FRANK J. FABOZZIROLAND FUSS

DIETER G. KAISER

John Wiley & Sons, Inc.

The Handbookof Commodity

Investing

The Handbookof Commodity

Investing

The Frank J. Fabozzi Series

Fixed Income Securities, Second Edition by Frank J. FabozziFocus on Value: A Corporate and Investor Guide to Wealth Creation by James L. Grant and

James A. AbateHandbook of Global Fixed Income Calculations by Dragomir KrginManaging a Corporate Bond Portfolio by Leland E. Crabbe and Frank J. FabozziReal Options and Option-Embedded Securities by William T. MooreCapital Budgeting: Theory and Practice by Pamela P. Peterson and Frank J. FabozziThe Exchange-Traded Funds Manual by Gary L. GastineauProfessional Perspectives on Fixed Income Portfolio Management, Volume 3 edited by Frank J.

FabozziInvesting in Emerging Fixed Income Markets edited by Frank J. Fabozzi and Efstathia PilarinuHandbook of Alternative Assets by Mark J. P. AnsonThe Global Money Markets by Frank J. Fabozzi, Steven V. Mann, and Moorad ChoudhryThe Handbook of Financial Instruments edited by Frank J. FabozziCollateralized Debt Obligations: Structures and Analysis by Laurie S. Goodman and Frank J.

FabozziInterest Rate, Term Structure, and Valuation Modeling edited by Frank J. FabozziInvestment Performance Measurement by Bruce J. FeibelThe Handbook of Equity Style Management edited by T. Daniel Coggin and Frank J. FabozziThe Theory and Practice of Investment Management edited by Frank J. Fabozzi and Harry M.

MarkowitzFoundations of Economic Value Added: Second Edition by James L. GrantFinancial Management and Analysis: Second Edition by Frank J. Fabozzi and Pamela P.

PetersonMeasuring and Controlling Interest Rate and Credit Risk: Second Edition by Frank J.

Fabozzi, Steven V. Mann, and Moorad ChoudhryProfessional Perspectives on Fixed Income Portfolio Management, Volume 4 edited by Frank J.

FabozziThe Handbook of European Fixed Income Securities edited by Frank J. Fabozzi and Moorad

ChoudhryThe Handbook of European Structured Financial Products edited by Frank J. Fabozzi and

Moorad ChoudhryThe Mathematics of Financial Modeling and Investment Management by Sergio M. Focardi

and Frank J. FabozziShort Selling: Strategies, Risks, and Rewards edited by Frank J. FabozziThe Real Estate Investment Handbook by G. Timothy Haight and Daniel SingerMarket Neutral Strategies edited by Bruce I. Jacobs and Kenneth N. LevySecurities Finance: Securities Lending and Repurchase Agreements edited by Frank J. Fabozzi

and Steven V. MannFat-Tailed and Skewed Asset Return Distributions by Svetlozar T. Rachev, Christian Menn,

and Frank J. FabozziFinancial Modeling of the Equity Market: From CAPM to Cointegration by Frank J. Fabozzi,

Sergio M. Focardi, and Petter N. KolmAdvanced Bond Portfolio Management: Best Practices in Modeling and Strategies edited by

Frank J. Fabozzi, Lionel Martellini, and Philippe PriauletAnalysis of Financial Statements, Second Edition by Pamela P. Peterson and Frank J. FabozziCollateralized Debt Obligations: Structures and Analysis, Second Edition by Douglas J. Lucas,

Laurie S. Goodman, and Frank J. FabozziHandbook of Alternative Assets, Second Edition by Mark J. P. AnsonIntroduction to Structured Finance by Frank J. Fabozzi, Henry A. Davis, and Moorad

ChoudhryFinancial Econometrics by Svetlozar T. Rachev, Stefan Mittnik, Frank J. Fabozzi, Sergio M.

Focardi, and Teo Jasic

FRANK J. FABOZZIROLAND FUSS

DIETER G. KAISER

John Wiley & Sons, Inc.

The Handbookof Commodity

Investing

Copyright # 2008 by John Wiley & Sons, Inc. All rights reserved.

