Learning Module 5: Introduction to Commodities and Commodity Derivatives

Learning Module 5 Introduction to Commodities and Commodity Derivatives EXAMPLE 1 Commodity Sector Demand 1. Industrial activity most likely affects the demand for which of the following commodities? A. Copper B. Natural gas C. Softs (eg., cotton, coffee, sugar and cocoa) Solution: A is correct. Copper is used for construction, infrastructure development, and the manufacture of durable goods, all of which are economically sen- sitive. B is incorrect because demand for natural gas is driven primarily by weather conditions (heating or cooling) and only secondarily by industrial activity. C is incorrect because demand for softs is driven primarily by global income. EXAMPLE 2 Commodity Sector Risks 1. Which of the following commodity sectors are least affected in the short term by weather-related risks? A. Energy B. Livestock C. Precious metals Solution: C is correct. Weather has very little impact on the availability of precious metals, given their ease of storage. Inflation expectations, fund flows, and industrial production are more important factors. A is incorrect because energy demand is strongly influenced by weather (e.g., heating demand in the winter or transportation demand in the summer). B is incorrect because the health of livestock is vulnerable to unfavorable weather conditions increasing the risks of death and disease by extreme cold, wetness, and heat. EXAMPLE 3 Energy Life Cycle 1. Which of the following is a primary difference in the production life cycle between crude oil and natural gas? A. Only crude oil needs to be stored. B. European companies are the only ones that store crude oil. C. Natural gas requires very little additional processing after extraction compared with crude oil. Solution: C is correct. Natural gas can be used after it is extracted from the ground upon delivery, but crude oil must first be processed for later use. A is important because both oil and natural gas are stored before usage. B is incorrect because many countries around the world store crude oil, both commercially and strategically. EXAMPLE 4 Industrial Metals Life Cycle 1. Because of large economies of scale for processing industrial metals, producers: A. immediately shuts down new capacity when supply exceeds demand. B. have an incentive to maintain maximum operating production levels when demand declines. C. find it difficult to cut back production or capacity even when supply exceeds demand or demand slows. Solution: C is correct. Given the sizable facilities in which metals are produced and their capital requirements, reducing capacity is difficult when demand slows. A is incorrect because of the time lag involved in responding to reduced demand conditions. B is incorrect because producers would face financial losses if they maintained maximum production levels when there is a decline in demand. EXAMPLE 5 Livestock Life Cycle 1. The US livestock sector has been among the least export-oriented commodity sectors because of: A. low technological innovation in the sector. B. high risk of spoilage once animals are slaughtered. C. little or no demand for US livestock from outside the United States. Solution: B is correct. Livestock incur a high risk of spoilage once they are slaughtered unless the meat is frozen. A is incorrect because advances in cryogenics have improved the ability to export from the United States. C is incorrect because demand for US livestock has expanded internationally, particularly in emerging market countries that are experiencing economic growth. EXAMPLE 6 Commodities versus Stocks and Bonds 1. In contrast to financial assets, such as stocks and bonds: A. commodities are always physical goods. B. commodities generate periodic cash flows. C. commodity investment is primarily via derivatives. Solution: C is correct. The most common way to invest in commodities is via derivatives. A is incorrect because although most commodities are physical goods, certain newer classes, such as electricity or weather, are not tangible. B is incorrect because commodities may incur, rather than generate, periodic cash flow through transportation and storage costs (when the commodities are physically owned). EXAMPLE 7 Spot Commodity Valuation 1. What is a key distinction between the valuation of commodities compared with the valuation of stocks and bonds? A. Valuation of commodities cannot be conducted using technical analysis. B. Valuation of commodities focuses on supply and demand, whereas valuation of stocks and bonds focuses on discounted cash flows. C. Valuation of stocks and bonds focuses on future supply and demand, whereas commodity valuation focuses on future profit margins and cash flow. Solution: B is correct. The valuation of commodities is based on a forecast of future prices based on supply and demand factors, as well as expected price volatility. In contrast, the valuation of stocks and bonds is based on estimating future profitability and/or cash flow. A is incorrect because technical analysis is sometimes applied to valuing commodities. C is incorrect for the reasons stated for choice B. EXAMPLE 8 Commodity Market Participants 1. Commodity traders that often provide insurance to hedgers are best described as: A. arbitrageurs. B. liquidity providers. C. informed investors. Solution: B is correct. Liquidity