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7/29/2019 A Study on Commodity Derivative
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A Study
on
Commodity
Derivatives
Group:
Rajeev Gupta
Kumar Bhaskar
Chander Mohan Chugh
Sanjay Kumar Sekhardeo
PGEXP-2011-13
IIM- Ranchi
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OVERVIEW: COMMODITY DERIVATIVE AND ITS IMPORTANCE
Commodities are the oldest asset class known to man but perhaps one of the least understood
today. For thousands of years, commodities have been traded in bulk or in the form of
promissory notes at a standardised quantity for a given price.
Dating from time immemorial, farmers and merchants have used futures contracts to alleviate
some of the uncertainty involved in bringing the annual harvest to market. For the modern
investor, most commodities are traded on highly regulated exchanges and cash settlement is
the norm (as opposed to physical delivery). The wide spectrum of traded goods ranges from
grains and livestock to industrial materials such as iron ore and precious metals like gold and
rhodium. One of the primary advantages commodities provide is a measure of global
exposure that crosses the divide between developed and emerging economies. Other
attractive aspects include the relatively low level of historical correlation with other asset
classes. Empirical evidence shows their potential for use in downside risk management.
In the aftermath of the 2008 credit crisis, investment fundamentals have been reassessed as
never before. The role of non-correlated asset classes has been elevated as a critical factor for
institutions. The dynamics of the global economy have tilted in a market that emphasises new
factors. In particular, central banks around the world are becoming more actively involved in
asset markets, injecting vast amounts of liquidity and making full use of their policy arsenal
in an attempt to reignite faster economic growth and keep deflationary pricing at bay.
Meanwhile, most emerging markets have resumed their robust growth trajectories and have
to contend with higher rates of inflation. Against this macroeconomic backdrop, demand for
commodities has picked up in the emerging world and remains latent in the developed world.
Even if demand from the developed world does not recover any time soon, the structural shift
towards emerging economies coupled with stagnant production levels of commodities could
significantly impact the global demand and supply balance. All of which is not to say, of
course, that individual commodities prices will be spared the volatility that has become a
defining characteristic of the asset class. However, there is much more to commodities as an
investment than merely return and volatility. Commodities may affect the long-run downside
risk of a portfolio in times of extreme market stress and hence gained much importance of
late.
Amid all the uncertainty over past few years, we believe that commodities may be the most
relevant asset class for investors to consider as a refuge from extreme price movementsup
or down. In this paper, we have tried to understand and explain what a commodity is, how is
it useful as a financial derivative, a brief history and characteristics of the commodity
derivative market, and we have tied to examine the Indian Commodity Derivative market- its
functions characteristics and usefulness.
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CONTENTS
Sl.
NoTopic
Page
No.
1 What is Commodity? 42 Commodity Types & Examples 4
3 What is Commodity Derivative? 4
4 What is a Commodity Futures Contract? 4
5 Major Participants of Commodity Futures Market 5
6 The Commodity Market & Brief History 7
7 Commodity Exchanges in India 10
8 Commodity Market Structure 11
9 Commodity Eco-system 12
10 Indian Commodity Market Present Scenario 13
11 How to invest in Commodity Market 13
12 Characteristics of Commodity Market 15
13 Strategies for Trading In Commodities and Futures 16
14 Ways to trade in Commodity Market 16
15 Different Segments in Commodities Market 17
16 Risk associated with Commodities Market 18
17 Trend of global commodity price movement 18
18 Performance of Commodity derivatives & Macro-economy 19
19 Conclusion 22
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WHAT IS COMMODITY?
A commodity is an article, product or material/goods that can be produced, transported, bought
and sold in the market, except Actionable Claims, Money & Securities.
COMMODITY TYPES & EXAMPLES:
Metal & Alloys Gold, Silver, Aluminum, Copper, Lead, Zinc, Nickel, Tin, Iron, Steel etc.
Agricultural Products
& Plantations
Cereals, Pulses, Spices, Coffee, Vegetables, Oil & Oil seeds, Cotton Seed,
Rubber, Areca nut Cashew Kernel etc.