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ISBN-13 978-0-470-11764-4

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10 9 8 7 6 5 4 3 2 1

Contents

Foreword xi

Preface xv

About the Editors xix

Contributing Authors xxi

PART ONE

Mechanics of the Commodity Market 1

CHAPTER 1A Primer on Commodity Investing 3Frank J. Fabozzi, Roland Fuss, and Dieter G. Kaiser

CHAPTER 2The Pricing and Economics of Commodity Futures 38Mark J. P. Anson

CHAPTER 3Commodity Futures Investments: A Review ofStrategic Motivations and Tactical Opportunities 56Joshua D. Woodard

CHAPTER 4Macroeconomic Determinants of CommodityFutures Returns 87Zeno Adams, Roland Fuss, and Dieter G. Kaiser

v

CHAPTER 5The Relationship Between Risk Premium andConvenience Yield Models 113Viola Markert and Heinz Zimmermann

CHAPTER 6The Optimal Rotation Period of Renewable Resources:Theoretical Evidence from the Timber Sector 145Dr. Fritz Helmedag

PART TWO

Performance Measurement 167

CHAPTER 7Review of Commodity Futures Performance Benchmarks 169Roland Fuss, Christian Hoppe, and Dieter G. Kaiser

CHAPTER 8Performance Characteristics of Commodity Futures 203Claude Erb, Campbell R. Harvey, and Christian Kempe

CHAPTER 9Statistical Analysis of Commodity Futures Returns 227Reinhold Hafner and Maria Heiden

CHAPTER 10The Diversification Benefits of Commodity Futures Indexes:A Mean-Variance Spanning Test 241Bernd Scherer and Li He

CHAPTER 11CTA/Managed Futures Strategy Benchmarks:Performance and Review 266Thomas Schneeweis, Raj Gupta, and Jason Remillard

vi CONTENTS

PART THREE

Risk Management 311

CHAPTER 12Some Thoughts on Risk Management for Commodity Portfolios 313Jeffrey M. Christian

CHAPTER 13Effective Risk Management Strategies forCommodity Portfolios 322Moazzam Khoja

CHAPTER 14Quantifying Cross-Commodity Risk in Portfoliosof Futures Contracts 335Ted Kury

CHAPTER 15Incorporating Futures in Commodity Price Forecasts 358Chakriya Bowman and Aasim M. Husain

PART FOUR

Asset Allocation 389

CHAPTER 16Commodity Trading Strategies: Examplesof Trading Rules and Signals from the CTA Sector 391Francois-Serge Lhabitant

CHAPTER 17How to Design a Commodity Futures Trading Program 406Hilary Till and Joseph Eagleeye

CHAPTER 18Sources of Alpha in Commodity Investing 423Markus Mezger

Contents vii

FM_1 05/20/2008 8

CHAPTER 19Efficient Frontier of Commodity Portfolios 454Juliane Proelss and Denis Schweizer

CHAPTER 20Active Management of Commodity Investments:The Role of CTAs and Hedge Funds 479R. McFall Lamm, Jr.

CHAPTER 21Introducing Alternative Investments in aTraditional Portfolio: The Case of Commodities,Hedge Funds, and Managed Futures 504Mark S. Shore

CHAPTER 22Strategic and Tactical Allocation to Commoditiesfor Retirement Savings Schemes 522Theo E. Nijman and Laurens A. P. Swinkels

PART FIVE

Commodity Products 547

CHAPTER 23Types of Commodity Investments 549Lynne Engelke and Jack C. Yuen

CHAPTER 24Commodity Options 570Carol Alexander and Aanand Venkatramanan

CHAPTER 25The Pricing of Electricity Forwards 596Dr. Matthias Muck and Markus Rudolf

CHAPTER 26Securitization of Commodity Price Risk 613Paul U. Ali

viii CONTENTS

CHAPTER 27Commodity Trading Advisors: A Review of HistoricalPerformance 626Martin Eling

CHAPTER 28Catching Future Stars Among Micro-CTAs 648Greg N. Gregoriou and Fabrice Douglas Rouah

CHAPTER 29A Primer on Energy Hedge Funds 660Oliver Engelen and Dieter G. Kaiser

PART SIX

Special Classes 679

CHAPTER 30An Overview of Commodity Sectors 681Roland Eller and Christian Sagerer

CHAPTER 31A Practical Guide to Gold as an Investment Asset 712Charlie X. Cai, lain Clacher, Robert Faff, and David Hillier

CHAPTER 32The Effect of Gold in a Traditional Portfolio 736Thomas Heidorn and Nadeshda Demidova-Menzel

Chapter 33Fundamental Analysis of the World Silver Market 763Jeffrey M. Christian

CHAPTER 34Investing in Base Metals 776Michael Killick

Contents ix

CHAPTER 35Electricity Trading in the European Union 803Stefan Ulreich

CHAPTER 36The Natural Gas Market in the United Kingdom 825Chris Harris

CHAPTER 37Emissions Trading in the European Union 844Stefan Ulreich

CHAPTER 38The Fundamentals of Agricultural and Livestock Commodities 863Ronald C. Spurga

