AI 2.1

Question 1

What are the commodity sectors as per the CRB?

Answer 1

There are six sectors:
1. Energy
2. Grains
3. Industrial Metals
4. Livestock
5. Precious Metals
6. Softs (Cash Crops)

Question 2

Discuss Energy

Answer 2

Three major components: Crude oil, Refined products & Natural gas.

Crude oil: Can be light, heavy or ‘sweet’ oil (depending on the density of the oil and sweet oil refers to low sulphur content in the oil). If oil has high sulphur content, it makes it more corrosive (thus making transportation of oil difficult).
Storage - naturally underground
transportation - via pipelines (but also via ships, trains or trucks)
Suppy impacts - political events, new technologies, Weather (not much effect in the long run)
Demand - Economic growth and oil consumption have a very high correlation. Oil availability stimulates economic growth.

Refined Products: gasoline (petrol), jet oil, propane, heating oil, etc.
Demand - Influenced by weather

Natural gas: two types -> associated (comes from an oil-well) & unassociated
Storage and transportation costs are high.
For associated gas, supply is driven by oil demand.
Demand for gas is influenced by weather.

Question 3

Describe Grains

Answer 3

Corn, Wheat, Rice & Soy (Staple foods).
Storage & Transportation - Grown in defined seasons, relatively easy to store & transport.
Supply - influenced heavily by weather, diseases & pests
Demand - Consumers (humans), animal feed, ethanol production.

Question 4

Describe Industrial Metals

Answer 4

Mined ore which are transformed/processed into copper, aluminium, nickel, zinc, lead, tin, iron.
Storage - Relatively easy
Transportation - difficult to transport
Supply - not influenced by weather
Demand - are majorly used in industrial production; copper price has a high correlation with industrial production & GDP growth.

Question 5

Describe Livestock

Answer 5

Poultry, cattle, sheep, hogs.
Storage - Where alive, costs are dependent on grain prices and slaughtered incur costs for keeping meat frozen
Transportation - relatively easy
Supply - impacted by weather, diseases and govt policies
Demand - tied to growth in emerging markets.

Question 6

Describe Precious Metals

Answer 6

Gold, silver, platinum.
Storage - very high and inexpensive
Transportation - relatively easy
Supply - no impact of weather
Demand - influenced by inflation, industrial production, technology, jewelry production (Status symbols in some countries)

Question 7

Describe Softs/Cash Crops

Answer 7

Cotton, Coffee, Sugar, Cocoa.
Storage - Is an issue cos of freshness which determines weight and quality.
Transportation - relatively easy
Supply - weather (very important factor)
Demand - impacted by global wealth (emerging markets)

Question 8

Discuss life Cycle of commodities

Answer 8

Where the life cycle is short, the impacts are absorbed quickly and adjustments are quick.
Life cycle varies across categories and can vary within categories as well.
The questions and different production cycles are pretty logical and based on common sense.
There’s not much to summarize.

Question 9

Valuation of Commodities

Answer 9

Valuation of Stocks and bonds are based on getting the present value of the future cash flows which will be generated.
However, commodities do not generate any cash flows. The valuation is solely done on the basis of expected future price, which in turn is based upon expected demand & supply of commodities.

Question 10

Who are the commodities Futures market participants?

Answer 10

Hedgers, Traders & Investors, Exchanges, Analysts & Regulators.

Question 11

What are Spot and Futures prices?

Answer 11

Spot is just like Fx spot price in eco, except the spot price is location specific and to deliver physical commodity.
Futures price is an agreed price to buy/sell a defined quantity (& often quality) of a commodity at a future date
Can be global, regional or national. Are standardised to promote liquidity. Are a reference for forward contracts, and provide data for market participants and govts.
Basis = Spot price - futures price

Question 12

What is backwardation and Contango?

Answer 12

Backwardation is positive basis and Contango is negative basis.

Question 13

What is Calendar Spread?

Answer 13

When someone trades in the futures of the same commodity based on the difference in price in futures as per different months, is known as trading on calendar spread. One leg of deal involves buying and the other will involve the opposite (selling).

Question 14

What are the theories of futures returns?

Answer 14

Insurance theory, The hedging pressure hypothesis and the theory of storage.

Question 15

What is the Insurance theory?

Answer 15

Insurance theory (made in 1930) states that the futures price should always be in backwardation. (remember the example of a corn farmer, who expects future price to be $20 but will lock in $19 to hedge risk of making further losses)

Question 16

What is the hedging pressure hypothesis?

Answer 16

In the insurance theory, we look at only the perspective of a corn producer. When we bring in the perspective of a consumer as well (Food manufacturer) then they too would like to hedge against future price volatality.
So the futures price depend on who wants to hedge the commodity more at a specific point of time (producers or consumers).

