The Handbook of Commodity Investing

CHAPTER 13

Effective Risk Management Strategies for Commodity Portfolios

Moazzam Khoja, CFA

Senior Vice President-Strategy

Sungard Kiodex

There is a lot of recent excitement around the commodity markets, particularly energy, as evidenced by the amount of press and editorials while oil prices reached record highs, leading many industry experts to predict that energy trading will become an integral part of broader financial markets in the near future. Number of banks, futures commission, merchants, and hedge funds that are entering, or considering entering, the potentially lucrative commodity market continues to increase.

There are, however, some fundamental differences between commodity markets and other markets such as stock, money, interest rate, and exchange market. This chapter will highlight those differences by outlining seven operational guidelines that should be part of a firm's best practices when trading commodities as well as things an investor should know before investing in commodity trading firms.

The data and conclusions presented in this chapter are drawn from the author's experience advising commodity trading firms and builds upon a case study surveying best practices among three top commodity trading firms.

MEAN REVERSION BEHAVIOR OF COMMODITY RETURNS

In the current market, absolute mean reversion, defined as the tendency of the commodity's spot prices (front month contract) to revert to a long term average price, is a myth. The historical price for West Texas ...