Alternative Investments - Primer On Commodity Investing

Front 1

Commodity Market participants

Back 1

1- Hedgers

2- Speculators

3- Arbitrageurs

Front 2

Hedgers

Back 2

Have exposure to commodity prices and take offsetting position in futures markets to lower risk

Front 3

Speculators

Back 3

1- Accept risk by taking opposite position as hedgers

2- Exposed to lot of risk because no offsetting physical position

3- Demand premium for providing liquidity

Front 4

Arbitrageurs

Back 4

Arbitrage profits between -

1- futures and spot

2- diff locations

3- over time

They keep relationship between spot and futures in line.

Front 5

Storability

Back 5

Commodity is storable if -

1- does not degrade over time

2- cost of storing is low

Front 6

Renewability

Back 6

Commodity is renewable if -

1- be produced without limit

Spot prices of such commodities is influenced by expected cost of future production

Front 7

Conveniance Yield

Back 7

It is the benefit from holding commodity instead having long futures position.

Convenience yield will rise if commodity will be more scarce in the future

Front 8

Theory of storage

Back 8

Inverse relation between inventory levels and conveniance yield

Front 9

main 3 asset classes

Back 9

1- capital assets

2- store of value assets

3- consumable or transferable assets

Front 10

capital assets

Back 10

1- expected to provide continuous cash flows in the future

2- can be valued by discounting back future cash flows

Front 11

store of value assets

Back 11

1- cannot be consumed nor generate income

Front 12

Consumable/transferable assets

Back 12

1- commodities

2- values by interaction of supply and demand

Front 13

ways of participating in commodities market:

Back 13

1- direct purchase

2- commodity stocks

3- commodity mutual funds

4- commodity futures

5- structured products based on commodity future indices

Front 14

direct purchase

Back 14

advantage- obvious & direct

disadvantage- impractical due to cost & storage, will depend highly on precious metal and lose diversification

Front 15

commodity stocks

Back 15

advantages - stock markets respnd quickly and sensibly to events that impacts a firms value

disadvantage- no direct exposure to commodity, prices depends less on commodity and more on the firm's unique risks

Front 16

commodity mutual funds

Back 16

1- diversified investment with low transaction costs

2- needs to be aware of a specific commodity fund's style & allocation strategy

Front 17

Commodity futures

Back 17

advantages - benefit from commodity price movements without the downsides of physical holdings. conveniant, flexible and highly leveraged. low transaction cost & highly liquid

disadvantage- leverage can lead to large losses and margin calls. time and effort required for rolling.

Front 18

Structured products on commodity future indices

Back 18

1- ETF on a commodity index

2- Commodity Index certificate based on a commodity index

Front 19

Index ETF

Back 19

Advantages - traded easily with low transaction costs. No concerns on credit risk.

Disadvantages - Risk, return will vary with sector weights, index construction and calculation methods.

Front 20

Commodity Index certificate

Back 20

Legal obligation issued by bank. Bank will make corrsponding investment in futures and will rolls those futures.

Advantage - can be issued cheaply and quickly. based on excess return which means low cost and managment fees

disadvantage - if interest rates are high, returns will be lower.

Front 21

Relation between forward and spot price

Back 21

F0 =S0 x (e^rT).

T= time to expiry

S0= spot price

F0= futures price

r= continous compunded risk-free interest rate

Front 22

Future parity

Back 22

Future price should be equal to expected spot price at maturity.

Not holds for commodity

Front 23

spot future relationship with storage cost

Back 23

F0 = S0 (e^ (r+U)T)

U= cost of storage as percentage of commodity price

Front 24

Commodity term structure

Back 24

Graph of future price relative to different maturities

Front 25

Backwardation

Back 25

Term structure has negative trend

Future prices lower than spot price

Front 26

Contango

Back 26

Term structure has +ve trend

Future prices higher than spot price

Buyers dominate market

Front 27

Conveniance yield effect on term structure

Back 27

F0 = S0 x (e^ (r+U-Y)T)

Y- conveniance yield

Front 28

Return components of commodity futures

Back 28

1- spot return

2- roll return

3- collateral return

4- rebalancing return

Front 29

toal return

Back 29

spot return + roll return + collateral return + rebalancing return

Front 30

spot return

Back 30

1- percentage change in commodity spot price

2- demand/supply drives spot return

3- correlated with unexplained inflation

Front 31

Roll Return

Back 31

Returns generated after maturing futures contracts are closed and new ones are initiated

(F(t-1,t)- F(t,T))/F(t-1,t)=(St- F(t,T))/St

Roll return -ve in contango, +ve in backwardation

Front 32

Collateral Return

Back 32

Interest received on a cash investment

Collateral (Contract Value - Margin Amount) is invested in g-secs thus it is T-bill rate.

Front 33

Rebalancing return

Back 33

Commodity indices are rebalanced and futures that have gone up in value are sold and futures that have decreased in value are bought

Front 34

Excess Return

Back 34

Spot Return + roll return = futures return

Front 35

total return

Back 35

collateral return + futures return

= collateral return + spot return + roll return

Front 36

Models of expected return

Back 36

1- CAPM

2- Insurance perspective

3- Hedging Pressure hypothesis

4- Theory of storage

Front 37

Insurance perspective

Back 37

1- desire of producers to hedge price risk

2- farmer will take short position to offset risk

3- will offer speculators risk premium to invest

Front 38

Normal backwardation

Back 38

1- farmer offering risk premium to investor will cause futures prices to drop

2- future prices will be lower than expected spot price

3- long position will have positive expected return

Front 39

Hedging pressure hypothesis

Back 39

1- desire of consumers to hedge price risk

2- consumers will take long position to offset risk

3- will offer speculators risk premium to invest

4- Money can be earned both ways depending on balance of hedgers in the market

Front 40

Normal contango

Back 40

1- consumer offering risk premium to investor will cause futures prices to rise

2- future prices will be higher than expected spot price

3- short position will have positive expected return

Front 41

Theory of storage

Back 41

1- considers impact of inventory levels on commodity prices

2- Higher levels of inventory decrease convenience yield

3-difficult to store commodities will have lower inventory levels and lower convenience yield