Help with Commodities

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AMITKPHF

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I am having trouble with commodity basics. Can anyone help?
My query:
Contango = Futures price > spot Price: upward sloping curve (normal)
Backwardation = Futures price < spot price: downward sloping (inverted)
Normal backwardation and normal contango speak to relation between the futures price (F0) and the expected future spot price (E(ST) (not observable and known only after the fact)
Normal Contango = futures price > expected future spot price.
Normal Backwardation = futures price < expected future spot price
Q - So on this basis there can be 4 permutations: contango with normal contango, contango with normal backwardation, backwardation with normal backwardation and backwardation with normal contango? Is this correct?
Q - While contango and backwardation also refer to the slope of the futures curve, normal contango and normal backwardation only refer to the relation between the futures price and the expected future spot price. There is no reference to the slope of the curve in normal contango and normal backwardation. Is this correct?
Q - On page 140 of CAIA Level 2 Advanced core topics - it says ‘In a bull spread, the investor is long the nearby contract and is short the distant contract. In backwardated markets the investors is hoping for the spread to narrow whereas in inverted markets (contango) the bull spread investor is hoping for the price difference to widen.
If my understanding of backwarded markets is correct, then the price of the nearby (near term) contract is higher than that of the distant (long term) contract. As the investor is long the nearby contract he would want its price to increase and the price of the distant contract (on which he has a short position) to fall. He would this hope for a spread widening.
If my understanding is flawed could you please correct me. If it is easier to do this over the phone I am willing to make the call.
I really want this sorted. Thanks and apologies for the long post.
 
You are right about the last question. Spreads should widen in backwarded markets if you took the bull spread and want to make a profit.
I believe you are also right in the first question, although this kind of permutations are not used in market language. E(S) does not need to equal F(0) so these combinations are possible.
I’m not 100% sure about your second questions but I think this just depends on how you draw your curve. In backwardation graph, you would have S on the y-axis and F on x-axis while in normal backwardation, you would have E(S) on y-axis => the curve will have the same shape.
 
Shootingstar, thanks for the replies, particularly to the question on bull spreads. The lack of an answer was creating a mental block and stopping me from moving ahead.
Everywhere that I have seen, futures expiration month is on the x-axis and contract price is on y-axis.
In the same book on page 141, while giving an example of spread P&L calculation it says ‘In March, a spreader observes an usually steep backwardation in the crude oil forward curve. Anticipating a flattening of the curve and a narrowing of the spread, the trader goes long three July Light Sweet Crude Oil Futures (traded on Nymex) at $44.37 simultaneously shorting three December Light Sweet Crude Oil futures at $50.74.
At first glance this looked odd to me. For backwardation the near term contract should be priced higher than the distant term contract. Then I thought crude oil futures can be humped and this may explain the contradiction above.
At least that’s the framework I am using. Otherwise I will get another mental block :)
Any thoughts on the above?
 
It must be, say, November of year one, with the July contract expiring in year two.
 
Just re-read the question, and I seem to have missed “in March”. I dont think we can expect humped slopes to be an assumption unless clearly stated in the Q, so that’s not it. This seems to be a book error to me.
 
Yeah I dropped them an email about that. great that such a simple thing is wrong so early in the book…
 
JaRvEy,
Thanks for pointing out the errata. I have saved it in my favourites :)
Jcrick,
Which email do you send the correction to? I sent a mail to [email protected] but did not get a response.
Thanks everyone. Seasons greetings and best wishes for the new year.
 
Topic: Commodities - Differences between real and financial assets
I have read in the level 1 material that it impossible to differentiate b/w systematic and unsystematic risk in commodities. I was wondering why is this so? If you have a commodity index you can define the beta (the market i.e., systematic risk). Regress the individual commodity futures returns against the index return and voila you should get a beta. Is it that this Beta does not have predictive value, like equity beta?
In Handbook of Alternative Assets (p279), Anson says ‘Bodie and and Rosansky and Dusak find that commodity values are not consistent with CAPM. The reason is twofold. First under CAPM, the market portfolio is typically defined as a portfolio of financial assets……Second, commodity prices are dependent upon global supply and demand factors, not what the market perceives as an adequate risk premium for this asset class.
As far as the first reason is concerned, that is a matter of definition. Definitions can be changed. As for the second this seems to make more sense…but does this not also ultimately boil down to supply and demand (fund flows, equity issuance etc)?
So is this actually an issue because we are dealing with futures and not the underlying asset? In that case, can we have systematic and unsystematic risk in other real asset classes such as real estate?
To give this more exam focus I could frame this as an essay question: Discuss why is it impossible to break down commodity risk into systematic and unsystematic components? What does this tell us about the differences between real and financial assets?
In a way we already have the ‘answer’ but can anyone please expound on this to make it more convincing?
 
Here is one on cost of carry
1. In the equation F = Se^(r+c-y)t is the cost of carry ¡®r+c¡¯ where r is the risk free rate and c is the storage cost?
2. Why does CAIA Level 2 Advanced Core Topics on page 122 say that ¡®the cost of carry is “equivalent” to the cost of storing a commodity¡¯? Is it that the risk free rate is very small as compared to the storage cost ¡®c¡¯ and so r+c ¡Ö c?
3. On the same page the book says that the major components of the cost of carry include financing cost, storage cost and spoilage. Is the financing cost same as r?
 
that should read
Point 1. is the cost of carry r+c
Point 2. Is it that the risk free rate is very small compared to the storage cost so r+c is equivalent to c
 
One more - does anyone understand the relationship between volatility and convenience yield? This relates to the first paragraph on p133 of CAIA Level 2 Advanced Core Topics in Alternative Investments.
I can’t understand any of it, particularly ‘an important part of convenience yield is risk premium’ all the way to the end of the paragraph
 
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