Chap 10 - Commodities

Question 1

One of the most popular methods of obtaining investment exposure to commodity returns is through positions in futures and forward contracts on commodities. This section discusses four other popular methods of obtaining exposure to commodity returns: direct physical commodity ownership, equity-related commodity investments, exchange-traded funds (or notes), and commodity-linked notes.

Question 2

What are the Three Disadvantages of Direct Investment in Physical Commodities ?

Answer 2

Institutional investors generally obtain exposure to commodities through derivative contracts such as futures contracts rather than through physical inventories for several reasons:
(1) to avoid storage costs and other disadvantages of moving, maintaining, and managing inventories.

(2) to avoid wasting the convenience yield implicit in physical inventories.

(3) to avoid the opportunity cost of capital or financing costs of purchasing physical
inventories.

Question 3

What is Convenience yield ?

Answer 3

Convenience yield is the marginal economic benefit that an investor obtains for having physical ownership of a commodity rather than synthetic ownership through futures contracts or other financial securities.

Question 4

Some firms are purely in the business of storing commodities. Natural gas is an
example of a commodity held by storage operators that do not consume that commodity in their business. The seasonal nature of natural gas demand causes periods of physical inventory buildup and drawdown throughout the year.

Question 5

What is Hotelling’s theory ?

Answer 5

Hotelling’s theory (1931) states that prices of exhaustible commodities, such as various forms of energy and metals, should increase by the prevailing nominal interest rate—perhaps with a risk premium. Therefore, ignoring storage costs, expected spot prices of commodity i at a horizon point of T years, E(Pi,T), should be equal to the future value of the current spot price compounded at the nominal riskless rate plus a risk premium as indicated :

E(Pi,T) = Pi,TerT (10.1)

Question 6

Consider the decision faced by the owner of an oil field who can leave the oil in the ground indefinitely or extract and sell it right away. In other words, the owner can keep the oil as a physical asset or turn it into a financial asset and begin to earn interest. In a competitive market, the expected long-run equilibrium price of oil in the market must cause owners of oil to be indifferent between the two alternatives.

Answer 6

This will happen if the price of oil (net of extraction costs) is expected to increase at the prevailing rate of interest plus a premium to compensate the owner for the risks associated with keeping the oil in the ground.

Question 7

Another way to gain exposure to commodities is to own the securities of firms that
derive a substantial part of their revenues from the sale of physical commodities but a major problem with this approach is that most firms have revenues related to a variety of commodities or have operations that extend outside of activities directly related to the ownership and extraction of commodities.

Answer 7

Some reasons it wouldn’t be a good idea:

1- A high correlation between the stock price and the commodity price assumes that the firm has not hedged its exposure to the commodity through short positions in forward or futures contracts. Also, the firm must own the underlying commodities (or rights) rather than purchasing the commodities or leasing the rights at market prices.

2- When commodity prices and inflation are increasing, the decline in overall market P/E ratios could arguably lead to a decline in the P/E ratio and prices of commodity-producing firms.

Commodity equities therefore may be viewed as having two betas: one to the underlying commodity market and a second to the equity market. Only the first is
attractive for investors with a goal of direct exposure to a commodity.

Question 8

There are several structures through which commodity ETFs can obtain exposure to commodity prices: futures markets, equity markets, and physical ownership. Many ETFs have underlying commodity exposures diversified across energy, metals, and agricultural commodities. Other ETFs focus on a specific commodity sector, such as
energy, or can invest in a single commodity, such as gold.

Answer 8

ETFs are correlated to both the equity market and the commodity market. In a falling equity market, equity-based commodity ETFs can decline in value, even if prices of commodities are rising in the spot or futures markets.

Question 9

Exchange-traded notes (ETNs) are similar to ETFs. Whereas investors in ETFs have a direct claim on an underlying pooled portfolio, investors in ETNs purchase a debt security with cash flows that are directly linked to the value of a portfolio. This debt security is typically issued by an investment bank or a commercial bank that agrees to pay interest and principal on the debt at a rate tied to the change in price of a referenced portfolio (or index).

