Alt Investments #42 - A Primer on Commodity Investing Flashcards Preview

CFA Level 2 2016 > Alt Investments #42 - A Primer on Commodity Investing > Flashcards

Flashcards in Alt Investments #42 - A Primer on Commodity Investing Deck (12)
Loading flashcards...
1
Q

List and describe the different participants in futures markets

A

LOS 42.a

hedgers - aim to reduce their natural exposure to commodity risk

  • have natural long (e.g. farmers) or short (bakers) exposure to commodity prices
  • seek to take an offsetting short position in the future to lower risk

speculators - seek to earn riskless profits

  • provide liquidity to hedgers
  • demand a premium for taking on risk and creating liquity

arbitrageurs - seek to create riskless returns

  • keep realtionship between spot and futures prices in line
  • can arbitrage over time, locations, or differences in spot and futures prices
2
Q

describe storability and renewability qualities of commodities

A

LOS 42.b

storability - a commodity is highly storable if it does not grade over time, and its cost of storage is relatively low compared to its value

  • highly storable: gold
  • nonstorable: cattle, oil

renewability - a commodity is highly rewable if it can be produced without limit

  • its price is highly influenced by the expected cost of future production
  • renewable: wheat, corn
  • nonrenewable: gold, oil
3
Q

convenience yield

A

LOS 42.c

convenience yield - the monetary benefit from holding a physical commodity vs. being long the equivalent futures contract

  • to a consumer of a storable input commodity (e.g. auto manufacturer holding steel), holding inventory is a valuable option that can be consumed at any time
4
Q

convenience yield vs theory of storage

A

LOS 42.c

there is an inverse relationship between inventories and convenience yield

  • high inventories (over supply) ⇒ low convenience yield
  • high inventories (over supply) ⇒ spot price < futures price
5
Q

distinguish among capital assets, store of value assets, and consumable/transferable (C/T) assets

A

LOS 42.d

capital asset - expected to provide continuous cash flows

  • e.g. stocks, bonds, rental real estate
  • valued by discounting all expected future cash flows

store of value asset - neither generate income nor can they be consumed

  • e.g. artworks, foreign currencies; owner-occupied real estate

consumable or transferable (C/T) asset - do not generate continuous cash flows but do have economic value as an input

  • e.g. wheat, oil, cattle
6
Q

ways that an investor can participate in commodity markets, and their advantages and disadvantages

A

LOS 42.e

  • direct purchase of a physical commodity
    • A: obvious and direct
    • D: cost of storage and maintenance
  • commodity stocks
    • A: respond quickly and sensibly to events that may impact a firm’s value
    • D: often low correlation to underlying commodity
  • commodity mutual funds
    • A: diversification; low transaction costs
    • D: differ by management style, allocation strategy, and other characterisitics among funds
  • commodity futures
    • A: convenient, flexible, low transaction costs, highly leveraged
    • D: continual maintenance time and effort
  • structured products based on commodity futures indicies
    • commodity index ETF
      • A: safe, liquid, low transaction costs
      • D: take care to understand risk/return aspects
    • commodity index certificate
      • A: issued cheaply and quickly; wrt excess-return-based index: have low intial costs and maintenance fees
      • D: when interest rates are high, excess return index will be lower than total return index
7
Q

commodity term structures

A

LOS 42.f

backwardation - term structure will have a negative trend i.e. futures prices are lower than current spot price

normal backwardation - futures price is lower than the corresponding expected spot price in the future; occurs when hedgers (producers) are short in the futures contract i.e. producers pay a premium for locking in prices

contango - term structure has a positive trend i.e. futures prices are higher than the current spot price

8
Q

components of the return of a commoidty futures investment

A

LOS 42.g

total return = spot + roll + collateral + rebalancing

spot return - change in commodity’s spot price

roll return - return from closing out maturing contracts and replacing with newer ones

collateral return - return on posted collateral that is invested in government securities

rebalance return (diversification return) - return from rebalancing process of a diversified portfolio of futures contracts

9
Q

relationship between spot and futures prices

A

LOS 42.f

F0 = S0e(r+U-Y)T

F0 = current futures price of the commodity contract

S0 = current spot price of the commodity

r = continuously compounded risk-free interest rate

U = cost of storage as % of commodity’s price

Y = convenience yield of commodity

10
Q

excess return vs total return

A

LOS 42.g

excess return = spot return + roll return = futures return

total return = collateral return + futures return = collateral return + spot return + roll return

11
Q

how the sign of roll return depends on the term structure of futures prices

A

LOS 42.h

term structure in backwardation ⇒ roll return is positive

term strucuture in contango ⇒ roll return is negative

roll return = (St - Ft,T) / St

12
Q

models of expected returns for commodities

A

LOS 42.i

  1. CAPM - appropiate for capital assets (stocks, bonds)–not appropriate for commodities
  2. insurance perspective - a long position in commodities will earn positive returns due to the speculator’s premium earned to support short hedgers
  3. hedging pressure hypothesis - a risk premium can be earned on either long or short positions depending on the balance of hedgers in the market
  4. theory of storage - according to the theory of storage, commodities that are difficult to store should ean a positive yield

Decks in CFA Level 2 2016 Class (43):