providers often play the role of providing an insurance service to hedgers who need to unload and transfer price risk by entering into futures contracts. A is incorrect because arbitrageurs typically seek to capitalize and profit on mispricing due to a lack of information in the marketplace. C is incorrect because informed investors predominantly keep commodity futures markets efficient by capitalizing on mispricing attributable to a lack of information in the marketplace. EXAMPLE 9 Spot and Futures Pricing (1) 1. The current price of the futures contract nearest to expiration for West Tex as Intermediate (WTI) crude oil is $65.00 per barrel, whereas the six-month futures contract for WTI is priced at $60.75 per barrel. Based on this information: A. the futures market for WTI crude oil is currently in a state of contango. B. the futures market for WTI crude oil is currently in a state of backwardation. C. the shipping and delivery cost of WTI crude oil for a futures contract expiring in six months with physical delivery to Cushing, Texas, is $4.25 per barrel. Solution: B is correct. Commodity futures markets are in a state of backwardation when the spot price is greater than the price of near-term (ie., nearest to expiration) futures contracts, and correspondingly, the price of near-term futures contracts is greater than longer-term contracts. A is incorrect because the market would be in contango only if the deferred futures price exceeded that of the nearby futures price. C is incorrect because the shipping and delivery costs associated with physical delivery of a commodity are only one component in determining a commodity futures contract price. Geopolitical, seasonal, and other factors also influence the difference in delivery months. EXAMPLE 10 Spot and Futures Pricing (2) 1. An important distinction between spot and futures prices for commodities is that: A. spot prices are universal across regions, but futures prices vary by location. B. futures prices do not reflect differences in quality or composition for a commodity. C spot prices vary across region based on quality/composition and local supply and demand factors. Solution: C is correct. Spot prices of commodities vary across regions, reflecting logistical constraints and supply and demand imbalances that hinder the movement of materials. A is incorrect because spot prices tend to vary by region while futures are purposely standardized to facilitate trading. B is incorrect because while futures contracts are based on standardized specifications, composition and quality can be assigned premiums or discounts for delivery. EXAMPLE 11 Spot and Futures Pricing (3) 1. An arbitrageur has two active positions in the commodity futures markets- one for lean hogs and the other for natural gas. The calendar spread on the lean hogs contract is quoted at -50 cents per pound, and the calendar spread on the natural gas contract is +$1.10 per million BTU (British ther mal units). Based on this information, we can say that: A. only the spreads of these commodities and not the individual prices. can be traded in commodity markets. B. the lean hogs futures market is in a state of backwardation and the natural gas futures market is in a state of contango. C. the lean hogs futures market is in a state of contango and the natural gas futures market is in a state of backwardation. Solution: C is correct. The spread is the difference between the current spot price for a commodity and the futures contract price. Because futures markets are in a state of contango, they will have futures prices that exceed the spot price, so the spread for these markets is negative. Conversely, in a state of backwardation, the spread is positive. A is incorrect because either the individual contract prices or the combined spreads can be traded. B is incorrect because, as mentioned earlier, the negative sign of the spread of lean hog futures indicates a state of contango, whereas the positive sign of the spread of natural gas futures indicates a state of backwardation. EXAMPLE 12 Spot and Futures Pricing (4) 1. A futures price curve for commodities in backwardation: A. always remains in backwardation in the long term. B. can fluctuate between contango and backwardation in the long term. C. reflects structural long-term industry factors, as opposed to dynamic market supply and demand pressures. Solution: B is correct. During periods of market stress or fundamental structural change in market conditions, some commodity futures price curves can rapidly shift from contango to backwardation or vice versa. A is incorrect because futures price curves can vacillate between contango and backwardation. C is incorrect because the shape of a commodity futures price curve reflects both long-term industry factors as well as market expectations of future supply and demand of the underlying commodity(ies). EXAMPLE 13 Theories of Commodity Futures Returns (1) 1. Which of the following best describes the insurance theory of futures re- turns? A. Speculators will not provide insurance unless the futures price exceeds the spot price. B. Producers of a commodity will accept a lower future price (versus the spot price) in exchange for the certainty of locking in that price. C. Commodity futures markets result in a state of contango because of speculators insisting on a risk premium in exchange