ETNs incur the credit risk of the issuing bank (i.e., counterparty risk), whereas ETF investments do not.

Question 10

What is a commodity-linked note (CLN) ?

Answer 10

A commodity-linked note (CLN) is an intermediate-term debt instrument whose value at maturity is a function of the value of an underlying commodity or basket of commodities. CLNs are often structured products created through financial engineering so that the commodity risk exposures are generated through positions in commodity derivatives.

Question 11

What are the 3 advantages of CLN’s and a disadvantage ?

Answer 11

1- A commodity-producing issuer of a CLN can benefit by better matching the risks of its assets and liabilities. For example, a gold-mining firm has assets and revenues highly positively correlated with the price of gold. A CLN offers the firm the opportunity to be financed with debt securities that hedge risk by having the expenses of the CLN’s coupon or principal payments directly related to the same commodity price that drives its revenues.

2- An investor does not have to execute the rolling of commodity futures contracts to maintain exposure. If the CLN uses futures contracts to obtain its commodity exposure, the mechanics of rolling the positions becomes the problem of the issuer of the note (who must roll futures contracts to hedge the commodity exposure embedded in the note).

3- The note is, in fact, a debt instrument. Although some institutional investors may have investment restrictions on direct positions in futures contracts (due to their implicit leverage and potentially large losses), they may be able to obtain commodity exposure through CLNs because they are debt instruments. They are recorded as a liability on the balance sheet of the issuer and as a bond investment on the balance sheet of the investor, and they can have a stated coupon rate and maturity just like any other debt instrument.

A major potential disadvantage of CLNs is that they contain the idiosyncratic default risk of the issuing firm.

Question 12

Example of a CLN:

Answer 12

A plain-vanilla note from a particular issuer carries a coupon rate of 7%. The
firm issues a CLN with a coupon of 4%. The CLN contains an implicit call option on the S&P GSCI (currently at 1,500) with a strike price set 10% out of-the-money, at 1,650. How much would the CLN distribute as a principal payment on a $1,000,000 note under the following four scenarios: The S&P GSCI value at the notes maturity is: 1,500, 1,600, 1,700, or 1,800? The principal payment is simply $1,000,000 for the two scenarios in which the implicit call option finishes out of the money (S&P GSCI is 1,500 or 1,600). For S&P GSCI=1,700, the payout is $1,000,000 × [1 + (1,700 1,650)/1,650]=$1,030,303. For S&P GSCI=1,800, the payout is $1,000,000 × [1 + (1,800 – 1,650)/1,650]=$1,090,909.

Question 13

What is Spoilage cost ?

Answer 13

Spoilage cost is the loss of value that may naturally occur through time during storage due to physical deterioration.

Question 14

What is Inventory shrinkage ?

Answer 14

Inventory shrinkage is loss of inventory through time due to theft, decline in moisture content, and so forth.

Question 15

What is a Perfectly elastic supply ?

Answer 15

Perfectly elastic supply describes a market in which any quantity demanded can be instantaneously and limitlessly supplied without changes in the market price, and is associated with little or no convenience yield.

Question 16

What is Inelastic supply ?

Answer 16

Inelastic supply is when supplies of the item change slowly in response to market prices or when large changes in market prices are necessary to effect supply changes, and is associated with high convenience yield. An example of sluggishly responding supply is an agricultural commodity that is harvested annually. At any particular point in time, not only is additional supply not available until the next harvest, but the size of the next harvest may have already been determined by such decisions as the acreage planted.

Question 17

When the supply of a commodity cannot respond quickly to meet changing demand, it is likely that its convenience yield will be higher, since users of the commodity may have greater fear of shortages.

Question 18

Demand for some goods, such as grain, may shift slowly or moderately as needs for livestock feed shift. The demand for other goods, such as natural gas, may change more rapidly due to factors such as weather. When demand can change quickly, the convenience yield is likely to be higher, since users of the commodity may have greater fear of shortages.

Question 19

What is an Inelastic demand ?

