Page 59 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Derivatives & Risk Management

Notes and specific to commodities. It is called the convenience yield, which refers to the "benefit" the
holder derives from physical possession of commodity. Consider, for example, a manufacturer
that uses the commodity as raw material. He would like to always store certain quantity of raw
material to ensure that the production process is not halted for want of raw material. We say that
there is a convenience yield by possessing the raw material.
The futures price of a commodity is now given by
Futures Price = Spot Price + Interest Cost + Storage & Insurance Cost – Cash Yield
– Convenience Yield
Thus, storage and insurance is the additional component in carry cost, and convenience yield is
the additional component in carry return. Unlike all other components, convenience yield is not
computable. We can compute it only if the futures price is given. This brings us to the important
point that the futures prices are an important source of information. From the traded futures
price, we can estimate the convenience yield of a commodity, which is otherwise not computable
or even readily observable.

Self Assessment

Fill in the blanks:
6. Cost-of-carry model is an ………………pricing model.
7. The theoretical price of a futures contract is spot price of the underlying plus the ……………...
8. Carry costs = Cost of funds + …………….. – convenience yield.
9. A ……………… traces the changes in the value of a hypothetical portfolio of stocks.

10. ……………= Spot Price + Interest Cost + Storage & Insurance Cost – Cash Yield –
Convenience Yield.

5.3 Beta

Beta is a measure of the systematic risk of a security that cannot be avoided through diversification.
Beta is a relative measure of risk-the risk of an individual stock relative to the market portfolio
of all stocks. If the security's returns move more (less) than the market's returns as the latter
changes, the security's returns have more (less) volatility (fluctuations in price) than those of the
market. It is important to note that beta measures a security's volatility, or fluctuations in price,
relative to a benchmark, the market portfolio of all stocks.
Securities with different slopes have different sensitivities to the returns of the market index. If
the slope of this relationship for a particular security is a 45-degree angle, the beta is 1.0. This
means that for every one per cent change in the market's return, on average this security's
returns change 1%. The market portfolio has a beta of 1.0. A security with a beta of 1.5 indicates
that, on average, security returns are 1.5 times as volatile as market returns, both up and down.
This would be considered an aggressive security because when the overall market return rises
or falls 10%, this security, on average, would rise or fall 15%. Stocks having a beta of less than 1.0
would be considered more conservative investments than the overall market.
Beta is useful for comparing the relative systematic risk of different stocks and, in practice, is
used by investors to judge a stock's riskiness. Stocks can be ranked by their betas. Because the
variance of the market is constant across all securities for a particular period, ranking stocks by
beta is the same as ranking them by their absolute systematic risk. Stocks with high betas are
said to be high-risk securities.

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