Explain how commodities differ in key respects from financial assets.
The idea
Financial assets such as stocks and bonds are held for investment. They cost nothing to store, can be sold short easily, and any benefit they give comes as a cash flow. Many commodities differ in several ways. They are consumption assets, used up in production, so holders may value the physical item itself. They cost money to store and transport, and some, like electricity, cannot be stored at all. Supply and demand are often seasonal or driven by weather, so prices swing and fall into patterns. Shorting is hard because physical owners rarely lend what they need. Quality grade and delivery location also change the price. The exam point is that arbitrage bounds a commodity forward from above, not below.
A practice question
Which statement correctly describes a key difference between a commodity such as natural gas and a financial asset such as a stock?
- Holding the physical commodity involves storage and transport costs, and the commodity may be consumed rather than held for investment. - correct
- The commodity always has a higher beta than the stock, so its price is driven by market risk alone.Why not: Confuses a commodity-specific feature with systematic risk; commodity betas vary and can be near zero or negative.
- The commodity has a fixed supply, whereas a stock's supply can change.Why not: Reverses reality: commodity supply responds to production, weather and inventories, and prices move on supply and demand shocks.
- The commodity pays no return of any kind, so its forward price cannot exceed spot.Why not: Ignores that a commodity forward is normally above spot in carry markets because interest and storage costs are added.
Commodities are often consumption assets with storage and transport costs, quality and location differences, and possible convenience yields. Financial assets cost nothing to store and are held for investment.
A harder one
A refiner holds large crude oil inventories even though its one-year forward price lies below spot. Which of the following is the most accurate statement about arbitrage bounds for this commodity?
- Arbitrage bounds the forward from both sides, so a forward below spot plus carry must offer a riskless reverse cash-and-carry profit.Why not: Applies the two-sided bound of an investment asset; shorting a consumed commodity is not practical.
- Cash-and-carry arbitrage caps the forward price from above, but no firm floor exists because owners who need the physical oil will not lend it. - correct
- Arbitrage requires the forward to be above the expected future spot price at all times.Why not: Mixes up no-arbitrage pricing with the forward versus expected spot relation, which depends on risk premiums.
- Arbitrage has no bearing on forward prices because oil is a physical product.Why not: Wrongly denies the upper bound: cash-and-carry arbitrage still limits how high the forward can go.
Anyone can buy, store and sell forward, which caps the forward. But reverse cash-and-carry needs borrowed oil, which holders will not provide, so the forward can be below spot plus carry; the gap shows up as a convenience yield.
The hardest tier
Spot copper trades at USD 60 per unit and the one-year forward is USD 57. The continuously compounded risk-free rate is 4% and storage costs are 2% per year. A trainee says a riskless profit is available by buying the forward and shorting copper. Which response is best?
- No arbitrage is implied; the forward is consistent with a convenience yield of about 11.1% that holders of physical copper earn. - correct
- The trainee is right; the forward is below spot, so a reverse cash-and-carry earns about USD 3 per unit.Why not: Ignores that few holders lend the copper and that owners enjoy a convenience yield; compares forward with spot instead of the carry value.
- The trainee is right, but the profit is the gap to the carry value, USD 6.71 per unit.Why not: Computes the gap to the cost-of-carry value and treats it as arbitrage; for a consumed commodity it only measures the convenience yield.
- No arbitrage is implied; the forward is consistent with a negative convenience yield of about -11.1%.Why not: Flips the sign of the implied convenience yield; a forward below carry value implies a positive yield.
Implied c = r + lambda - ln(F/S)/T = 0.06 - ln(57/60) = 11.13%. A forward below S x exp((r + lambda) x T) = 63.71 cannot be exploited by shorting a commodity others will not lend, so the gap is read as a convenience yield.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in Commodity Forwards and Futures
- State what storage costs, carry markets, the lease rate and convenience yield mean, and apply these concepts to commodities.
- Name the influences on the prices of agricultural, metal and energy commodities and of weather derivatives.
- Set out the formula by which commodity forwards are priced.
- Walk through an arbitrage trade using commodity forwards and compute the profit that could be earned.
- Show how the lease rate sets the no-arbitrage values of futures and forwards on commodities, and define the lease rate.
- Work through the cost of carry model to see how commodity forward prices and no-arbitrage bounds respond to convenience yields and to storage costs.
- Find a commodity's forward price when storing it costs money.
- Explain how a synthetic commodity position is built, then use it to account for how the forward price relates to the future spot price that is expected.
- Explain how a commodity's current futures price and expected future spot price are affected by systematic risk and by nonsystematic risk.
- Define normal backwardation and contango and interpret each.