Portfolio Design: A Modern Approach to Asset Allocation

SOURCES OF RETURN ON COMMODITY FUTURES

Before considering actual returns on commodity contracts, it’s important to understand the sources of return on commodity futures. There are two main sources of return, risk premiums and forecast errors.

John Maynard Keynes wrote extensively about futures contracts in his Treatise on Money (1930). Keynes was an active investor himself both for his own account and that of King’s College, Cambridge. In analyzing futures, Keynes focused on factors that might make the current futures price different from the expected spot price at the end of the futures contract. He argued that there was a systematic tendency for the futures price to be lower than the expected future spot price. Hedging demand by commodity producers (like Barrick in later years) push down the price of the futures contracts relative to the expected future spot prices. That’s because the producers typically sell the commodity in the futures market. He called the resulting gap between the current futures price and the expected future spot price normal backwardation. It’s a risk premium that entices investors to take the other side of the position—buying commodities in the futures market so that the producers can sell them.

Figure 12.1 illustrates the risk premium due to normal backwardation. The expected price of oil at the end of the current futures contract is $72 per barrel. Because of selling pressure by commodity producers who are hedging their positions, the current futures ...