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Concepts

Description
Private Real Estate Investments

Form of real estate

Real estate characteristics

Debt

Equity

Private market

Mortgages

Direct investments (sole ownership, partnership, and other forms of
commingled funds)

Public market

Mortgage-backed securities

Share of REITs and REOCs (real estate operating companies)

1
...
High unit value : real estate is indivisible → unit value is significantly higher than stocks and bonds → difficult to construct a diversified por olio
3
...
High transaction costs : involve appraisers, lawyers, brokers and construction personnel
5
...
Buildings may become less desirable due to location, design or obsolescence
6
...

Lower interest rate + Scarce capital = Lower real estate values
7
...
Difficult in determining price : limited participants + lack of knowledge of local market → difficult for outsider to value property
(*) REIT overcome problems:
- REIT shares are actively traded → more liquidity
- REIT more likely to reflect market value
- REIT provide exposure to diversified real estate portfolio
- investors don't need property management expertise

Real estate classifications

1
...
Non-residential real estate : multi-family, office, industrial / warehouse, retail, hospitality, parking facilities, restaurants, recreational properties
3
...
Current income : from collecting rent (after paying off OPEX, financing costs, taxes)
2
...
Inflation hedge : during inflation, both rents and property value are expected to rise
4
...
Tax benefits : favorable tax treatment in some countries

Risks of real estate investment

1
...
New property lead time : market conditions can change significantly while approvals are obtained and property are completed
...
Cost and availability of capital : High interest rate + Scarce capital → lower demand for real estate
4
...
However, weak market + high vacancy rate → Real estate value may not keep up with infla on
...
Demographic factor : Demand for real estate is affected by size and age distribution of local market population, distribution of socioeconomic groups, and new household formation
rates
6
...
Environmental issues : real estate values can be significantly reduced if being contaminated by prior owner / adjacent property owner
8
...
Management expertise : manager must make operational decision (negotiating leases, maintenance, marketing and renovation)
10
...
Other undefined factors : unobservable defect, natural disasters, terrorism, etc
...
Office : demand heavily depend on job growth
- Gross lease : owner is responsible for OPEX
- Net lease : tenant is responsible for OPEX
2
...
Also depend on import/export activity
3
...
Multi-family: demand depends on population growth (especially age demographic) and cost of buying vs cost of renting

Real estate appraisals

Appraisals : due to infrequent real estate transactions → appraisal is used to es mate value / assess changes in value over me → measure performance
- Market value : most probable sales price a typical investors is willing to pay
- Investment value : value / worth that considers a particular investor's motivation
- Value in use : value to a particular user
- assessed value : value used by tax authority
- Mortgage lending value : for the purpose of valuing collateral

Valuation approaches

1
...
Sale comparison approach : buyer would not pay more for a property than others paying for similar property
- Most useful when there are a number of similar properties recently sold
3
...
g
...
Part of the loss might already be reflected in MV of land
- Economic obsolescence : occur when new construction is not feasible under current economic conditions
(*) Cost approach is considered the upper limit of value since an investor would never pay more than the cost to build a comparable building

Valuation approaches - Sale
comparison approach

Value of subjected property = sales prices of comparable properties ± adjustments for differences
Differences may relate to : size, age, location, property condition, market conditions
- Upward adjustments for undesirable difference with subject property
- Downward adjustments for desirable difference with subject property

Highest and best use

Highest and best use : the use that produces highest implied land value
Implied land value = Value of property once contruction is completed - Cost of constructing the improvement (including profit to the developer)

Due diligence in private equity real Due diligence : to confirm the fact + conditions that might affect the value of the transaction→ lower the risk of unexpected legal and physical problems
estate investment
- Lease review and rental history
- Confirm OPEX by examining bills
- Review CF statements
- Obtain environment report → iden fy possible contamina on
- Physical / Engineer inspection → iden fy structural issues + Check condi on of the building system
- Inspect the title and other legal documents for deficiencies
- Survey the property → confirm the boundaries + iden fy easements
- Verify compliance with zoning laws, building codes and environment regulations
- Verify payment of taxes, insurance, special assessments and other expenditures