Answer 19

Inelastic demand is a market condition in which the demand for a good does not increase or decrease substantially due to changes in price and therefore is a potential cause of higher price volatility and higher convenience yield.

Question 20

What is a Contango market ?

Answer 20

When the term structure of forward prices is upward sloping (i.e., when more distant forward contracts have higher prices than contracts that are nearby), the market is said to be in contango. Contango also refers to a forward price exceeding the current spot price.

Question 21

What is backwardation market ?

Answer 21

When the slope of the term structure of forward prices is negative, the market is in backwardation, or is backwardated.

Question 22

The term structure of forward prices on financial securities is upward sloping (i.e., in contango) when the riskless rate exceeds the underlying asset’s dividend yield. In rare cases, the slope may be downward (i.e., in backwardation) if the dividend yield on the deliverable (underlier) exceeds the risk-free rate.

Question 23

A close look at the determination of financial forward prices illustrates two
important points: (1) backwardation, contango, and, in fact, the entire slope and shape of the term structure are determined by differences in cost of carry, and (2) in an efficient market, all forward contracts offer equal risk-adjusted expected returns, regardless of the slope and shape of the term structure of forward prices.

Question 24

Backwardation and Contango in an Imperfect Market What are 3major issues inhibit the arbitrage activity that ensures the relation between carrying costs and the shape of forward curves ?

Answer 24

1- Unlike the cost of carry to a financial security (the cost of financing), the
storage costs of commodities can vary substantially through time and among market participants. The supply of physical storage facilities is inelastic, meaning that changes in demand for storage can dramatically affect marginal storage costs.

2- Unlike the benefit of carry to a financial security (dividends and other
distributions), the convenience yield to commodities can vary substantially through time and among market participants. The marginal benefits of holding inventories can change dramatically based on current and anticipated inventory levels.

3- Difficulties in borrowing commodities—especially those that are in short supply—inhibit the ability of arbitrageurs to short-sell such that forward prices are driven to levels based on the cost-of-carry model including convenience yield.
As a result, the slope of the forward curves for commodities (backwardation vs.
contango), as well as the shape, is driven by complex factors.

Question 25

What is the basis ?

Answer 25

The basis of futures or forward contracts is commonly defined as the spot price minus the futures or forward price, although in some literature the basis is defined as the
forward price minus the spot price.

Question 26

What is basis risk ?

Answer 26

Basis risk is the dispersion in economic returns
associated with changes in the relation between spot prices and futures prices.

Question 27

Convergence, previously defined as the spot price approaching the forward price as delivery approaches, can also be viewed as the basis approaching
zero as the time of delivery approaches. An arbitrageur or trader hedging spot positions against forward positions analyzes the basis, compares it to carrying costs, and attempts to identify mispricing. To the extent that markets are informationally efficient, a position that is short the forward contract and long the spot price is hedged and should offer an expected return equal to the cost of carry (before transaction costs). The opposite position (long the futures and short the spot) is, in effect, borrowing money by selling or short selling an
asset. That trade is also riskless and generates a borrowing cost equal to the carrying costs.

Question 28

What is a calendar spread ?

Answer 28

A calendar spread can be viewed as the difference between futures prices (or forward prices) on the same underlying asset but with different settlement dates. A calendar spread can also be viewed as a position: the simultaneous long and short positions in forward contracts with the same underlying commodity but with different times to delivery. Thus, the trader may calculate the calendar spread as a numerical concept, and may put on a calendar spread by taking hedged positions in the contracts. Other types of spreads may be formed based on distinctions between contracts other than settlement dates.

Returns on calendar spreads are primarily driven by two equivalent concepts: changes in the slope of the term structure of forward prices, and changes in carrying costs. Calendar spreads that contain long and short positions of equal notional value are hedged against changes in the spot price.

Question 29

Note that the sensitivity of the price of a forward contract with respect to the carrying costs is proportional to the time to settlement of the contract (T). This leads to 2 properties regarding the risks of calendar spreads. What are they ?

