Introduction To Commodities & Commodity Derivatives

Question 1

What are 4 tools & considerations when doing fundamental research of commodities?

Answer 1

• direct announcement: announcements from government or news regarding commodities (eg. Production & inventory levels)
• component analysis: breaking down high level supply & demand into components (eg. lower emissions law by government will increase electric car production)
• timing considerations: timing of production & money (eg. you can only grow certain crops in certain seasons)
• money flow: prices can be affected by sentiment and macro conditions (eg. If investor risk tolerance is particularly high or low than you can expect exaggerated price movements)

Question 2

What are the 6 main commodity sectors?

Answer 2

• energy (eg. Oil, gas, coal)
• grains (eg. Wheat, corn, rice)
• industrial/base metals (eg. Copper, iron, aluminum)
• livestock (eg. Sheep, cattle, etc)
• precious metals (eg. Gold, silver, platinum)
• soft (aka cash crop) (eg. Cotton, sugar, cocoa)

Question 3

What is the difference between hard commodities and soft commodities?

Answer 3

• Hard commodities: are mined or extracted
• Soft commodities: grown over period of time

Question 4

What is the difference between crude oil and natural gas?

Answer 4

• crude oil needs to be refined into gas and natural gas can be used right away after extraction

Question 5

What is the cost of the energy sector?

Answer 5

• very expensive: creating pipelines, setting up a extraction base, and exploration for oil

Question 6

Why is it hard for producers of industrials/ precious metals to cut back on production when supply is greater than demand or increase production when demand is greater than supply?

Answer 6

• due to the marginal costs they need to maintain consistent production levels to make a profit (costs to set up and use equipment is expensive)

Question 7

What is one risk of the livestock commodity sector and what is the life cycle of livestock?

Answer 7

• high risk of spoilage
• life cycle: various based on animal (eg. Hogs take a couple months, whereas cattle take a couple years)

Question 8

For the grain commodity sector what are the 4 steps to plants maturing?

Answer 8

1. Planting (seeds in ground)
2. Growth
3. Pod/Ear/Head Formation (food grain created by plant)
4. Harvest (collection of grain by farmer)

Question 9

How long does it take for corn, soybean, and wheat to grow?

Answer 9

• corn: 8 months
• soybean: 6 months
• wheat: 11 months

Question 10

Where is grain stored and why are they stored?

Answer 10

• stored in silos or warehouses
• stored since demand for grains is year round

Question 11

What is the difference between equities/bonds and commodities?

Answer 11

• equities/bonds: financial assets
• commodities: physical assets usually (exception would be electricity)

Question 12

What is the difference in valuation of stocks/bonds vs commodities?

Answer 12

• stock/bonds: valuation focuses on discounted cash flows
• commodities: valuation focuses on future supply and demand

Question 13

What are the 3 types of trading participants for commodities?

Answer 13

• informed investors/hedgers
• speculators
• arbitrageurs.

Question 14

Which commodity traders provide insurance to hedgers of commodities?

Answer 14

• liquidity providers

Liquidity providers often play the role of providing an insurance service to hedgers who need to unload and transfer price risk by entering into futures contracts.

Question 15

What’s the difference between the spot price and the future price?

Answer 15

• spot price: current price/cost for immediate purchase and delivery.
• futures price: locks in the cost of the commodity that will be delivered at some time in the future

Question 16

What’s the difference between forward and future contract?

Answer 16

• forward contract: private, customizable agreement that settles at the end of the agreement and is traded over the counter (OTC).
• futures contract: is standardized and trades on an exchange, where prices are settled daily until the end of the contract.

Question 17

What is the difference between future price and spot price called?

Answer 17

• the basis

Question 18

What’s the difference between contango and backwardation?

Answer 18

• contango: spot price is lower than future price
• backwardation: spot price is higher than future price

Question 19

What is calendar spread, what’s the difference between negative & positive calendar spread, what the calendar spread formula, and how does calendar spread affect contango and backwardation?

Answer 19

• the difference between the spot price and future price
• positive calendar spread: spot price > future price (backwardation)
• negative calendar spread: spot price < future price (contango)

calendar spread: spot price - future price

Question 20

What are 2 ways commodity futures are settled?

Answer 20

• cash or physical delivery

Question 21

Why do spot prices vary from region to region?

Answer 21

• due to logistical constraints and supply and demand imbalances

Question 22

What are the 3 primary theories of futures returns?

Answer 22

• insurance theory
• hedging pressure theory
• theory of storage

Question 23

What are the 3 primary theories of futures returns?

Answer 23

• insurance theory: producers of a commodity would prefer to accept a discount on the potential future spot price in return for the certainty of knowing the future selling price in advance
• hedging pressure theory: both producers and consumers seek to protect themselves from commodity market price volatility which create the price curve
• theory of storage: level of commodity inventories influences commodity price and price curve

Question 24

What is the formula for theory of storage futures prices? How is the convenience yield impacted by the supply?

Answer 24

Futures prices = spot price of physical commodity + direct storage costs (eg. Rent & insurance) - convenience yield

• convenience yield increases when supply of commodity is scarce
• convenience yield decreases when supply of commodity is not scarce

Question 25

What 3 components is total return on commodity futures broken up into, describe them. What is the formula for total return on commodity futures?

Answer 25

• price return (spot yield) (change in commodity future prices)
• roll return (roll yield) (when investors sell future contract close to expiring and purchase the next contract)
• collateral return (collateral yield) (yield on securities that the investor deposits as collateral to establish future position) (aka interest on margin you put up for collateral)

Total return = price return + roll return + collateral return

Question 26

What is the formula for the 3 components total return on commodity futures are broken up into?

Answer 26

• price return = (current price- previous price) / (previous price)
• roll return = ( (near term futures contract closing price - farther term futures contract closing price) / (near term futures contract closing price) = gross roll return (gross roll return * Percentage of the position in the futures contract being rolled) )
• collateral return = risk free rate

Question 27

What is a commodity swap?

Answer 27

• commodity swap: legal contract between two parties calling for the exchange of payments over multiple dates as determined by several reference prices or indexes

Question 28

What are the 4 most relevant types of commodity swaps?

Answer 28

• excess return swaps
• total return swaps
• basis swaps
• variance/ volatility swaps

Question 29

Describe the 4 most relevant types of commodity swaps?

Answer 29

• excess return swaps: producer pays premium and if price goes higher than reference point they receive a payment in the amount of the excess above reference point
• total return swaps: each party pays depending on performance. If return is 1% short party pays long party 1%, if return is -10% long party pays short party -10%
• basis swaps: periodic payments worth the difference between similar highly liquid and not highly liquid commodities (eg. payment for difference in Soybean contract and physical soybeans)
• variance/ volatility swaps: exchange periodic payments based on volatility or variance (eg. if variance positive buy of variance receives payment if variance is negative seller of variance receives payment)