Raw Materials Iron Ore, Bauxite, Coal, Lignite,
Petrochemicals Crude Oil, Furnace Oil, Natural Gas, Coal-chemicalsFiber Cotton Staple, Cotton Yarn, Kapas
Precious Stones Diamond, Emerald, quartz, etc.
Others Anything which can be produced & transported except money & securities
HOW ARE COMMODITIES TRADED?
Trading of commodities consists of physical and derivatives trading. In this paper, though we
shall try to see trading of both, we will focus mainly on commodity derivatives that are traded on
exchanges and OTC derivatives markets.
WHAT IS COMMODITY DERIVATIVE?
Commodity Derivatives like other Financial Derivatives are basically Contracts i.e. Futures and
Options involving any of the above mentioned commodities as an underlying asset. The value of
the contract is derived from the underlying asset i.e. a commodity, hence the name Commodity
Derivative. Commodities actually offer immense potential to become a separate asset class for
market-savvy investors, arbitrageurs and speculators. Derivatives as a tool for managing risk first
originated from commodity trading only. They were then found useful as a hedging tool in many
financial markets for the Investors, Hedgers, Arbitrageurs and Day Traders.
WHAT IS A COMMODITY FUTURES CONTRACT?
Suppose a farmer of wheat is trying to secure a selling price for next season's crop, while a bread
maker may be trying to secure a buying price to determine how much bread can be made and at
what profit. So the farmer and the bread maker may enter into a futures contract requiring the
delivery of 5,000 bushels of grain to the buyer in June at a price of $4 per bushel. By entering into
this futures contract, the farmer and the bread maker secure a price that both parties believe will
be a fair price in June. It is this contract that can then be bought and sold in the commodity
market.
A futures contract is an agreement between two parties: a short position, the party who agrees todeliver a commodity, and a long position, the party who agrees to receive a commodity. In the
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above scenario, the farmer would be the holder of the short position (agreeing to sell) while the
bread maker would be the holder of the long (agreeing to buy). In every commodity contract,
everything is specified: the quantity and quality of the commodity, the specific price per unit, and
the date and method of delivery. The price of a futures contract is represented by the agreed -
upon price of the underlying commodity or financial instrument that will be delivered in the
future. For example, in the above scenario, the price of the contract is 5,000 bushels of grain at a
price of $4 per bushel. 2
The profits and losses of futures depend on the daily movements of the market for that contract
and are calculated on a daily basis. Unlike the stock market, futures positions are settled on a daily
basis, which means that gains and losses from a day's trading are deducted or credited to a
person's account each day. In the stock market, the capital gains or losses from movements in
price aren't realized until the investor decides to sell the stock or cover his or her short position.
As the accounts of the parties in futures contracts are adjusted every day, most transactions in the
futures market are settled in cash, and the actual physical commodity is bought or sold in the cash
market.
Prices in the cash and futures market tend to move parallel to one another, and when a futures
contract expires, the prices merge into one price. So on the date either party decides to close out
their futures position, the contract will be settled. Futures contract is really more like a financial
position. The two parties in the wheat futures contract discussed above could be two speculators
rather than a farmer and a bread maker. In such a case, the short speculator would simply have
lost $5,000 while the long speculator would have gained that amount. (Neither would have to go
to the cash market to buy or sell the commodity after the contract expires.)
Major Participants of Commodity Futures Market
1. Hedgersa. ProducersFarmers, manufacturers, importers and exporter
b. ConsumersRefineries, Food processing companies2. Speculators
a. Institutional proprietary tradersb. Brokerage housesc. Spot Commodity traders
3. Arbitrageursa. Brokerage houses
b. InvestorsHedgers
A Hedger can be Farmers, manufacturers, importers and exporter. A hedger buys or sells in the
futures market to secure the future price of a commodity intended to be sold at a later date in the
cash market. This helps protect against price risks.
The holders of the long position in futures contracts (buyers of the commodity), are trying to
secure as low a price as possible. The short holders of the contract (sellers of the commodity) will
want to secure as high a price as possible. The commodity contract, however, provides a definiteprice certainty for both parties, which reduces the risks associated with price volatility. By means
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of futures contracts, Hedging can also be used as a means to lock in an acceptable price margin
between the cost of the raw material and the retail cost of the final product sold.
