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Trade of The Month: Commodity Linked Products

While almost all retail structured products are linked to equities, those linked to commodities or commodity indexes have been slow to be introduced to retail investors. In many markets, commodities are a natural alternative. Over the long term, the prices of commodities can be expected to increase as they provide a natural hedge against inflation, and typically they also have low correlations with equities, making them an excellent diversification tool in any portfolio. But perhaps most importantly, they represent a straightforward investment story for retail investors, who often hear about rising commodity prices, particularly oil and gas.

Commodity based structured products are very different from other products based on different asset classes; a fact that becomes quickly apparent when investigating the pricing or hedging of these instruments. Furthermore, ‘commodity based' can mean two things: products that are based on a physical commodity, and products that are based on a commodity index. This month we will look at the link to the spot prices of physical commodities.

The main difference between commodities and equities comes down to the construction of the forward curve for pricing. The forward curve for any asset is the market implied level of the spot value at future points in time. Usually it is not directly connected to any market consensus about where the asset price is heading, but arises out of pricing data and is therefore used as the basis for constructing a hedge. For equities (indexes or stocks), the forward curve is constructed by the risk free interest rate minus any dividend yield over a given maturity. This is because there is an easy way to replicate an equity future: simply buy the index or stock, pay interest on the borrowing and receive dividends that are due. The net carry is given by the excess (if any) of interest rates over dividend yields. The interest rate can be locked in from the interest rate yield curve, and while dividends are not entirely fixed, there is generally known and expected behaviour when studying forward equity prices. The implied volatility equity levels are derived from option prices, so with the forward and volatility curve we can price any equity option and thus construct the building blocks for the structured product.

For commodities, the dynamic is fundamentally different. First, there is the issue of physically holding or storing the commodity. Second, the futures market for commodities is used much more often than its equities counterpart as a fundamental hedge, particularly by commodities producers, most of whom rely extensively on futures markets because of the volatility of commodity prices and the time to delivery.

In the case of soft commodities such as sugar, soy, corn and cotton, the time taken to produce the commodity and bring them to market is also a factor. Commodities that require extraction, such as oil, gas and metals, involve a lengthy process of identifying target sites and completing the extraction. In both cases, this time delay suits providers seeking a fixed forward price in the future. Because most of their cost base of labour, technology and raw materials is fairly fixed, it is much easier to identify whether any given process is economic if the price they will receive is known. In the case of soft commodities and metals in particular, this usually leads to what is called backwardation — that is, the futures price is lower than the spot price.

Oil and gold often behave differently owing to their relative scarcity, constant demand and roles as key elements in the global economy. The use of one or more commodities that exhibit backwardation will result in an asset that has a low forward price; meaning options to provide upside growth will be relatively cheap. As a result, commodity linked products typically achieve higher participation rates than equivalent equity linked products.

This article first appeared on on 21 April 2011.