Handbook of Alternative Assets Ch 12 - Commodities

Question 1

State the Five Ways to Obtain Economic Exposure to Commodity Assets

Answer 1

1. Purchase the Underlying Commodity
2. Natural Resource Companies
3. Commodity Futures Contracts
4. Commodity Swaps and Forward Contracts
5. Commodity-Linked Notes

Question 2

State the Challenges with Investing in Natural Resource Companies

Answer 2

Exposure to market risk

Weak correlation between oil company stock prices and oil price movements

Exposure to firm specific risk

Operating risks

Hedging (company may already be hedged)

Question 3

State the Advantages of Commodity Futures Contracts

Answer 3

1. Traded on an exchange
   Ÿ Liquidity, central marketplace, transparent pricing, clearinghouse security, uniform
   contract size/terms, etc.
2. Does not require automatic delivery of the underlying commodity
3. Futures contracts can be purchased without paying the full price for the commodity

Question 4

State the Disadvantages of Commodity Futures Contracts

Answer 4

1. Rolling of futures contracts can be costly
2. Once a long futures position is established, there may be ongoing margin calls if
   the futures contract declines in value

Question 5

Briefly describe the following terms:

Initial margin

Variation margin

Maintenance margin

Margin call

Answer 5

Initial margin is a good faith deposit (approx 10% of the purchase price of the
underlying commodity) to ensure full payment upon delivery of the underlying
commodity

Variation margin fluctuates depending on day-to-day movements in the value of
futures contracts

Maintenance margin - minimum amount of equity that a futures margin account
may have

Margin call - demand for additional cash to be contributed to the account to bring
the equity in the account back over the maintenance margin level

Question 6

State the Advantages of Commodity-Linked Notes

Answer 6

Investor does not have to worry about the rolling of the underlying futures
contracts

Commodity-linked notes are debt instruments, and may be a way to get
commodity exposure for investors with restrictions on investing in commodity
markets

Holder of the note does not have to worry about any tracking error issues with
respect to the commodity price

Question 7

State the Relationship Between Futures Prices and Spot Prices for:

Financial futures

Currency futures

Commodity futures

Answer 7

1. Financial futures: F SeprqqpTtq (called the Futures Pricing Eqn)
2. Currency futures: F Seprf qpTtq (called the Interest Parity Thm)
3. Commodity futures: F Sepr􀀀cyqpTtq

Question 8

Compare Contango vs Backwardation

Answer 8

Case Inequality Slope Hedger
Backwardation EpST q ¡ FT Downwards Sloping Long Commodity
Contango EpST q FT Upwards Sloping Short Commodity
Note: “Slope” refers to the slope of the pricing curve, which shows how the futures
price varies based on different expiration dates.