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2024 Curriculum CFA Program Level II Alternative Investments


In the upcoming sections, we present the characteristics and valuation of commodities and commodity derivatives. Given that investment in commodities is conducted primarily through futures markets, the concepts and theories behind commodity futures is a primary focus of the reading. In particular, the relationship between spot and futures prices, as well as the underlying components of futures returns, are key analytical considerations.

What do we mean when we talk about investing in commodities? A basic economic definition is that a commodity is a physical good attributable to a natural resource that is tradable and supplied without substantial differentiation by the general public.

Commodities trade in physical (spot) markets and in futures and forward markets. Spot markets involve the physical transfer of goods between buyers and sellers; prices in these markets reflect current (or very near term) supply and demand conditions. Global commodity futures markets constitute financial exchanges of standardized futures contracts in which a price is established in the market today for the sale of some defined quantity and quality of a commodity at a future date of delivery; completion of the contract may permit cash settlement or require physical delivery.

Commodity futures exchanges allow for risk transfer and provide a valuable price discovery mechanism that reflects the collective views of all market participants with regard to the future supply and demand prospects of a commodity. Given the financial (versus physical) nature of their contract execution, commodity exchanges allow important parties beyond traditional suppliers and buyers—speculators, arbitrageurs, private equity, endowments, and other institutional investors—to participate in these price discovery and risk transfer processes. Standardized contracts and organized exchanges also offer liquidity (i.e., trading volumes) to facilitate closing, reducing, expanding, or opening new hedges or exposures as circumstances change on a daily basis.

Forward markets exist alongside futures markets in certain commodities for use by entities that require customization in contract terms. Forwards are largely outside the scope of this reading and are discussed only briefly. Exposure to commodities is also traded in the swap markets for both speculative and hedging purposes. Investment managers may want to establish swap positions to match certain portfolio needs, whereas producers may want to more precisely adjust their commodity risk (e.g., the origin of their cattle or the chemical specifications of their crude oil).

Commodities offer the potential for diversification benefits in a multi-asset class portfolio because of historically low average return correlation with stocks and bonds. In addition, certain academic studies (e.g., Gorton and Rouwenhorst 2006; Erb and Harvey 2006) demonstrate that some commodities have historically had inflation hedging qualities.

Our coverage of the commodities topic is organized as follows: We provide an overview of physical commodity markets, including the major sectors, their life cycles, and their valuation. We then describe futures market participants, commodity futures pricing, and the analysis of commodity returns, including the concepts of contango and backwardation. The subsequent section reviews the use of swap instruments rather than futures to gain exposure to commodities. We then review the various commodity indexes given their importance as benchmarks for the asset class and investment vehicles. Finally, we conclude with a summary of the major points.

Learning Outcomes

The member should be able to:

  1. compare characteristics of commodity sectors;

  2. compare the life cycle of commodity sectors from production through trading or consumption;

  3. contrast the valuation of commodities with the valuation of equities and bonds;

  4. describe types of participants in commodity futures markets;

  5. analyze the relationship between spot prices and futures prices in markets in contango and markets in backwardation;

  6. compare theories of commodity futures returns;

  7. describe, calculate, and interpret the components of total return for a fully collateralized commodity futures contract;

  8. contrast roll return in markets in contango and markets in backwardation;

  9. describe how commodity swaps are used to obtain or modify exposure to commodities;

  10. describe how the construction of commodity indexes affects index returns.


  • Commodities are a diverse asset class comprising various sectors: energy, grains, industrial (base) metals, livestock, precious metals, and softs (cash crops). Each of these sectors has a number of characteristics that are important in determining the supply and demand for each commodity, including ease of storage, geopolitics, and weather.

  • Fundamental analysis of commodities relies on analyzing supply and demand for each of the products as well as estimating the reaction to the inevitable shocks to their equilibrium or underlying direction.

  • The life cycle of commodities varies considerably depending on the economic, technical, and structural (i.e., industry, value chain) profile of each commodity as well as the sector. A short life cycle allows for relatively rapid adjustment to outside events, whereas a long life cycle generally limits the ability of the market to react.

  • The valuation of commodities relative to that of equities and bonds can be summarized by noting that equities and bonds represent financial assets whereas commodities are physical assets. The valuation of commodities is not based on the estimation of future profitability and cash flows but rather on a discounted forecast of future possible prices based on such factors as the supply and demand of the physical item.

  • The commodity trading environment is similar to other asset classes, with three types of trading participants: (1) informed investors/hedgers, (2) speculators, and (3) arbitrageurs.

  • Commodities have two general pricing forms: spot prices in the physical markets and futures prices for later delivery. The spot price is the current price to deliver or purchase a physical commodity at a specific location. A futures price is an exchange-based price agreed on to deliver or receive a defined quantity and often quality of a commodity at a future date.

  • The difference between spot and futures prices is generally called the basis. When the spot price is higher than the futures price, it is called backwardation, and when it is lower, it is called contango. Backwardation and contango are also used to describe the relationship between two futures contracts of the same commodity.

  • Commodity contracts can be settled by either cash or physical delivery.

  • There are three primary theories of futures returns.

    • In insurance theory, commodity producers who are long the physical good are motived to sell the commodity for future delivery to hedge their production price risk exposure.

    • The hedging pressure hypothesis describes when producers along with consumers seek to protect themselves from commodity market price volatility by entering into price hedges to stabilize their projected profits and cash flow.

    • The theory of storage focuses on supply and demand dynamics of commodity inventories, including the concept of “convenience yield.”

  • The total return of a fully collateralized commodity futures contract can be quantified as the spot price return plus the roll return plus the collateral return (risk-free rate return).

  • The roll return is effectively the weighted accounting difference (in percentage terms) between the near-term commodity futures contract price and the farther-term commodity futures contract price.

  • A commodity swap is a legal contract between two parties calling for the exchange of payments over multiple dates as determined by several reference prices or indexes.

  • The most relevant commodity swaps include excess return swaps, total return swaps, basis swaps, and variance/volatility swaps.

  • The five primary commodity indexes based on assets are (1) the S&P GSCI; (2) the Bloomberg Commodity Index, formerly the Dow Jones–UBS Commodity Index; (3) the Deutsche Bank Liquid Commodity Index; (4) the Thomson Reuters/CoreCommodity CRB Index; and (5) the Rogers International Commodities Index.

  • The key differentiating characteristics of commodity indexes are

    • the breadth and selection methodology of coverage (number of commodities and sectors) included in each index, noting that some commodities have multiple reference contracts,

    • the relative weightings assigned to each component/commodity and the related methodology for how these weights are determined,

    • the methodology and frequency for rolling the individual futures contracts,

    • the methodology and frequency for rebalancing the weights of the individual commodities and sectors, and

    • the governance that determines which commodities are selected.

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