Nicole Seaman

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Learning objectives: Explain the key differences between commodities and financial assets. Define and apply commodity concepts such as storage costs, carry markets, lease rate, and convenience yield. Identify factors that impact prices on agricultural commodities, metals, energy, and weather derivatives.

Questions:

22.20.1. A commodities trading firm is exploring new arbitrage strategies based on exploiting advanced cost of carry model pricing techniques. These strategies must operate in commodity futures markets where it is easy to take a long or short position. But different commodities obviously have different properties. The firm's potential strategies have two requirements. First, the commodity's storage cost should be low in relative terms, although it is acceptable if inventory levels contribute to the commodity's price. Second, the commodity's price should NOT be seasonal, or should at least have low seasonality.

Given these two preferences (low storage cost and non-seasonality), the firm identifies several commodities that meet the criteria. Among the following choices, which pair is most suitable for the firm?

a. Electricity or cattle
b. Copper or Aluminum
c. Natural gas or wheat
d. Heating oil or gasoline


22.20.2. Futures (and forwards) on commodities can be broadly classified according to the underlying asset type, where the broadest categories are the following:
  • Consumption commodities including energy, agricultural products (e.g., corn, sugar, and even livestock), and metals
  • Financial assets (aka, investment commodities) including equity index products; e.g., S&P 500 or Nasdaq-100 indexes
  • Commodities that are both: they are consumed and also held for investment purposes, and this includes gold and silver, but also (to a lesser extent) platinum and palladium
About the essential features of consumption commodities, each of the following statements is true EXCEPT which is false?

a. The consumption commodity has a storage cost (but a financial asset has little or no storage cost)
b. The consumption commodity has a convenience yield (but a financial asset has no convenience yield)
c. The consumption commodity probably has a lease rate (but a financial asset instead might pay income or dividends)
d. The consumption commodity gives investors an expected return (but a financial asset's price tends to revert to the mean)


22.20.3. In a certain location, during the winter months, the minimum temperature during a certain day was 45.0 degrees Fahrenheit and the maximum temperature during the same day was 77.0 degrees. Because weather contracts for winter months are based on heating degree days (HDD) where HDD = max(0, 65 - A), the associated daily HDD was given by HDD = max(0, 65 - 61) = +4.0.

Six months later, at the same location, during the summer months, the minimum temperature during a day was 52.0 degrees Fahrenheit and the maximum temperature during the same day was 88.0 degrees. About this day, which of the following is true?

a. The daily HDD is -5.0
b. The daily HDD is +5.0
c. The daily CDD is +1.0
d. The daily CDD is +5.0

Answers here:
 
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