3.2 Commodities

Question 1

Hotelling’s theory states that prices of exhaustible commodities (e.g., forms of energy and metals) should increase by the prevailing ______ interest rate, perhaps with a risk premium.

Answer 1

Nominal

Question 2

Cost of carry model for commodities depend on three factors:

Answer 2

1. Market interest rate
2. Storage costs
3. Convenience yield

Others: spoilage, inventory shrinkage

Question 3

What is the formula for calculating cost of carry?

Answer 3

Futures price = spot price + costs - convenience yield

Question 4

Backwardation: forward price is ___ than spot price

Contango: forward price is ___ than spot price

Answer 4

Backwardation: forward price is LOWER than spot price. DOWNWARD sloping. Risk-free rate > Dividend Yield

Contango: forward price is HIGHER than spot price. UPWARD sloping. Risk-free rate < Dividend yield

Question 5

A key concept in commodity futures is the relationship between the slope of the forward curve and the sources of return from holding futures contracts.

• In backwardated markets (which have downward-sloping forward curves), ________ dated positions can earn consistently superior risk-adjusted returns from positive roll returns. This positive roll return is generated since futures prices _______ as the contracts approach maturity and “roll up” the downward-sloping forward curve.
• This implies that, in contango markets (which have upward-sloping forward curves), roll return generates superior returns for ______ futures positions.

Answer 5

• In backwardated markets (which have downward-sloping forward curves), LONG futures positions can earn consistently superior risk-adjusted returns from positive roll returns. This positive roll return is generated since futures prices INCREASE as the contracts approach maturity and “roll up” the downward-sloping forward curve.
• This implies that, in contango markets (which have upward-sloping forward curves), roll return generates superior returns for SHORT futures positions.

Question 6

Contago = Upward Sloping = inventory ____ demand levels (ie when convenience yield is low)

Backwardation = Downward slowing = Downward sloping = inventories are ____

Answer 6

Contago = Upward Sloping = inventory FAR EXCEEDS demand levels (ie when convenience yield is low)

Backwardation = Downward slowing = Downward sloping = inventories are LOW

Question 7

Excess return of a futures position is best represented by which of the following?

A. spot return plus change in basis
B. roll return plus change in basis
C. spot price plus basis
D. roll return plus basis

Answer 7

A. spot return plus change in basis

Question 8

What is the working curve?

Answer 8

Upward-sloping curve that describes the relationship between a commodity’s inventory level and the slope of the forward curve.

The Working curve illustrates the theory of storage, which maintains that when a commodity’s inventory levels are high, the forward curve is upward sloping (i.e., its slope is positive and the curve is in contango); and when a commodity’s inventory levels are low, the forward curve is downward sloping (i.e., its slope is negative and the curve is in backwardation.

Question 9

Which of the following is the best example of the optimal weight that investors should allocate to a specific commodity in a CAPM-based perfect market?

A. The optimal weight is the percentage of the total value of the market portfolio attributable to the commodity.
B. The optimal weight is based on the statistical properties of returns of the assets in the specific portfolio.
C. The optimal weight is determined by the portfolio’s risk characteristics such that the resulting portfolio risk is minimized.
D. The optimal weight for a commodity depends on each individual investor’s risk preference.

Answer 9

Market weight

Question 10

Roll returns is positive when

Answer 10

Roll return is positive for financial futures held to maturity with dividend yields that exceed the risk-free rate.

Question 11

Commodity Indices:
1. S&P: ____-weighted
2. BCOM: ____-weighted
3. Reuters: ____-weighted

Answer 11

1. S&P: Production-weighted
2. BCOM: Market-weighted
3. Reuters: Tier-weighted