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Reading 37 introduction to commodities and commodity

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Reading 37Introduction to Commodities and Commodity Derivatives35411.2Bloomberg Commodity IndexThe BCOM (formerly the DJ–UBS) is based on 23 commodities. It includes liquidity asboth a weighting factor and a screening factor, although the index is selection- based,meaning a committee uses judgment to pick the included commodities. The rulesof index construction also place caps on the size of the sectors (33% maximum) andfloors on individual commodities (2% minimum). These differences mean that verydifferent index composition and weights can occur. For example, the energy sectorcurrently dominates the S&P GSCI (as high as 80% weight), whereas the BCOM’sexposure is much lower (approximately 30%). However, exposure to natural gas as asingle component of energy is higher in the BCOM (approximately 9%) than in theS&P GSCI (approximately 3%). Given that natural gas had an annualized roll cost ofabout 19% (often the highest roll cost of all the commodities), the higher weightingof natural gas in the BCOM implies that the index has to find other sources of return(e.g., price return and rebalance return) to overcome the drag that natural gas inven-tory storage creates through negative roll return. The rolling methodology focuses onowning the front (i.e., near-term) contracts.11.3Deutsche Bank Liquid Commodity IndexThe DBLCI uses a fixed-weighting scheme to allocate exposure. The most notable/unique feature of this index is its rolling methodology. Instead of focusing on near-term contracts, it is optimized based on the time value of maximized backwardation/minimized contango for the contracts that fall within the next 12 calendar months. Asan example, a June 2014 copper futures contract may be at 1% backwardation versus aMay 2014 copper contract. But if the July 2014 copper contract is at a 3% backward-ation (1.5% per month, or 3% divided by two months) versus the 1% backwardationper month on the June 2014 contract, then the DBLCI will roll to the July 2014 con-tract in preference to the June 2014 contract. Therefore, one could argue the DBLCItakes an active decision with regard to roll return positioning as compared with theother indexes.11.4Thomson Reuters/CoreCommodity CRB IndexThe TR/CC CRB consists of 19 commodities and is a continuation of the first investablecommodity index published by the Commodities Research Bureau in 1978 (although anearlier iteration started in 1957). It uses a fixed-weighting scheme to allocate exposure.An index management committee decides the weights based on a number of factors,including diversification, sector representation, liquidity, and economic importance.It also clusters the fixed weights into a number of tiers. As a result, constituents aremoved from tier to tier. The rolling methodology focuses on owning the front (i.e.,near-term) contracts that mechanically focus on the front month or second frontmonth and do not require a particular calculation.

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