Answer 29

1- . The value of a calendar spread is sensitive to carrying costs. The degree of sensitivity that a calendar spread has to carry costs is driven by the amount of time that separates the times to settlement of the contracts that form the spread. Thus, spreads with underlying contracts that differ more in longevity tend to be riskier.

2- Spreads that are long the longer-term contract benefit when costs of carry rise, and suffer when costs of carry decline. The intuition is that the benefit of a forward contract is avoiding the costs of carrying a cash position in an asset. When carrying costs rise, longer-term forward contracts enjoy a larger increase in total benefits than is enjoyed by shorter-term contracts.

Question 30

What is the excess return of a futures contract ?

Answer 30

The excess return of a futures contract is the return generated exclusively from changes in futures prices and is not to be confused with the definition of excess return of a cash security, which is its return minus the riskless rate. Thus, if the futures price of a particular contract on gold rises from $1,000 per ounce to $1,050 per ounce, the contract experiences an excess return of 5%.

Question 31

What is a fully collateralized position ?

Answer 31

A fully collateralized position is a position in which the cash necessary to
settle the contract has been posted in the form of short-term, riskless bonds. The total returns from fully collateralized futures or forward returns differ from returns on spot positions on the same asset primarily due to basis risk.

Fully collateralized positions are unleveraged, since the cash invested equals the economic exposure of the futures contract.

Question 32

The three primary sources are depicted in Equation 10.7 as: (1) changes in the
spot price of the underlying commodity, (2) the interest earned from the riskless
bonds used to collateralize the futures contract, and (3) changes in the contract’s basis (i.e., roll yield):

Rfcoll = Spot Return + Collateral Yield + Roll Yield (10.7)

Answer 32

1- Spot return, is the return on the price of the underlying asset in the spot market. The returns of unhedged futures positions are primarily driven by the spot return. Exposure to spot price changes is the primary reason that most market participants enter futures contracts, and is also why market participants wishing to gain exposure to commodity prices establish positions in futures contracts on commodities.

2- Collateral yield is the interest earned from the riskless bonds or other money market assets used to collateralize the futures contract. Positions in futures contracts are often partially collateralized in that they only post collateral that is equal to the margin required by the futures exchanges. Partial collateralization generates leveraged returns, since the value changes of the entire futures position is borne by a smaller collateral amount.

3- Changes in the basis: Roll yield or roll return is properly defined as the portion of the return of a futures position from the change in the contract’s basis through time.

Question 33

What are the 2 reasons for the basis of a futures contract changes ?

Answer 33

1- As time passes, the time to settlement of the futures contract shortens, and the contract’s price (and basis) rolls up or down the term structure of forward prices
toward the spot price.

2- As components of the cost of carry vary (interest
rates, dividend yields for financial futures contracts, storage costs, or convenience
yields), the basis will also vary, since the basis depends directly on the four components of cost of carry.

Question 34

The argument that roll return generates superior returns in backwardated markets for long futures positions implies that roll return generates superior returns in
contango markets for short futures positions. Also, roll return could be similarly argued to lead to inferior returns for long positions in markets that are in contango and inferior returns for short positions in markets that are backwardated.

Answer 34

In an informationally efficient market, roll return is simply the change in the
basis that allows identical exposures in cash and futures markets to offer identical total returns. However, no market is perfectly efficient, especially those involving real assets, such as commodities.

Question 35

The key for a market participant to generate alpha through analysis of
carrying costs and the basis is to execute trades when the prices of futures contracts imply costs of carry that deviate from the participant’s costs of carry. For example, a trader can generate alpha if the trader’s storage costs are less than the storage costs implicit in the basis of the futures contract.

Question 36

Classic rollover strategy: Each contract is held to settlement and then is rolled over into the shortest available contract. All other rollover strategies generate a return that is equal to the return of that classic rollover strategy plus, at some or all times, the return of a short calendar spread. If markets are inefficient, it may be possible to earn a consistently superior or inferior risk-adjusted return through the adoption of a particular rollover strategy (which is to say that superior return is possible if calendar spreads are inefficiently priced). In other words, any advantage between two rollover strategies is identical to the advantage of an equivalent strategy using calendar spreads (in a perfect market).

