Alt Investments #42 - A Primer on Commodity Investing

Question 1

List and describe the different participants in futures markets

Answer 1

LOS 42.a

hedgers - aim to reduce their natural exposure to commodity risk

• have natural long (e.g. farmers) or short (bakers) exposure to commodity prices
• seek to take an offsetting short position in the future to lower risk

speculators - seek to earn riskless profits

• provide liquidity to hedgers
• demand a premium for taking on risk and creating liquity

arbitrageurs - seek to create riskless returns

• keep realtionship between spot and futures prices in line
• can arbitrage over time, locations, or differences in spot and futures prices

Question 2

describe storability and renewability qualities of commodities

Answer 2

LOS 42.b

storability - a commodity is highly storable if it does not grade over time, and its cost of storage is relatively low compared to its value

• highly storable: gold
• nonstorable: cattle, oil

renewability - a commodity is highly rewable if it can be produced without limit

• its price is highly influenced by the expected cost of future production
• renewable: wheat, corn
• nonrenewable: gold, oil

Question 3

convenience yield

Answer 3

LOS 42.c

convenience yield - the monetary benefit from holding a physical commodity vs. being long the equivalent futures contract

• to a consumer of a storable input commodity (e.g. auto manufacturer holding steel), holding inventory is a valuable option that can be consumed at any time

Question 4

convenience yield vs theory of storage

Answer 4

LOS 42.c

there is an inverse relationship between inventories and convenience yield

• high inventories (over supply) ⇒ low convenience yield
• high inventories (over supply) ⇒ spot price < futures price

Question 5

distinguish among capital assets, store of value assets, and consumable/transferable (C/T) assets

Answer 5

LOS 42.d

capital asset - expected to provide continuous cash flows

• e.g. stocks, bonds, rental real estate
• valued by discounting all expected future cash flows

store of value asset - neither generate income nor can they be consumed

• e.g. artworks, foreign currencies; owner-occupied real estate

consumable or transferable (C/T) asset - do not generate continuous cash flows but do have economic value as an input

• e.g. wheat, oil, cattle

Question 6

ways that an investor can participate in commodity markets, and their advantages and disadvantages

Answer 6

LOS 42.e

• direct purchase of a physical commodity
  
  • A: obvious and direct
  • D: cost of storage and maintenance
• commodity stocks
  
  • A: respond quickly and sensibly to events that may impact a firm’s value
  • D: often low correlation to underlying commodity
• commodity mutual funds
  
  • A: diversification; low transaction costs
  • D: differ by management style, allocation strategy, and other characterisitics among funds
• commodity futures
  
  • A: convenient, flexible, low transaction costs, highly leveraged
  • D: continual maintenance time and effort
• structured products based on commodity futures indicies
  
  • commodity index ETF
    
    • A: safe, liquid, low transaction costs
    • D: take care to understand risk/return aspects
  • commodity index certificate
    
    • A: issued cheaply and quickly; wrt excess-return-based index: have low intial costs and maintenance fees
    • D: when interest rates are high, excess return index will be lower than total return index

Question 7

commodity term structures

Answer 7

LOS 42.f

backwardation - term structure will have a negative trend i.e. futures prices are lower than current spot price

normal backwardation - futures price is lower than the corresponding expected spot price in the future; occurs when hedgers (producers) are short in the futures contract i.e. producers pay a premium for locking in prices

contango - term structure has a positive trend i.e. futures prices are higher than the current spot price

Question 8

components of the return of a commoidty futures investment

Answer 8

LOS 42.g

total return = spot + roll + collateral + rebalancing

spot return - change in commodity’s spot price

roll return - return from closing out maturing contracts and replacing with newer ones

collateral return - return on posted collateral that is invested in government securities

rebalance return (diversification return) - return from rebalancing process of a diversified portfolio of futures contracts

Question 9

relationship between spot and futures prices

Answer 9

LOS 42.f

F₀ = S₀e^(r+U-Y)T

F₀ = current futures price of the commodity contract

S₀ = current spot price of the commodity

r = continuously compounded risk-free interest rate

U = cost of storage as % of commodity’s price

Y = convenience yield of commodity

Question 10

excess return vs total return

Answer 10

LOS 42.g

excess return = spot return + roll return = futures return

total return = collateral return + futures return = collateral return + spot return + roll return

Question 11

how the sign of roll return depends on the term structure of futures prices

Answer 11

LOS 42.h

term structure in backwardation ⇒ roll return is positive

term strucuture in contango ⇒ roll return is negative

roll return = (S_t - F_t,T) / S_t

Question 12

models of expected returns for commodities

Answer 12

LOS 42.i

1. CAPM - appropiate for capital assets (stocks, bonds)–not appropriate for commodities
2. insurance perspective - a long position in commodities will earn positive returns due to the speculator’s premium earned to support short hedgers
3. hedging pressure hypothesis - a risk premium can be earned on either long or short positions depending on the balance of hedgers in the market
4. theory of storage - according to the theory of storage, commodities that are difficult to store should ean a positive yield