Title LM05 Introduction to Commodities and Commodity Derivatives IFT Notes.pdf ✅

LM05 Commodities 2023 Level II Notes © IFT. All rights reserved 1 LM05 Introduction to Commodities and Commodity Derivatives 1. Introduction ....................................................................................................................................................... 3 2. Commodities Sectors ...................................................................................................................................... 3 2.1 Commodity Sectors .................................................................................................................................. 3 3. Life Cycle of Commodities ............................................................................................................................. 6 4. Valuation of Commodities .......................................................................................................................... 10 5. Commodities Futures Markets: Participants ...................................................................................... 11 5.1 Futures Market Participants .............................................................................................................. 11 6. Commodity Spot and Futures Pricing ................................................................................................... 13 7. Theories of Futures Returns ..................................................................................................................... 15 8. Components of Futures Returns .............................................................................................................. 17 9. Contango, Backwardation and the Roll return .................................................................................. 20 10. Commodity Swaps ...................................................................................................................................... 21 11. Commodity Indexes ................................................................................................................................... 23 Summary ............................................................................................................................................................... 26 This document should be read in conjunction with the corresponding reading in the 2023 Level II CFA® Program curriculum. Some of the graphs, charts, tables, examples, and figures are copyright 2022, CFA Institute. Reproduced and republished with permission from CFA Institute. All rights reserved. Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by IFT. CFA Institute, CFA®, and Chartered Financial Analyst® are trademarks owned by CFA Institute. Version 1.0

LM05 Commodities 2023 Level II Notes © IFT. All rights reserved 3 economic activity, the higher the demand for crude oil. Likewise, the demand for crude oil falls during times of recession. Natural Gas  Natural gas is formed underground, where dead plants and organisms are exposed to immense heat and pressure over millions of years. The formation process is similar to crude oil; however, natural gas occurs in vapor form.  When natural gas occurs along with oil, it is called ‘associated gas’.  When natural gas occurs in isolation, it is called ‘unassociated gas’.  Natural gas requires less refining than crude oil.  Natural gas is typically transported through gas pipelines; transportation costs can be high because gas must be kept under pressure.  Natural gas can be converted into liquid form and transported in containers as liquefied natural gas or LNG.  Supply and demand: Natural gas supply and demand dynamics are similar to those of crude oil. Economic activity and seasonal heating or cooling requirements drive its demand, and supply disruptions from natural gas producers remain a supply side risk. Refined Products  Refined products are end-use fuels made after refining crude oil.  Refined products include gasoline, diesel, jet fuel, propane, heating oil, etc.  Demand: Demand for refined products is influenced by economic activity and weather. Grains  Grains include crops such as corn, soy, wheat, and rice that are consumed as food.  Grains are produced in farms and are typically produced at particular times of the year when weather and rainfall conditions are suitable.  Grains are easy to store and transport.  Supply: Supply can be affected by weather conditions, pests, and disease. These factors determine the quality and quantity of the crop produced.  Demand: Grains are consumed as food for humans and livestock. Some grains such as corn are also used for ethanol production. Industrial (Base) Metals  Industrial metals include mined ores processed into copper, aluminum, nickel, iron, lead, tin, and zinc.  They are used in industrial production and the manufacturing of various goods.  They are relatively easy to store, however, transportation can be challenging due to their high weight.  Supply: Supply is affected by available reserves and their commercial viability. Industrial metals can be stored for long periods of time as they are relatively
LM05 Commodities 2023 Level II Notes © IFT. All rights reserved 4 unaffected by weather.  Demand: Demand is directly impacted by economic activity and infrastructure development. Livestock  Livestock includes hogs, cattle, sheep, and poultry.  It can be stored as frozen products for long periods of time.  Supply: Supply can be affected by weather conditions, disease in livestock, and availability of quality fodder.  Demand: Demand is tied to growth in emerging markets. As emerging market countries develop, their diets move away from grains to animal products. Precious metals  Precious metals include gold, silver, and platinum.  Precious metals have long storability of over thousands of years as weather or surrounding factors do not impact these metals.  High inflation in paper currency causes value of precious metals to increase as they serve as an alternative form of money. Thus, precious metals act as an inflation hedge.  Supply: Supply is determined largely by availability of commercially extractable reserves. Weather has no impact on the supply.  Demand: Demand is influenced by fund flows, industrial production, and inflation in paper currency. During times of economic uncertainty, investors rush to precious metals as a store of value. Jewelry demand from developing countries such as China and India has also increased with growing wealth. Softs (Cash crops)  Cash crops include cotton, coffee, sugar, cocoa, etc.  Storage can be difficult because freshness determines the commercial value of cash crops.  Supply: Supply can be affected by weather conditions, pests, and disease as these factors determine the quality and quantity of the crop produced.  Demand: Demand is driven by economic activity and consumer wealth (particularly in emerging markets.) Example: Commodity Sector Demand (This is Example 1 from the curriculum.) Industrial activity most likely affects the demand for which of the following commodities? A. Copper B. Natural gas C. Softs (e.g., cotton, coffee, sugar and cocoa) Solution: