Commodities: Applications and Evidence

Question 1

1. List four explanations that commodities should help diversify a portfolio of traditional assets.

Answer 1

• Unlike financial securities, commodities have prices that are not directly determined by the discounted value of future cash flows
• More so than traditional asset prices, nominal commodity prices should be positively correlated with inflation largely because commodity prices form part of the definition and computation of inflation
• Commodity price changes may be negatively correlated with the returns to stocks and bonds is that they may react very differently at different parts of the business cycle
• Low or negative correlation between commodity prices and financial assets is based on commodities being a major cost of corporate production and thus consistent with lowered corporate profits.

Question 2

2. In an inflationary environment, would the real price of a commodity in 2015 based on 2010 prices be expected to be higher or lower than its nominal price in 2015?

Answer 2

• Lower. The 2015 real price of a commodity is adjusted for inflation and would roughly approximate its 2010 nominal price, whereas inflation would tend to cause the nominal 2015 price to be higher than the 2010 nominal price.

Question 3

3. Consider an investor with a portfolio of risky assets in an economy in which markets are in the perfect equilibrium of the capital asset pricing model. What would determine the investor’s allocation to commodity X?

Answer 3

• The market weight. The market weight of commodities is equal to the percentage of the total global value of commodities relative to the total global value of all assets.

Question 4

4. Would inflation risk tend to be higher in an economy with high inflation? Why?

Answer 4

• Yes, though not necessarily. Inflation risk emanates from the divergence between realized and anticipated rates of inflation, known an unanticipated inflation. When anticipated inflation rates are high, unanticipated rates of inflation would also tend to be high.

Question 5

5. Consider an economy in which markets are in equilibrium. If commodities offer diversification benefits and protection against inflation risk, would the expected return of commodity investments tend to be high or low?

Answer 5

• If markets are perfect and in equilibrium, market participants should expect receiving lower returns in exchange for enjoying lower risk. Thus, if commodities have substantial risk benefits they should tend to offer lower expected returns.

Question 6

6. In the context of analyzing the returns of futures contracts, what is excess return?

Answer 6

• The excess return of a futures contract is the return generated exclusively from changes in futures prices. The term “excess return” is used elsewhere in investment with a different meaning: the total return minus the riskless rate.

Question 7

7. What is the definition of roll return that is earned through holding futures contracts?

Answer 7

• Roll return or roll yield from holding futures contracts is defined as the portion of the return of a futures position attributable only from the change in the contract’s basis through time.

Question 8

8. What is the primary reason that causes a commodity futures market to be in contango or backwardation?

Answer 8

• The term structure takes on a positive or negative slope (contango or backwardated) based on carrying costs so that the risk-adjusted returns of spot positions and fully-collateralized futures positions will tend to be equal.

Question 9

9. What happens to the basis of a futures contract as the contract approaches and reaches settlement?

Answer 9

The basis of a futures contact or forward contract tends towards being zero at settlement (convergence).

Question 10

10. List three important propositions regarding the accrual of roll return through holding futures contracts through time.

Answer 10

• Proposition 1: Roll return is not generated at the time that one position is closed and a new position is opened.
• Proposition2: Realized roll return is not necessarily positive when markets are backwardated.
• Proposition3: 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).

Question 11

basis risk

Answer 11

is the dispersion in economic returns associated
with changes in the relationship between spot prices and
futures prices.

Question 12

The Bloomberg Commodity Index (BCOM)

Answer 12

formerly the
Dow Jones-UBS Commodity Index, is a long-only index
composed of futures contracts on 22 physical commodities.

Question 13

collateral yield

Answer 13

is the interest earned from the riskless bonds
or other money market assets used to collateralize the futures
contract.

Question 14

commodity-linked note

Answer 14

(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.

Question 15

convergence at settlement

Answer 15

is the process of the futures price
nearing the spot price as settlement approaches, and the two
prices matching each other at settlement.

Question 16

excess return of a futures contract

Answer 16

The return generated exclusively from changes in futures

prices is known as this.

Question 17

fully collateralised position

Answer 17

is a position in which the cash
necessary to settle the contract has been posted in the form of
short-term, riskless bonds.

Question 18

heterogeneous

Answer 18

value differs across one or more dimensions.

Question 19

inflation

Answer 19

is the decline in the value of money relative to the

value of a general bundle of goods and services.

Question 20

inflation risk

Answer 20

is the dispersion in economic outcomes caused

by uncertainty regarding the value of a currency.

Question 21

investable index

Answer 21

has returns that an investor can match
in practice by maintaining the same positions that constitute
the index.

Question 22

nominal price

Answer 22

refers to the stated price of an asset

measured using the contemporaneous values of a currency.

Question 23

production-weighted index

Answer 23

weights each underlying
commodity using estimates of the quantity of each
commodity produced.

Question 24

real price

Answer 24

refers to the price of an asset that is adjusted
for inflation through being expressed in the value of currency
from a different time period.

Question 25

Reuters/Jefferies Commodity Research Bureau (CRB)

Index

Answer 25

is the oldest major commodity index and is currently

made up of 19 commodities traded on various exchanges.

Question 26

roll yield or roll return

Answer 26

is properly defined as the portion of
the return of a futures position from the change in the
contract’s basis through time.

Question 27

roll yield or roll return

Answer 27

is properly defined as the portion of
the return of a futures position from the change in the
contract’s basis through time.

Question 28

spot return

Answer 28

is the return on the underlying asset in the spot

market.

Question 29

The Standard & Poor’s Goldman Sachs Commodity Index

S&P GSCI

Answer 29

is a longonly index of physical commodity

futures.