Commodities Flashcards
Intro level 2
Characterise uniqueness of commodity markets with 8 points
It costs money to move, maintain and store the LSD thief
Susceptible to:
- Leakage
- Spoilage
- Death
- Theft
Cash flow is often negative due to:
- Transportation
- Maintenance and storage
Correlation with other asset classes is historically low
List the 6 types of commodities
LG PIES are commodities
Livestock
Grains
Precious Metals
Industrial Metals
Energy
Softs
Outline 5 factors for Crude Oil Sector Supply and demand
SupplieRs Demand Credit for Alternatives to Political Risk
SUPPLY DEPENDS ON:
- Refinery efficiency
- Drilling & Extraction - sales price must exceed costs of extraction and transport
DEMAND - depends on:
- Credit cycle
- Alternatives
- Political risk
Outline 4 factors for supply and demand of refined energy products
- Refinary concentration 2. Short storage times Seasonal factors: 3. Travel holidays 4. Weather - demand and disruption
Give 5 factors contributing to oil price volatility
Oil affects respiratory TRACT 1. TRANSPORT COSTS 2. Refinary - Limited number 3. Alternatives 4. CONFLICTS 5. Technology ADVANCES
Give one positive and one negative factor for Natural Gas
- It can be used directly without refining 2. Transport and storage costs are relatively high e. g. Liquification and shipping
Give 4 factors that effect supply and demand of natural gas
Wet greenhouse Weather Economic conditions Technology of electricity production Greenhouse gas emissions
Give 3 issues with refined energy products
Limited shelf life Storage costs Transportation costs
What mnemonic works for supply & demand for Natural gas and refined energy products How is it different?
Wet greenhouse Technology of electricity generation from gas and extraction of oil to make refined products
Which countries are the largest grain producers
Cub 1. China 2. United States 3. BRAZIL
Give 4 factors for supply of grains
Weather POD Weather Pests Opposite growing seasons Disease
Describe how grain prices and GDP effect Livestock prices
Grain prices 1. Livestock growing costs depend on grain prices 2. An increase in grain prices means cattle are slaughtered early and sold or frozen 3. A fall in grain leads to an increase in grain inventory and larger Livestock supplies Increases in GDP increase meat consumption and demand for livestock
Give 3 factors that increase demand for precious metals
Inflation hedge Government deficits Fund flows
What is a cash crop, give two examples
A crop grown and sold for income not consumed for subsistence 1. Coffee 2. Sugar
List 4 commodity lifecycle types
- Year round production - cash crops e. g. Coffee 2. Seasonal planting / harvesting e. g. Grains 3. Straight through processing e. g. Natural Gas 4. Extraction of inputs to refined outputs e. g. Crude Oil and refined energy, metal ore to refined metal
Describe the spot price of a commodity in 4 ways:
- It’s economic value now 2. Market price for current delivery 3. The estimated PV of its future selling price 4. Spot is a local price
Name 7 participants in futures markets
Hedgers are not TIMERS 1. Hedgers 2. Traders 3. Investors 4. Market Analysts 5. Exchanges 6. Regulators 7. Speculators
Describe Hedgers in 3 points
- Hedgers are Producers or Consumers 2. Have a natural position long (Producers) or short (Consumers) 3. Hedgers “do in the futures market what they must do in the future”
Describe Producers in 3 points
- Must sell their product in the future 2. Future risk is the product price will fall 3. Hedge by shorting the future
Describe Consumers in 3 points:
- Must buy the product in the future 2. The risk is price of the product is higher in the future 3. Consumers will go the future
What is a cash crop
Grown to be sold
What is a staple
Grown to be consumed
Describe speculators in 2 ways
- Informed Investors 2. Liquidity providers
What is Basis?
Basis = Future - Spot
What sign is Basis when future>spot
Positive
Describe the futures price of a commodity in 4 ways
- Market price for delivery in the future 2. Futures price = Spot + cost of carry - convenience (of current possession, inventory) 3. If having inventory is a benefit, Futures price goes lower 4. If storage costs fall, Futures price goes lower 5. If having inventory is not a benefit, convenience = 0 therefore Futures price = Spot + cost of carry
What is convenience yield?
