Valuation of Commodities in Contrast to Equities and Bonds

We can use the following modes of valuation to compare commodities and equities.

Nature of Asset

Commodities are mostly physical or tangible assets, e.g., a lump of gold, a pile of corn, etc., except for some energy commodities, e.g., electricity. Equities and bonds are intangible.

Return on Investment

Commodities are intrinsic with variable economic value. They also don’t generate future cash flows since they trade in derivative contracts with finite lifetimes, e.g., future contracts. Equities and bonds have a claim on the economic output of a firm,i.e., profits. They also generate future cash flow.

Price Determinants

For commodities, the forward price and future contracts are affected by demand and supply, ongoing expenditures, e.g., transportation and storage costs. Equities and bonds receive periodic income hence they are not affected by ongoing expenditures, e.g., storage and transportation costs.

Terms of Delivery

Some commodity contracts require actual delivery of the physical commodity. Equity and bonds are settled through cash payments.

Arbitrage Process

It is difficult to arbitrage commodity prices since some participants cannot make or take delivery of the physical commodity. It is easy to arbitrage equity and bond prices.

Question

Which of the following is most likely a key difference between the valuation of commodities and valuation of stocks and bonds?

1. Valuation of stocks and bonds focuses on future supply and demand, whereas commodity valuation focuses on future profit margins and cash flow.
2. The valuation of commodities focuses on supply and demand, whereas the valuation of stocks and bonds focuses on discounted cash flows.
3. Valuation of commodities cannot be conducted using technical analysis.

Solution

The correct answer is B.

Valuation of commodities is based on a forecast of future prices based on supply and demand factors and expected price volatility. In contrast, valuation of stocks and bonds is based on estimating future profitability and cash flow.

A is incorrect. Choice B provides a stuck contrast to this position.

C is incorrect. Technical analysis is sometimes applied to valuing commodities.

Reading 35: Introduction to Commodities and Commodity Derivatives

LOS 35 (c) Contrast the valuation of commodities with the valuation of equities and bonds.

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