To enable investment in commodity markets, several indices have been designed to measure commodity market performance over time. They trace the yield or return of one or several commodity markers. It often pertains a basket of the most liquid commodity futures. Sub-indices are defined as well, allowing investors to build exposure to specific sectors of activity. Index composition and the relative weight of each marker vary per index.
Contract are on a physical commodity, to guarantee correlation between the index and general price movements in the commodities markets. Annual production and trading volumes in USD terms of the commodity underlying the contract must be of the magnitude of several billions. The contract must be liquid and actively traded to guarantee reliable, competitive prices.
Contract must have a specified expiration schedule and be tradable several months before its expiry.
Daily release of reliable data
Reference contract prices must be available daily and reliable sources should exist for the production volume data. To safeguard continuity, only proven contract, existing for a couple of years are considered.
Contract must be traded on a facility accepting bids and offers from a broad range of participants and making price quotations generally available to all participants.
Relative weight of each contract in the index basket is based on its economical relevance in terms of both production and trade volume (liquidity). Exact calculus is specific to each index, but entails following steps:
- Over a specified observation period (usually the most recent 5 years for which data have been released), worldwide production quantity is compiled from reliable sources for each commodity and each year. Those production figures are then expressed in the quantity unit of the designated contract of each underlying commodity and sometimes resized (however without affecting relative percentages).
- Those production figures are then expressed in USD terms, by multiplying production data for each commodity with the reference (settlement) price of the corresponding designated contract. Which settlement prices are taken and how they are averaged along the observation period is specific to each index.
- Further adjustments may happen, such as:
- Balancing between production data for each underlying commodity and trading volumes data for the corresponding designated contracts.
- Promote diversification by capping the overall weight of individual commodities or a group of related commodities (asset).
- At each step, verify eligibility criteria and if required, eliminate thin tails, excluding commodities which contribution falls below certain designated tresholds.
The outcome of this calculus is the Economic Weight (EW) or the relative percentage weight of each contract in the index. As stated, it is based primarily on production and liquidity data, further adjusted by the index composition rules. It translates the relative economic importance of each commodity into the percentage of the corresponding designated contract in the index composition. All weights should sum up to 100%. Those figures are reviewed on a regular basis (usually anually) and published well in advance of taking effect.
The index value is calculated daily. It is roughly the sum for all contracts of its reference price multiplied by its economic weight. In this multiplication one should consider as well the pricing terms of each contract, with heterogeneous lotsizes and quantity units. Economic Weight is thus normalized in USD terms, to express relative contribution of each contract to the total USD value of the index, called Index Value (IV). The relative contribution of each contract to the Index Value obviously varies daily, based on its reference price, but to ease the calculus, the different indices methodologies foresee pre-defined dates when this normalization will happen. This first calculation step is further adjusted to minimize jumps in relative contribution from one calculation period to the other. The result is a single factor per contract or Contract Weight (CW), which remains valid for an entire calculation period (often yearly), until the index is balanced again. We give hereafter a simplified example:
To avoid illiquid maturities, each index defines a specific expiration schedule, detailing for each calendar month which contract maturities (expirations) are considered to retrieve the reference prices.
To smooth transition from one maturity to the other, a so-called roll period is defined, during which the Index Value is gradually shifted from utilization of the Reference Price of the nearby contract to this of the next contract, at a rate which is usually equal to 1 divided by the number of days in the roll period (e.g. for 5 days roll: 0.8 Nearby + 0.2 Next, 0.6 + 0.4, 0.4 + 0.6, 0.2 + 0.8, 0 + 1). This is reiterated each month.
In January of each year, rolling applies not only on the Reference Prices of contract maturities, but as well on the Contract Weights of previous versus current year. Roll period and phasing in/out rates are identical to those of the Reference Prices.
If a Reference Price for one of the contracts is not available (market disruption) on a given day, postponement of rolling is foreseen according rules specific to each index.
On any given business day, the Index Value or Total Dollar Weight of the basket, equals:
Most adopted indices