Value of having the commodity now (+) rather than in the future, 0
Explain the relationship between Basis, cost of carry and convenience
Basis = (Future - Spot) (Future - Spot) = ( cost of carry - convenience) If Basis is positive, cost of carry > convenience If Basis is negative, convenience > convenience
What is contango, what is the premium for, what is the convenience yield
- Future > Spot 2. Premium rewards the producer for holding the product for longer 3. The convenience yield < cost of storage
What is a market in backward action? What is the discount for?
- Spot > Future 2. Convenience yield > Cost of storage 3. The discount is to reward the buyer for the inconvenience of taking delivery later
What is the effect of a near term shock on spot and future prices
- Both Spot and Futures prices move in the same direction 2. Spot will move by a greater % than Futures
What happens to Futures and Spot prices as time passes
They converge
What is the price difference between two futures price of different tenors
Calendar spread
- What theory states backwardation is normal? 2. What is the discount to the buyer for? 3. Does it explain the real world?
- Insurance Theory (Keynes) 2. The discount is a premium to the Buyer for providing insurance to Sellers. 3. No. Contango is normal.
Explain hedging pressure hypothesis with 4 points
- Extends Insurance Theory 2. Includes both long and short as hedgers to explain supply vs demand pressures 3. Contango if Consumer hedging demand dominates, too many hedgers long, bidding up future, F>S 4. Backwardation if Producer hedging demand dominates, too many hedgers short, bidding down the future, F
Explain in 4 points the Theory of storage and its components in price of a futures contract
- Futures = Spot + Storage costs - convenience yield 2. Producers transfer storage costs to future buyers. This explains contango. 3. Buyers delay purchase if there is no value in having inventory and would incur storage costs for no benefit 4. Convenience yield is positive if there is a benefit for the consumer to hold the commodity now. This explains backwardation.
What is the role of futures markets regulators
Monitor market participants to ensure 1. Efficiency 2. Fairness
Describe speculators. How are they different to Hedgers
- Speculators are informed Investors 2. Speculators have No natural position in spot market 3. Speculators Trade on expectations of future commodity prices 4. Hedgers only take positions when they expect markets to move against their natural position
What do Market Analysts provide
- Information for investors, fundamental and TA, volatility, supply a D demand forecasts 2. Inflation research, valuable for investors, financial institutions and governments (monetary & fiscal policies)
Describe Arbitrageurs in 3 points
- Have access to storage and or transportation 2. Take a position for a risk free profit because the real costs of carry are different to the costs implied in the futures price
What are the components of future returns
“The PRC is the future” Price return Roll return Collateral return
Describe the price return component of a futures return in 4 points
- This is called the Spot Yield = (P2-P1)/P1 = (P2/P1-1)
- The percentage change in spot price during the period the contract is held
- The percentage change in price of the current (the near term futures) contract while held by the investor
- Typically measured by the near-term contract which is a proxy for the Spot yield
Explain the difference between Gross Roll return and Net Roll return
Gross Roll = Net Roll x #days rolling
What is Gross Roll Return
The percentage change in price from the current contract when rolled to another contract
Roll Return % = (Fnew contract / Fcurrent contract) -1
What is the Net Roll Return
Net Roll Return is the percentage of total exposure rolled in the measurement period (1 day)
Net Roll Return = Gross Roll Return / (#measurement periods during roll)
e.g. 10 days rolling a total Gross Roll Return of 10% gives a Net Roll Return of 1% per day
Explain the Roll Return for Hedgers holding long positions in Contango
Will a hedger buy the same, more or fewer contracts
- The hedgers will pay more for each new contract in the next period because the market is in Contango
- Since Fm+1 > Fm Roll Return will be Negative
- Hedger will buy fewer contracts when rolling in Contango because the same $ amount is worth fewer new contracts
Explain the Roll Return for Hedgers holding long positions in Backwardation
Will a hedger buy the same, more or fewer contracts
- The hedgers will pay less for each contract in the next period because the market is in Backwardation
- Since Fm+1 < Fm Roll Return will be Positive
- Hedger will buy more contracts when rolling in Backwardation because the same $ amount is worth more new contracts
What is Collateral Return
The return paid to the holder of the contracts on the assets it has used for margin during the period it has held the contract
Is Roll Return a function of Future or Spot rates?
Roll Return is a function of both Spot and Future rates, because Spot influences the Futures price.