CHAPTER 39Fundamental Analysis of the World Sugar Market 888Rohit Savant

PART SEVEN

Technical Analysis 907

CHAPTER 40The Profitability of Technical Analysis in Commodity Markets 909Cheol-Ho Park and Scott H. Irwin

Index 949

x CONTENTS

Foreword

‘‘T hose who cannot remember the past are condemned to repeat it.’’—Sowrote the philosopher and poet George Santayana about a hundred

years ago. He was not writing about commodities, of course, but doubtlesshe would recognize the conundrum present in today’s capital markets.Powerful commodity cycles of significant duration—such as the one we arein—are extremely rare events, separated by such long interludes of weakperformance. When they do occur, there are few people around with thespecialized knowledge necessary to understand them properly. In otherwords, each generation of fund managers and asset allocators has to learnafresh about the market characteristics of commodities. This lack of knowl-edge, together with the opaque nature of many terminal markets, gives com-modities an aura of mystery, with the news media often portraying theexchanges as little more than casinos and labeling the market participantsas ‘‘speculators’’ rather than ‘‘investors.’’

By trivializing and demonizing investment in commodities, the newsmedia is to some degree responsible for deterring fund managers from mak-ing appropriate and profitable asset allocation decisions. For example, at thebottom of the last commodity cycle, the Financial Times reduced its com-modities coverage to an eighth of one page—tantamount to a news black-out. Small wonder then that many institutions forgot how to tradecommodities altogether and had zero asset allocations to commodities.Armed with this handbook—which brings together views from experts inmany different fields engaged with the commodities markets—market pro-fessionals can gain new illumination as well as confidence in this complexinvestment process. The chapters in this book allow readers to take a‘‘knowledge shortcut,’’ and, perhaps, avoid some of the pitfalls that lie inwait for the unwary.

Of course, there are many ways of approaching commodity investment.A good starting point is to formulate a top-down view and then calibrate thetime horizons over which the chosen strategy plays out. For instance, in the‘‘softs’’ and ‘‘agricultural’’ markets, traders often focus on short-term,‘‘high-frequency,’’ seasonal cycles that relate, say, to weather patterns incrop-producing areas. So a long-term view in agricultural commoditieswould be 12 to 24 months—equating to one or two planting and harvesting

xi

cycles. Agricultural trading remains dominated by producers and consum-ers: Financial market investors are relative newcomers to this arena, perhapsput off until now by the sharp swings in the futures curves that are seen fromtime to time. In the metals markets, on the other hand, trends of shortagesand surpluses can persist for years on end, as the supply-side response tohigh or low prices can be very extended. Building a new copper mine in re-sponse to a high copper price might take five years or more. In this case, along-term view might be measured in years rather than months. As a result,there is usually more depth to the futures markets for metals and plenty ofopportunities for investors to take a fundamental view. For strategic com-modities such as gold, investors, governments, and central banks might befocusing on cycles of supply and demand measured in decades. Such com-modities have efficient and deep futures markets that can sometimes bedominated by financial participants rather than producers and consumers.

A common reason that investors give for seeking commodityexposure—irrespective of their time horizon—is to gain exposure to theso-called ‘‘super cycle.’’ Great changes are under way in the world economy,with the urbanization of China and, to a lesser extent, India, driving a mas-sive surge in infrastructure spending. For the first time in history, more peo-ple live in cities than in the countryside and their material needs have led toan acceleration in demand-trend growth rates for metals, energy, and food.The supply side has been slow to react fully to this change for many reasons:skills shortages, environmental factors, infrastructure constraints, and polit-ical interference. Many commodities have reached ‘‘tipping points,’’ flip-ping from surpluses into shortages.

These changes are proving to be persistent. The shift in the balance ofeconomic growth from the developed world to the developing world showsno sign of reversal. Industries that once existed mainly to serve the devel-oped world now have to reconfigure to feed the new world too—and thattakes vast quantities of money and a long period of time. In a nutshell, it islikely that the current period of elevated commodity prices will be pro-longed, with the prices of commodities rationing demand rather thansupply.

It is the curse of markets that while there is much hard data to analyzeabout the past, there is no such data about the future. This means thatanalysts are typically biased toward previous commodity prices when pre-dicting future commodity price behavior. As a consequence, market com-mentators have been consistently underestimating the price of manycommodities. In the 1980s and 1990s, the view that commodity prices al-ways fall in real terms in the long run became deeply entrenched. The slowrealization that changes in the structure of the world economy will likely

xii FOREWORD

lead to permanent upwards shift in the real cost of raw materials for indus-try has been hard for many people to accept.