Appraisal-based indices

Appraisal-based indices: combine valuations of individual properties that can be used to measure market movements → could compare performance with other asset classes
MCREIF Property index (NPI) : popular index in US
...
𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒
𝑁𝑂𝐼
𝐸𝑛𝑑 𝑀𝑉 − 𝐵𝑒𝑔
...
𝑀𝑉
𝐵𝑒𝑔
...

capital
return𝑣𝑎𝑙𝑢𝑒
Cons of appraisal-based indices :
- Actual transactions occur before appraisals → appraisal-based indices tend to lag actual transac on → smooth the index
- Appraisal lag → lowe correla on with other asset classes

Transaction-based Indices

Transaction-based indices : constructed using repeat-sales index and hedonic index
Repeat-sale index : rely on repeat sale of same property → regression is developed to allocate change in value each quarter
Hedonic index : require only 1 sale → regression is developed based on changes in property characteris cs (age, loca on, etc
...
Real Estate Investment Trusts (REITs)
securities
- Tax-advantaged companies (exempt from CIT)
- Actively managed
- Own income-producing real estate
- Seek to profit by growing CF, improving existing properties, and purchase additional properties
- Specialised in particular kind of property, and diversify by geography and other factors
2
...
Residential / Commercial mortgage-backed securities (MBS) :
- Publicly traded asset-backed securitised debt obligations
- Receive CF from underlying pool of mortgage loans
4
...
g
...
g
...
)
- Active professional management
- Protections accorded to publicly traded securities (rules to financial reporting,
disclosure and governance
- Greater potential for diversification

Drawback

- Taxes vs Direct ownership (Direct ownership could deduct losses on real estate from
taxable income / replace one property with other property without tax on the gains)
- Lack of control
- Costs of publicly traded corporate structure
- Price is determined by stock market
- Structural conflict of interest

- Taxes vs Direct ownership (Direct ownership could deduct losses on real estate from
taxable income / replace one property with other property without tax on the gains)
- Lack of control
- Costs of publicly traded corporate structure
- Price is determined by stock market
- Structural conflict of interest
- Limited potential for growth (due to high payout ratio)
- Forced equity issuance (participate in bond markets to refinance maturing debt to
maintain leverage
...
Exemption from CIT
2
...
Low income volatility : REITs' rental income is fixed by contracts
4
...
Remaining lease term :
- Short remaining lease term → opprtunity to raise rents in expansionary economy
- Long remaining lease term → advantageous in declining economy / so ening rental market
2
...
In-place rents vs
...
Cost to re-lease space : lost rent, new lease incentives offered, cost of tenant-demand improvement, and broker commission when the lease expires
5
...
Tenant's financial health
7
...
BS analysis : special focus on amount of leverage, cost of debt, and debt's maturity
9
...

demand

- Long lease term (5-25 yrs)
- Stable demand

- Change in office vacancy and
rental rates over the econ cycle

- new space under construction
- Quality of office space (location, building condition, etc
...

demand

- REITs lease faciities to healthcare - Demographic
providers
- Gov
...
demand

Industrial

- retail sales growth
- Population growth

- Less cycle than some other REIT - Shift in compsition of local and
types
national industrial bases and trade
- 5-25 yrs net lease
- Slow change in income and values

- Trends intenants' requirements
- Obsolescence of existing space
- Need for new types of space
- Proximity to transportation
- Trends in local supply and demand

Hotel

- Job creation
- New space supply vs
...
industry avg
...
𝑜𝑓 𝑆ℎ𝑎𝑟𝑒 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
𝑁𝑜
...
: 𝑑𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑡𝑎𝑥 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
Liability will not be paid for many years
−𝐺𝑎𝑖𝑛𝑠 𝑓𝑟𝑜𝑚 𝑠𝑎𝑙𝑒𝑠 𝑜𝑓 𝑝𝑟𝑜𝑝𝑒𝑟𝑡𝑦 𝑎𝑛𝑑 𝑑𝑒𝑏𝑡 𝑟𝑒𝑠𝑡𝑟𝑢𝑐𝑡𝑢𝑟𝑖𝑛𝑔
Considered as part of continuing income
+𝐿𝑜𝑠𝑠𝑒𝑠 𝑓𝑟𝑜𝑚 𝑠𝑎𝑙𝑒𝑠 𝑜𝑓 𝑝𝑟𝑜𝑝𝑒𝑟𝑡𝑦 𝑎𝑛𝑑 𝑑𝑒𝑏𝑡 𝑟𝑒𝑠𝑡𝑟𝑢𝑐𝑡𝑢𝑟𝑖𝑛𝑔
Considered as part of continuing income
= 𝐹𝑢𝑛𝑑𝑠 𝑓𝑟𝑜𝑚 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛

