6.1 / 22 - Key Concepts in Commodity Markets

Question 1

LO 22.1: Demonstrate knowledge of the economics of commodity spot markets.

Answer 1

• Analyze factors affecting the relationship between commodity prices and the business cycle. • Describe the properties of spot commodity prices, including evidence regarding long-run returns, and the causes and effects of supercycles and short-term fluctuations.

Question 2

Factors Affecting Commodity Markets

Answer 2

• Business cycle has big impact, more so on metals / industrial than on agriculture - Currency changes with USD has effect on commodity Mkts, as mkts typically denominated in USD. Monetary policy thus affects Commodity mkts - INterest rates impact relationship between prices and business cycle. Lower interest rates drive demand / lower supply. Companies desire to hold investories goes up - Central bank policies influence Commodity prices. When rates are cut and real interest rates fall, inflation does decline, the cost of real commodity prices increases, until commodities are overvalued. Contractionary policy causes the opposite - Commodity Prices tend to move with inflation (positvely correlated).

Question 3

Hotelling Theory

Answer 3

• created by Harold Hotelling in 1931 - exhaustible commodities’ real prices increase at the real interest rate. (doesn’t apply to ag, only exhaustible). - evidence does not support this - returns of exhaustibles over the last 150 years have been been negative. This does not take into account production costs changes though.

Question 4

SUPERCYCLES

Answer 4

Extended periods of price increases followed by estended periods of price decreases. - Over past 150 years, there have been 4 supercycles, each lasting 30 to 40 years. - Supercycles for non-oil commodities are impacted by demand; oil prices impacted by supply. Tropical ag prices have seen the biggest price decline over the long term, followed by non-tropical ag and metals. Oil prices have seen opposite trend.

Question 5

Supercycles vs. short term financial changes

Answer 5

1) supcercyles last much longer (upswing from 10 to 35 years with full cycle lasting 20 to 70 years 2) supercycles can be seen over many varying commodities - e.g. post-WWII reconstruction of Europe and Japan’s post WWII recovery, both led to huge demand for raw materials. Current supercycle with subside once growth rates in major developing countries subside (China & India).

Question 6

LO 22.2: Demonstrate knowledge of commodity trading firms, risks, and speculation.

Answer 6

• Describe the process of commodity transformation. • List and discuss the seven risks to which commodity trading exposes trading firms. • Discuss speculation in commodity markets. • Discuss the effects of commodity speculation on pricing and risk

Question 7

Transforming commodities

Answer 7

process of altering a commodity in terms of space, time, or form. - e.g. transformations of space involve moving commodities from the production site (supply) to the consumption site (demand). -AGENTS OF TRANSFORMATION - commodity firms exectue the transformation steps. Determine the most profitable transformation, then perform the steps

Question 8

Transformation Steps (for Commodities)

Answer 8

TRANSFORMING IN SPACE - profitable transformation invoolves purchasing commodity where it is cheap, selling it where it is priced high enough to cover transaction costs TRANSFORMATION IN TIME - profit opportunity based on mispricings across time (buy cheap now, sell/deliver high later). Profit = difference between forward price, and the spot price less transaction costs TRANSFORMATION IN FORM - commodity is processed or blended into new form. eg corn/ethonal crush spread earned when buying corn, crushing it, and selling corn ethanol. profit is the differential in selling and purchase price, less processing costs

Question 9

7 Commodity Trading Risks

Answer 9

1. Flat Price Risk - arising from changes in spot prices - generally hedge with offsetting futures contracts 2. Basis Risk - price differential between the hedged commodity and the price of the underlying commodity for the corresponding forward or futures contract (rarely teh same) 3. Spread Risk - posions that are subject to relative price differences between contracts that differ in maturity dates - timing mismatch could result in losses but may be unavoidable 4. Margin and Volume Risk - When commodity merchandise profits are based on margin differentials between purchase and sale prices, as well as volume of transactions. 5. Operational Risk - risk of loss arising from an operational failure (vs. unfavorable prices or quanitity variances). faulty manufacturing process is one eg. 6. Market Liquidity Risk - when it is more difficult to enter or exit positions without having large and unfavorable price impact 7. Funding liquidity Risk - when access to financing is limited. Restrictions on firm in terms of taking leveraged positions to purchase commodities will lmimit its profits and can lead to losses.

Question 10

PRICE SPECULATION

Answer 10

purchase or sale of a commodity - related asset with the anticipation that it will increase or decrease sufficiently to net a gain that exceeds the required return for taking on systematic risk.

Question 11

financialization of commodities

Answer 11

describes the increased use of financial contracts and derivatives products to increase the level of commodity trading. - e.g. growth in commodity index investments between 2003 and 2009 that occursed with the longest and most signficant increase in commodity prices in recorded history

Question 12

4 Conclusions on data analysis around speculators and commodity markets

Answer 12

• Most commodities without futures markets or institutional fund investments also experienced significant price increases (e.g., steel, coal) - Markets where index trading dominates total open interest experienced price declines (between 2007 and 2008) - The amount of speculation in agriculture and crude oil has stayed fixed on a percentage basis even though prices have increased - Speculators in commodity markets engage in both buying and selling activities.

