4: Commodities

Question 0

3 elements of cost of carry

Answer 0

Financing cost, storage cost and spoilage cost

Question 1

Normal backwardation vs backwardation

Answer 1

Normal backwardation is when the futures price is less than the expected futures price. This is an unobservable phenomenon.

Backwardation is when the futures price is less then the observable current spot price. Note that is a downward tending term structure.

Note that normal backwardation can exist in backwardated or contangoed markets.

Question 2

What is the relationship between geometric mean and standard deviation?

Answer 2

The equation is Geometric mean = Arithmetic Mean - Variance/2

A portfolio that displays good diversification will tend to have less variance and consequently less standard deviation. Thus, this portfolio will have a higher geometric mean.

Question 3

What are the main types of commodity spreads?

Answer 3

1. Time Spreads
   
   • Calendar Spreads (ex: Bull Spread, Bear Spread)
2. Correlation Spreads
   
   • Processing Spreads (ex: Crush Spread, Crack Spread)
   • Substitution Spreads (these are harder to implement)
3. Location Spreads

Question 4

Methods of obtaining indirect ownership of commodities

Answer 4

1. Commodity Index Swaps (preferred method)
2. Public commodity based equities (stock market risk)
3. Bonds issued by commodity firms
4. Commodity based mutual funds and ETFs
5. Public and private Commodity Partnerships (ex: MLPs, these behave like REITs)
6. Commodity debt instruments (ex: index linked notes, exchange traded funds)
7. Commodity based HFs
8. Commodity trade financing and production financing

Question 5

What is a commodity index linked note?

Answer 5

It’s a debt instrument that provides repayment of principle and a return linked to a fully collateralized index. Nite that this index collaterization is done with very low paying vehicles such as T Bills, money market instruments etc.

CILNs are more expensive than a commodity index swap but offers these 3 advantages:

1. Smaller minimum capital requirement
2. No need for collateral, because the note is fully collateralized
3. An active secondary market, unlike SWAPs, keeps liquidity concerns low

Question 6

Commodities returns and the business cycle

Answer 6

• commodities and equites generally perform similarly during the growth and expansion phase of the business cycle. However, the performances differ based on the phase of recession or expansion. Commodities outperform stocks/bonds in the late expansion and early recession phases
• note that commodities perform well in the early phase of the recession and poorly in the later phase

Question 7

3 ways to stress test a commodities portfolio

Answer 7

1. Randomly shift forward curves and observe change in portfolio NAV
2. Shock the commodities’ FME with different correlations and observe change in portfolio NAV
3. Stimulate price movements to mimic historical event

Question 8

6 effective risk management measures for commodity investments

Answer 8

1. Estimate NAV
2. Measure event risks
3. Stress test using VAR
4. Measure liquidity risks
5. Performance attribution
6. Mitigate operational risks

Question 9

Observations about risk relevant to commodities, stocks and bonds

Answer 9

In terms of volatility, as measured by SD, stocks>commodities>bonds

Stocks are negatively skewed while commodity futures and bonds are slightly positively skewed

All 3 asset classes exhibit positive kurtosis, therefore, the returns cannot be fully measured by measures such as mean and SD

Question 10

Crack Spread

Answer 10

Long crude oil futures and short gasoline and heating oil futures

Question 11

Crush Spread

Answer 11

Long Soybean futures and short soybean oil and soybean meal futures

Question 12

Article C takeaways

Answer 12

• financialization and structural changes reduced risk premiums.
• increased activity is attributed to electronic trading, improved market access (from financial innovation), and new passive market participants (such as institutions and pensions)
• both open interest and trading volume increased a lot
• participation by small, non-reporting traders reduced a lot

Question 13

What is a commodity index swap?

