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

26.3 INDIRECT OWNERSHIP OF COMMODITIES

The most common method of obtaining commodity exposure is through indirect commodity investments (equity, fixed income). Most investors actually have this type of exposure embedded in their traditional investment portfolios. These exposures can be as simple as traditional stock or bond investments in companies that are involved in the production, transportation, and marketing of commodities, or they can be one of a number of more specialized commodity-based investments, as outlined in the following pages. A great deal of institutional investment in commodities takes the form of index-based investments. The primary vehicle used by institutional investors for exposure to commodity indices is commodity index swaps.

26.3.1 Commodity Index Swaps

A commodity index swap is an exchange of cash flows in which one of the cash flows is based on the price of a specific commodity index, while the other cash flow is based on an interest rate. Commodity index swaps are the preferred vehicle for most institutional commodity investments. Swaps are competitively priced, with multiple dealers making markets in swaps on several major commodity indices. Competition among vendors ensures liquidity and provides multiple counterparties to spread the default risk that stems from over-the-counter (OTC) swap transactions. Investors sometimes prefer this structure because it allows them to maintain control of their cash. While most indices include a collateral return ...