Question 13

LO 22.3: Demonstrate knowledge of the economics of commodity futures markets.

Answer 13

• Discuss the theory of storage and the concept of convenience yield. • List and explain the three determinants of convenience yield. • List and describe the major components of the cost of carry, and calculate convenience yield for a given commodity. • Describe commodity arbitrage and the cost of carry without convenience yield. • Describe commodity arbitrage and the cost of carry with convenience yield.

Question 14

THEORY OF STORAGE

Answer 14

states that investors derive benefits from holding physical commodities rather than only investing in futures and forward contracts. Benefits accrue from economic value that physical commodities hold by being able to meet unexpected supply and demand shocks in the market.

Question 15

CONVENIENCE YIELD

Answer 15

refers to the non-monetary benefits received from physically holding a commodity, and measures the convenience of owning an asset available for use. - The convenience yield is a risk premium that is inversely related to the level of inventories. Convenience yields are high when inventories are in short supply, but low when inventories are plentiful.

Question 16

marginal convenience yield

Answer 16

the lowest convenience yield that clears the market (i.e., matches buyers with sellers)

Question 17

Consumer surplus

Answer 17

refers to the difference between the price a firm would be willing to pay for a commodity (i.e., the reservation price) and the market price.

Question 18

3 factors affecting the convenience Yield (for Commodities)

Answer 18

1. Investor Levels - have a negative impact on the level of commodity prices. Low investnory levels correspond to high convenience yields 2. Correlation between volatility and commodity prices - low investory levels tend to correspond to higher prices and higher vol., increasing the convenience yield 3. Commodity futures prices - Rising future prices are associated with lower convenience yield. because specculative increase in future prices leads to inventory buildiup, reducing benefit of owning additional commodity supply, reducing convenience yield

Question 19

Cost of Carry (of commodities)

Answer 19

measure of storage costs, comprising four elements:

1) Financing costs - based on investor’s cost of capital, different for each investor
2) Storage costs 0 storage space rental costs, insurance costs, inspection, mainentnace, transportation costs (think whiskey barrels)
3) Potential Spoilage - refers to the natural loss of value during storage - not applicable for all commodities
4) Convenience Yield

Question 20

Cost of Carry Formula (for Commodities)

Answer 20

cost of carry = financing costs + storage costs + spoilage costs – convenience yield Cost of carry can be used with the futures and spot price of a commodity to determine convenience yield: Futures Price = Spot price + financing costs + storage costs + spoilage costs – convenience yield

Question 21

CASH-AND-CARRY ARBITRAGE

Answer 21

concurrent purchase of a commodity in the spot market and sale in the futures market to earn a risk-free profit. (if the spot + cost of carry < futures price)

Question 22

reverse cash-and-carry arbitrage

Answer 22

when futures price is below the breakeven price

Question 23

Formula for Breakeven Futures Price

Answer 23

breakeven futures price = spot price + cost of carry or, with the convenience yield broken out: breakeven futures price = spot price + costs – convenience yield

Question 24

LO 22.4: Demonstrate knowledge of commodity forward curve theories

Answer 24

• Discuss the relationship between the slope of the forward curve and the cost of carry. • Discuss the relationship between market expectations and forward curves. • Describe the concept of normal backwardation, and discuss its relationship to the liquidity preference hypothesis. • Discuss commodity storage models, and the relationship between storage models and the futures curve for a commodity. • Discuss the preferred habitat hypothesis, segmented markets, and option-based models of the term structure, and their effects on forward curves.

Question 25

Term Structure of Future Prices (or, FORWARD CURVE) [Commodities]

Answer 25

Relationship between the futures price and maturity of the contract: CONTANGO - refers to a price pattern where the futures price is above the spot price and converges to that price from above over time. Contango markets have an upward sloping forward curve. BACKWARDATION - refers to instances in which the futures price is less than the current spot price. In these cases, the forward curve will be downward sloping, indicating that the futures price is lower for longer-term contracts.

Question 26

Contango.

Answer 26

This refers to a price pattern where the futures price is above the spot price and converges to that price from above over time. Contango markets have an upward sloping forward curve.

Question 27

Backwardation.

Answer 27

This refers to instances in which the futures price is less than the current spot price. In these cases, the forward curve will be downward sloping, indicating that the futures price is lower for longer-term contracts.

Question 28

Unbiased Expectations Hypothesis (for Commodities forward curve)

Answer 28

states that the futures price is an unbiased predictor of the expected future spot price. - futures price = expected future spot price - only holds if markets are risk-neutral and there are no transaction costs, taxes, or borrowing limits. Under this theory, - generally DOES NOT explain futures markets well

Question 29

Liquidity Preference Hypothesis (for Commodities forward curve)

Answer 29

• producers prefer long maturity futures (to hedge future production), users prefer short maturity futures or spots to maintain flexibility - Producers must accept a lower futures price (discount) to entice users to accept longer maturity futures and clear natural oversupply of futures contracts - NORMAL BACKWARDATION - occurs when futures price is lower than expected future spot price

Question 30

NORMAL BACKWARDATION

Answer 30

• occurs when futures price is lower than expected future spot price (plain BACKWARDATION is when futures price is lower than CURRENT spot price).

