Chartered Financial Analyst Level 2

Explanation

Commodity futures are primarily valued based on supply and demand for the physical item (Option B), which is fundamentally different from how equities and bonds are valued.

Key Differences:

Equities and Bonds Valuation:

• Equities: Valued based on future profitability, discounted cash flows, and company earnings
• Bonds: Valued based on future cash flows (coupon payments and principal repayment), discounted at appropriate interest rates

Commodity Futures Valuation:

• Supply factors: Production levels, weather conditions, geopolitical events, extraction costs
• Demand factors: Industrial usage, consumer consumption, economic growth, seasonal patterns
• Storage costs and convenience yields: Physical storage considerations affect futures pricing
• No cash flows: Unlike equities and bonds, commodities don't generate ongoing cash flows while held

Why Option B is Correct:

Commodity futures prices are determined by the expected future spot price of the physical commodity, which is driven by fundamental supply and demand dynamics in the physical markets. This contrasts with financial assets like stocks and bonds that derive value from expected future cash flows.

Why Other Options are Incorrect:

• Option A (future profitability): This applies to equities, not commodities
• Option C (cash flows generated): Commodities don't generate cash flows while held; this applies to bonds and dividend-paying stocks

This fundamental difference in valuation approaches is why commodity futures are often used as portfolio diversifiers.