Answer 13

• primary vehicles used by investors to gain exposure to commodity indices
• one party makes a payment based on the price of a commodity index and the other party makes a payment based on an interest rate
• no upfront capital required and the investors can manage the collateral posted, this aspect is better than say a commodity index linked note where the collateral posted would be earning something close to a risk free rate
• drawbacks:
  limited to large creditworthy investors
  illiquid secondary markets which demands heavy negotiations to amend or terminate a swap, so SWAPs have more counterparty risk exposure than commodity futures

Question 14

3 main theories about the shape of commodity forward curves

Answer 14

1. Rational expectations hypothesis: the price of an asset for future delivery should be the same as the market’s current forecast of the spot price of the asset on the future delivery date
2. Normal Backwardation (Keynes): futures prices trade at prices below the rational expectations price
3. Preferred Habitat Hypothesis: bond producers want long maturities and bond consumers (lenders) want short maturities. Producers offer attractive yields, via low bond prices, to entice lenders to extend their maturity or induce speculators to borrow at short maturities and lend at long maturities

Question 15

Benefits of commodities in a portolfio

Answer 15

1. good inflation hedge
2. profitable returns
3. help reduce volatility (negative correlation to stocks/bonds, like when there is event risk)

Question 16

Roll Return

Answer 16

Portion of the returns of a future contract that is due to basis change and accrues over time

Question 17

Futures profit and realized margin

Answer 17

Futures Profit = Initial Crack Spread - Closing Crack Spread (A)
Realized Margin = Cash Margin + (A)

• Crack Spread uses futures prices of C:G:H*
• Cash Margin uses spot prices of C:G:H*

Question 18

Drawbacks of commodity index swaps

Answer 18

1. Only available to high creditworthy investors
2. Illiquid secondary markets
3. Greater counter-party risk than the futures markets

Note: CISs are still the preferred instrument of institutional investors, b/c they are still cheaper than index linked notes, investors can manage the collateral posted to earn decent returns (not just risk free or money market rates) and the reward attained via the liquidity premium

Question 19

How are commodities based ETNs different from commodities based ETFs?

Answer 19

1. ETNs are zero coupon instruments
2. ETN returns are dependent on creditworthiness of investors
3. Price of ETN depends on contract relationship with underlying index
4. ETNs may qualify for capital gains tax treatments if held for sufficiently long period

Question 20

Improvements offered by second and third generation enhanced indices

Answer 20

• unique roll strategies
• unique weighting methodologies
• enhanced rebalancing
• rules-based trading strategies

Question 21

Why is futures curve positioning important?

Answer 21

forward curves are nonlinear so the impact of term structures can vary significantly due to curve positioning strategy. I.E. sensitivity of the return of a futures contract to the shape of the forward curve can vary depending on whether we are near the short-end or the long-end of the curve

Question 22

What part of commodity index methodology has the largest impact on index returns?

Answer 22

Largest impact comes mostly from the weighting methodology (WM) which determines degree of diversification or concentration of an index on particular sectors or commodities. WMs can incorporate active weights and short positions for long/short or short-biased indices

Question 23

Spot commodity prices vs. collaterized futures returns

Answer 23

• historical performance of spot prices vs. futures returns show large differences
• futures returns have far exceeded return on investment in spot commodities
• both have outpaced inflation

Question 24

Rational vs. Irrational Market Impacts

Answer 24

• rational impacts result from broader market participation and more active trading. These are beneficial impacts such as reduced risk premiums and increased market liquidity
• irrational market impacts arise from market’s inability to react to some of the above mentioned impacts. An example is the commodity market bubble or a flash crash

Question 26

3 large 21st century structural changes in the commodities markets

Answer 26

1. shift in 2006-2008 from a primarily telephone/open cry system to a computer/electronic order matching platform. This helped to reduce trading costs and to improve information transmission
2. Trading shift to an electronic platform improved entrance to futures markets entrances dramatically
3. New financial participants, such as pension funds, in the commodity futures markets

Question 27

Relationships between commodity prices and macro factors

Answer 27

1. • with US inflation
2. lagged + with global demand for commodities (with a lag of one quarter)
3. • with US$
4. • with real interest rate

Question 28

Masters Hypothesis

Answer 28

maintains that buying pressure from commodity index fund investors created a bubble in commodity futures prices, which resulted in commodity prices exceeding their fundamental values

Question 29

Commodity beta

Answer 29

The definition of commodity beta is the return associated with holding the active futures contract until its roll date and then rolling to the next active futures contract. Commodity beta is often used as a performance benchmark for other commodity futures strategies.