Answer 36

Other strategy : Suppose that Investor A rolls over contracts one month prior to settlement and establishes a new position in the first deferred contract.

Question 37

The more common definition of roll return (or roll yield) is that it is the return accrued in a futures position through time, attributable to changes in the basis of the futures contract.

Question 38

What are the 3 propositions regarding roll return ?

Answer 38

1- Proposition 1: Roll return is not generated when one position is closed and a new position is opened. Roll return occurs throughout the time that a particular futures or forward contract is held. Roll return can be viewed as the difference between the price at which a particular contract is opened and the price at which that same contract is closed in excess of the return on a spot position in the contract’s underlying commodity.

2- Proposition 2: Roll return is not necessarily positive when markets are backwardated for holding periods shorter than being held to settlement. It is true that roll return is positive in backwardated markets if none of the components of the costs of carry change. However, if the costs of carry change, then even in backwardated markets there is no guarantee that roll return will be positive prior to settlement.

3- Proposition 3: A position that generated a positive roll return does not indicate that the position’s total returns were superior (i.e., that there was alpha). Thus, if the dividend yield of a financial asset exceeds the riskless rate, then roll return is positive if the position is held to settlement.

Question 39

What is the difference between backwardation and normal backwardation ?

Answer 39

In normal backwardation, the forward price is believed to be below the
expected spot price. We say “believed to be” because we cannot observe the expected spot price; we can only estimate it, and those estimations may differ between market participants. Since in normal backwardation the expected spot price exceeds the
forward price, there is a positive expected return from holding the futures contract.

Question 40

What happens in normal contango ?

Answer 40

Normal contango is an infrequently used term that refers to the relationship between forward prices and expected spot prices in which the forward price is believed to be above the expected spot price. In normal contango, the entity on the short side of the forward contract should expect to earn a profit from bearing the risk of being short the commodity. Conversely, the entity on the long side of the forward contract should expect to bear a loss.

In an informationally efficient market, normal contango would only exist for commodity forwards with negative betas (i.e., with returns that tend
to hedge systematic risk). Since it would be relatively rare to expect a commodity to have negative beta, normal contango should be viewed as a rare occurrence.

Question 41

The excess of the expected spot price over the forward price is the expected reward for bearing the risk of being long the forward contract when the underlying asset has positive systematic risk. The expected loss to the short side of the contract is the cost of using the forward contract to hedge systematic risk. The only time that forward or futures prices should equal expected spot prices in an informationally efficient market is when the underlying asset contains no systematic risk.

Question 42

In summary, in perfect capital markets, the price (or rates) of forward contracts
on financial assets have term structures with slopes and curves that are driven entirely by the observable costs of carry (interest rates and distributions). In this case the relation between forward prices and expected spot prices is driven by risk premiums
based on the systematic risks of the assets underlying the forwards. This understanding helps put the concepts of normal backwardation and normal contango in context: The relationship between expected spot prices and futures prices is not directly observable, it is determined by risk premiums, and it is distinct from the relation between current spot prices and current futures prices (which is determined by the costs of carry).

Question 43

John Maynard Keynes: commodity futures prices should typically be
lower than the expected future spot prices (i.e., futures and forward markets should be in normal backwardation).

Assumption :
producers of a commodity have a strong incentive to lock in a sales price today for future production by selling futures contracts (artificially pushing down futures prices), but that users of the commodity have a strong incentive to purchase at spot prices (artificially raising spot pricing). If there is a natural oversupply of futures contracts, then speculators will enter the market to purchase the excess supply, but only at a discount to the expected future spot price, exerting a downward pressure on long-term futures prices relative to expected spot prices, leading to markets with normal backwardation.

Answer 43

Models of a commodity forward curve predict that the curve will be upward sloping when the current inventory levels are much greater than the threshold levels of demand (low convenience yield), and that it will be downward sloping when inventories are exceptionally tight (high convenience yield). Storage models are unique to real assets.

