StudySession 18
Cross-Reference to CFA Institute Assigned Reading #67 - Investing in Commodities
markets, so that backwardation was the typical situation and sometimes referred to as normal backwardation.
LOS 67.b: Describe the sources of return and risk for a commodity investment and the effect on a portfolio of adding an allocation to commodities.
CPA® Program Curriculum, Volume 6, page 234
An investor who desires long exposure to a commodity price will typically achieve this exposure through a derivative investment in forwards or futures. Some physical
commodities cannot be effectively purchased and stored long term, and for others, such as precious metals, derivative positions may be a more efficient means of gaining long exposure than purchasing the commodities outright and storing them long term.
To take a position in forwards or futures, a speculator or hedger must post collateral. If U.S. Treasury bills are deposited as collateral, the collateral yield is simply the yield on the T-bills. Active management of the collateral, within the bounds ofwhat is acceptable collateral, can increase the collateral yield above the 90-day T-bill rate.
The price return on a long-only investment in commodities derivatives can be positive or negative depending on the direction of change in the spot price for the commodity over the life of the derivatives contract employed.
Since commodity derivative contracts expire, a speculator or hedger who wants to maintain a position over time must close out the expiring derivative position and re-establish a new position with a settlement date further in the future. This process is referred to as rolling over the position and leads to gains or losses which are termed the roll yield. The roll yield can be positive or negative depending on whether the derivative contract used to establish the long exposure is in backwardation or contango. You can view this roll yield as the gains or losses that would be realized on the position if the spot price remained unchanged over the life of the contract.
As a futures contract gets closer to expiration, the futures price converges toward the spot price. At expiration, the futures price must equal the spot price. For a future or forward in backwardation (i.e., the futures/forward price is less than the current spot price) the roll yield is positive, since an unchanged spot price at contract settlement would mean the futures/forward price increased over the life of the contract, and the investor would have gains at settlement. For a future or forward in contango, the roll yield is negative. Since contango means the forward/futures price is greater than the spot price, an unchanged spot price over the life of the contract means the futures price will have fallen and losses will result when the position is closed out.
When commodity derivative markets were dominated by short hedgers (commodity producers) and markets were typically in backwardation, the roll yield was positive. In current market conditions, with futures and forwards typically in contango, the roll yield is negative. It may be the case that structural changes in the markets for commodities derivatives mean that a zero or negative roll yield has become the new norm for these markets.
