CAIA Level II: Advanced Core Topics in Alternative Investments, 2nd Edition

25.4 COMMODITY-BASED EQUITY AND DEBT STRATEGIES

Equity-based commodity strategies involve hedging the commodity price risk associated with the share price of a particular company. They can also involve buying the commodity to hedge a production input. An example of this would be buying jet fuel as a hedge for an airline stock.

Commodity-based corporations are typically valued as the sum of the firm's commodity rights and its enterprise value. Commodity rights reflect the current value of untapped commodity assets, such as oil reserves. The enterprise value is the residual value of corporate assets. If an analyst determines that the enterprise value of a particular firm is overpriced, a common strategy is to sell the firm's equity short and buy commodity futures to hedge out exposure to the commodity rights. Conversely, if the enterprise value is underpriced, the strategy involves buying the equity and selling futures to hedge the commodity rights.

Debt strategies use commodity futures and options to hedge the default risk of commodity producers and consumers. Because default risk is highly nonlinear, commodity options are commonly utilized for this type of hedge. For example, a lender to a copper producer might purchase put options on copper to hedge this exposure. The owner of airline bonds would buy call options on jet fuel to hedge the negative effect on margins of higher fuel costs.