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CFA Level II · CFA Level II Exam

Introduction to Commodities and Commodity Derivatives for CFA Level II

This chapter covers commodity sectors, spot, forward and futures markets, the shape of futures curves, theories of futures returns, the components of commodity returns, and index access. To solve questions, read the futures prices in the vignette, classify the curve, then compute roll yield or total return by component.

What this chapter covers

This chapter explains how commodities differ from stocks and bonds. They are real assets with no cash flows, so their prices depend on supply, demand, storage and transport. You learn the main sectors (energy, grains, industrial and precious metals, livestock, softs) and how each behaves.

The core of the chapter is the futures curve. You learn why futures prices differ from spot, what contango and backwardation mean, and how the convenience yield and storage costs shape the curve. Then you study theories of futures returns, such as insurance theory, hedging pressure, and the theory of storage. You finish with return components (spot return, roll yield, collateral return) and the main commodity indexes.

The chapter links to the Derivatives and Risk Management, Alternative Investments and Portfolio Construction material. Cost-of-carry logic from forwards and futures reappears here. Commodities also appear as a diversifier and inflation hedge in portfolio questions. In the exam, it is tested inside an item set, so you must pull the right prices and dates from the vignette and then apply the concept.

Commodities sit inside the Alternative Investments block, which carries a modest weight, but the chapter is compact and highly rule-based. Once you can read a futures curve and split a return into components, most questions become routine and you can bank points quickly. Because every question comes from a vignette, the marks go to candidates who can find the relevant prices, classify the curve and avoid sign errors, not to those who only memorise definitions. Since there is no minimum score per topic, a strong result here can offset weaker areas elsewhere.

Introduction to Commodities and Commodity Derivatives: topics in the order to study them

  1. 1Commodity Sectors and Market FeaturesStart here to learn the vocabulary and why commodities behave differently from financial assets, since later topics build on it.
  2. 2Commodity Spot, Forward and Futures MarketsYou need to know how spot and derivative prices relate, and who uses them, before you can read a futures curve.
  3. 3Futures Curves: Contango and BackwardationThis is the core concept. It uses the spot-futures link and drives every return calculation that follows.
  4. 4Theories of Commodity Futures ReturnsThese theories explain why curves take their shape and why futures may differ from expected spot prices, so study them once the curve shapes are clear.
  5. 5Commodity Return Components and Roll YieldThis is the calculation section. It needs the curve shapes and the theories as background, so it comes after them.
  6. 6Commodity Indexes and Investment AccessLast, because index design and access methods apply the return components and curve ideas to real products.

How to prepare Introduction to Commodities and Commodity Derivatives

Treat this as a concept chapter with a small set of calculations. Aim to explain each idea in a sentence and then apply it to numbers in a vignette.

  1. Read the sector material once, quickly, and note the main drivers of each sector, such as storage costs, seasonality and weather.
  2. Draw a futures curve for contango and one for backwardation. Write beside each what it implies for roll yield and for the convenience yield.
  3. Learn the three or four theories of futures returns and write one line each on what they predict about the curve and returns.
  4. Practise return decomposition: spot return, roll yield and collateral return. Always check the sign of roll yield before you compute.
  5. Compare index designs in a short table you make yourself: weighting, roll rules and sector tilts, and which choices affect returns.
  6. Do full item sets. For each, mark the futures prices and contract months in the vignette before reading the questions.
  7. Finish by redoing the questions you missed and explaining each error in one sentence.

Common mistakes in Introduction to Commodities and Commodity Derivatives

  • Getting the sign of roll yield wrong

    Fix: For a long position, roll yield = (nearby futures price − farther futures price) ÷ nearby (or spot) price. It is positive in backwardation and negative in contango. The sign reverses for a short position. Check that the sign matches the curve shape and your position.

  • Confusing the curve shape with the direction of price movement

    Fix: Describe the curve only by comparing futures prices across maturities and to spot, and keep the price outlook as a separate question.

  • Mixing up the theories of futures returns

    Fix: Write one line for each theory with its key actor or driver, such as hedgers and speculators for insurance theory, and inventories for storage theory.

  • Using the wrong contracts from the vignette

    Fix: Underline the contract months before answering, and match each price to the position you actually hold or roll.

  • Leaving out collateral return in total return

    Fix: For a fully collateralised position, add the return on the collateral as a separate component whenever the vignette gives an interest rate.

  • Treating all commodity index products as the same

    Fix: Compare the weighting method, roll rule and sector mix, and remember that tracking products carry costs and tracking error.

Last-day revision: Introduction to Commodities and Commodity Derivatives

  • Commodities are real assets with no cash flows, so returns come from price changes and the futures structure.
  • Contango: futures prices are above spot, and longer-dated futures are higher than shorter-dated ones.
  • Backwardation: futures prices are below spot, and longer-dated futures are lower than shorter-dated ones.
  • Rolling a long position in contango usually gives negative roll yield, since you buy the higher-priced contract later.
  • Rolling a long position in backwardation usually gives positive roll yield.
  • A high convenience yield pushes the curve toward backwardation; high storage costs push it toward contango.
  • Total return on a fully collateralised futures position = spot return + roll yield + collateral return.
  • Insurance theory (normal backwardation in the Keynes sense) implies futures prices are below expected future spot prices, because hedgers pay a premium to speculators, so long positions earn a risk premium. This is a statement about futures versus expected spot, which is distinct from the curve shape comparing futures with current spot.
  • The theory of storage links the curve to inventory levels, storage costs and convenience yield.
  • Index design choices, such as weights and roll rules, can change returns even when the same commodities are held.
  • Investors can access commodities through futures, funds, ETFs, equities of producers or notes, each with different tracking risks.
  • Read the contract months in the vignette carefully, because roll yield depends on which two contracts you compare.

Introduction to Commodities and Commodity Derivatives in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Introduction to Commodities and Commodity Derivatives: frequently asked questions

How do I tell contango from backwardation in a vignette?

Compare the futures prices with the spot price and with each other across maturities. If longer-dated futures cost more, it is contango. If they cost less, it is backwardation.

What is roll yield in simple terms?

It is the gain or loss from replacing an expiring futures contract with a later one while holding a position. In backwardation it is usually positive for a long position, and in contango it is usually negative.

Is this chapter mostly calculation or theory?

It is a mix, with more concept than calculation. The numbers are usually simple, but you must pick the right data and interpret the sign correctly.

Do I need to memorise the commodity indexes?

You should know the main design features, such as weighting and roll rules, and how they affect returns. Focus on understanding how differences in design change outcomes rather than on memorising details.