Reading 44 - A Primer on Commodity Investing

Question 1

Who are the 3 main market participants in the commodity futures markets?

Answer 1

1. Hedgers - An entity that has an exposure to commodity prices and takes on an offsetting position in the futures market to lower risk (ex. Wheat Farmer, iron ore miner)
2. Speculators - usually the opposite side of the Hedgers trade. In exchange for providing liquidity they will on average demand a premium
3. Arbitrageurs - try to create riskless profits from price differences over time, between locations, or from differences between futures and spot prices.

Question 2

What is the concept of Storability in the context of commodities?

Answer 2

• A commodity is considered to be highly storable if it does not degrade over time and if the cost of storing the commodity is relatively low compared to its value
• ex Gold , silver

Question 3

What is the concept of Renewability in the context of commodities?

Answer 3

• A commodity that over time can be produced without limit

Question 4

What is the Convenience Yield?

Answer 4

The non-monetary benefit from holding a physical commodity vs being long the equivalent futures contract. It reflects the market’s expectations about future availability of a nonrenewable resource

Question 5

What are the 3 asset “super classes”?

Answer 5

1. Capital Assets - they are expected to provide continuous cash flows in the future (ex. stocks, bonds, rental properties)
2. Store of value assets - neither generate income nor can they be consumed. (ex. artwork, foreign currencies)
3. Consumable or transferable (C/T) assets - have value but do not provide a stream of cash flow (ex. wheat, oil, cattle, gold)

Question 6

What are the 5 ways an investor can participate in commodities markets?

Answer 6

1. Direct purchase of a physical commodity
2. Commodity stocks
3. Commodity mutual funds
4. Commodity futures
5. Structured products based on commodity future indices

Question 7

What are the advantages and disadvantages of using direct purchases of a physical commodity to participate in commodity markets?

Answer 7

Adv:

Obvious and direct

Neg:

For many commodities, the cost of storing and maintaining the asset is impractical

Question 8

What are the advantages and disadvantages of using commodity stocks to participate in commodity markets?

Answer 8

Adv:

stock markets respond quickly and sensibly to events that may impact firm value

Neg:

does not provide direct exposure to the commodity.**The returns of commodity stocks has been lower that the actual commodity***

Question 9

What are the advantages and disadvantages of using commodity mutual funds to participate in commodity markets?

Answer 9

Adv:

can provide diversification with low transaction costs

Neg:

need to be aware of the fund’s specific management style, allocation strategy and other characteristics

Question 10

What are the advantages and disadvantages of using commodity futures to participate in commodity markets?

Answer 10

Adv:

able to benefit from commodities’ price movements without the downsides associated with holding the physical commodity.Are convenient, flexible and easy to leverage

Neg:

to gain the right exposure, it is necessary to spend time and effort to continously close maturing contracts and open new positions

Question 11

What are the advantages and disadvantages of using structured products based on commodity futures indices to participate in commodity markets?

Answer 11

1. ETF on a commodity index

• adv- easily traded with low transaction costs
• neg- must consider the characteristics of the index being used for the etf

1. Commodity index Certificate (ETN)

• adv- for issuing bank, a cheap way to offer exposure
• neg- bank can go bankrupt and investment lost

Question 12

What is the formula for the relationship between the futures price and the spot price of a commodity?

***Formula***

Answer 12

Question 13

What is the formula for the relationship between the forward price and the spot price of a commodity when storage costs are also included?

**Formula**

Answer 13

**Storage Costs = U**

which is the storage costs as a % of the commodities’ price

Question 14

What is a commodity term structure?

Answer 14

A graph of the futures prices of a commodity relative to different maturities.

Question 15

What is Backwardation?

Answer 15

• the term structure will have a negative trend, meaning futures price today will be lower than the current spot price.
• An investor can profit by taking long positions in sucessive futures contracts and holding them until maturity

Question 16

What is Contango?

Answer 16

• The term structure has a positive slope, meaning the futures price today is above the spot price
• A Contangoed market may arise when buyers dominate the futures market

Question 17

What is the formula for the relationship between the forward price and the spot price of a commodity when storage costs and the convenience yield are also included?

**Formula**

Answer 17

Question 18

The return components of commodity futures investments are?

Answer 18

1. Spot Return - % change in a commodities’ spot price.Spot return is highly correlated with unexpected inflation.
2. Roll Return - the income generated as we close out maturing contracts and replace them with newer futures contracts.
3. Collateral Return - corresponds to the interest received on a cash investment. Since the futures contract needs to be paid only at its maturity - you set aside the money today in anticipation of meeting the futures payout at expiration of the contract - and it earns the interest for that time period.
4. Rebalancing Return - profit earned from rebalancing in trendless but volatile markets

Question 19

What is an Excess return index and how is the excess return calculated?

Answer 19

• reflects an uncollateralized futures investment.
• excess return = spot return + roll return = futures return

Question 20

What is a total return index & how is the return calculated?

Answer 20

• represents a fully cash-collateralized commodity investment
• =collateral return+spot return + roll return

Question 21

What is the Roll Return and how is it calculated?

Answer 21

• represents the profit(loss) that results from the continuous convergence of futures prices towards the spot prices as the futures contract approaches maturity

Question 22

When a commodity’s term structure is in backwardation, the roll return will be ______?

Answer 22

Positive

Question 23

When a commodity’s term structure is in contango, the roll return will be ______?

Answer 23

Negative

Question 24

Can CAPM be used to model expected returns for commodity futures?

Answer 24

No b/c commodities are not capital assets

Question 25

What are the 3 theories on how to model expected returns for commodity futures?

Answer 25

1. The Insurance Perspective - focuses on the desire by commodity producers to hedge commodity price risk
2. The Hedging Pressure Hypothesis- expands on the insurance perspective to include the idea that not only do commodity producers wish to hedge their natural long positions, but commodity consumers seek to hedge their natural short positions
3. The Theory of Storage - considers the impact of inventory levels on commodity futures prices and states that the difference between futures prices and spot prices is caused by the convenience yield and storage costs.

Question 26

What is The Insurance Perspective in regards to modeling expected returns for commodity futures?

Answer 26

focuses on the desire by commodity producers to hedge commodity price risk

Question 27

What is The Hedging Pressure Hypothesis in regards to modeling expected returns for commodity futures?

Answer 27

expands on the insurance perspective to include the idea that not only do commodity producers wish to hedge their natural long positions, but commodity consumers seek to hedge their natural short positions

Question 28

What is The Theory of Storage in regards to modeling expected returns for commodity futures?

Answer 28

considers the impact of inventory levels on commodity futures prices and states that the difference between futures prices and spot prices is caused by the convenience yield and storage