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LOS b: Describe the sources of return and risk for a commodity investment and the effect on a portfolio of adding an allocation to commodities.

If a commodities market has a downward-sloping term structure of futures prices, this would be associated with:

A)
normal backwardation and a positive roll return.

B)
normal backwardation and a negative roll return.

C)
contango and a positive roll return.

Normal backwardation, when it exists, produces a downward-sloping term structure of futures prices. Such a condition predicts a positive roll return. If the term structure is positive, which is a result of contango, the roll return would be negative.

The component of the return on a futures position that results from interest earned on U.S. Treasury bills deposited to establish the position is called the:

Collateral yield is the return earned on the collateral posted to satisfy margin requirements. In most cases, the collateral posted will be U.S. Treasury Bills, in which case the collateral yield is the T-bill yield.

Which of the following will result from the term structure of futures prices for a particular commodity being in contango?

A)	Negative roll yield.

B)	Negative collateral yield.

C)	Positive current yield.

Which of the following best describes why adding a commodities index position to a portfolio of stocks and bonds may be beneficial? Commodities index positions:

A)	are positively correlated with stock and bond prices.

B)	serve as a hedge against inflation.

C)	benefit from commodity markets oscillating between contango and backwardation.

The correlation between commodity futures and inflation is positive, while the correlation between inflation and stocks and bonds is negative. Therefore, declining stock and bond prices due to high inflation can be offset by the rising prices of commodities that occur during times of high inflation. While it is possible for commodity futures markets to change between backwardation and contango, this alone is not a reason to add a commodities position to a traditional portfolio.

Which of the following market conditions most accurately describes the conditions of a particular commodity market for the roll yield to be positive?

Contango.

B)	Futures prices are lower than spot prices.

C)	Market is dominated by long hedgers.

A positive roll yield results from a backwardated market, whereas a negative yield is produced in a contango market. In backwardated (contango) markets, futures prices are lower (higher) than spot prices. Futures markets that are dominated by long (short) hedgers tend to be in contango (backwardation).