Archive for the 'Investing in Commodities' Category

Credit Exposures for Derivative Contracts

Derivative agreements are contracts between two parties, under which at least one of the parties faces a financial obligation to the other. Each counterparty to a contract can be subjected to credit risk, or the possibility that the other party fails to meet its obigation.

In a forward contract, commitments are made at the contract outset but settlement is due at expiration. Consider an agreement under which party A agrees to buy the S&P 500 index from party B for 1,500 in one year. If  the S&P 500 is at 1,400, party A owes party B 100, and party B faces potential credit risk (prior to settlement) and actual credit risk (at the time of settlement.) When the S&P 500 is higher than 1,500 it is party A that is subject to credit risk.

Swap contracts are similar to a series of forward contracts, with interim payments occurring along the way. Each payment exposes one party to credit risk. As each payment is made, the total potential credit risk is reduced.

Option contracts have unilateral credit risk – only the seller is obligated to make a payment, so only the buyer is exposed to credit risk once the initial premium has been paid.

Posted on 29th November 2008
Under: Derivatives, Futures, Investing in Commodities, Options, Portfolio Management, Risk Management, Swaps | No Comments »

Characteristics of Managed Futures Investments and Their Role in a Portfolio

Derivative markets are zero-sum games, with each long position offset by a corresponding short. As such, the aggregate return to all participants in the futures market is the risk-free rate, less any management fees. In order for managed accounts to earn a positive risk-adjusted return after fees implies other market participants who systematically earn less than the risk-free rate. This is possible because many participants in the futures markets are hedgers, who may be willing to accept the lower return as an insurance premium protecting them from outlying events.

Managed futures managers can also exploit mispricing opportunities that arise when certain contracts are not trading at the proper relationship to other contracts.

Even with limited return opportunities, managed futures may play a role in the portfolio due to a low correlation of returns with those of traditional investments such as stocks and bonds. The diversification benefits have been shown to accrue even for portfolios that include other alternative assets such as hedge funds.

The Sharpe ratios of portfolios that include managed futures dominate those that do not. However, the benefits may be specific to the investment vehicle, time period and strategy under consideration. Managers have been shown to demonstrate short-term persistence in returns and a manager’s beta relative to his benchmark is often a good indicator of future returns.

Since futures involve leverage and derivatives, particular consideration should be paid to risk management strategies.

Posted on 28th September 2008
Under: Active Management, Alternative Assets, Asset Allocation, Futures, Investing in Commodities, Investment Returns, Personal Finance | No Comments »

Types of Managed Futures Accounts

Managed futures investments are investments in commodities by professional managers using skill-based strategies. The strategies employed may be either systematic trading methods which usually are trend-following or discretionary strategies based on analysis and judgment of the manager.

Managed futures accounts are often classified according to market focus as either:

  • Financial – investing in financial and currency futures and options
  • Currency
  • Diversified – financial and physical commodities

Typically, managers are benchmarked to a group of managers employing a similar style. Investable benchmarks have also been established that rely on mechanical trend-following strategies. When comparing returns, it is important to understand that historical data is affected by survivorship bias.

Posted on 28th August 2008
Under: Active Management, Alternative Assets, Asset Allocation, Futures, Investing in Commodities, Portfolio Management | No Comments »

Six Stages of Business Cycle Investing

In Technical Analysis Explained, Martin Pring notes that since there are three major financial markets (stocks, bonds and commodities) and each has two turning points in a given cycle, there are six turning points in each cycle. He calls these turning points the six stages and uses them as a reference point for identifying the current phase of the business cycle and by extension the next likely turning point.

Stage 1: Slowing growth rates or early recession. Interest rates start to fall and bonds rally.

Stage 2: Business cycle trough. Stocks begin to rally.

Stage 3: Late recession and early recovery. Commodities begin to rally.

Stage 4: Early recovery. Interest rates trough and bonds peak.

Stage 5: Cycle peak. Stocks peak.

Stage 6: Slowing growth, commodities peak.