for accepting price risk. Solution: B is correct. Under the insurance theory of futures returns, Keynes stated that producers of a commodity would prefer to accept a discount on the potential future spot price in return for the certainty of knowing the future selling price in advance. A is incorrect because the futures price must be below the spot price (normal backwardation) under the insurance theory of futures returns. C is incorrect because the insurance theory of futures returns implies markets are in backwardation, not contango. EXAMPLE 14 Theories of Commodity Futures Returns (2) 1. Under the hedging pressure hypothesis, when the hedging activity of commodity futures buyers exceeds that of commodity futures sellers, that futures market is most likely. A. flat. B. in contango. C. in backwardation. Solution: B is correct. Under the hedging pressure hypothesis, a market in contango typically results when excess demand for price insurance among commodity futures buyers drives up the futures price to induce speculators to take on price uncertainty risk. A is incorrect because a flat market would likely exist if futures demand activity largely equaled that of supply. C is incorrect because under this scenario, the futures market would be in contango, not backwardation. EXAMPLE 15 Theories of Commodity Futures Returns (3) 1. Under the theory of storage, the convenience yield is: A. not affected by the supply of a commodity. B. typically low when the supply of a commodity is scarce. C. typically high when the supply of a commodity is scarce. Solution: C is correct. Under the theory of storage, the convenience yield of a commodity increases as supply (inventories) diminish and concerns about the future availability increase. A is incorrect because supply levels have a discernible effect on the convenience yield, as mentioned. B is incorrect because the convenience yield would likely be high, as opposed to low, when supply is limited. EXAMPLE 16 Theories of Commodity Futures Returns (4) 1. Which of the following represents the formula for a futures price according to the theory of storage? A. Futures price = Spot price of the physical commodity + Direct storage costs - Convenience yield. 8. Futures price = Spot price of the physical commodity + Direct storage costs + Convenience yield. C. Futures price Spot price of the physical commodity Direct storage costs + Convenience yield. Solution: A is correct. According to the theory of storage, the futures price reflects the current spot price as well as costs incurred in actually holding the commodity until its delivery. Such costs include direct storage, such as inventory and insurance costs. Finally, because there is a convenience yield (or benefit) to owning a commodity as a form of insurance against potential supply disruptions, this term is subtracted from the current price of the commodity. EXAMPLE 17 Total Returns for Futures Contracts (1) 1. A commodity futures market with pricing in backwardation will exhibit which of the following characteristics? A. The roll return is usually negative. B. Rolling an expiring futures contract forward will require buying more contracts in order to maintain the same dollar position in the futures markets. C. Rolling an expiring futures contract forward will require buying fewer contracts in order to maintain the same dollar position in the futures markets. Solution: B is correct. Commodity futures markets in backwardation exhibit price curves in which longer-dated futures prices are priced lower than near-dated contracts and the nearest-dated contract is priced lower than the current spot price. With a lower futures price on the futures curve, rolling contracts forward in backwardation would require purchasing more contracts to maintain the same dollar position. A is incorrect because the roll return is usually positive, not negative, in markets in backwardation. C is incorrect because an investor would need to purchase more, not fewer, contracts in backward markets to maintain his or her total dollar position. EXAMPLE 18 Total Returns for Futures Contracts (2) 1. An investor has realized a 5% price return on a commodity futures contract position and a 2.5% roll return after all her contracts were rolled forward. She had held this position for one year with collateral equal to 100% of the position at a risk-free rate of 2% per year. Her total return on this position (annualized excluding leverage) was: A. 5.5% B.7.3% C9.5% Solution: C is correct. Total return on a commodity futures position is expressed as Total return Price return Roll return, and Collateral return. In this case, she held the contracts for one year, so the price return of 5% is an annualized figure. In addition, the roll return is also an annual 2.5%. Her collateral return equals 2% per year × 100% initial collateral investment = 2% So, her total return (annualized) is Total return 5%+2.5%+2%-9.5% EXAMPLE 19 Total Returns for Futures Contracts (3) 1. An investor has a $10,000 position in long futures contracts (for a hypo-thertical commodity) that he wants to roll forward. The current contracts, which are close to expiration, are valued at 54.00 per contract, whereas the longer-term contract he wants to roll into is valued at $2.50 per contract. What are the transactions he needs to execute in terms of buying and selling new contracts in order