Commodity returns are driven by three factors: the risk premium, the interest earned on collateral and unexpected movements in the future spot price. It is important to expand on the first two however the most important of these is the risk premium.
Commodity futures returns are driven by a range of factors distinct from the spot price and it is important to understand these differences. The spot price of any physical commodity is the price at which it is selling at a given time and place - the cash price. A futures contract is a legal agreement to make or take delivery of a specified commodity (e.g. barrels of oil or bags of coffee) at a fixed future date at a price determined at the time of dealing. Producers of commodities use futures to guarantee their selling price whilst consumers of commodities buy futures to lock-in their buying price. In so doing the buyers of futures take the risk of unexpected movements in the future spot price. Following conventional economic theory these buyers need to be rewarded for taking this risk - hence the sellers need to offer a return to the buyer. This is the risk premium. In practise this means that the futures price normally trades below the expected future spot price. As you move closer to maturity the futures price moves closer to the expected futures spot price allowing the investor to realise this risk premium. The risk premium is independent of trends in the underlying spot price. What this means is that commodity futures can generate positive returns even in periods of falling spot prices.
The secondary source of returns is the collateral return. Collateral returns are achieved because, in entering a futures contract, no cash changes hands. However at expiration of the contract either side pays out to or receives cash from the other party based which side has made money. Therefore buyers of contracts need to hold collateral to match the size of the commitment in the event of having to pay out. This collateral is invested in short term money market instruments and therefore earns a return.
Hermes Commodities Umbrella Fund Limited is authorised by the Guernsey Financial Services Commission and its constituent units are listed on the Channel Islands Stock Exchange.