Posted on 25th July 2008
Under: Economic Analysis, Investing in Commodities, Investing in Stocks, Investing in bonds, Technical Analysis | No Comments »

Characteristics of Investments in Commodities and Their Role in a Portfolio

Commodities have very low correlations with traditional assets such as stocks and bonds, and therefore can be strong diversifying agents even though their long-term expected return is lower. In particular, commodities often rise during times of financial distress while other assets are falling and the diversification benefit is needed most.

Over the long term, commodity returns are explained by the business cycle, a convenience yield resulting from the ability to time consumption, and real options that allow the producers of commodities to adjust their production levels in response to prices.

Commodity investments, particularly those in storable commodities such as oil and metals, also offer a hedge against inflation. This is especially true during periods in which inflation rates change unexpectedly.

Posted on 28th February 2008
Under: Active Management, Asset Allocation, Investing in Commodities, Investment Returns, Portfolio Management, Risk Management | No Comments »

Components of Total Return for Investments in Commodity Futures

The total return for a commodity futures contract is made up of three components.

  1. Spot return represents the change in spot price of the underlying asset. Since commodities tend to have positive exposure to event risk, it can make up a significant portion of the total return.
  2. Collateral yield or collateral return arises because futures contracts do not require the entire cash position to be paid up front (only margin is due at the outset of the contract.) Collateral yield is the return earned by investing the remaining cash during the term of the contract.
  3. Roll yield or roll return is generated as contracts roll forward in time due to the necessary convergence of spot prices and futures prices. A downward-sloping term structure (which is known as backwardation) results in a positive roll yield, and an upward-sloping term structure (known as contango) results in a negative roll yield.

Posted on 28th January 2008
Under: Active Management, Asset Allocation, Futures, Investing in Commodities, Investment Returns, Portfolio Management | No Comments »

Momentum Strategies in Commodity Futures Markets

In the June 2007 Journal of Banking and Finance, Miffre and Rallis compare strategies for investing in commodity futures based on short-term momentum and long-term reversal, based on a variety of formation and holding periods.

Momentum strategies based on selling past losers and buying past winners generated positive and significant returns in 13 of the 16 combinations of formation and holding periods, with a significant portion of that return being derived from short positions in the losers. These strategies generate positive alpha and have low correlations with the returns on equity or fixed income securities.

The reversal strategies do not exhibit consistent outperformance in this study.

Posted on 10th January 2008
Under: Futures, Investing in Commodities, Investment Returns, Momentum Strategies, Portfolio Management, Research | No Comments »

Commodity Benchmarks

As with any asset class, investments in commodities should be compared with an appropriate benchmark for risk and return. A number of commodity indices are in wide use, which all attempt to replicate the returns available to holding long positions in commodities. The indices can vary widely in terms of composition (which commodities are included), weighting scheme, and purpose. It is important to choose an index that matches the investment practices being used.

Since a futures contract is a zero-sum game (every long position is offset by a corresponding short position) it is not possible to market-weight a futures index. Instead, weighting strategies range from judgment-based methods, to equal-weight, to weightings based on world production levels. The benchmarks typically offer representations of both spot return and total return.

Posted on 28th December 2007
Under: Active Management, Asset Allocation, Futures, Investing in Commodities, Investment Returns, Portfolio Management | No Comments »

Investing in Commodities

Investors wanting exposure to commodity prices in their portfolio can gain exposure either directly or indirectly.

Direct investment in commodities has traditionally taken the form of cash purchase of physical commodities such as metal, oil or agricultural products. The development of derivatives markets has resulted in most of the direct commodity transactions involving futures products. Direct investment obviously provides a direct link to commodity prices, but can require possession, storage, financing, insurance and transaction costs which are either paid directly or through the basis in the futures contract.

Indirect investment in commodities is typically manifest as buying the equities of a commodity producer such as a mining company. It does not provide a direct exposure to the commodity prices, in part because many producers uses hedges to control their own exposure.

Posted on 28th November 2007
Under: Active Management, Asset Allocation, Futures, Investing in Commodities, Investment Returns, Portfolio Management | No Comments »