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

28.7 CONCLUSION

The low correlation of commodity markets to stock and bond markets provides an opportunity for return enhancement and risk reduction. When an investor performs careful due diligence, investing in a commodities trading fund can be highly lucrative. This chapter highlights six golden principles of risk management:

1. An independent source of market data should be used to calculate net asset value. Confirming position valuation with an independent pricing source can reduce the chance of fraud and misrepresentation.

2. Unexpected events, such as Hurricane Katrina, may be the greatest threat to a commodity trading firm. Although events can't be prevented, a firm can assess the impact of a catastrophic event on its viability.

3. A commodity trading firm that is prone to huge shocks, and where traders can take highly leveraged positions, should not rely exclusively on VaR as a measure of potential risk. Furthermore, a firm's inability to liquidate positions can have undesirable consequences. The Long-Term Capital Management and Amaranth disasters are attributed to the funds' inability to quickly liquidate large positions at a reasonable cost.

4. Funds should have a mechanism for measuring the market impact cost of liquidating positions. Concentration limits help ensure that a firm will have the capital necessary to pay all liquidation costs.

5. A good fund not only measures profitability, but also keenly measures its performance attributes. The fund knows how profits ...