Adjusted funds from operations
(AFFO)

Adjusted funds from operation (AFFO) : extension of FFO
...
Income than FFO, due to consider CAPEX required to sustain the property's economic income
AFFO also relies more on estimates → more subjec ve

𝐹𝐹𝑂
−𝑁𝑜𝑛 𝑐𝑎𝑠ℎ 𝑠𝑡𝑟𝑎𝑖𝑔ℎ𝑡 𝑙𝑖𝑛𝑒 𝑟𝑒𝑛𝑡 𝑎𝑑𝑗𝑢𝑠𝑡𝑒𝑛𝑡
−𝑅𝑒𝑐𝑢𝑟𝑟𝑖𝑛𝑔 𝑚𝑎𝑖𝑛𝑡𝑒𝑛𝑎𝑛𝑐𝑒 𝑡𝑦𝑝𝑒 𝐶𝐴𝑃𝐸𝑋 𝑎𝑛𝑑 𝑙𝑒𝑎𝑠𝑖𝑛𝑔 𝑐𝑜𝑚𝑚𝑖𝑠𝑠𝑖𝑜𝑛
= 𝐴𝐹𝐹𝑂
Valuation of REITs and REOCs

1
...
Relative value (price-to-FFO and price-to-AFFO) : 3 impact factors
- Expectations for growth of FFO and AFFO
- Level of risks inherent in the underlying real estate
- Risk related to firm's leverage and access to capital
3
...
Ability to re-engineer the portfolio company and operate more efficiently : have in-house staff, including experienced industry CEOs, CFOs, and other former senior executives → can
equity
share expertise and contacts
2
...
Superior alignment of interest between management and private equity ownership
Control mechanism to align Private Terms of the private equity firm's investment are specified in the term sheet, including :
equity firm's interest with
1
...
Tag-along, drag-along clauses : when acquirer acquires control of the company → must extend the acquisiton offer to all shareholders, including firm management
3
...
Non-compete clauses : prevent company founders to compete againse the firm within a prespecified period
5
...
Required approvals : changes of strategic importance must be approved by the private equity firm
7
...
CF
2
...
Product
4
...
Management team

1
...
New product market with uncertain future
3
...
Weak
5
...
Individual member typically have strong
entrepreneurial record
6
...
Stable and predictable CF
2
...
Established products
4
...
Strong and experienced management team

6
...
Risk assessment
8
...
Operations
10
...
Due diligence
performed by PE firms
12
...
Investment return

7
...
Exit via IPO or company sales → difficult to forecast
9
...
Increasing requirement due to growth
11
...
Investigate of
financials is limited due to short history
12
...
plan and growth strategy
13
...
Not active in capital markets

14
...
Sales transactions
15
...
Ability to grow thru
16
...
Source of GP's variable 17
...
High debt + large % of senior debt + substantial amounts of junior and
mezzanine debt
7
...
Exit is predictable
9
...
Low working cap requirement
11
...
Goals reference CF, strategic plan and business plan
13
...
Active in capital markets
15
...
Stronger performance can increase subsequent funding amounts
17
...
DCF analysis : most appropriate for companies with significant operating history
- Beta and Cost of capital : estimated from public companies + adjustment for differences in operating and financial leverage
- Terminal value : calculated using price multiple of company's EBITDA
2
...
Real option analysis : applicable for immature companies with flexibility in their future strategies
4
...
Venture capital method
6
...
Control premium :
- Buyout : private equity investors have complete control
- Venture capital : private equity investors have minority position ; their control depends on the alignment of their interest with controlling shareholders interest
2
...
Illiquidity discount : ability to sell the company's shares
4
...
Target company's forecasted CF
2
...
Total amount of financing
(*) CF forecast : provided by target's management + scrutinise by the PE firm
(*) Exit date : evaluate @ different dates to determine its influence on the projected returns
(*) Value of the company @ exit date : forecast using relative value / market approach
Components of returns upon exit :
- Return on preference shares for PE firm
- Increased multiple upon exit
- Reduction in debt claims

