FMP11 - Commodity Forwards and Futures

Question 1

Explain key differences between commodities and financial assets

Answer 1

• Storage costs for financial assets almost zero, cam be substantial for commodities
• Commodities can be costly to transport so price varies by location
• Lease charge for shorting commodities far exceeds that for financials
• Most commodities have a price that is mean reverting

Question 2

Define and apply commodity concepts such as storage costs, carry markets, lease rate, and convenience yield

Answer 2

• Storage costs: how much it costs to keep the asset, considered negative income
• Lease rate: interest rate charged to borrow the asset
• Convenience yield: where consumer has commodity stored ready for use

Question 3

Identify factors that impact prices on agricultural commodities, metals, energy, and weather derivatives

Answer 3

Agricultural:
- prices can be seasonal
- expected weather affecting harvest
- politics

Metals:
- FX rates can affect
- Availability

Energy:
- very seasonal

Question 4

Explain the formula for pricing commodity forwards

Answer 4

Same as normal forwards but treat lease rate as Q if no storage costs (known income forward) and remove storage costs from S (so term becomes S-U) for known yield case, convenience yield is Q

Question 5

Define lease rate and explain how it determines the no-arbitrage values for commodity forwards and futures

Answer 5

Interest rate charged to borrow underlying asset

Question 6

Describe the cost of carry model and determine the impact of storage costs and convenience yields on commodity forwards prices and no-arbitrage bounds

Answer 6

Cost of carry reflects impact of storage, financing, income earned on the asset.

C = ((1 + R) / (1 + Q)) - 1, R-Q if continuous

Increasing yield means smaller cost of carry, increasing storage costs increases C

Question 7

Compute the forward price of a commodity with storage costs

Answer 7

F = (S - U) * ((1 + R) / (1 + y))^T,

U is the present value of storage costs

Question 8

Explain how to create a synthetic commodity position and use it to explain the relationship between the forward price and the expected future spot price

Answer 8

Invest P = F / (1 + R)^T at the risk free rate and enter into long futures contract to buy the asset for F at time T to create synthetic position

Question 9

Explain the impact of systematic and non-systematic risk on current futures and expected futures spot prices

Answer 9

E(St) = P(1 + X)^T where X is expected return

Systematic risk of an investment depends on correlation between underlying asset return and market return
- correlation positive means X > R and E(St) > F
- correlation negative means X < R and E(St) < F

Question 10

Define and interpret normal backwardation and contango

Answer 10

• if F < E(St) then normal backwardation
• if F > E(St) then contango