CAIA Level I: An Introduction to Core Topics in Alternative Investments, 2nd Edition

CHAPTER 19

Commodities: Applications and Evidence

This chapter discusses the motivations for seeking exposure to commodity returns, practical issues with obtaining commodity exposure, and the evidence regarding risks and returns to commodity exposure.

19.1 COMMODITY INVESTING FOR DIVERSIFICATION

There are two primary motivations for seeking exposure to commodity returns: diversification and return enhancement. This section is about diversification as a motive. The exact meaning of diversification depends on how risk is defined. We begin with a discussion of commodities and their diversification with traditional assets, leading to alternative views of diversification: an equilibrium-based view of diversification, a disequilibrium-based view of diversification, and an inflation risk view of diversification.

19.1.1 Diversification with Traditional Assets

Commodities are often viewed as an asset class that is distinct from stocks and bonds (financial assets) in several regards. Here we discuss four reasons that commodity prices may not have high positive correlation with stock prices and bond prices.

First, commodity prices are not directly determined by the discounted value of future cash flows. Accordingly, commodity prices are not as directly related to changes in forecasted cash flows and changes in market discount rates. Instead, commodity prices are determined by current and anticipated supply and by the demand for the perceived benefits that the commodity can directly generate. ...