commodities

Question 1

Commodities can be defined as

Answer 1

any products that can be used in commerce, ie any goods that are traded. For most people the term refers to internationally traded agricultural goods such as coffee, fuels such as oil and raw materials such as copper. However, institutional investment in commodities rarely means direct investment in the goods themselves, such as the purchase of a warehouse full of coffee. Institutional commodity investment is investment in derivatives based on the price of the underlying commodity.

Question 2

Commodity futures were originally devised to

Answer 2

reduce the risks to which farmers and others were exposed.

Question 3

Consider a farmer who is about to plant a crop of potatoes.

Answer 3

He has no idea what the crop will ultimately be worth. It may be that there is a glut of potatoes at the time he brings his crop to market, and the price is very low. Alternatively potatoes may be very scarce, and the farmer may be able to obtain a correspondingly higher price for his crop.
Clearly the uncertainty to which he is exposed would be substantially reduced if he could guarantee the price that he might obtain in advance. To do this he needs to sell sufficient potato futures to cover the amount of the crop that he expects to harvest. If he can do this, then he is guaranteed to receive a fixed price for the crop when it is harvested.
Similarly, it may be advantageous for a consumer of potatoes (eg a chip manufacturer) to ensure his future supplies at a fixed price in advance. The consumer will need to buy sufficient potato futures to cover the amounts he expects to need to purchase. It was to meet the needs of those people who needed to reduce their exposure to future commodity price movements that commodity futures were originally devised.

Question 4

Who else, apart from producers and consumers, might need to hedge their risks in this way?

Answer 4

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Question 5

For futures contracts,

Answer 5

details of the contract prices are published each day in the Financial Times. Information published includes the settlement price, the change on the day, high and low prices for the day, the volume of contracts traded and the open interest. In addition the size of the contract (eg 10 tonnes of cocoa) and the unit of trading is usually given.
Commodity futures are widely traded on major exchanges such as NYSE Liffe and the Chicago Mercantile Exchange (CME). Options on the futures are also available. Some of the commodities on which exchange traded futures are available are listed in the table below.

Question 6

Contract specification

Answer 6

The specification of a futures contract in, say, lead is considerably more complex than that of a contract for a future based on an investment index. It will be necessary to specify:
contract size
delivery dates
quality of the product
method of packaging
package size
delivery site
method of resolving disputes about quality.

Question 7

example, the contract for a lumber futures contract might specify:

Answer 7

the types of wood which are acceptable
the lengths into which the wood must be cut
the grade of the timber
the country or state in which the timber has been grown
the places which are acceptable for delivery of the contract.
Most of this trading will take place on exchanges and will therefore involve standardised contracts. These will specify the type and quality of the underlying asset as well as delivery dates, quantities and prices. Over the counter non- standardised contracts can also be arranged.
Commodity futures contracts usually call for settlement by physical delivery of the underlying asset or by transfer of warehouse receipts. Most contracts, however, are closed-out before the contract maturity date.

Question 8

Commodity indices

Answer 8

Indices of commodity prices are produced by investment banks such as Goldman Sachs and other compilers. Contracts based on an index allow diversification (and avoid the danger of having to take delivery of the underlying product).
This is because contracts based on an index are always cash settled, so there is no possibility of taking delivery (or of being required to make delivery) of the underlying commodity.

Question 9

The Goldman Sachs Commodity Index (GSCI) is

Answer 9

a weighted average of the prices of 24 highly liquid exchange-traded futures contracts. Futures and options based on the GSCI have been traded on the Chicago Mercantile Exchange since 1992. The underlying futures contracts include base metal futures traded on the London Metal Exchange, agricultural futures traded on the Chicago Mercantile Exchange, and a number of other futures contracts. The exact components of the index vary slightly depending on the time of year. By buying a future on the index, an investor gains exposure to a whole portfolio of commodity prices.

Question 10

Commodity futures and forward contracts are used for risk management by

Answer 10

 commodity producers who wish to reduce uncertainty in the future cash flows that they will receive for their product; and 

 commodity consumers who wish to reduce the uncertainty in the amount they will have to pay for their future supplies. 
Such users of futures contracts are contracting to supply or to take delivery of a specified quantity of the commodity at some future date. The reduction in uncertainty has a cost in reduced flexibility, particularly for consumers who are likely to be less certain of the amount of raw materials they will require in the future than producers are of the amount they will wish to sell. 


Question 11

It has been argued that commodity futures should be considered as

Answer 11

“short-term equities”. They are real assets whose value is determined by short-term economic factors rather than expectations over the longer term. This gives some diversification from the traditional institutional real assets of property and equity shares. 


