Commodity Prices and Investments | CFA Level I Alternative Investments

Today, we’ll explore factors that influence commodity prices and the mechanisms of pricing commodity futures contracts.

Factors Influencing Commodity Prices

Spot prices for commodities are affected by supply and demand. Let’s break it down:

• Supply: Influenced by production costs, storage costs, and existing inventories.
• Demand: Affected by the value of the commodity to end-users, global economic conditions, and cycles.
• Speculators: Both supply and demand are impacted by non-hedging investors or speculators.

Due to long lead times to alter production levels and external forces like weather, commodity prices can be volatile. Investors can potentially benefit from this volatility by analyzing inventory levels, production forecasts, government policy changes, and economic growth expectations.

Pricing Commodity Futures Contracts

Now, let’s learn how commodity futures are priced. A futures contract is an obligation for the long to buy and the short to sell a stated quantity of the commodity at a stated price on a specified date in the future. To determine an appropriate price for this futures contract, we need to consider:

• Risk-free rate: Multiply the spot price by (1 + risk-free rate).
• Storage costs: Add storage costs to the futures price to compensate the short.
• Convenience yield: Subtract the convenience yield from the futures price to compensate the long.

Depending on the convenience yield, the futures price can be lower or higher than the spot price. If the convenience yield is low or nonexistent, the futures price will be higher than the spot price (contango). If the convenience yield is high, futures prices may be lower than spot prices (backwardation).

Components of Commodity Futures Returns

There are three sources of returns for commodity futures:

1. Roll yield: The difference between the spot price and futures price at initiation, which rolls towards the spot price as the contract nears expiration.
2. Change in spot price: The increase or decrease in the spot price at expiration, which also contributes to the return.
3. Collateral yield: The interest earned on the margin posted as collateral, which should be paid to the long.