Someone going long in a securities future contract now can hedge against rising equity prices in
three months. If at the time of the contract's expiration the equity price has risen, the investor's
contract can be closed out at the higher price. The opposite could happen as well: a hedger could
go short in a contract today to hedge against declining stock prices in the future. A potato farmerwould hedge against lower French fry prices, while a fast food chain would hedge against higher
potato prices. A company in need of a loan in six months could hedge against rising in the interest
rates future, while a coffee beanery could hedge against rising coffee bean prices next year.
Speculator
Other commodity market participants, however, do not aim to minimize risk but rather to benefit
from the inherently risky nature of the commodity market. These are the speculators, and they aim
to profit from the very price change that hedgers are protecting themselves against. A hedger
would want to minimize their risk no matter what they're investing in, while speculators want to
increase their risk and therefore maximize their profits. In the commodity market, a speculatorbuying a contract low in order to sell high in the future would most likely be buying that contract
from a hedger selling a contract low in anticipation of declining prices in the future. Unlike the
hedger, the speculator does not actually seek to own the commodity in question. Rather, he or she
will enter the market seeking profits by offsetting rising and declining prices through the buying
and selling of contracts.
Long Short
Hedger Secure a price now to protect
against future rising prices
Secure a price now to protect against
future declining prices
Speculator Secure a price now inanticipation of rising prices
Secure a price now in anticipation ofdeclining prices
In a fast-paced market into which information is continuously being fed, speculators and hedgers
bounce off of--and benefit from--each other. The closer it gets to the time of the contract's
expiration, the more solid the information entering the market will be regarding the commodity in
question. Thus, all can expect a more accurate reflection of supply and demand and the
corresponding price. Regulatory Bodies the United States' futures market is regulated by the
Commodity Futures Trading Commission, CFTC, and an independent agency of the U.S.
government. The market is also subject to regulation by the National Futures Association, NFA, aself-regulatory body authorized by the U.S. Congress and subject to CFTC supervision.
A Commodity broker and/or firm must be registered with the CFTC in order to issue or buy or
sell futures contracts. Futures brokers must also be registered with the NFA and the CFTC in
order to conduct business. The CFTC has the power to seek criminal prosecution through the
Department of Justice in cases of illegal activity, while violations against the NFA's business
ethics and code of conduct can permanently bar a company or a person from dealing on the
futures exchange. It is imperative for investors wanting to enter the futures market to understand
these regulations and make sure that the brokers, traders or companies acting on their behalf are
licensed by the CFTC.
Arbitrageurs
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Arbitrage refers to the opportunity of taking advantage between the price difference between two
different markets for that same stock or commodity.
In simple terms one can understand by an example of a commodity selling in one market at price
x and the same commodity selling in another market at price x + y. Now this y, is the difference
between the two markets is the arbitrage available to the trader. The trade is carried
simultaneously at both the markets so theoretically there is no risk. (This arbitrage should not beconfused with the word arbitration, as arbitration is referred to solving of dispute between two or
more parties.)
The person who conducts and takes advantage of arbitrage in stocks, commodities, interest rate
bonds, derivative products, forex is know as an arbitrageur.
An arbitrage opportunity exists between different markets because there are different kind of
players in the market, some might be speculators, others jobbers, some market-markets, and some
might be arbitrageurs.
In India there are a good amount of Arbitrage opportunities between NCDEX, MCX in
commodities.
THE COMMODITY MARKET
Commodity market is an important constituent of the financial markets of any country. It is the
market where a wide range of commodities are traded. It is important for any country to develop a
vibrant, active and liquid commodity market. This helps investors hedge their risk, take
speculative positions in commodities and exploit arbitrage opportunities in the market. Raw
commodities and related derivatives are traded on regulated commodities exchanges, in which
they are bought and sold in standardized contracts.
Exchange trading
(Standardized contract size and
maturity dates)
OTC trading
(Individually tailored)
Physical
trading
Accounts for a small proportion of
trading on exchanges. It is typically
used to balance out an excess of
demand or supply on the physical
market
Accounts for most OTC trading.