Question 17

What is the theory of Storage?

Answer 17

States that the future prices of commodities are impacted by the supply and demand dynamics of commodity inventories, including the concept of convenience yield. Convenience yield is inversely related to general availability of the commodity (remember the textile manufacturer example and owning cotton in it’s inventory can be beneficial or not). Thus, Futures price = spot price + storage costs - convenience yield.

Question 18

What are the components of futures returns?

Answer 18

There are three major components which together comprise the total return from futures:
Price Return (Spot yield), Roll Return & Collateral Return.

Question 19

How to calculate spot yield?

Answer 19

Spot yield can be calculated as [current futures price - previous futures price (price when you entered futures)] / previous futures price

Question 20

How to calculate Roll Return?

Answer 20

Roll return can be calculated as (near-term futures contract closing price - farther-term futures contract rolling price) / near-term futures contract closing price which gives the gross roll % and for the net roll return, multiply the gross roll % with the % of the position in futures contract being rolled.

Question 21

When is Roll Return positive or negative?

Answer 21

When in Backwardation, Roll Return will be +ve & when in Contango, Roll Return will be -ve.

Question 22

When will we end up having more number of contracts vs less number of contracts while rolling?

Answer 22

Also, backwardation leads to having more number of contracts vs contango where we have lesser number of contracts when we roll.

Question 23

How significant are roll returns?

Answer 23

Roll Return can be significant in some specific periods, will end up being only a small % of the total return over multiple periods.
Roll Return is also sector dependent.

Question 24

How to calculate collateral yield?

Answer 24

Collateral yield is the return we get on the money which we’ve put in as collateral to trade in the futures markets.
The return earned on that money is the collateral return.

Question 25

What is a Commodity Swap?

Answer 25

A commodity swap (just like a swap derivative) is a legal contract involving the exchange of payments over multiple dates as determined by specified reference prices or indexes relating to commodities.
Swaps allow participants to customize contracts (unlike futures contracts)

Question 26

What are the different kinds of swaps?

Answer 26

1. Excess Return swap - Where one party pays a premium to earn excess money over a strike price decided while entering the swap and up to a specific time in the future. (Oil refinery with swap dealer example with strike price of 100 for one year)
2. Total Return swap - One party receives payment based on the change in the level of an index.
   (* difference between excess and total return is that in total return, entire amount of profit/loss is transferred to another party vs in excess only the difference over an established strike price is exchanged.)
3. Basis swap - Periodic payments are exchanged based on the values of two related commodity reference prices that are not perfectly correlated.
   (example can be two different kinds of oil)
4. Variance swap - A swap between a Variance buyer and a Variance seller. Variance buyer benefits if the difference between actual/observed variance is higher than the fixed amount of variance & vice versa. Often, the variance differences are capped to limit upside and losses. Direction does matter.
5. Volatility swap - Between a volatility buyer and seller. If higher than expected, buyer benefits & vice versa. Direction doesn’t matter.
   Price variance = price volatility squared.

Question 27

What are commodity indexes and what are its primary roles?

Answer 27

Just like a stock index, commodities do have indexes of commodity constituents.
Primary roles: Forecasting, Benchmark to evaluate moves in commodity prices & basis for investment vehicles.

Question 28

What are the characteristics that can distinguish one kind of commodity index from another?

Answer 28

The key characteristics are:
Breadth - refers to how many commodity categories are included in the index as well as the different types of commodities which are included in the index.

Weighting method - It can be based on production/liquidity/can be fixed or can also be a combination of 2. Production weightage means it’s weighed based on the production in the world.
Liquidity can be a screening factor as well, besides being a weighting factor.
Some indexes can have caps/floors on size of sectors or individual commodities.

Rolling methodology - Can be done in two ways:
Either by owning front contracts -> which are near-term to expiry (highly liquid and price volatile)
vs maximizing rolling benefits (or minimising rolling losses) which is a more active approach of choosing contracts to be included in the index.

Rebalancing frequency - Monthly or Annual
Rebalancing return - is a return which is earned when an index is re-balanced (mostly to happen in fixed weighted indexes)
Greater chances of earning rebalancing returns when the constituents are mean reverting.
Frequent mean reversions favours monthly rebalance indexes

Governance - Constituents are selected based on some rules or by some methods of the index provider.

Question 29

What are some important points about commodity index to remember?

Answer 29

Commodity indexes have a high correlation with futures exchanges and low correlation with traditional assets.
A Commodity index will have 4 types of returns in total returns -> Price return, Roll return, Collateral return & Rebalancing return.