Assignment 3: Commodity Futures Markets.

Write your assignment as a self-contained report, using full sentences rather than telegram style, and present all results in nicely-formatted tables. The way you discuss and interpret your results is a key determinant of the grade.

All submissions are automatically checked against plagiarism.

Synopsis.

You are being interviewed for a job at an Asset Management Company that manages a large, active well-diversified equity portfolio of U.S. stocks. The management believes that their diversification strategy across a wide variety of industries is sufficient and therefore they do not consider investments in other asset classes.

However, the management is puzzled by the recent unprecedented increase in commodities investments, where many institutional investors, including Harvard University Endowment (a bellwether for many as an indicator of progressive thinking in institutional portfolio management) has entered the commodity futures markets. Given that the management believes that buying equities of companies involved in producing commodities is a good way to gain exospore to commodities, they do not understand the reasons for such a high interest in investments directly in commodity markets.

As part of this job interview you will be asked to make a case for whether the management should consider expanding their portfolio into the commodity futures markets or whether their diversification strategy is indeed able to capture commodity risk well. This assignment will help you to prepare this advice so that you can excel at your job interview.

Objective

The goal of this assignment is to understand the pros and cons of investing in commodity futures markets. By solving this assignment, you will learn how to gather relevant information and analyze historical data in order to arrive at an advice that is supported by well-grounded arguments.

Data

The excel file uploaded on Blackboard contains all the necessary data for this case. Please read the notes regarding the data included in that file carefully.

Instructions

1.Qualitative case of the rationale for investments in commodities.

Before analyzing the quantitative aspects of commodity futures markets as a separate asset class it is important to understand their role in the global economy. Why should one invest in commodity futures markets in the first place?

What is the rationale for investments in commodity futures markets? List at least three reasons that would advocate the need to invest in commodity futures markets. Explain the rationale behind each reason and what kind of investments in commodity futures markets they argue for (e.g., long/short, passive/active, speculative/hedging, etc…). Make use of academic and/or practitioner literature to answer these questions.

2.Quantitative case for commodities as an asset class.

Gorton and Rouwenhorst in their paper titled “Facts and Fantasies about Commodity Futures” analyzed commodity futures markets as an asset class. They found that over the sample period between 1959 and 2004, commodity futures markets offered similar historical returns and Sharpe ratio as U.S. equities, they were negatively correlated with stock and bonds markets and positively correlated with inflation. As such, they concluded that commodity futures market can offer diversification benefits over the U.S. equities.

However, around the end of 2002 commodity futures markets have experience a dramatic increase in commodity index investments, which is now referred to as a period of financialization of commodities. It is therefore not clear whether the conclusions drawn by Gorton and Rouwenhorst are still valid and that is why you need to perform your own analysis.

Use the data in the excel file that is provided with this assignment on Canvas. The data for this question is in the Sheet: Benchmark returns. Please read the notes regarding the data included in that file carefully. Compute the necessary statistics, fill in the tables and make the plot as described in Sheet: Analysis 1.

Based on your own computations answer the following questions:

Are commodities an attractive asset class? What are the average returns and Sharpe ratios from investing in commodity futures? Are stocks of commodity producers indeed exposed to commodity risk? Based on these results, can commodity futures provide diversification benefits? Would you prefer to invest in the open-interest weighted commodity index (OIW), the equally-weighted commodity index (EW) or the stocks of commodity producers (StkCom)? What is the impact of financialization on these conclusions?

Paste both tables and the plot into your answers, do not submit your excel file with the assignment.

3.Quantitative case for active commodity investment

Based on your knowledge from academic literature you’ve identified a profitable active trading strategy that buys commodity futures contracts that have the lowest basis and sells the ones with the highest basis. Such strategy has been shown to provide sizeable profits in a large number of studies. It is not clear, though, what is the impact of financialization on this strategy returns, and whether it can provide diversification benefits to the portfolio that is currently held by the asset management team you are preparing this analysis for. Therefore, you need to perform an additional analysis yourself.

Use the data in the excel file that is provided with this assignment on Canvas. In Sheet: Returns Individual Futures, you can find monthly returns for the first nearby roll-over strategy for 16 different commodity futures (e.g., crude oil, soybeans, lean hogs, etc). In Sheet: Basis you find a current basis for the same 16 contracts. The basis is the difference in prices of two futures contracts written on the same underlying commodities. The two contracts differ by maturity only, such that the basis is the difference between the price of a contract with longer maturity minus the price of the contract with the shortest maturity available. Construct the return on this long-short trading strategy and assess its performance by following the steps outlined in Sheet: Analysis 2.

Based on your own computations answer the following questions:

Does the long-short trading strategy indeed deliver strong returns in the absolute terms? What about risk adjusted returns? What is the exposure of this strategy to stock market risk? Which leg of the strategy (short of long) delivers stronger returns? What is the impact of financialization on these conclusions?

Paste the table into your answers.

4. Your advice to the management team.

Should the management add to their portfolio a passive investment in commodity futures market, or rather an active strategy based on the basis, or perhaps a bit of both? Compute (using the full sample) the weights in two optimal portfolio that maximizes Sharpe ratio. The first portfolio combines the investment in the portfolio that the Asset Management company currently has (Fund) with the investments in the open-interest weighted commodity index (OIW), and the equally-weighted commodity index (EW). The second portfolio adds also the long-short trading strategy based on basis (Low-High). Construct the weights for these two portfolios and their summary statistics by following the steps outlined in Sheet: Analysis 3. Paste the tables into your answers.

Discuss summary statistics of these two optimal portfolios (you may also want to relate to the summary statistics from Analysis 1). Explain the differences in weight composition in the two optimal portfolios.

Based on all the information you have gathered and the analysis you’ve performed formulate an advice that you would offer to the management team during the interview. Should the management add futures returns to their current portfolio and if so what kind of the investments in the futures markets you recommend? Or the management was indeed correct in their initial intuition and their current portfolio is already well diversified such that adding commodity future is not needed. Choose the arguments to make your case carefully.