Appropriate methods for Venture
capital valuation

Pre-money valuation and invesment : negotiate between investee company and VC investor
...
IPO :
- Highest exit value, due to increase in liquidity, access to capital, and potential to hire quality manager
- Less flexible, more costly and more cumbersome process
- Most appropriate for companies with strong growth prospects + significant operating history and size
2
...
Management buyout :
- Company is sold to manamgent, who utilised a large amount of leverage
- Although management will have strong interest in subsequent success of the company, high leverage may limit management's flexibility
4
...
g
...
These fees are usually split evenly with the LPs, and are deducted from management fees
- Carried interest / Performance fee : GP's share of fund profit
- Ratchet : specify the allocation of equity between stockholders and management of the portfolio company, allow management to increase their allocation, depend on company's
performance
- Hurdle rate : IRR that the fund must meet before GP can receive carried interest
- Target fund size : maximum of PE fund size
- Vintage : fund's age
- Term of the fund : Life of the firm

Private equity fund terms Corporate Governance terms

- Key man clause : key named executive leaves the fund / does not spend sufficient amount of time at fund → GP may be prohibited from making addi onal investments un l another key
executive is selected
- Performance disclosure and confidentiality : specify fund performance information that can be disclosed
...
At cost, adjusting for subsequent financing and devaluation
2
...
by revaluing portfolio company anytime there is new financing
4
...
Using discount factor for restricted securities
6
...
If NAV is only adjusted when there are subsequent rounds of financing → NAV will be more stale when financings are infrequent
2
...
Undraw LP capital commitments are not included in NAV calculation, but are liabilities for LP
...
GP has trouble raising
funds → value of these commitments is low
4
...

- Early stages : VC investment value @ cost
- Later stages : value method based on comparables
- Mature : use market comparables for investemtns that near exit
5
...
PE funds have returns that tend to persist : Outperformers → keep outperforming; Underperformers → keep underperforming
2
...
PE investments are usually illiquid, LT investments
...
Liquidity risk : PE investment are not publicly traded → difficult to liquidate
2
...
Competitive environment risk : high competition for finding reasonably-priced PE investment
4
...
Capital risk : Increase in business and financial risk → withdrawal of capital + subequent rounds of financing are difficult to obtain by por olio company
6
...
Tax risk : tax treatment of investment returns may change overtime
8
...
Diversification risk : PE investment may be poorly diversified
10
...
Transaction costs : include due diligence, bank financing, legal fees from acquisitions, sakes transactions in portfolio companies
2
...
Administrative costs : charged on a yearly basis, include custodian, transfer agent and accounting costs
4
...
Management and performance costs
6
...
Placement fees : for agents who raise funds for PE firms

Compare financial performance of 1
...
Multiples : popular tools, due to simplicity, ease of use, ability to differentiate between realised and unrealised returns, but ignore time value of money
- Quantitative measures
+ Paid-in capital (PIC) : Cummulative capital utilised by GP
+ Distributed to paid-in capital (DPI) : measure LP's realised return

𝐶𝑢𝑚𝑚𝑢𝑙𝑎𝑡𝑒𝑑 𝑑𝑖𝑠𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑝𝑎𝑖𝑑 𝑡𝑜 𝐿𝑃𝑠 (𝑛𝑒𝑡 𝑜𝑓 𝑚𝑎𝑛𝑎𝑔𝑒𝑚𝑒𝑛𝑡 𝑓𝑒𝑒 𝑎𝑛𝑑 𝑐𝑎𝑟𝑟𝑖𝑒𝑑 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡)
𝐷𝑖𝑠𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑡𝑜 𝑝𝑎𝑖𝑑 𝑖𝑛 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 =
𝐶𝑢𝑚𝑚𝑢𝑙𝑎𝑡𝑒𝑑 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
+ Residual value to paid-in capital (RVPI) : measure LP's unrealised return

𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐿𝑃𝑠 ℎ𝑜𝑙𝑑𝑖𝑛𝑔 𝑖𝑛 𝑡ℎ𝑒 𝑓𝑢𝑛𝑑 (𝑛𝑒𝑡 𝑜𝑓 𝑚𝑎𝑛𝑎𝑔𝑒𝑚𝑒𝑛𝑡 𝑓𝑒𝑒 𝑎𝑛𝑑 𝑐𝑎𝑟𝑟𝑖𝑒𝑑 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡)
𝑅𝑒𝑠𝑖𝑑𝑢𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑡𝑜 𝑝𝑎𝑖𝑑 𝑖𝑛 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 =
𝐶𝑢𝑚𝑚𝑢𝑙𝑎𝑡𝑒𝑑 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
+ Total value to paid-in capital (TVPI) = DPI + RVPI
- Qualitative measures
+ Realised investments, with evaluation of successes and failures
+ Unrealised investment, with valuation of exit horizons and potential problems
+ CF projections at the fund and portfolio company level
+ Fund valuation, NAV, and FS
3
...
Adjusting discount
rate : to reflect the risk that the company may fail in any given year
1+𝑟
𝑟∗ =
−1
1−𝑞
𝑟 ∗ = 𝑎𝑑𝑗𝑢𝑠𝑡𝑒𝑑 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑟𝑎𝑡𝑒
𝑞 = 𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝑓𝑎𝑖𝑙𝑢𝑟𝑒
2
...
Energy - Crude oil, natural gas, refined petroleum products
2
...
Grains - Wheat, Soy beans, Corn, and rice
4
...
Precious metals - gold, silver and platinum
6
...
Crude oil :
- Light oil (low viscocity) + sweet oil (low sulfur content) : less costly to refine → sell @ premium rela ve to heavier or higher sulfur crude oils
- Can be stored indefinitely
- Factors that drive demand / supply for crude oil:
+ Global economic growth → increase demand
+ Improvement in refining technology → more petroleum dis llates output per barrel of crude oil → decrease demand
+ Improved engines → more work from each gallon of dis llates → decreasse demand
+ Econ
...
Refined products : gasoline, heating oil, jetfuel
- Can be stored for short period
- Factors that drive demand / supply for refined products:
+ Geographic concentrtion of refinery capacity → extreme weather can decrease supply
+ Seasonal factors : Summer → increase vaca on travel → increasse gasoline demand ; Winter → increase demand for hea ng oil
3
...
Natural gas can be transported via pipe, or cooled down to its liquid state to be transported by ship
- Factors that drive demand / supply for natural gas:
+ Associated gas (gas harvested during the extraction of crude oil) → supply ed to produc on of crude oil
+ Unassociated gas → supply does not e to demand / produc on of crude oil
+ Same factors with crude oil
+ Seasonal factors : Summer → increase gas demand as fuel for electrical power genera on for cooling ; Winter → increase gas demand for hea ng fuel

Characteristic of industrial metals

- Factors that drive demand / supply of industrial metals
+ GDP growth + Business cycle : metals are used extensively in construction and manufacturing
+ Political factors (union strikes, restrictive environmental regulations) : significant impact on supply
- Low storage cost
- Mines + Smelters : large-scale operations with high developmen costs and high fixed costs

Characteristic of grains

- Grains are grown over an annual cycle and stored
- Important for feeding world's population + potential for political instability when grain stocks are insufficient
- Factors that affect supply of grains : droughts, hails, floods, pests, diseases, changes in climate, etc

Characteristic of precious metals

- Used in electronics and jewelry
- Can be stored indefinitely
- Gold : used as stored of value + hedge against inflation risk
- Factors that affect supply / demand of precious metals :
+ Wealth accumulated
+ Business cycle

