Explain how valuing commodities differs from valuing equities and bonds
The idea
Shares and bonds are valued by discounting the cash flows they promise or are expected to pay. A physical commodity pays no dividend or coupon, so there is nothing to discount: its spot price reflects current and expected supply and demand, and holding it costs money for storage, insurance and transport. Futures on commodities are priced from spot plus the cost of carry, so the futures price is roughly F = spot × (1 + financing rate) + storage costs − convenience yield. News about weather, harvests or mine output therefore moves prices directly through expected supply. The trap is trying to build a discounted cash flow model for the commodity itself, or treating storage as though it earned income rather than cost money.
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- Contrast the features of the different commodity sectors
- Contrast how commodity sectors move through their life cycle, from production to trading or consumption
- Set out the kinds of participant found in commodity futures markets
- Analyse how spot and futures prices relate when markets are in contango and when they are in backwardation
- Contrast theories explaining commodity futures returns
- Set out, work out and interpret each part of the total return on a fully collateralised commodity futures contract
- Contrast roll return when markets are in contango with roll return when they are in backwardation
- Explain how commodity swaps can be used to gain or adjust exposure to commodities
- Explain how the way a commodity index is built influences its returns