Question 44

What is Working curve ?

Answer 44

Working curve, which positively relates
the slope of the forward curve to current levels of inventory such that low inventory levels tend to be associated with a negative and nonlinear forward curve slope. The nonlinearity is due to embedded real options related to inventory levels. When inventory is low, users of the commodity may face costs related to searching, delays, rush charges, and transportation. In the extreme, they may face significant costs from
stock-outs as inventory is depleted.

Question 45

What is a humped curve ?

Answer 45

The crude oil futures market has often exhibited a humped curve, which in
the typical case of commodity futures means that the market is in contango in the short term, but gives way to backwardation for longer-maturity contracts.

Question 46

What is volatility asymmetry ?

Answer 46

A volatility asymmetry is a difference in values between two analogous volatilities, such as is the case with commodities, in which volatility tends to be higher when prices are rising than when they are falling. This is because shortages tend to cause more serious problems than surpluses. The volatility asymmetry favors owning physical inventory (or short-dated futures contracts) over longer-dated futures contracts. All other things being equal, this factor will tend to flatten commodity futures curves or lead to backwardation.

Question 47

What are Four Explanations of Commodities as Diversifiers ?

Commodities are often viewed as an asset class that helps diversify a portfolio of traditional assets (stocks and bonds) through a lack of return correlation between commodities and traditional assets.

Answer 47

1- Commodities have prices that are not directly determined by the discounted value of future cash flows.

2- Nominal commodity prices should be positively correlated with inflation largely because commodity prices form part of the definition and computation of inflation.

3- Commodities may react very differently at different parts of the business cycle.

4- Commodities are a major cost of some corporate producers. In the short run, a major increase in commodity prices (e.g., oil) may cause a substantial decline in corporate profits, and a decline in commodity prices may result in an increase in profits.

Question 48

Theory provides an explanation for the long-term history of commodity price
declines (due to increasing technologies) and supports the likelihood that the verylong-term downward trends of real commodity prices will continue. Technology is
likely to continue to improve efficiency in the extraction (i.e., lower the cost of extraction) and efficiency in the use of commodities (reducing demand). Technology is also likely to improve the rate of reclamation of many commodities and to develop alternatives to utilizing commodities that experience increasing real prices.

Question 49

Commodities do not enhance expected returns when they are efficiently priced and when their systematic risk exposures (betas) are low. If markets are perfect and in equilibrium, market participants should hold exposures to commodities and other asset classes, expecting lower returns in exchange for enjoying lower risk. Financial institutions can utilize forward contracts and futures contracts to attain those exposures.

Question 50

Spot prices of physical commodities are not generally traded in a single centralized market, and therefore the spot prices vary between locations (a difference that cannot be arbitraged to near zero due to transportation costs). Some commodities have different qualities or grades that trade at different prices. For these reasons, commodity price indices are commonly constructed using futures prices on commodities rather than cash commodity prices.

Question 51

How does a production-weighted index works ?

Answer 51

A production-weighted index weights each underlying commodity exposure using estimates of the quantity of each commodity produced. A production-weighted index is designed to reflect the relative importance of each of the constituent commodities to the world economy in terms of production levels.

Question 52

How does a Market-Liquidity-Weighted Long-Only Commodity Indexes works ?

Answer 52

Based on market liquidity as a measure of global economic significance. The weights of each commodity in the index rely primarily on liquidity data, such as trading activity. This index considers the relative amount of trading activity associated with a particular commodity to determine its weight in the index.

Question 53

How does a Tier-Weighted Long-Only Commodity Indices works ?

Answer 53

Groups commodities of similar characteristics into tiers and then assigns weights to each tier. . The system is designed to reflect the importance of each commodity to global economic development. For example, Tier I currently has 33% of the index weight and includes only petroleum products. Weights are described as being determined to make the index a representative indicator of global commodity markets.

Question 54

Short-term to medium-term long-only commodity returns may have volatility emanating from many sources, including commodity supply and demand, interest rates, inflation, trading activity, and currency markets.