Commodities Flashcards
Commodities and inflation
Strong for energy commods. Somewhat strong for metals. Positively related to inflation.
Interest rates and ag commods is negatively correlated and stronger than energy and metals.
Risks commod firms exposed to
Flat price Spread Margin and volume Funding Liquidity Basis. Difference between spot and futures. Operational Market liquidity
Convenience yield determined by:
Inventories -
Volatility (of spot prices) +
Increase in futures price -
Decreases the cost of carry
Cash and carry arbitrage
Commods purchased in spot market, sold in futures.
Reverse - short spot market, long misprinted futures.
Commodity forward curve
Positive relationship between slope of forward curve and cost of carry.
Normal backwardation
Futures price trades below spot price due to producers preference to lock in profit but selling futures.
Forward curve is relationship between time to delivery and commod futures contract price.
Cost of carry
Positive when convenience yield is zero or low. Contango market.
Negative when convenience yield is higher than costs of carry. Backwardation.
Unbiased expectation theory
Current futures prices represent markets expectations of future spot prices.
Main problem with testing it is that the future spot price cannot be observed.
Stock out
Storage drops to zero. Consumption is dependant on production and transportation
Volatility asymmetry
Vol tends to be higher when prices are rising
Total futures return
Spot return + collateral return + roll return
Business cycles
Ags less sensitive to them, perform better in market downturn. Are more sensitive to interest rates.
Energy and industrials are more sensitive to inflation, tend to move with business cycle.
Diversification return
Enhanced average or expected geometric mean return from rebalancing
Calendar spread
Bull spread: long nearby leg and short distant leg.
Bear spread: short nearby leg, long distant leg.
Leveraged ETFs and ETNs
Can decline in value even when the underlying is increasing due to daily rebalancing procedures.
Bonds issued by commodity firms
High yield bonds will be more correlated to commodities in a similar way to equities. IG bonds have little to no correlation with commods.
Principal guaranteed notes
Offer upside opportunity to profit if commod prices rise, combined with downside guarantee that some or all of the principal will be returned on maturity.
Spot return
Return left over after accounting for roll return. Excess return - roll return.
First generation commod index
Passive. Size and concentration of rolling from short to longer maturities in a short time frame makes them suboptimal.
Drag on performance when markets in contango.
Total return index
Performance of fully collateralised portfolio, so includes the risk free asset return.
Excess return index
Tracks performance of a portfolio of commodity futures contracts in excess of the risk free rate of return.
Grows before any index changes, rolls or change in no of contracts.
Second generations index
Enhance returns through forward curve positioning to spread the roll period across points along the forward curve or to target different segments of the curve.
Third generation index
Include active commodity selection which may be predicted in objective rules or could be discretionary.
Academic research says second and third generation outperform first generation.
4 factors influence commodity index returns
Variability in collateral returns
Entry points
Exit points
Weights
Roll yield/return
= excess return index - spot return
Return from a futures contract that is due to the change in basis over time. Is positive if futures curve slopes downward
Value index
Quantity index
Holds contracts according to a fixed percent of the total index value.
Quantity holds fixed number of contracts. Allows weights to change daily as a % if value if futures price change.
Commodity index return sources (8)
Commodity beta, roll return, spot return, dynamic asset allocation, diversification, weighting’s and maturity and collateral.