There are, of course, as many ways to gain exposure to the commoditymarkets as there are reasons for doing so. Some investors, especially pensionfunds, are looking for diversification. Commodities bring to a larger portfo-lio returns that are correlated with inflation but are uncorrelated with equi-ties and bonds. This type of investor is usually allocating only a smallportion of their asset base to the theme, and has thus far focused predomi-nantly on passive commodity futures strategies. Other investors are focusingmore on the long-term returns that are available from procyclical exposure.These strategies can be implemented using either actively managed com-modity related equities, or commodity futures. The returns from either ofthese approaches can be truly spectacular, albeit volatile. The clear trendover time however, is for more assets to be allocated into commodity expo-sure of various types.

Whatever your motivation for investment in commodities, this bookwill help to increase your understanding, hence reducing risk and—hopefully—enhancing returns.

Graham Birch, Ph.D.Managing Director

Head of Global Natural ResourcesBlackRock Investment Management (U.K.) Limited

Foreword xiii

Preface

T he Handbook of Commodity Investing provides an overview of the ba-sics and foundations of commodity investing, as well as recent theory

and empirical evidence on the commodity markets. The chapters are writtenby leading practitioners and academics, and explain the complexities ofcommodity investments, their associated risks, and how investors can opti-mize their portfolios by including different types of commodity investments.Each chapter contains valuable information relevant to both practitioners,who are currently using or contemplating using commodities as part of theirasset allocation, and academics, who are analyzing the commodity marketstheoretically or empirically.

The book is divided into six parts. Part One covers the mechanics of thecommodity markets. Chapter 1, by Frank Fabozzi, Roland Fuss, and DieterKaiser, is a primer on the basics of commodity investing. The authors pro-vide insight into the market participants, commodity sectors, commodityexchanges, return components of commodity futures, and the risk and per-formance characteristics of the sectors. The chapter concludes that, basedon a Markowitz mean-variance analysis, commodity futures can yield diver-sification benefits in a traditional investor portfolio consisting of U.S. andglobal equities, bonds, and a riskless asset. In Chapter 2, Mark Anson dis-cusses the pricing and economics of commodity futures. Chapter 3, by Josh-ua Woodard, provides a review of commodity investments in the context ofa diversified portfolio in several tactical and strategic dimensions. Chapter4, by Zeno Adams, Roland Fuss, and Dieter Kaiser, explores the macroeco-nomic determinants of commodity futures returns, and finds that most com-modities exhibit an inflation hedge property when compared with U.S.inflation. In Chapter 5, Viola Markert and Heinz Zimmermann discuss therelationship between risk premiums and convenience yield models. Theydemonstrate, both theoretically and empirically, that the futures term struc-ture, convenience yields, and roll returns largely anticipate subsequent spotprice changes. Chapter 6 is a survey by Fritz Helmedag of the different ap-proaches to calculating the optimal rotation period for renewable sourcessuch as the timber sector.

Part Two is devoted to the performance measurement of commodity in-vestments. In Chapter 7, Roland Fuss, Christian Hoppe, and Dieter Kaiser

xv

provide an overview of commodity futures indexes, and shed new light onthe problems arising from the heterogeneity of these benchmarks. ClaudeErb, Campbell Harvey, and Christian Kempe highlight in Chapter 8 theproblems of determining the strategic value of commodities. In Chapter 9,Reinhold Hafner and Maria Heiden provide a statistical analysis of com-modity futures returns using the Dow Jones-AIG commodity index. BerndScherer and Li He use the mean-variance spanning test in Chapter 10 todetermine whether commodities should be considered an asset class of theirown. Chapter 11, by Thomas Schneeweis, Raj Gupta, and Jason Remillard,gives a theoretical overview of the construction of indexes that try to cap-ture the performance of commodity trading advisors (CTAs). The chapter isalso an empirical study of the relative performance benefits of CTAstrategies.

Part Three covers the important topic of risk management for commod-ity investments. In Chapter 12, Jeffrey Christian provides an introductionto risk management from a practitioner’s perspective. In Chapter 13,Moazzam Khoja offers his seven golden principles for effective risk manage-ment of commodity futures portfolios. Chapter 14, by Ted Kury, presents amodel of forward prices with time-varying volatility and time-varying corre-lation. The model can be used to quantify cross-commodity risk in portfo-lios of futures contracts. In Chapter 15, Chakriya Bowman and AasimHusain show how futures can be incorporated into commodity price fore-casts. Their empirical results suggest that futures prices can provide reason-able guidance about likely spot price developments over the longer term.

