R.45 Commodities and Commodity Derivatives

Question 1

a. compare characteristics of commodity sectors;
b. compare the life cycle of commodity sectors from production through trading or consumption;

Characteristics of Commodity Sectors

Sector Life Cycles

Answer 1

Characteristics of Commodity Sectors

• energy (crude oil, natural gas, and refined petroleum products}, industrial metals (aluminum, nickel, zinc, lead, tin, iron, and copper), grains (wheat, corn, soybeans, and rice), livestock (hogs, sheep, carrle, and poultry), precious metals (gold, silver, and platinum), and softs or cash crops (coffee, sugar, cocoa, and cotton).
• Crude oil must be refined into usable products but may be shipped and stored in its natural form.
• Natural gas may be used in its natural form but must be liquified to be shipped overseas.
• Indusuial and precious metals demand is sensitive to business cycles and typically can be stored for long periods.
• Grain/soft production is sensitive to weather.
• Livesrock supply is sensitive to the price of feed grains.

Commodity Sector Life Cycles

• Includes the time to produce, transport, score, and process the commodities.
• Crude oil production→ drilling a well and extracting and transporting oil. Oil stored for short period before refined into products and sent to consumers.
• Natural gas→ little processing required; pipeline transportation available.
• Metals→ mining/smelting ore production require large-scale fixed plants and equipment.
• Metals→ stored long term
• Livestock→ production cycles vary w/ animal size. Meat frozen/shipped.
• Grain production→ seasonal, grains stored after harvest. Northern/southern hemispheres opposites in growthing seasons.
• Softs→ warm climate production with cycles and storage

Question 2

d. describe types of participants in commodity futures markets;

Types of participants in commodity futures markets

Answer 2

Commodity Hedgers

• Knowledgeable market participants working in industry. Accuracy in forecasting varies.
• Want to mitigate their risks (vs speculators who want risk.

Commodity Traders and Investors

• Traders→ informed investors, liquidity providers, and arbitrageurs.
  
  • Informed investors include hedgers and speculators.
  • Speculators try to profit from opposite positions of hedgers and provide liquidity
  • Arbitrageurs try to take advantage of mispricing between commodity and futures prices.

Commodity Exchanges

• CME and ICE are the primary exchanges for US markets.
• Foudn around world

Commodity Market Analysts

• Non-market participants use info from commodity exchanges.
• Research may impact commodity markets.

Commodity Regulators

• Commodity Futures Trading Commission (CFTC) in US regulates commodities and futures.
  
  • separated from other financial regulatory bodies like SEC
  • CFTC delegates monitoring to National Futures Association (NFA), which is a self-regulated body.
• Most other countries utilize regulatory bodies to oversee both futures and securities.

Question 3

e. analyze the relationship between spot prices and future prices in markets in contango and markets in backwardation;

Spot and Futures Pricing

Backwardation

Contango

Answer 3

Spot and Futures Pricing

• Spot prices used in physical markets. Highly localized and associated with physical delivery.
• Futures prices used for later delivery. Publicly available contracts, which enhances the price discovery for the market participants.
• Basis: difference b/w Spot and Futures prices
• Terms backwardation and contango may describe spot/future price relationships or the futures market in general.
• Calendar spread
  
  • price difference of futures contracts calculated as
  • [Futures contract earlier expiration] - [Futures contract w/ later expiration]

Backwardation

• Spot > Future price
• Positive calendar spread
• Roll return → Positive
• More contracts purchased

Contango

• Future price > Spot price
• Futures markets w/ positive slope regarding time to expiration
• Roll return → Negative
• Fewer contracts purchased

Backwardation and contango periods will not persist indefinitely, which leads to periods of positive and negative roll returns.

Tendancies:

• Positive roll returns: Energy commodities have a greater chance
• Negative roll returns:
  
  • Industrial metals,
  • agriculture,
  • livestock,
  • precious metals, and
  • softs

Question 4

f. compare theories of commodity futures returns

Theories of Commodity futures returns

Three Components of Futures Returns:

1. Price return (or spot yield)
2. Roll return
3. Collateral return

Answer 4

Theories:

• Insurance theory states rhat futures returns compensate contract buyers for providing protection against price risk to furores contract sellers (i.e., the producers). This theory implies that backwardacion is a normal condition.
• Hedging pressure hypothesis expands on insurance theory by including long hedgers as well as short hedgers. This theory suggests futures markers will be in backwardation when short hedgers dominate in contango when long hedgers dominate.
• Theory of storage states that spot and futures prices are related through storage costs (such as rent and insurance) and convenience yield.
  
  • Futures price = Spot price physical commodity + Direct storage costs – Convenience yield

Three Components of Futures Returns:

1. Price return (or spot yield): is the percentage change in the commodity futures price, usually the front month contract. This is different than the change in price in the physical commodity, which is not often standardized.

2. Roll return

• ​comes from rolling long futures positions through time.
• In long hedge position, current contracts must be sold and another contract purchases (likely at different price).
  
  • ​Backwardation: More contracts must be purchased
  • Contango: Fewer contracts purchased

3. Collateral return assumes full value of underlying contract is invested at risk-free rate.

Question 5

j. describe how the construction of commodity indexes affects index returns.

Commodity Indexes

• Key Characterics
• Major Indexes and their characterics

Answer 5

Key characteristics such as the following differentiate indexes:

Breadth number of commodities and sectors in the index.

Weightings examples include weight based on production, using the physical trade value. This is similar to market-capitalization weighting used in many stock indexes. Some place caps and floors on sector and commodity weights.

Rolling methodology will impact the roll return. Some strive to maximize backwardation and minimize contango when making roll decisions.

Rebalancing frequently is beneficial if commodity prices tend to be mean reverting.

Governance Processes must be established to execute the decisions above. Rules-based indexes are quantitative, while selection-based indexes are more qualitative.