Answers - Reading 34 Introduction to Commodities and Commodity Derivatives

Question #1 of 15 Question ID: 1473892 As opposed to stocks and bonds, commodities are most likely: A) traded on futures exchanges. B) characterized by lack of intrinsic value. C) physical assets. Explanation As opposed to financial assets such as stocks and bonds, commodities are usually physical assets. While commodities do not have any cash flows, they do have intrinsic value and can trade in spot markets. (Module 34.1, LOS 34.c) Question #2 of 15 Question ID: 1473894 Suppose that corn futures contracts are in backwardation. Which of the following is least likely to be true? A) the basis for corn futures contract is negative. B) Spot price of corn is higher than the futures price. C) roll yield on the corn futures is positive. Explanation When the futures contract is in backwardation, the spot price is greater than the futures price and the difference between the spot and futures price (i.e., the basis) will be positive. If the market is in backwardation, roll yield will be positive. (Module 34.1, LOS 34.e) Question #3 of 15 Question ID: 1473895 Which of the following statements regarding the pricing of commodity futures contracts is most accurate? A) B) C) The convenience yield for a commodity is positively correlated with the futures price. The arbitrage free price of a commodities futures contract is often lower than that of a financial security futures contract due to storage costs. Commodities that are subject to sudden and large demand shocks may exhibit backwardation in the futures market due to significant convenience yields. Explanation Storage costs increase the price of commodities futures contracts. If a commodity is subject to demand shocks the benefit from holding the commodity is higher and hence the higher convenience yield may force the futures market into backwardation. Higher convenience yields reduce the futures price. (Module 34.1, LOS 34.f) Question #4 of 15 Question ID: 1473896 Roger Torsten is studying historical data on the commodities markets to assist with his a forecast he is producing in his role as an economic researcher. He has observed long periods in the past when the term structure of the futures market for a commodity displays a negative trend. Which of the following explanations is most likely an explanation for this observed trend? A) B) C) Producers concerned about a potential drop in price of the commodity are taking hedging positions to lock in a sales price. Manufacturers, concerned about increasing commodity prices are buying commodity futures to hedge input costs. Due to an increase in the supply of the commodity, the convenience yield has dropped to nearly zero. Explanation Producers taking short hedges will force the futures price down and may well lead to backwardation. If manufacturers are taking out long hedges the term structure is likely to be in contango. High convenience yields would lead to backwardation. (Module 34.1, LOS 34.f) Question #5 of 15 Question ID: 1473902 An oil refiner wants to hedge oil price risk using a swap. The swap pays the oil price above $50 per barrel in exchange for a fixed price of $1 per barrel. The notional principal is 1 million barrels. If the refiner enters the swap, the total profit to the refiner if the price of oil is $52 is closest to: A) +$1,000,000 B) –$2,000,000 C) +$2,000,000 Explanation An oil refiner would be concerned about oil prices rising (i.e. input costs going up) and hence would hedge their exposure by choosing to receive the return on oil (i.e., the difference between the market price and $50) and pay the fixed $1. In this instance the net payoff is ($52-$50)-$1 = $1 per barrel (recall that the notional is 1 million barrels). (Module 34.2, LOS 34.i) Question #6 of 15 Question ID: 1473899 An investor establishes a long position in 800 WTI (oil) contracts at $45 per barrel. Which of the following components of investor's return will have a non-negative value? A) price return B) rebalancing return C) roll return Explanation Rebalancing return is applicable on a commodity index (or portfolio) and is zero for a single commodity position. (Module 34.2, LOS 34.g) Question #7 of 15 Question ID: 1473898 Don Chancery is working on a forecast of commodity price movements for the economic research department at his investment firm. He is basing his predictions on the theory that pricing is driven solely by producers who hold (or expect to hold) commodities, and hedge their position with a short futures contract, leading to normal backwardation. Which of the following theories is Chancery most likely using? A) The Theory of Storage. B) The Insurance Theory. C) The Hedging Pressure Hypothesis. Explanation Under the Insurance