Question 31

Storage models (Commodities futures curve)

Answer 31

consider the impact that current and expected future storage levels of a commodity have on the relationship between spot and futures prices. -Storage models incorporate the costs to store, the feasibility to store, and costs to transport a commodity for delivery. -Storage models generally forecast upward (downward) sloping forward curves when commodity inventory levels are above (below) demand. - Storage models also consider the risk of a stock-out.

Question 32

Stock Out (Commodities)

Answer 32

• Occurs when inventory levels fall to zero and consumption is dependent on current production - highest risk for markets with seasonal demand (natural gas, grains). - Commodity users more actively hedge maturities on forward curve that have hghest stock out risk.

Question 33

Working curve (Commodities curve)

Answer 33

• illustration of the theory of storage, and looks at the slope of the forward curve relative to current inventory levels. - The Working curve is typically upward sloping and concave, where low inventory levels may be due to delays and costs, causing convenience yields to be high.

Question 34

Other Models for Commodity Markets Forward Curve

Answer 34

• Preferred habitat hypothesis - generalized version of the liquidity preference hypothesis. producers favor different parts of futures curves to hedge positions, but could be enticed to different maturities based on pricing. supply/demand imbalance picked up by speculators - Segmented Markets - geographic separation, time preferences, or other market frictions cause markets for same product to operate independently - forward curve is useless since spot traders and futures traders act without regard for eachother. - Normal Contango - When commodity users outweigh prodcuers as the hedgers in a market, producers must be enticed into futures market by premium above expected future spot price - Humped Curve - occurs when the market for long-term contracts is in backwardation, but in contango for short-term contracts. This has often been observed in the futures market for crude oil. - Option-based models = rely on real options to describe the forward curve. known as real options embedded in commodity markets.

Question 35

volatility asymmetry (options based commodities forward curve)

Answer 35

• Commodities are less volatile when prices are falling since the resulting surpluses are less important than shortages. - leads to a downward sloping forward curve.

Question 36

LO 22.5: Demonstrate knowledge of the decomposition of returns to futures-based commodity investment.

Answer 36

• List and discuss the three sources into which returns on commodity contracts may be decomposed. • Describe how the forward curve can indicate scarcity in commodity markets.

Question 37

3 Sources of return for Commodity futures contracts

Answer 37

Spot Return - caused by movements in the spot commodity price in cash markets, influenced by macro factors, including S&D changes Collateral Yield/Income Return - arises from return on cash collateral, typically from gov’t treasury sec’s or money market instruments Roll Yield/Roll Return - arises from “rolling” commodity futures contracts over at maturity. portion of return that can be attributed to the change in the basis (difference between spot and future prices) over time. Positive when forward curve slopes downward (backwardation), negative when forward curve slopes upward (contango). Particularly influenced by the convenience yield.

Question 38

LO 22.6: Demonstrate knowledge of the use of commodities as an inflation hedge.

Answer 38

• Describe the rationale for using commodities as an inflation hedge. • Discuss evidence regarding the efficacy of commodities as an inflation hedge. • Describe the rationale for the inverse relationship between financial assets and both commodities and inflation.

Question 39

3 Factors to consider that affect effectives of inflation hedge through Commodities

Answer 39

1. INflation measures may be calculated as the averages of inflation in many countries - this biases the results 2. Investors have to consider the effects of exchange rate movements 3. Correlations between commodities and inflation are typically stronger over the long term

Question 40

LO 22.7: Demonstrate knowledge of the relationship between commodity prices and exchange rates.

Answer 40

• Discuss the effects of exchange rate changes and risks on commodity market prices and participants. • Discuss the effects commodity prices have on currencies and national economies.

Question 41

Commodity currencies

Answer 41

• refer to the currencies of countries where commodities are a primary export. - Commodity currencies typically have signficant positive correlation with the price of the given commodity - stronger commodity price, stronger currency.

Question 42

LO 22.8: Demonstrate knowledge of the effects of rebalancing and the historical performance of commodity futures.

Answer 42

• Discuss empirical evidence on the effects of rebalancing on return. • Describe the effects of rebalancing when commodity prices are not mean-reverting. • Recognize and approximate the effect of rebalancing on geometric and arithmetic mean returns. • Analyze historical performance of commodity investments. • Discuss research findings regarding the financialization of commodity returns.

Question 43

rebalancing yield

Answer 43

the additional return to a portfolio through the process of rebalancing indexed commodities.

Question 44

Portfolio Geometric Return, as a function of Arithmetic return and risk

Answer 44

Question 45

Historical Commodity Return Performance

Answer 45

• Generally provided positive returns and diversification benefits
• 1959 to 2014, commodity futures earned nominal annual return of 3.88%, spot commodities eared 2.98%. performance varied a lot within that frame though.
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