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

26.4 LEVERAGED AND OPTION-BASED STRUCTURES

While most commodity investments are delivered through standard index-based beta-one structures such as swaps, ETFs, and structured notes, an array of complex structures, such as principal-protected notes, levered notes, and options, are available to investors.2

Most commodity index-based products are designed to provide an unleveraged long exposure to a commodity index; however, there are a variety of ETFs and ETNs designed to provide leveraged (usually two times) long, leveraged short, or unleveraged short exposure to commodity indices. It is worth noting that these funds are designed to provide the levered return on a daily basis, and rebalancing (as well as the associated transaction costs) may be required to achieve the desired levered return over longer time periods, particularly in high-volatility market environments (Hill and Teller 2009).

Many index-linked notes offer leveraged exposure to commodity indices. These are referred to as leveraged notes. A common structure offers three-times-leveraged exposure to a commodity index. Because these notes can lose 100% of their value when a decline of more than 33% in the index is experienced, the issuer and investor can be viewed as having or needing options. The issuer typically purchases option protection against further declines in the commodity. The investor enjoys an implicit protective put through the limited liability of the notes, since the price of the note cannot become negative. ...