Give two properties of Roll Returns
- Sector dependant
- Energy sector is volatile and has a high statistical probability of generating positive Roll Returns
Describe Commodity Swaps in 4 points
- Commodities Swaps transfer risk by adjusting exposure to a commodity - whereas futures manage risk (hedge)
- They are cash settled
- No daily settlement
- Customized between two parties
What is the formula for an Excess Return Swap
Describe it
NET = – FIXED + (P-R)
Price P, where P above a reference price, R
The parties swap a fixed payment for a variable payment when the current market price is above a reference price.
For example:
An Oil producer receives fixed. This is like writing call options.
For the receiver of variable, they pay Fixed to own future cash flows similar to owning a series of call options.
What is the formula for a Total Return Swap
Describe a total return swap
NET = – FIXED + INDEX RETURN
The receiver pays FIXED for a stream of future cash flows equal to the return on the Index
Typically used by Institutional Investors to gain commodity exposure
What is the formula for a Basis Swap
Describe a Basis swap
NET = – BASISComm #1 + BASISComm #2
Two commodities are not highly correlated
Usually the commodities have different levels of liquidity, one commodity having a futures contract for hedging and the other commodity not having a hedge instrument
Essentially combining the Basis swap with a futures position allows the illiquid commodity to be better hedged.
What is the formula for a Variance Swap
Describe a Variance Swap
NET = – VARIANCEComm #1 + VARIANCEComm #2
This is a relative volatility bet
What is the formula for a Volatility Swap
Describe a volatility Swap
NET = – VOL < Vref + VOL >Vref
Swaps actual volatility below a threshold for future volatility if it rises above a threshold
Give 5 important factors for Commodity indexes
The following affect Commodity index returns
- Should be investible, with liquid futures contracts
- The actual mix of commodities included (selection)
- Weighting methodology - e.g. value weighting emphasises Energy companies returns
- Rebalancing methodology - capturing trends or mean-reversion or volatility
- Rolling methodology - alpha from Roll Yield
Explain how Rolling methodology affects Commodity Index returns
Passive Rolling strategies will roll into the near month and have little effect on returns
Active Rolling strategies will select contract months out into the future to:
a) either maximise backwardation or
b) minimise contango
Explain how rebalancing frequency can affect Commodity Index Returns
In general if short-term price action is choppy or mean-reverting and long-term price action is trending then
- Frequent rebalancing during trending markets reduces returns by capturing less of the trend
- Rebalancing during choppy or mean-reverting markets increases returns when
* (a)* monthly rebalancing - mean reversion occurs more than once per month (within periods less than 1 month)
* (b) annual rebalancing- _mean reversion is multi-year_ and occurs less than once per year and _more trend following_ is *captured
How many commodities in the GSCI
What is the weighting method
What is the roll method
What is the rebalancing frequency
The S&P GS Commodity Index has
24 Commodities
Uses:
A Production or Value Weighting method
Near most-liquid-month roll method - most subject to Economic shocks
Rebalances ANNUALLY
How many commodities in the Bloomberg Commodity Index
What is the weighting method
What is the roll method
What is the rebalancing frequency
The Bloomberg Commodity Index has
22 Commodities
Uses:
A selection based Production and Liquidity Weighting method - less exposure to Oil than GSCI
Front-month to 1st or 2nd-month roll method
Rebalances ANNUALLY
How many commodities in the Deutsche Bank Liquid Commodity Index
What is the weighting method
What is the roll method
What is the rebalancing frequency
The Deutsche Bank Commodity Index has
14 Commodities
Uses:
A FIXED Weight method
Optimised roll method to maximise Roll yield - backwardation maximised, contango minimised
Rebalances ANNUALLY
How many commodities in the Thompson Reuters Core Commodity CRB Index
What is the weighting method
What is the roll method
What is the rebalancing frequency
The Reuters Commodity Index has
19 Commodities
Uses:
A selection and liquidity based, FIXED Weight method
Front-month to first or second-month roll method
Rebalances MONTHLY
No investor funds
ETF
How many commodities in the Rogers Commodity Index
What is the weighting method
What is the roll method
What is the rebalancing frequency
The Rogers Commodity Index has
37 Commodities
Uses:
A selection based (including foreign commodities and liquidity) FIXED Weight method
Front-month to next-monthroll method
Rebalances MONTHLY
No investor funds
No ETC