Part Four comprises seven chapters that explore how commodity prod-ucts can be implemented within an investor’s asset allocation. In Chapter16, Francois-Serge Lhabitant provides an overview of the tools CTAs use torun their futures portfolios, and illustrates how they differ from other com-modity investments. Hilary Till and Joseph Eagleeye demonstrate in Chap-ter 17 how to efficiently design a commodity futures trading program. InChapter 18, Markus Mezger distinguishes between the different sources ofreturn in commodity investing, showing how investment managers can ex-tract alpha from commodity investing. Juliane Proelss and Denis Schweizerin Chapter 19 demonstrate how to reach the efficient frontier of commodityinvestments. They stress the importance of analyzing the return distributioncharacteristics of single commodities before considering them as portfoliodiversifiers. In Chapter 20, R. McFall Lamm discusses whether CTAs andhedge funds can be suitable choices for investors seeking active commodityinvestments. Mark Shore, in Chapter 21, shows how the introduction ofcommodities, hedge funds, and CTAs can change the risk and performancemetrics of a traditional portfolio. He also compares the impacts of these dif-ferent forms of alternative investments. In Chapter 22, Theo Nijman and

xvi PREFACE

Laurens Swinkels clarify the benefits of commodity investing for investorswith a liability structure sensitive to the nominal or real interest rate andinflation.

Part Five presents the various commodity products currently availableto investors. In Chapter 23, Lynne Engelke and Jack Yuen provide an over-view of the different types of commodity investments. In Chapter 24, CarolAlexander and Aanand Venkatramanan discuss the valuation principles ofcommodity options. In Chapter 25, Matthias Muck and Markus Rudolf il-lustrate, both theoretically and empirically, that the nonarbitrage approachcannot be used effectively for pricing nonstorable goods such as electricityforwards. Paul Ali, in Chapter 26, explores the securitization of commodityprice risk, explaining how collateralized commodity obligations can be usedfor financial institutions to hedge credit risk or for investors to obtain expo-sure to commodity prices in the form of a debt instrument. Chapter 27, byMartin Eling, uses the CISDM CTA indexes to review historical CTA per-formance using several performance measures. Greg Gregoriou and FabriceRouah, in Chapter 28, investigate the performance and the survival of microCTAs. Their findings suggest that micro CTAs are at high risk of failure, butcan nonetheless be attractive investments because of their potential to pro-duce future stars. In Chapter 29, Oliver Engelen and Dieter Kaiser give anoverview and statistical analysis of hedge funds investing in energy markets.

The final section, Part Six, covers some of the more important commod-ity sectors. In Chapter 30, Roland Eller and Christian Sagerer provide a clas-sification scheme for commodities, as well as an overview of all commoditysectors. Charlie Cai, Iain Clacher, Robert Faff, and David Hillier provide apractical guide to gold as an investment asset in Chapter 31. In Chapter 32,Thomas Heidorn and Nadeshda Demidova-Menzel show that gold may beconsidered a hedge against the U.S. dollar exchange rate for ‘‘soft’’ curren-cies, but not for the euro. Chapter 33, by Jeffrey Christian, is a fundamentalanalysis of the world silver market. He shows how silver can be an interest-ing investment, both on its own and as part of a diversified investment port-folio. Chapter 34, by Michael Killick, is a primer on base metals investingcovering an overview of the industry, its market structure, and investmentstrategies associated with this commodity. Stefan Ulreich, in Chapter 35,covers electricity trading in the European Union, a market where prices areinfluenced by fuel market movements, weather incidents, political decisions,and the general economy. In Chapter 36, Chris Harris provides an overviewof the natural gas market in Great Britain, particularly the relationship ofnatural gas to other commodities such as oil, electricity, coal, and carbondioxide. Stefan Ulreich, in Chapter 37, covers emissions trading in the Euro-pean Union. He concludes that by linking schemes of other countries to theEuropean Union’s emissions trading scheme, the market has the potential to

Preface xvii

become global. Chapter 38 is an overview of commodity market fundamen-tals for grain, cattle, and hogs by Ronald Spurga, who shows that the driv-ing forces of agricultural commodity prices are characterized by supply,demand, seasonality, carry-over, and the stocks-to-use ratio. Rohit Savant,in Chapter 39, provides a fundamental analysis of the world sugar market,and highlights arbitrage opportunities between futures and options on sugartraded on the Intercontinental Exchange (ICE), Nybot, and the London In-ternational Financial Futures and Options Exchange (LIFFE).

