn profits from the relative mispricing between related forward or futures contracts.
Calendar Spread Equation
Calendar Spread = F(T + t) - F(T)
where:
F(T) = price of a forward contract that expires at time T
F(T + t) = price of the forward contract that expires at T+t
t = amount of time between expiration of contracts
Reasons Commodity Prices Should Have Low Correlation to Prices of Stocks and Bonds
- Supply and Demand: commodities don’t have cash flows to discount, but are driven by supple and demand interactions.
- Correlation with Inflation: inflation and changes in the inflation rate are positively correlated to commodity prices.
- Short Term vs. Long Term Expectations: commodities reflect current economic conditions
- Capital Costs vs. Raw Material Costs: significant increase in the cost of raw materials will negatively effect the value of stocks and bonds.
Inflation
Occurs when the value of a currency decreases in relation to a representative basket of goods and services.
Commodities as Protection again Inflation Risk
- Commodity prices are a factor in inflation measures and are, therefore, positively correlated with inflation.
- Commodity prices represent the value of consumption. The real value of consumption is independent of inflation rates.
Commodity Alpha Return Enhancement
- believe commodities are mispriced based on forcasted prices derived through fundamental and technical analysis.
- goal of strategy: to gain commodity exposure and hold the position long enough to profit from the anticipated price correction.
Equilibrium Beta Return Enhancement
Commodities do NOT enhance returns in equilibrium markets.
Disequilibrium Beta Return Enhancement
- Investors often do not hold commodities according to their market weights, thus causing a disequilibrium.
- Commodities in disequilibrium provide greater return per unit of beta risk than other beta exposures.
Physical Commodities
Physical commodity ownership is an inefficient method of obtaining commodity exposure unless the investor has a high convenience yield or a competitive storage advantage.
Commodity Related Equity Investments
Pure play investments such as Freeport-McMoRan for copper exposure, has commodity beta in addition to market beta resulting from equity market exposure.
**Many reason that a pure play may not give the same exposure as commodities.
Commodity Exchange Traded Funds
Low cost opportunities for retail investors to gain commodity exposure.
- physical: not directly exposed to equity market or futures market risk.
- futures: exposed to basis risk
- equities: exposed to equity market and commodity market risk
Commodity Exchange Traded Notes (ETNs)
Similar to commodity ETFs, but represent a claim to a debt security with cash flows linked to commodity prices.
- exposed to credit risk of the issuing investment or commercial bank.
Commodity Linked Notes (CLNs)
- combine a standard interest paying debt instrument with either a commodity futures contract or an option on commodity prices.
- contains both commodity risk and default risk of the issuer
Several Advantages: - investor does not have to worry about rolling futures to maintain long term exposure.
- CLN effectively a bond, can be a way to avoid restrictions
- tracking error issues responsibility of the note issuer.
Basis Risk
uncertainty in economic outcomes resulting from changes in the spot price/futures price relationship
Reasons Return to Commodity Futures Contracts can differ from Spot Returns
- Cost of carry implies by the basis differs from the cost of carry for the spot.
- Basis changes
Futures contracts with different maturities: - Calendar spread changes
- Cost to roll over the long term exposure changes over time.
Return on a Fully Collateralized Futures Position
- Spot Return: reflects changes in the spot price of a commodity
- Collateral Yield: interest earned on the risk free asset
- Excess Return: changes in futures prices
Roll Yield
- return that results from changes in the basis of a futures contract
Reasons:
1. passage of time: closer to maturity, futures prices and basis converge
2. Changes in cost of carry
Positive Roll Yield: backwardated market
Negative Roll Yield: contango market
Roll Yield on Financial Assets
Assuming constant spot prices and term structure, the roll yield on a futures contract for a financial asset with high dividend yield will be positive, while the roll yield on a futures contract for a financial asset with a low dividend yield will be negative.
Roll Return Fallacies
- Roll return is directly attributable to closing and opening positions: Roll return occurs over the contract holding period, and is the difference between the futures price when the contract is opened and the futures price when it is closed less the change in spot price over holding period.
- Backwardated markets always generate positive roll return: cost of carry and term structure are not always static.
- Positive roll return always generate alpha: futures contracts on financial assets not related to roll return
Commodity Futures Index_Use by Managers
- Benchmark for return attribution and performance analysis
- Tool to execute tactical investment strategies on the performance of commodities.
- Tool to execute passive investment strategies designed to diversify portfolio risk.
Standard and Poor’s Goldman Sachs Commodity Index (S&P GSCI)
- long only tradable index of nearby physical commodity futures contracts
- created in 1991
- production-value weighted, using 5 year averages to reflect importance to global economy
- asset weights set at the beginning of the year, and change with price fluctuations
- comprised of: precious metals, industial metals, livestock, agriculture, and energy (energy make up over 70% of the index).
- unique attribute, is that contracts trade on S&P GSCI itself
Dow Jones- UBS Commodity Index (DJ-UBSCI)
- long only , diversified index of 19 physical commodities
- trade on US commodity exchanges and London Metals Exchange (LME)
- comprised of: energy, precious metals, industrial metals, grains, livestock, and soft commodities (i.e. coffee, cotton, sugar)
- weighted primarily by trading volume, secondarily on production
- requires no group to be more than 33% or less than 2%
- rebalanced January
- momentum based
Reuters/Jeffries Commodity Research Bureau (CRB) Index
- monthly rebalancing
- traded on NYMEX, Chicago Board of Trade, CME, COMEX, LME
- four weighted tiers:
1. (33%) petroleum products
2. (42%) liquid contracts
3. (20%) broad diversification
4. (5%) additional diversification
Historical Risk and Returns of Commodity Investments
as represented by GSCI monthly returns January 2000-December 2012
- high mean returns with an accompanying high volatility
- maximum drawdown of-67.6, worst single month -28.2%
- relatively uniform distribution of monthly returns -9-(-11)%, indicating no mean return
- significant impact from both large price increases before financial crisis and during
- negative price reaction to market stress
- modest diversification effect
- negatively skewed and leptokurtic returns
- moderate positive correlation with global bond & US high yield
- moderate negative correlation with credit spreads and equity volatility
- moderate positive correlation with global equities