Characteristic of livestock

- Factors that affect supply / demand of livestock :
+ Weather and disease → affect supply
+ Income growth in developing countries → affect demand
+ Price of grain (primary input in production) → affect supply
...
Drill well → 2
...
transport + strorage for few months → 4
...
transport to customers
Life cycle of natural gas
1
...
transporta on to consumer thru pipeline / or cooled to liquid form and transported by ship
Life cycle of industrial metals
1
...
Smelted into the quality of metal required by end users
(*) Economies of scale due to large, efficient mining and smelting operations → most efficient running near capacity → producers hesistant to decrease produc on when price fall
Life cycle of lifestock
1
...
Slaughter (chichken : a er weeks ; hogs : 6 months ; ca le : few years) → 3
...
Plant → 2
...
Storage
(*) Deliverable futures contracts are available on dates to coincide with the harvest
Life cycle of softs - vary by products
E
...
: Coffee
1
...
Harvest (up to 4 years a er plant for the 1st harvest) → 3
...
Roasted by local roaster → 5
...
Commodities are physical assets, have no CF, and may incur storage and transportation costs
vs
...
Spot price of commodity can be viewed as discounted value of expected future selling price
3
...
Hedgers :
- Informed investors, either produce or use the commodity
- Reduce risk by long / short futures contracts
2
...
Arbitrageurs :
- Buying, selling, storing the physical commodities when the differnce between spot and futures price is too large / too small, due to the actual cost of storing the commodity
- Futures price > Spot price + Storage cost → buy and store commodity + short futures
- Futures price < Spot price + Storage cost → Selling commodity + long futures
4
...
Commodity market analysts : non-market participants, use information to analyse for various entities
6
...
Insurance theory : Commodity producers want to reduce price risk → drives down futures price
- Disadvantages : lack based on 2 empirical findings
+ No buyers' extra returns for providing insurance in backwardation markets
+ Cannot explain the buyers' negative return for providing insurance in contango markets
2
...
Theory of storage : Backwardation / Contango futures markets depends on the relationship between storage costs of the commodity and benefits of holding physical commodity
(Convenience yield)
Future price = Spot price + Storage costs - Convenience yield
→ Storage costs < Convenience yield → Backwarda on
→ Storage costs > Convenience yield → Contango
- To take position in futures, investor must post collateral
- Fully collateralised futures : Value of posted cash / accepted securities = notional value of futures contract
Total return = Collateral return + Price return + Roll return
Collateral return (Collateral yield) : holding period yield on the T-bills, if T-bills are deposited as collateral
Price return (Spot yield) = (Current return - Previous price) / Previous price
Roll return (Roll yield) : gains / losses for rollover the position of the future when commodity deriative contract expires
- Backwardation market : longer-dated futures are trading @ lower price → buy more contracts to hold the value of long posi on
- Contango market : longer-dated futures are trading @ higher price → buy less contracts to hold the value of long posi on

𝑅𝑜𝑙𝑙 𝑟𝑒𝑡𝑢𝑟𝑛 =

𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑒𝑥𝑝𝑖𝑟𝑖𝑛𝑔 𝑓𝑢𝑡𝑢𝑟𝑒𝑠 𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡 − 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑛𝑒𝑤 𝑓𝑢𝑡𝑢𝑟𝑒𝑠 𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡
𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑒𝑥𝑝𝑖𝑟𝑖𝑛𝑔 𝑓𝑢𝑡𝑢𝑟𝑒𝑠 𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡

Commodity swap

Swaps :
- payments between 2 parties are based on various risk factors : excess returns, total returns of measure of price volatility on the commodity
- Used to increase / decrease exposure to comodities risk
1
...
Excess return swap :
- A party makes a single payment @ initiation, and receive periodic payments of (% of commodity price exceeding benchmark value × notional value)
- In months that commodity price < benchmark value → no payments are made
3
...
Commodity volatility swap :
- Underlying factor : volatility of commodity price
- Volatility of commodity price > expected level specified in the swap → swap buyer receives payment
- Volatility of commodity price < expected level specified in the swap → swap seller receives payment

Commodity index

- Commodity index should be investable : able to replicate with available liquid futures contracts
- Differences between commodity indexes
+ Which commodities are included
+ Weighting of each included commodity
+ Method for rolling contracts
+ Method of rebalancing portfolio weights
- Short period : difference in metodology → return differences
- Long period : difference between mix and weights of commodities → return differences
- Indexes may be equal weighted, or weighted on some factors (e
...
: value of global production of individual commodity / commodity sector)
- Roll method : Passive (roll into near-month contract each month), or Active (select contract woth greatest backwardation / smallest contango)
- Frequency of rebalancing affects commodity index returns

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