We wish to express our deepest gratitude to the contributors to thisbook. We are delighted by the efforts every single author put into their chap-ters, despite their already overwhelming workloads, to create what we be-lieve to be a landmark commodity investing book. We are also very gratefulto Graham Birch for providing the foreword. Finally, we would like tothank our families for continued understanding and support of this bookproject.

Frank J. FabozziRoland Fuss

Dieter G. Kaiser

xviii PREFACE

About the Editors

Frank J. Fabozzi is Professor in the Practice of Finance and Becton Fel-low in the School of Management at Yale University. Prior to joining theYale faculty, he was a Visiting Professor of Finance in the Sloan School atMIT. Professor Fabozzi is a Fellow of the International Center for Financeat Yale University and on the Advisory Council for the Department of Oper-ations Research and Financial Engineering at Princeton University. He is theeditor of the Journal of Portfolio Management. He earned a doctorate ineconomics from the City University of New York in 1972. In 2002, ProfessorFabozzi was inducted into the Fixed Income Analysts Society’s Hall of Fameand is the 2007 recipient of the C. Stewart Sheppard Award given by theCFA Institute. He earned the designation of Chartered Financial Analystand Certified Public Accountant. He has authored and edited numerousbooks about finance.

Dieter G. Kaiser is a Director, Alternative Investments, in the hedgefund portfolio management team at Feri Institutional Advisors GmbH inBad Homburg, Germany, where he also runs a fund of commodity hedgefunds. From 2003 to 2007, he was responsible for institutional research atBenchmark Alternative Strategies GmbH in Frankfurt, Germany. He haswritten several articles on alternative investments (hedge funds, venture cap-ital, and commodities) that have been published in renowned academic andprofessional journals. He is also the author and editor of seven books. DieterKaiser holds a Diploma in Business Administration from the University ofApplied Sciences Offenburg, a Master of Arts in Banking and Finance fromthe Frankfurt School of Finance and Management, and a Ph.D. in Financefrom the Chemnitz University of Technology. On the academic side, he is aResearch Fellow at the Centre of Practical Quantitative Finance at theFrankfurt School of Finance andManagement.

Roland Fuss is a full professor in the Department of Finance, Account-ing and Real Estate at the European Business School (EBS), InternationalUniversity Schloss Reichartshausen in Oestrich-Winkel, Germany. He holdsa diploma in Business Administration from the University of Applied Sci-ence in Lorrach, and a diploma in Economics from the University of Frei-burg, Germany, where he also obtained his Ph.D. and his Habilitation.

xix

From 2000 to 2007, he worked at the University of Freiburg as research as-sistant and lecturer in the Department of Applied Econometrics, and assis-tant professor in the Department of Finance and Banking. His researchfocuses on alternative investments, politics and financial markets, risk man-agement, and applied econometrics. Professor Fuss has authored numerousarticles in finance journals as well as book chapters. He is a member of theVerein fur Socialpolitik, the German Finance Association, and the GermanAcademic Association for Business Research.

xx ABOUT THE EDITORS

Contributing Authors

Zeno Adams University of FreiburgCommerzbank Ag Frankfurt School of Finance and ManagementCarol Alexander University of ReadingPaul U. Ali Melbourne University Law SchoolMark J. P. Anson Hermes Pensions Management Ltd.Chakriya Bowman Australian National UniversityCharlie X. Cai The University of LeedsJeffrey M. Christian CPM Grouplain Clacher The University of LeedsNadeshda Demidova-Menzel Equinet AG (ESN)Joseph Eagleeye Premia Capital Management, LLCMartin Eling University of St. GallenRoland Eller Roland Eller Consulting GmbHOliver Engelen Benchmark Capital Management GmbHLynne Engelke Citi Alternative InvestmentsClaude Erb Managing Director TCWFrank J. Fabozzi Yale UniversityRobert Faff The University of LeedsRoland Fuss University of FreiburgGreg N. Gregoriou State University of New York (Plattsburgh)Raj Gupta University of MassachusettsReinhold Hafner Risklab Germany GmbHChris Harris Networks and Agreements RWE npowerCampbell R. Harvey Duke UniversityLi He QS Research Center, Deutsche Asset

Management, New YorkMaria Heiden Risklab Germany GmbHThomas Heidorn Frankfurt School of Finance and

ManagementDavid Hillier The University of LeedsFritz Helmedag Chemnitz University of TechnologyChristian Hoppe Senior Specialist Securitization and Credit

