Red-Blooded Risk: The Secret History of Wall Street

Commodity Futures

Table 5.1 shows the average returns and standard deviations of return for seven commodities from 1970 to 2010. It's easy to understand what an investment in silver means, but what about investments in perishable commodities? These returns are computed by rolling futures contracts. In January 1970, you enter into a long March futures contract in cocoa. That means you promise to accept delivery of 10 tons of cocoa of an agreed type and quality at an agreed location in March, and pay in exchange an agreed amount of money at that time. You must post cash to guarantee your promise; it might be 5 percent to 10 percent of the value of the cocoa.

You have no use for cocoa, so you won't accept delivery. Instead, at the end of February you will exit the March futures contract and enter into a May futures contract. By constantly rolling your contracts, you never have to accept delivery. However, you are paid the gains and must pay the losses as if you owned 10 tons of cocoa. If the price of cocoa goes up $10 per ton, you collect $100. If it goes down $25 per ton, you pay $250.

I have stated all returns as what you would earn investing in the commodity above what you could get in a low-risk asset like Treasury bills or bank certificates of deposit. If you prefer, you can think of them as the return you would earn above inflation, which comes to about the same thing.

Table 5.1 Average Annual and Total Period Excess Returns of Selected Commodities, 1970 to 2010

The table shows ...