to maintain his current exposure? A. Close out (sell) 2,500 near-term contracts and initiate (buy) 4,000 of the longer-term contracts. B. Close out (buy) 2,500 near-term contracts and initiate (sell) 4,000 of the longer-term contracts. C. Let the 2,500 near-term contracts expire and use any proceeds to purchase an additional 2,500 of the longer-term contracts. Solution: A is correct. To roll over the sarne level of total exposure ($10,000), he will need to do the following: Sell $10,000/54.00 per contract 2,500 existing contracts. And replace this position by purchasing $10,000/52.50 per contract 4,000 existing contracts. EXAMPLE 20 Roll Return 1. When measuring its contribution to the total return of a commodity futures position, the roll return: A. typically has a significant contribution to total return over both single and multiple periods. B. typically has a modest contribution to total return in any single period but can be significant over multiple periods. C is always close to zero. Solution: B is correct. Historically, the roll return has had a relatively modest impact on overall commodity futures return in the short term but can be meaningful over longer time periods. A is incorrect because the roll return is typically modest over shorter periods of time, as noted earlier. C is incorrect because futures contracts generate positive or negative roll returns depending on the commodity and prevailing market conditions, EXAMPLE 21 Commodity Swaps (1) 1. A portfolio manager enters into a $100 million (notional) total return commodity swap to obtain a long position in commodity exposure. The position is reset monthly against a broad-based commodity index. At the end of the first month, the index is up 3%, and at the end of the second month, the index declines 2%. What are two payments that would occur between the portfolio manager and the swap dealer on the other side of the swap transaction? A. No payments are exchanged because a net cash flow only occurs when the swap agreement expires. B. $3 million would be paid by the swap dealer to the portfolio manager (after Month 1), and $2 million would be paid by the portfolio manager to the swap dealer (after Month 2). C. $3 million would be paid by the portfolio manager to the swap dealer (after Month 1), and $2 million would be paid by the swap dealer to the portfolio manager (after Month 2). Solution: B is correct. Because the portfolio manager has a long position in the total return commodity swap, he or she will receive payments when the commodity index rises and make payments when the commodity index declines. The payment calculations after the first two months are as follows: Month 1: $100 million 3% $3 million Month 2: $100 million-2%-$2 million A is incorrect because swap payments are made periodically (in this case monthly) and not withheld to the end of the contract. C is incorrect because the payments would be in the opposite direction for each month. EXAMPLE 22 Commodity Swaps (2) 1. In a commodity volatility swap, the direction and amount of payments are determined relative to the observed versus reference: A. direction in the price of a commodity. B. variance for the price of a commodity. Cvolatility for the price of a commodity. Solution: C is correct. In a commodity volatility swap, the two sides of the transaction are speculating on expected volatility. A volatility seller will profit if realized volatility is lower than expectations, whereas the volatility buyer benefits from higher than expected volatility. A is incorrect because a volatility swap is based on price volatility, not direction, B is incorrect because a volatility swap is based on price volatility as opposed to price variance (price volatility squared). EXAMPLE 23 Commodity Indexes (1) 1. All else being equal, compared with an equally weighted commodity index, a production value-weighted index (such as the S&P GSCI) will be: A. less sensitive to energy sector returns. B. more sensitive to energy sector returns. C. equally sensitive to energy sector returns. Solution: B is correct. The energy sector will make up a sizable portion of a production value-weighted index and thus will be a meaningful driver of returns for such an index. A is incorrect because a production value-weighted index will be more, not less, sensitive to the energy sector. C is incorrect because a production value-weighted index will be more sensitive to the energy sector, but not equally sensitive. EXAMPLE 24 Commodity Indexes (2) 1. Which of the following statements is not correct regarding commodity futures indexes? A. Commodity sectors in backwardation typically improve index returns. B. An index that invests in several futures exchanges provides a high degree of diversification. C. Total returns of the major commodity indexes have low correlation with traditional asset classes, such as equities and bonds. Solution: B is correct. Commodity futures exchanges throughout the world are highly correlated and thus provide little diversification benefits. A is incorrect because markets in backwardation typically have positive roll yields and thus will likely improve index returns (although the price return may still not be positive and thus the total return may still be negative). C is incorrect be- cause commodity index returns do indeed have historically low correlation with equities and bonds.