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Subject 5. Models of expected returns

The Insurance Perspective

Commodity futures allow producers to hedge their commodity price exposures, and because hedging is a form of insurance, hedgers must offer investors in long-only commodity futures an insurance premium.

The Hedging Pressure Hypothesis

Hedging pressure plays an important role in explaining futures returns. Hedging by risk-averse producers causes futures prices to be below the expected spot rate in the future. On the other hand, hedging by risk-averse consumers such as Boeing causes future prices to be higher than the expected spot rate in the future.

Both the insurance perspective and the hedging pressure hypothesis reflect a view that commodity futures are a means of risk transfer and that the providers of risk capital charge an insurance premium. The hedging pressure hypothesis is more flexible in that it does not presume that hedgers only go short futures contracts.

The Theory of Storage

The theory focuses on the role that inventories of commodities play in the determination of commodity futures prices. In this framework, inventories allow producers to avoid stockouts and production disruptions. As a result, having a level of inventory that will reduce the impact of production disruption is beneficial. This benefit is termed convenience yield. The convenience yield is high when desired inventories are low and is low when desired inventories are high.

In the theory of storage, the price of a commodity futures contract is driven by storage costs, the interest rate, and the convenience yield. The convenience yield can be thought of as a risk premium linked to inventory levels that helps explain observed futures prices.

Practice Question 1

The insurance perspective suggests all ______ in commodity futures have a positive expected excess return.

A. long positions.
B. producer hedgers.
C. short positions.

Correct Answer: A

Practice Question 2

The theory of storage predicts there's ______ relationship between the level of inventories and the convenience yield.

A. a direct
B. an inverse
C. no

Correct Answer: B

The lower the inventories, the higher the convenience yield.

Practice Question 3

The insurance perspective and the hedging pressure hypothesis suggest that a portfolio that is ______ is an attractive way to allocate capital.

I. long backwardated futures.
II. short backwardated futures.
III. long contangoed futures.
IV. short contangoed futures.

Correct Answer: I and IV

Study notes from a previous year's CFA exam:

c. explain the convenience yield and how it relates to the stock (inventory level) of a commodity;

i. compare the insurance perspective, the hedging pressure hypothesis, and the theory of storage and their implications for futures prices and expected future spot prices.