Tuesday, September 28, 2010

Commodity fund

All About Alpha investigates commodity funds.

Because of the capital costs of holding commodities directly, investing is almost exclusively done using futures (exceptions include commodity producers, consumers, etc.) Commodity indices, ETFs, ETNs and mutual funds manage their portfolios very similarly when using futures contracts. For the most part, they construct the portfolio by purchasing near-dated futures contracts. As the contracts near maturity, they sell the contract at or near the spot price of the commodity and purchase new near-dated contracts and the process repeats itself. The frequency and magnitude of this roll leads to the importance of the yield it generates.

Unfortunately, investing in commodity futures contracts can be complicated since total returns are comprised of three return components:

  • Collateral Yield: Futures contracts require very little collateralization (~10%). The remainder is frequently invested in high-quality, short-term instruments such as a 90-Day T-Bill. The yield from these investments is often very small relative to the total return and is known as the collateral yield.
  • Spot Price Change/Yield: This represents the price change in the underlying commodity contract and is often quoted during a discussion of a commodity’s return. Investors are usually seeking exposure to these returns when choosing to invest in commodities.
  • Roll Yield: This component of return is the focal point of the recent articles and is a little more complicated. Commodity investors (e.g. indices, funds, etc.) tend to buy near-dated contracts (e.g. 1-month from expiration) and sell them just prior to settlement. The revenue generated is immediately used to purchase another near-dated contract to maintain exposure to the commodity. This process continues indefinitely and represents the roll yield (sale price less purchase price). If the subsequent purchase cost is less than the revenue gained from the sale, then the roll yield is positive; if the sale prices is less than the purchase price the roll yield is negative. A positive roll yield is referred to as backwardation while a negative yield is called contango.

Saturday, September 25, 2010


Ben Bernanke looks at what the financial crisis means for economics. In the middle of this there is an overview of information and expectations under uncertainty.

Most fundamentally, and perhaps most challenging for researchers, the crisis should motivate economists to think further about their modeling of human behavior. Most economic researchers continue to work within the classical paradigm that assumes rational, self-interested behavior and the maximization of "expected utility"--a framework based on a formal description of risky situations and a theory of individual choice that has been very useful through its integration of economics, statistics, and decision theory.9 An important assumption of that framework is that, in making decisions under uncertainty, economic agents can assign meaningful probabilities to alternative outcomes. However, during the worst phase of the financial crisis, many economic actors--including investors, employers, and consumers--metaphorically threw up their hands and admitted that, given the extreme and, in some ways, unprecedented nature of the crisis, they did not know what they did not know. Or, as Donald Rumsfeld might have put it, there were too many "unknown unknowns." The profound uncertainty associated with the "unknown unknowns" during the crisis resulted in panicky selling by investors, sharp cuts in payrolls by employers, and significant increases in households' precautionary saving.

The idea that, at certain times, decisionmakers simply cannot assign meaningful probabilities to alternative outcomes--indeed, cannot even think of all the possible outcomes--is known as Knightian uncertainty, after the economist Frank Knight who discussed the idea in the 1920s. Although economists and psychologists have long recognized the challenges such ambiguity presents and have analyzed the distinction between risk aversion and ambiguity aversion, much of this work has been abstract and relatively little progress has been made in describing and predicting the behavior of human beings under circumstances in which their knowledge and experience provide little useful information.10 Research in this area could aid our understanding of crises and other extreme situations. I suspect that progress will require careful empirical research with attention to psychological as well as economic factors.

This can be tied to the modelling of expectations in the UIP model. There may be a non-linear model that is distributed with a negative skew and kurtosis in regular times and collapses into something binary in a crisis.

Tuesday, September 21, 2010

Not poisoned but starved

Gary Wenk speaks about "brain food" and the way that the shared ancestory of ourselves and plants makes components of our food most effective in affecting our bodies and minds. Amidst this:

No, he does not die, because his species and that of the creature on this foreign planet do not share an evolutionary past or a common ancestor. Although they may both be made of proteins formed from amino acids, their independent evolutionary paths should made it highly improbable that they use similar neurotransmitter molecules within their respective brains and bodies. Every spaceman from Flash Gordon to Captain Kirk to Luke Skywalker should feel safe walking around any planet (except their own) with impunity from animal and plant toxins. For this same reason, the intoxicating drinks and powerful medicines that always seem to be popular in these foreign worlds in science fiction movies would also have totally different effects, if any effects at all, on the brains of our plucky spaceman. Eating otherworldly foods might be the most disappointing and distressing experience of all: Even if they were filling and somehow tasted delicious, as products of utterly alien biochemistries they would probably prove devoid of nourishment for our Earthly bodies. Thus, starvation might be the greatest threat to any future explorers of alien biospheres. Unless, perhaps, they’d brought along a large supply of chocolate.

Monday, September 20, 2010


Another look at the nature of risk in the coverage of EMH in the FT.

Second is the pro-cyclical nature of value-at-risk, a measure of the risk of loss. Recent high market volatility is sharpening attention towards risk and the need to measure and manage it. At the same time, rapid financial innovation has increased the ability to monitor and control risks, allowing measures like Var to gain further ground. This would all be good news, if the markets were using the right type of Var for establishing the risk limits.

Generally, when prices move down, Var goes up, eventually triggering the risk limits and thus enlarging the troops of sellers. Symmetrically, the reduction of Var in good times encourages traders and fund managers to pile on risk, increasing their risk exposures when prices are already high and while demand is thriving. This can compound the positive feedback mentioned earlier.

The interesting thing here is the way that a period of low volatility will provide a sample of low volatility and increased risk taking. Increased volatility leads to less risk taking. Can we model this?

Wednesday, September 08, 2010

Mobile phone and microfinance

Amidst a discussion of mobile phones in Kenya in the Guardian, the possibility that microfinance improvements may also be seen.

Besides enabling millions of people to easily communicate over distance for the first time, the mobile phone has spurred a host of other life-improving innovations, including a money transfer service that allows people to send cash instantly across the country via text message.