Commodities

A fully collateralised long futures position generates return from three distinct sources. The spot return is the change in the price of the nearby contract over the holding period. The roll return arises when a maturing contract is closed and replaced with a longer-dated one: if the deferred contract trades below the expiring one, the investor buys more exposure per dollar and roll return is positive; if it trades above, roll return is negative. The collateral return is the yield earned on the cash posted against the notional exposure, since futures require only margin rather than full payment.

Total return is therefore the sum of price change, roll and collateral yield, less fees. Over long horizons in persistently upward-sloping markets, the cumulative drag from rolling can dominate, which is why a futures index and the underlying spot series can diverge sharply over years even though both reference the same physical good.

The futures curve links today's spot price to deliverable prices at future dates. Under the cost-of-carry relationship, the no-arbitrage futures price equals the spot price compounded at the risk-free rate, plus storage and insurance costs, minus the convenience yield, which is the non-monetary benefit of physically holding inventory. When financing and storage costs exceed convenience yield, the curve slopes upward and the market is in contango. When inventories are tight and convenience yield is high, the curve slopes downward into backwardation.

Two explanations are commonly examined. The theory of storage ties curve shape to inventory levels, so scarce stocks produce backwardation. The hedging-pressure or insurance argument holds that producers seeking to lock in prices pay a premium to speculators, biasing futures below expected future spot and creating a risk premium for the long side.

Direct exposure is dominated by exchange-traded futures on venues such as CME and ICE, supplemented by over-the-counter swaps that pay the return of an index against a floating rate. Retail and many institutional investors access the asset class through exchange-traded funds and notes that hold futures, or through broad indices such as the S&P GSCI and the Bloomberg Commodity Index, which differ materially in sector weighting: production-weighted constructions carry heavy energy exposure, while capped indices spread risk across metals and agriculture.

Indirect routes include equities of producers and miners, which add equity beta, operating leverage and hedging policy to the underlying price exposure, and physically backed vehicles, practical mainly for precious metals where storage costs are low relative to value. Note that on financial statements, commodity inventories and hedges surface through inventory valuation methods and cash-flow hedge accounting.

A candidate should be able to state the arbitrage relationship in words, compute a theoretical futures price from spot, financing rate, storage cost and convenience yield, and infer which component must be large when the observed curve is inverted. Given the shape of a curve, identify contango or backwardation, state the sign of roll return for a long position, and explain why a passive long index can lose money while spot prices rise.

Equally testable is the portfolio case: low or unstable correlation with equities and bonds, positive sensitivity to unexpected inflation because commodity prices feed directly into price indices, and exposure to supply disruptions that hurt other assets. Balance this against high volatility, no income stream, negative roll in oversupplied markets, and the reality that correlations tend to rise during broad liquidity crises.