Theory, the shape of the futures price curve can be explained by producers of a commodity (i.e. market participants that are long the physical good) selling the commodity for future delivery in order to hedge their exposure to price risk. The Hedging Pressure Hypothesis extends the insurance perspective to include consumers who hedge long positions, not solely producers with short positions. The Theory of Storage links convenience yields to inventory levels. (Module 34.1, LOS 34.f) Question #8 of 15 Question ID: 1473900 A commodity futures contract in contango will most likely: A) entail purchasing fewer contracts to maintain same value exposure to the commodity. B) lead to positive roll return. C) entail purchasing more contracts to maintain same value exposure to the commodity. Explanation Contango markets have negative roll returns and entail purchasing fewer, higher-priced new contracts to replace the expiring lower-priced contracts. (Module 34.2, LOS 34.g) Question #9 of 15 Political risk is least likely to affect the price of which commodity? A) Industrial Metals. B) Coffee. C) Oil. Explanation Question ID: 1473889 Political risk is an important concern affecting the supply of oil. Political risk (especially union strikes and restrictive environmental regulations) affects the supply of industrial metals. Softs such as coffee are more affected by weather and disease. (Module 34.1, LOS 34.a) Question #10 of 15 Question ID: 1473901 The current spot price of a commodity is $85.20. An investor purchases a 6 month futures contract on the underlying commodity at a price of $84.80. Which of the following statements regarding the roll yield is most accurate? A) Roll return will only be negative if the spot price drops below $84.80 at maturity. B) Roll return will only be positive if the spot price drops below $85.20 at maturity. C) If the market stays in backwardation, the roll return will be positive regardless of the movement in spot price. Explanation Roll return reflects the convergence of the futures price to the spot price. When the market is in backwardation (futures price below spot) the roll yield is always positive. (Module 34.2, LOS 34.h) Question #11 of 15 Question ID: 1473897 Which of the following statements regarding commodity returns is least accurate? A) B) C) A commodity futures market in backwardation will increase the return on an investor’s position via a positive roll yield. The collateral yield on a commodity futures position is negative if the convenience yield is lower than the storage cost. Due to roll yield and collateral yield, a commodity futures position may have a positive yield despite a drop in the spot price. Explanation The collateral yield is the return on the cash used to collateralize the futures position and is independent of the futures price. (Module 34.1, LOS 34.f) Question #12 of 15 Question ID: 1473903 As compared to a production value-weighted index, an equally weighted index would most likely have: A) equal weight to oil. B) higher weight to oil. C) lower weight to oil. Explanation Production value weighted indexes have higher weight to energy (e.g., oil) as compared to equal weighted index. (Module 34.2, LOS 34.j) Question #13 of 15 Question ID: 1473891 Which of the following commodities has historically been least likely to be traded globally? A) Livestock. B) Natural gas. C) Corn. Explanation Historically, the US livestock industry has not been oriented towards export due to high spoilage risk. More recently, improvements in freezing technology have meant that livestock products (i.e. frozen meat) are now being traded globally. (Module 34.1, LOS 34.b) Question #14 of 15 Question ID: 1473890 Which commodity is most likely to be characterized by large economies of scale in production? A) Cattle. B) Wheat. C) Copper. Explanation Production of industrial metals such as copper has large economies of scale in mining and processing. (Module 34.1, LOS 34.b) Question #15 of 15 Question ID: 1473893 Ben Tarson, CFA is currently undertaking an analysis of the commodity markets to present to a potential client. Part of his presentation concerns the impact short hedgers have on the price of commodity futures contracts. Which of the following market participants is most likely to take a short hedge position? A) Wheat farmer looking to sell wheat forward. B) A hedge fund buying copper in the spot market and selling copper futures contracts. C) Airline looking to purchase fuel forward. Explanation The wheat farmer is looking to lock in the sales price of his product. This is a short hedge as the farmer will sell contracts. The airline is looking to undertake a long hedge and the hedge fund is looking to make an arbitrage trade. (Module 34.1, LOS 34.d)