CAIA Book 2 Flashcards
What do advanced versions of the CAPM such as multi beta CAPM capture?
Multi beta CAPM captures risk exposures not explained by the market portfolio
Why are traditional asset pricing models like CAPM not easily applied to commodities?
According to the CAPM risks can be segmented into systematic (market) risk and unsystematic (firm specific) risk. MPT tells us that unsystematic risk can be diversified away so the investor is only compensated for systematic risk in the form of a market risk premium. For commodities it is difficult to differentiate between systematic and unsystematic risk using the CAPM because it’s application is commonly used on a portfolio of financial assets.
Why is the concept of international diversification irrelevant with regards to commodities?
Commodity prices are determined by international supply and demand, making the concept of international diversification irrelevant
How does one gain access to the commodities market via a pure play investment?
Investing in a firm with all or a significant portion of its revenue tied to a specific commodity
Three Advantages of investing in commodities futures markets
Commodity futures are traded on an organized exchange
Delivery of the commodity is not required to close the futures position
Futures contracts can be purchased without paying the full commodity price
Differences between commodity swaps and forward contracts and futures contracts
Swaps and forwards are customized privately negotiated instruments between two parties
Swaps and forward contracts trade OTC
Swaps and forwards trade out of the view of the public
Commodity Linked Notes
Combines a standard interest paying debt instrument with either a commodity futures contract or an option on commodity prices. The bond investor accepts a lower coupon payment on the debt instrument in exchange for receiving the upside potential from commodity prices.
Advantages of investing in Commodity Linked Notes
Investor does not have to worry about rolling futures contracts to maintain long term exposure
Since a commodity linked note is effectively a bond, it can be a means to avoid violating any restrictions an investor may have against investing in commodities
Any tracking error issues with a specific commodity are the responsibility of the note issuer, not the investor
Commodity Exchange Traded Funds
Investment funds that trade over an exchange and seek to replicate the returns on a commodity, a basket of commodities, or an index. An example of an EFT that follows a single commodity is UNG, which replicates the returns on US natural gas.
Futures prices
Futures prices are a function of the current price of an asset today (spot price), and the carrying costs involved with holding the asset until expiration of the futures contract
Under what conditions could a trader make a profit by using a reverse cash and carry arbitrage strategy?
If the price of a futures contract is greater than the price implied by the futures pricing relationship, a trader could make a risk free profit by using a cash and carry arbitrage strategy
Steps in the cash and carry arbitrage strategy when a futures contract is greater than the price implied by the futures pricing relationship
Sell a futures contract at the current futures price
Borrow cash at the risk free rate for the term of the futures contract
Use the borrowed funds to buy the underlying asset at the current spot price
Deliver the underlying asset to settle the futures contract and receive the futures price
Repay the interest and principal on the loan
If the price of a futures contract is lower than the price implied by the futures trading relationship, a trader could make a risk free profit by using the following steps to execute a reverse cash and carry arbitrage strategy.
Buy a futures contract at the current futures price
Sell the underlying asset short at the current spot price
Lend cash received from the short sale at the risk free rate
Collect loan proceeds, plus interest
Use the collected loan proceeds to take delivery of the asset at the futures price and cover the short sale commitment
Interest Rate Parity Theorem
The forward exchange rate measured in domestic currency per unit of foreign currency, must be related to the spot exchange rate and the interest rate differential between the domestic and foreign currency.
The difference in interest rates between two countries determines the difference in the countries’ exchange rates.
Convenience Yield
Reflects a return from holding the physical asset. The convenience yield reduces the cost of ownership for a physical asset the same way receiving a dividend reduces the cost of ownership for a financial asset.
Mispriced arbitrage opportunities in the commodity markets
Overpriced commodity futures can create a cash and carry arbitrage opportunity
Underpriced commodity futures are generally difficult to exploit through reverse cash and carry arbitrage
Normal Backwardation
A price pattern where the futures price is below the expected future spot price and converges so that price from below over time
Contango Market
A price pattern where the futures price is above the expected future spot price and converges to that price from above over time
How are futures contracts commonly used to hedge the risk of loss that commodity producers face
To reduce the risk of declining commodity prices, a firm could sell futures contracts
Backwardated commodity markets
Backwardated commodity markets are based on the relationship between hedgers and speculators. The theory suggests that hedgers will tend to hold more short contracts than long contracts. Since hedgers are risk averse they are willing to accept a lower futures price.
Contango markets
Assumes that hedgers are net long futures contracts rather than net short. A contango market suggests that when hedgers are net long futures contracts, they must pay a premium above the expected future spot price in order to coax speculators to take the corresponding short positions.
Commodity prices should be negatively correlated to the prices of stocks and bonds for the following reasons:
Inflation is positively related to commodities prices but negatively related to the prices of stocks and bonds
The time period for expectations is different for commodity futures (short term), than for stocks and bonds (long term).
The production process can result in a trade off between the cost of capital and the cost of raw materials. When the cost of capital rises, the cost of raw materials falls and vice versa.
What is the impact of rising commodity prices on inflation and short term interest rates?
As the prices of commodities increases, inflation also increases, which will cause short term interest rates to rise. Higher levels of short term interest rates result in higher interest rates on margin deposits and, therefore lower returns to investors in stocks and bonds.
In general, how are the returns on commodities distributed?
Commodities in general have positively skewed distributions as a result of price increases caused by unexpected supply reductions.
Of what impact is an event that decreases the supply of a commodity?
