Investing in commodities
physical ownership, commodity related equity, ETFs and Commodity linked notes
Drawbacks of physical ownership
storage costs, maintaining and managing inventories, opportunity cost of capital, wasting convenience yield
Hotelling’s theory
prices of exhaustible commodities should rise at nominal interest rate, perhaps with risk premium
Julian Simon on long-term spot commodity prices
long-term spot commodity prices decline in real terms (due to innovation & tech) -> expected spot commodity prices may be less than predicted by Hotellings theory
Beta of Commodity equities
exposed to 2 betas 1) commodity market 2) equity market (not good for diversification)
Exchange traded notes
debt instruments issued by bank; CFs linked to prices of reference portfolio. Exposed to issuing bank’s credit risk
advantage to CLN issuers - can better match risks of their assets and liabilities
Advantage to investors - no need to roll over futures to maintain commodity exposure
Non-principal protected CLNs
no guaranteed payment of FV at maturity; note holders fully share in upside & downside of commodity price changes
Principal protected CLNs
guaranteed payment of FV at maturity (unless issuer defaults) & note holders share in price increase if commodity exceeds set level
Perfectly elastic supply (commodities)
any quantity demanded can be immediately and limitlessly supplied without changes in market price. Associated with little/no convenience yield
Inelastic supply
supply of commodity changes slowly in response to market prices. Associated with high convenience yields
Demand for Commodities: inelastic demand
demand for a good does not change significantly due to changes in price. Potential cause of higher price vol. and convenience yield
Backwardation
Term structure is downward sloping i.e. deferred forwards priced lower than nearby forwards F< P0 (when r < dividend yield)
Contango
Term structure is upward sloping i.e. deferred forwards priced higher than nearby forwrads F > p0 (when r > dividend yield)
Slope and shape of fwd curve in perfect market
driven by carrying costs. In perfect market, slope of curve for financial fwds driven by interest rates and dividends
Slope and shape of fwd curve in imperfect market
Different storage costs, convenience yields and difficulty borrowing commodities
Basis of fwd/futures
difference between spot and fwd/future prices
Basis risk
dispersion in economic returns due to changes in relationship between spot and futures prices
Calendar spread
difference between fwd/futures prices with same underlying but different settlement dates
Sources of basis risk
carry costs for spot position differ from costs implied by basis, convenience yield from spot position differs from storage costs, basis changes.
Sources of commodity futures return (4)
- excess return - return generate from changes in futures prices
- spot return - return on underlying commodity’s spot price
- Collateral yield - interest earned from risk free bonds used to collateralise the futures contract
- roll return or roll yield - results from change in basis (futures time to maturity gets shorter & price rolls up or down term structure. Basis depends on carry costs, which change over time
Roll return
gain in futures price relative to spot price from change in basis aka return accrued due to changes in basis; differs from accounting definition (i.e. closing one futures position & opening another
Rollover strategies: 2 decisions
1) rollover decisions (time to exit, longevity of new position)
2) collateral investment decisions (fully collateralised position’s return is based on interest earnged on collateral investments; may have different durations and thus different returns
Normal backwardation
long forwards earn positive expected return (does not indicate alpha or systamatic risk premium)
Normal Contango
Short forwards earn positive expected return
