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LOS e: Discuss why investing in commodities offers diversification opportunities during periods of economic fluctuation in the short-run and inflation in the long-run.

Which of the following statements best describes why commodities may offer portfolio diversification benefits to a portfolio of stocks?

A)	Commodity returns are strong during the early stages of expansion.

B)	Commodity returns are strong during the late stages of expansion.

C)	Commodity returns are negatively correlated with inflation.

Commodity returns have historically been positively correlated with inflation. Demand for commodities is generally weak during the early stages of economic expansion, and strong during the late stages. By contrast, equities peak during the early stages and decline during the late stages.

A pension fund with an aging retirement population would most likely benefit from adding commodity futures to its portfolio since:

A)	the fund’s liabilities are valued in nominal, while commodities are generally valued in real terms.

B)	the fund’s liabilities are valued in real, while commodities are generally valued in nominal terms.

C)	neither the fund’s liabilities nor the commodities are valued in real terms.

Pension fund liabilities are valued in nominal terms, hence inflation (and the corresponding increase in interest rates) would increase the value of the fund’s accrued liabilities. Commodities hold their value with increases in inflation as they are valued in real terms, thereby decreasing the pension fund’s overall liability exposure.

Jean Chan, CFA, is an analyst following the commodity futures market. In a conversation with a colleague, Chan mentions that precious metals generally have limited contango, which makes them a weak hedge against inflation in the long run.

A)	No, because precious metals provide long-term inflation protection.

B)	No, because precious metals do not have limited contango.

Yes.

For commodities that are easily traded, costless to store and provide no income, investors can take advantage of perceived mispricings between spot and futures prices through arbitrage, keeping futures prices close to their theoretical minimum and maximum prices. Precious metals thus have limited contango. Regardless, however, whether the commodities market is in backwardation or contango, commodities are generally valued in real terms and offer long-run inflation protection.

Which of the following portfolios will most likely provide the greatest amount of downside protection?

A)	55% U.S. stocks, 35% U.S. bonds, and 10% TIPS.

B)	55% U.S. stocks, 35% U.S. bonds, and 10% foreign stocks.

C)	55% U.S. stocks, 35% U.S. bonds, and 10% commodities.

Studies indicate that a portfolio with 10% allocated to commodities (with 55% to U.S. stocks and 35% to U.S. bonds) provides the largest amount of downside protection compared to the other portfolios.