Introduction to Commodities and Commodity Derivatives

Question 1

Backwardation

Answer 1

Downward sloping curve.
Todays spot price > future price.
Bearish indicator.
Expected future spot price is lower than current spot price.

Positive calander spread, convience yield doesn’t limit slope of the curve.

Positive Roll Yield and Positive Calander Spread

Question 2

Contango

Answer 2

Bullish indicator
Current spot prices < Future spot price.
Expected future price is higher

There is a limit to the slope of the curve due to arbitrage limit.

Negative Calander spread and negative roll yield.

Question 3

Trading Strategy for Backwardation

Answer 3

Strategy 1: Buy short dated contract, Sell long dated contract.

Strategy 2: Buy long dated contracts.

Question 4

Trading Strategy for Contango

Answer 4

Strategy 1: Buy Long dated contract, Sell Short dated contract.

Strategy 2: Buy short dated contracts.

Question 5

Insurance Theory (Keynes)

Answer 5

Theory of normal backwardation

Producers will use commodity futures for insurance by locking in prices. Thereby having more predictible revenue.

This selling forward pushed down prices in the future.

Prices would have to be lower in the future to induce a buyer to take a price risk.

Question 6

Hedging pressure hypothesis

Answer 6

Producers want to sell to hedge
End users want to buy to hedge

If hedging demand from producers and users are equal, then the future curve should be flat.

Question 7

Hedging pressure hypothesis

Producers demand > Consumers Demand

Answer 7

Backwardation.

Future prices has to be lower to induce speculators to fill gap.

This is part of Insurance theory.

Question 8

Hedging pressure hypothesis

Producers demand < Consumers Demand

Answer 8

Contango

Future prices will be higher

Question 9

Positive Calender Spread

Answer 9

Backwardation

Future < Spot

Question 10

Negative Calender Spread

Answer 10

Contango

Spot < Future

Question 11

Total Return Swap

Answer 11

One party receives payment based on the change in the level of an index

Total Return Swap = Notional Principal (△ Commodity Price - Fixed Payment)

Question 12

Basis Swap

Answer 12

Periodic payments are exchanged based on the values of 2 related commodity reference prices that are not perfectly correlated.

Often used between highly liqiuid futurers contract and an illiquid but related material.

Question 13

Variance Swap

Answer 13

For a specific commodity

Question 14

Volatiltiy Swap

Answer 14

Relative to the volatility of a reference commodity

Question 15

What is Calender Yield

Answer 15

Future prices converge to spot prices over the term of futures contract.

The difference between the futures price of a nearer maturity and the futures price of a more distant maturity is known as Calendar Spread

Question 16

Positive roll yiled

Answer 16

Backwardation.

Question 17

Formula for total return of future commodity contracts

Answer 17

Total Return = Spot Price Return + Roll Return + Collateral Return

Total Return = Spot Return + (Excess Return - Spot Return) + (Total Return - Excess Return)

Spot Price Returns: Usually Fluctuates

Roll Return and Collateral Return: Usually remains constant.

Question 18

Variance Swap

Actual Variance > Fixed Variance

Answer 18

Long receives payment

Question 19

Variance Swap

Actual Variance < Fixed Variance

Answer 19

Long makes payment

Question 20

Commodity Volatility Swap

Volatility of Commodity’s Price > Expected Level of Volatility

Answer 20

Long receives payment

Question 21

Commodity Volatility Swap

Volatility of Commodity’s Price < Expected Level of Volatility

Answer 21

Long makes payment

Question 22

Excess Return Swap

Answer 22

Excess Return Swap = Notional Principal (Fixed Payment - Variable Payment).

the variable payments are based on the difference between a commodity price and a benchmark value.

In months in which the commodity price doesn’t exceed the fixed value, no payments are
made.

Question 23

Roll Return Formula

Answer 23

[(Near Term Future Price) - (Farther Term Future Price)]/ (Near Term Future Price) x % of position being rolled

Question 24

What does a negative calander spread mean

Answer 24

That the near-dated futures contracts are priced lower than farther-dated ones.

Contango.

Question 25

What does a Positive calander spread mean

Answer 25

Backwardation

That the near-dated futures contracts are priced higher than farther-dated ones.

Question 26

Theory of storage

Answer 26

It is based on the idea that whether a futures market is in backwardation or contango, depends on the relationship between the costs of storing and the benefits of holding physical inventory of the commodity.

Futures Price = Spot Price + Storage Costs - Convenience Yield

Convenience Yield: The benefits of having physical inventory available