DerivativesAasim M. Husain International Monetary Fund

xxi

Dieter G. Kaiser Frankfurt School of Finance and ManagementChristian Kempe Berlin & CoMoazzam Khoja Sungard KiodexMichael Killick Lincoln Vale GroupTed Kury The Energy Authority1

Francois-Serge Lhabitant HEC Lausanne and EDHEC Business SchoolViola Markert CYD Research GmbHR. McFallLamm, Jr. Global Investment Management Deutsche

BankMarkus Mezger Tiberius Asset ManagementMatthias Muck University of BambergTheo E. Nijman Tilburg UniversityJuliane Proelss European Business School, International

UniversityJason Remillard University of MassachusettsFabrice Douglas Rouah State Street CorporationMarkus Rudolf WHU–Otto Beisheim School of

ManagementChristian Sagerer JPMorgan Chase BankRohit Savant CPM GroupBernd Scherer Morgan Stanley Investment ManagementThomas Schneeweis University of MassachusettsDenis Schweizer European Business School, International

UniversityMark S. Shore Alternative Investment ConsultantRonald C. Spurga ABN AMRO BankLaurens A. P. Swinkels Erasmus University RotterdamHilary Till Premia Capital Management, LLCStefan Ulreich E.ON Energie AGAanand Venkatramanan University of ReadingJoshua D. Woodard University of IllinoisJack C. Yuen Citi Alternative InvestmentsHeinz Zimmermann University of Basel

xxii CONTRIBUTING AUTHORS

PART

OneMechanics of the

Commodity Market

CHAPTER 1A Primer on

Commodity InvestingFrank J. Fabozzi, Ph.D., CFA

Professor in the Practice of FinanceSchool of Management

Yale University

Roland Fuss, Ph.D.Professor of Finance

Endowed Chair of Asset ManagementEuropean Business School (EBS)

International University Schloss Reichartshausen

Dieter G. Kaiser, Ph.D.Director Alternative Investments

Feri Institutional Advisors GmbHResearch Fellow

Centre for Practical Quantitative FinanceFrankfurt School of Finance and Management

Commodities are currently enjoying a renaissance due to institutional in-vestors such as pension funds and traditional portfolio managers. Many

market participants attribute the recent dramatic price increases in com-modities to increased demand for consumer goods, particularly from thepopulous countries of India and China. Demand from Brazil and Russia,two of the fastest-growing economies currently, has undoubtedly alsoplayed a part. (Collectively, these four countries are referred to as the BRICcountries.)

Globalization and economic and political convergence have been behindthe stimulated growth in these economies to a large extent. Besides

3

increased investment on an enterprise level, increasing state investment ininfrastructure in China has also led to enormous demand for commodities.This has caused a shock to the worldwide supply and demand dynamics,leading to at least short-term price increases.

Such dramatic increases in commodity prices are often explained by thecommodity super cycle theory. According to Heap, a super cycle is a lastingboom in real commodity prices, usually brought on by urbanization and in-dustrialization in a major economy.1 Hence, super cycles are driven by de-mand caused by an expansion of material-based production due to intenseeconomic activity. The economic situation in China is of crucial importanceto the commodity markets. China has greatly increased its share of globalcommodity consumption over the past few years, and is seen as the majordriver of the current commodity boom.

For example, between 2001 and 2005, China’s demand for copper, alu-minum, and iron increased by 78%, 85%, and 92%, respectively. Thisclearly shows China’s considerable influence on commodity pricing. Thissuper cycle, however, is not characterized by a continuous growth phase, asthe events of May 2006 show. Many commodities were under pressure dur-ing that time, and actually lost about one-fourth of their value.

Under market conditions like these, the question inevitably arises as towhether this is a temporary price correction or a general trend change. Fol-lowing the super cycle theory, a long-lasting upward trend in commoditiesin the future is likely, as most remain far below their historic highs whenadjusted for inflation.

Compared to foreign exchange or equity markets, there is almost no wayto intervene in commodity markets. Because the production side reacts verysluggishly to market distortions, short-term supply and demand shocks arecompensated for only by price movements.2 These inherent asset class vola-tilities are the main reason many investors have refrained from investing incommodities, despite the fact they can provide valuable diversification

1Alan Heap, ‘‘China—The Engine of Commodities Super Cycle,’’ Citigroup GlobalEquity Research (March 2005). The past 200 years have seen several such upswings,lasting from between 15 and 25 years. For example, in the late nineteenth century,industrialization in the United States triggered such a boom. The postwar period of1945 to 1975, when enormous resources were needed to rebuild Europe, can also becharacterized as a super cycle.2In contrast, central banks possess a variety of money market instruments to main-tain the value and stability of their currency. At the same time, central banks cancontrol—at least to some extent—the economic development of an economythrough changes in interest rates to avoid inflationary or deflationary tendencies.

