AI Risk premiums in commodities future markets

Question 1

Key differences btw. futures contracts and stocks/bonds?

Answer 1

future contracts are derivatives (written on real assets). Stocks are financial assets.

Question 2

Are commodity future markets an attractive asset class to stock/bonds?

Answer 2

-yes they provide diversification

Question 3

Theory of Normal Backwardation

Answer 3

Keynes and Hicks

• future price will be on average below expected future spot price
• selling pressure by short hedgers provides premium to speculators

Question 4

Implications of the Theory of Normal Backwardation

Answer 4

• Commodity futures prices will on average rise over the lifetime of their contract
  (this is because at the beginning they are cheaper and they converge to the spot price which does not really change)
• Hedgers are net short (hedging on a short outnumbers hedging on a long)

Question 5

Forward contract

Answer 5

obligation for both parties on a transaction in the future

Question 6

Hedging pressure

Answer 6

idiosyncratic risk (specific risk)

Question 7

Are hedgers net short?

Answer 7

Yes on average (consistent with theory of normal backwardation) but large SD, times when net long

Question 8

What Is a Non-Marketable Security?

Answer 8

A non-marketable security is typically a debt security that is difficult to buy or sell due to the fact that they are not traded on any major secondary market exchanges.

Question 9

According to the theory of normal backwardation, what would the risk premium be when beta of the underlying commodity is zero (absence of the systematic risk)?

Answer 9

The risk premium should be zero to0 and the futures price is the same as the expected future spot price. The futures spot price normally is lower only because the speculator wants a risk compensation for being exposed to the systematic risk (beta of the security)

Question 10

What is the Fama-MacBeth regression?

Answer 10

a cross-sectional regression

Question 11

What is a cross-sectional regression?

Answer 11

In statistics and econometrics, a cross-sectional regression is a type of regression in which the explained and explanatory variables are all associated with the same single period or point in time.

Question 12

What did Fama-MacBeth find out?

Answer 12

In hedging pressure neither systematic nor idiosyncratic risk is priced –> inconsistent with the theory of normal backwardation

Question 13

Conclusion on the theory of normal backwardation

Answer 13

• weak empirical support for theory of normal backwardation
  (weak evidence that on average future prices deliver positive returns)
• no clear pattern of profits accumulated by speculators
• hedging pressure does not seem to be related to the size of the risk premium

Question 14

Theory of Storage

Answer 14

• links commodity prices through storage decisions (cost-of-carry)

Question 15

What is the cost of storage?

Answer 15

• interest costs and warehousing

Question 16

convenience yield

Answer 16

marginal benefit to inventory holder

Question 17

What is the Basis in the theory of storage?

Answer 17

Ft-St (F is futures price, S is spot price)

Question 18

What does a negative basis imply?

Answer 18

backwardation (Ft

Question 19

What does a positive basis imply?

Answer 19

con tango (Ft>St)

Question 20

What are the forces that drive a forward price up or down in the theory of storage?

Answer 20

Drive up:
- interest rate (risk free rate) can be seen as the time value of money
- storage cost of the asset
Drive down:
- income or dividend (ownership of holding the asset)
- convenience yield (compounds anything not included in the other factors which are positive to hold the asset)

Question 21

What is a Convenience Yield?

Answer 21

A convenience yield is the benefit or premium associated with holding an underlying product or physical good, rather than the associated derivative security or contract.

• marginal benefit to inventory holder
• explains why stocks are held when prices are expected to fall
• convenience yield is declining function of inventory
• low inventory (risk of stock-out) there is a high convenience yield, high volatility of futures prices

Question 22

Example Convenience Yield

Answer 22

Consider purchasing physical bales of wheat rather than wheat future contracts. If there’s a sudden drought, and the need for wheat increases, the difference between the first purchase price of the wheat versus the price after the shock would be the convenience yield.

Question 23

Which relationship exists btw. inventories and convenience yields?

Answer 23

Negative relation between inventories and convenience yield

Question 24

In what can the premier be decomposed?

Answer 24

spot and term

Question 25

spot

Answer 25

underlying commodity price risk (demand/supply factors)

Question 26

term

Answer 26

e.g. convenience yield risk

Question 27

spot premium

Answer 27

long position in a short-term futures contract

Question 28

term premium

Answer 28

spreading strategies combining a long position in an n-period futures contract with a short position in an m-period futures contract on the same underlying commodity

Question 29

short roll

Answer 29

multiperiod long positions in the short-term contracts

Question 30

excess holding

Answer 30

long position in long-term bond and short position in short-term contracts rolled over to maturity of the long-term bond

Question 31

Can futures prices vary?

Answer 31

Yes, because convenience yield and discount rates both vary

Question 32

The basis for futures contracts has the same function as?

Answer 32

dividend yield for stocks.

Question 33

Which commodities have the highest average returns?

Answer 33

those with the lowest basis (low forward price) (because of highest convenience yield which lowers the forward price)

• not sure about this

Question 34

What drives commodity futures risk premier?

Answer 34

• Theory of Normal Backwardation (hedging/ speculating pressure)
• Theory of Storage (convenience yield)
• Modern Asset Pricing Theory
  (systematic risk, basis risk)