Question 12

Does a commodity buyer who wishes to fix the price of the commodity in advance have to take delivery of the asset specified in the futures contract?

Answer 12

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Question 13

In what sense is a commodity future a real asset?

Answer 13

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Question 14

In the valuation of commodity futures

Answer 14

a distinction has to be drawn between commodities which are commonly held as investment assets and those which are held for commercial purposes.
For commodities, such as precious metals, which are held as investments, no- arbitrage arguments can be used to show that the value of a future must be given by a formula very similar to the one used for gilt and equity index futures:
Future price = spot price of underlying + cost of carry.
Here the cost of carry is the financing cost of holding the underlying, plus storage costs. Because the cost of carry is positive, the futures price is normally above the spot price. This is known as a contango market.

Question 15

Explain in general terms by using an arbitrage argument how the equation above is derived.

Answer 15

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Question 16

The spot price of gold is $1,442 per ounce. The price of a three month gold future is $1,448. The cost of storage/insurance for gold is 20c per ounce per quarter, and the current risk free interest rate is 0.4% pa. Explain how to make riskless profits in excess of the risk free rate by using gold futures.

Answer 16

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Question 17

For the above formula to be enforced by arbitrage the underlying commodity must be loanable.

Answer 17

In other words it would be possible for a speculator to synthesise a short futures position by borrowing the underlying asset and selling it at the spot price.
In the case where the underlying commodity is not widely held as an investment there is no such simple mathematical relationship between the futures price and the spot price. If the commodity is not held as an investment, there will not be arbitrageurs who are prepared to trade in the commodity on their own account. So arbitrage arguments to determine the futures price will not be valid, and there is no reason why the equation used in the previous paragraph should hold. The usual situation is that there is a positive value to ownership of the physical commodity (eg as a protection against future shortages or in order to be able to take advantage of them by selling at a high price).

Question 18

Backwardation

Answer 18

This value is described as the convenience yield of the commodity and the formula becomes:
Future price = spot price + cost of carry – convenience yield.
When the convenience yield is higher than the cost of carry the futures price will
be below the spot price, a situation known as backwardation.

Question 19

Suitability for institutional investors

Answer 19

role of commodities as a diversifying asset class is that: 
		 commodities offer significant real returns that are produced by doing real economic work within the economy 

		 the returns accrue to the long-only investor without the need for active management, and 

		 commodities offer a package of diversification benefits unlike any other asset. 
Specifically, in those environments that have produced the worst results from financial assets – rising inflation, excessive global demand, supply disruptions – commodities have produced higher returns than any other asset class used by institutional investors. 
Crude oil and gold are good examples of this. In times of uncertainty about supply, eg major political instability, these commodities have increased in value because of their high intrinsic value compared to financial assets. 
More importantly, those returns have been based on real underlying economics, suggesting that a similar pattern of returns is likely to recur in the future. 
One of the difficulties in predicting future returns on financial assets is the problem of identifying other (non-economic) effects such as changes in investors’ incomes or preferences. 
Unlike other asset classes, commodities are concerned with short-term supply and demand and short-term risk.

Question 20

For which futures markets might you expect the convenience yield to be higher than the cost of carry?

Answer 20

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Question 21

the suitability of commodities as an institutional asset class.

Answer 21

Arguments for institutional investment in commodities, particularly in recent times, include:
 There is a genuine squeeze on supply in many raw materials due to the growth in China (among others), which has lead to substantial rises in base metals, energy and certain other commodities. If this continues, then the prices will continue to rise until demand weakens or alternatives are found. 

 The uncertainties in the oil sector in particular appear likely to continue for some time. 

 Returns show low correlation with other assets in institutional portfolios. 
Although the arguments presented above would seem to imply that commodity futures are a suitable investment for institutional investors they are not widely held by UK institutions. Those who do not see commodities as attractive would argue that 

 there is no strong historical evidence for a real return from commodities 

 the markets are volatile, being driven by a number of factors unrelated to 
the underlying economic factors that affect institutional liabilities. 

 the high level of specialist expertise required to trade commodities profitably 
can be prohibitive. 


Question 22

The carbon markets

Answer 22

A recent development has been the emergence of trading in carbon credits, where carbon is a regulatory derived commodity. A variety of tradable instruments have been created in an attempt to regulate greenhouse gas emissions. The most liquid markets are in Certified Emission Reductions (CERs) from Clean Development Mechanisms (CDMs) carried out in developing countries and in European Union Allowances (EUAs). EUAs are traded both on exchanges (such as the European Climate Exchange) and through the OTC market. Exchange activity is currently confined to spot and future transactions, but options on EUAs are expected to be launched in the future. There is also growing indirect investment through Carbon Funds and indices based on carbon credit prices.