4 MECHANICS OF THE COMMODITY MARKET

benefits to traditional security portfolios because of their low correlationwith bonds and stocks.3

This chapter first discusses the basics of commodity markets by describ-ing the market participants, the commodity subsectors, and the differentkinds of commodity investment vehicles available to investors. Subse-quently, we illustrate the return components of index-based, that is, passivelong-only, commodity futures investments in the context of the price discov-ery process, and we investigate the risk/return characteristics of commodityfutures indexes. Following this, we provide an empirical analysis of portfo-lio allocation of traditional security portfolios, explicitly taking commodityfutures into account.

MARKET PARTICIPANTS

Futures market participants are normally classified into hedgers, speculators(traders), and arbitrageurs. Commodity producers pass on the price riskthat results from highly volatile and difficult to forecast commodity futuresmarkets to speculators, and therefore pay a premium. Commodity pro-ducers have a distinct interest in hedging the price of their product in ad-vance (a short hedge).

For example, consider the situation in the classic agricultural market.Farmers face a weather-dependent, volatile supply that is met by a relativelystable demand. Contrary to the maintenance cost for cattle breeding or thepurchase cost of seed, the selling price generally is known only uponcompletion.

We see the opposite in the manufacturing industry: As the manufactur-ing industry hedges increasing commodity prices (a long hedge), the contra-rian position to the commodity producers’ short positions is taken. Airlinecompanies, for example, often appear as long hedgers to guard against in-creasing fuel prices, the underlying in which the airline companies are short.If an existing or expected cash position is compensated for via an oppositefuture, the market participant is classified as a hedger. Hence, for the com-modity producer, there is a fixed net profit; for the commodity manufac-turer, there is a fixed purchase price.

Speculators represent the largest group in the futures markets. Theirmain task is to provide liquidity on the one hand, while balancing the longand short hedges on the other hand. Contrary to the commodity producersor the manufacturing industry, which try to avoid susceptibility to

3Kenneth A. Froot, ‘‘Hedging Portfolios with Real Assets,’’ Journal of PortfolioManagement (Summer 1995), pp. 60–77.

A Primer on Commodity Investing 5

unfavorable price developments, the intention of speculators is to take a dis-tinct market position and speculate for a price change. To make a profit,speculators deliberately take on risk by betting on rising or falling prices.As opposed to hedging, speculation is subject to both huge gains and hugelosses, since speculators do not hold compensating cash positions.

The third and smallest group of market participants is the arbitrageurs,who try to take advantage of time- or location-based price differences incommodity futures markets, or between spot and futures markets, in orderto generate riskless profits. Clearly, this group also intends to make profits,but their trading activity does not involve taking risky positions. Moreover,they use economic and financial data to detect existing price differenceswith respect to time and location. If these price differences exceed interlocalor intertemporal transfer costs such as shipping, interest rates, warehousecosts, or insurance costs, riskless profits can be realized. Consequently, pricedifferences among the markets are adjusted, price relationships among themarkets are restored, and arbitrageurs guarantee market balancing.

In the case of cash and carry arbitrage, the resale price of today’s lever-aged spot position is simultaneously set by selling the commodity futures.This short futures position implies an unconditional commitment to pur-chase the underlying at maturity. At maturity of the futures, the specifiedcommodities are tendered against the maturing short futures. If the profitfrom the spot trade of the physical commodity exceeds the value of the fu-tures plus the cost of debt financing, the arbitrageur will realize a profitfrom what is known as a basis trade.

COMMODITY SECTORS

Investments in international commodity markets differ greatly from otherinvestments in several important ways. First, commodities are real as-sets—primarily consumption and not investment goods. They have an in-trinsic value, and provide utility by use in industrial manufacturing or inconsumption. Furthermore, supply is limited because in any given period,commodities have only a limited availability. For example, renewablecommodities like grains can be produced virtually without limitation.However, their yearly harvest is strictly limited. In addition, the supply ofcertain commodities shows a strong seasonal component. While metalscan be mined almost all year, agricultural commodities like soybeans de-pend on the harvesting cycle.

Another important aspect of commodities as an asset class is heteroge-neity. The quality of commodities is not standardized; every commodity hasits own specific properties. A common way to classify them is to distinguish

6 MECHANICS OF THE COMMODITY MARKET