An event that decreases the supply of a commodity that rapidly increases the commodity’s price will decrease stock and bond prices because the cost of production has increased. As an example, a rapid increase in the cost of raw materials will decrease expected returns to stockholders
Characteristics of a desirable commodity index
The index should represent the total return from only long positions (investable)
The index should be unleveraged (no margin purchases)
The index should exclude financial futures because of their linkage to underlying financial assets (linkage means there are no diversification benefits to a portfolio of financial assets).
For commodity indices, define an unleveraged index
The face values of the commodities contracts in an unleveraged index are assumed to be fully collateralized by the purchase of an equal dollar amount of US T-Bills.
What are managed futures accounts
Actively managed portfolios of futures contracts that include long and short positions in financial and commodity futures contracts. MFA ‘s are highly leveraged because of the low initial margins on most futures contracts. They stand in sharp contrast to commodity indices, which are passive investments, unleveraged, and invest only in long commodity futures.
Sources of return for commodity indices
Commodity price changes
Collateral yield
Roll yield
What is a collateral yield and how does it serve as an inflation hedge?
Collateral yield is the interest earned on the US T-bills purchased to collateralise the face amount of the futures index. The collateral yield serves as an inflation hedge as the T-bill is adjusted, in part, based on inflation rate changes.
Roll Yield
The holding period return that results from the commodity futures term structure. With the passage of time, futures prices for a given commodity will approach the spot price and at maturity will converge. The roll yield is thus the change in the futures price less the change in the spot price of the commodity.
Positive Roll Yield
A positive roll yield is earned in a backwardated market. In backwardated markets, futures prices are lower than spot prices. A backwardated market structure implies that investors who are long in the commodity are willing to pay a premium to hedge their price risk in the future by selling their future production today at a discount. Speculators in these markets are receiving a discount on the commodity price for taking on the uncertainty related to the future spot price. As time passes this risk will decline and the discount will decrease.
Negative Roll Yields
A negative roll yield is earned in a contango market. In a contango market, futures prices are higher than spot prices. A contango market structure implies that investors who are short in the commodity are willing to pay a premium to hedge their price risk in the future by buying he commodity in the future at a premium
Characteristics of the Goldman Sachs Commodities Index (GSCI).
Long only tradeable index for physical commodity futures contracts
Index comprised of the shortest maturity contract for each of the 24 physical commodities contracts included in the index.
The weighting methodology of the GSCI
GSCI is a production value weighted using 5 year averages of exogenous economic data to reflect the importance of each component of the global economy. The asset weights of the index are set at the beginning of each year and change throughout the year based on commodity price fluctuations. Commodities with price gains will become a part of the index as the year progresses.
The five groups of real assets represented in the GSCI
Precious metals Industrial metals Livestock Agriculture Energy Energy makes up over 70% of the index
What does the negative skew in the GSCI an indication of?
The distribution of returns for the GSCI is described as being slightly negatively skewed and leptokurtic (fat tails), therefore indicating an exposure to event risk. It is expected that there would be a positive skew reflecting the benefit that supply shocks have on commodity prices. The negative skew found for the GSCI may indicate that it is not a completely passive index.
Components of the DJ AIG Commodity Index, identify the components.
The physical commodities in the DJ-AIGCI are from the following groups: energy, precious metals, industrial metals, grains, livestock, and soft commodities (which include coffee, cotton, and sugar).
For the DJ-AIG Commodity Index, describe the weighting methodology.
The DJ-AIGCI is weighted primarily by the trading volume of the futures contracts and secondarily on production. The index also requires that no group comprise more than 33% of the index and that each commodity must represent at least 2% of the index. Although the index weights are rebalanced each January, the commodity weights in the index vary based on each commodity’s value. Thus the index is momentum based because of its reliance on the liquidity as indicated by the trading volume.
For the DJ-AIG commodity Index, identify the main characteristics of the historical return distributions.
The distributions of returns is described as being slightly negatively skewed and leptokurtic, therefore indicating an exposure to event risk.
Why are TIPS not the best alternative to protect a portfolio against inflation as compared to the use of commodity futures. Explain
The use of commodity futures in a portfolio context provides a better hedge against inflation because their values will actually increase during periods of high inflation.
Why are international stocks not considered an inflationary protection device for a US portfolio of stocks and bonds
Similar to US stocks, international stocks are also negatively correlated with US inflation. This relationship indicates that higher raw materials prices affect foreign securities in the same way as US securities.
Define and explain the Efficient Frontier
The efficient frontier is a graph in risk/return space of the most efficient combinations of risky assets. Each point on the efficient frontier represents the combination of risky assets that produces the highest level of return for a given level of risk for a given return
How can adding a passive commodity index to a portfolio of stocks and bonds change the efficient frontier
Adding a commodity futures index to a portfolio will produce a more efficient portfolio. That is for each level of risk, the portfolio’s returns are higher, and for each level of return, the portfolio’s risk is lower.
Why is it said that global equity markets are more integrated and more correlated?
- Int’l efforts and treaties between countries to coordinate their fiscal and monetary policies
- An increase in multi national companies with operations in numerous countries
- Increases in capital flows between countries
- Greater individual investor access to foreign investors
What are commodity pools?
A collection of investors who combine their funds to invest in the commodity futures market
Public Commodity Pools
Public commodity pools are available to the general public and are required to register with the SEC and file reports with the commodity Futures Trading Commission (CFTC).. Public commodity pools have low initial minimum levels of investment and are considered liquid investments.
Private Commodity Pools
Private Commodity Pools avoid SEC registration requirements by selling to institutional investors and to high net worth individuals