Participants include farmers, refiners
and whole-sellers. Trading is done on
the spot and forwards market and is
delivery based.
Derivativestrading
Accounts for most of trading on
exchanges. Traders include hedgers,
speculators and arbitragers. Dominates
soft commodities trading.
Precious metals and more recently
energy contracts are often traded
through OTC derivatives markets.
Trading of commodities consists of direct physical trading and derivatives trading. Commodities
include a range of diverse products. More recently there has been growing sophistication of
commodities investments with the introduction of new exotic products such as weather
derivatives, telecommunications bandwidth, gas and power derivatives and environmental
emissions trading. Other products that are traded on commodity markets include foreign
currencies and financial instruments and indexes.
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Commodity trading is conducted on OTC markets and exchanges, and consists of spot trading,
physical forwards and derivatives.
OTC Commodities Markets
Physical trading OTC commodities markets are essentially wholesale markets in which
individually-tailored contracts are traded. The most popular physical commodities contracts can
be broken down into: metals, energy, grains and soy, livestock, food and fibre and exotic
commodities as shown in table at page-3. A large proportion of OTC commodities trading is
transacted between producers, refiners and wholesalers on the spot market. Trading is delivery
based and typically done through intermediaries. For most commodities that are physically traded
there is no market in a central meeting place and where it exists it typically handles only a small
part of the total trade.
Derivatives trading The notional value outstanding of banks OTC commodities derivatives
contracts fell 3% in the six months to June 2010 to $2.9 trillion. This was down two-thirds on thevalue outstanding three years earlier as investors reduced risk following a five-fold increase in
value outstanding in the previous three years. Commodities share of the overall notional value
outstanding of OTC derivatives fell during this period from around 2.0% to 0.5% as investors
retreated from this market due to uncertain global economic conditions. Precious metals
accounted for 19% of the total in 2010, down from their 41% share a decade earlier as trading in
energy derivatives rose. The vast majority of OTC derivatives trading is in interest rate contracts
and foreign exchange contracts.
OTC trading accounts for the majority of trading in gold. Twice as much gold was traded on
OTC markets than on exchanges in 2010. Around 40% of silver is traded on OTC markets.
London is by far the largest global centre for OTC transactions in precious metals and accounts
for much of global physical trade. Other important centres include New York, Zurich and Tokyo.
London is also a leading centre for energy brokers operating in energy and carbon markets.
Exchange traded commodities
Exchange trading provides a central regulated market in which large numbers of buyers and
sellers can come together to deal in a competitive, transparent and open environment. Derivatives
exchanges are more standardised in terms of contract sizes, maturity dates and marginrequirements than OTC markets and tend to dominate trading of soft commodities. The vast
majority of trading on commodity exchanges is in derivatives.
Commodity exchanges have gradually developed from physical markets where deals were made
out of warehouses, to futures markets which allow for both hedging to protect against losses in a
declining market and speculation for gains in a rising market. The derivative markets for futures
were developed initially to help agricultural producers and consumers manage their price risks.
Commodities accounted for 9.0% of the value of global exchange-traded derivatives in 2010. This
was up from 6.4% two years earlier and less than 3% in 2005. During these five yearscommodities share of the number ofcontracts outstanding increased from 8.7% to 12.3%.
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Largest commodity exchanges Worldwide, there are around 50 major commodity exchanges that
trade in more than 90 commodities. Softcommodities are traded around the world and dominate
exchange trading in Asia and Latin America. Metals are predominantly traded in London, New
York, Chicago and Shanghai. Energy contracts are mainly traded in New York, London, Tokyo
and the Middle East. More recently a number of energy exchanges have emerged in several
European countries. In terms of the number of futures contracts traded, in 2009 China and the
UK had three exchanges amongst the largest ten, the US two and Japan and India one each. The
Dalian Commodity Exchange was the largest commodities exchange in the world followed by the
Shanghai Futures Exchange and CME Group. The UKs ICE Futures Europe was fifth and the
London Metal Exchange seventh. Trading on exchanges is fairly concentrated. In 2009 the top
five exchanges accounted for 86% of contracts traded globally up on their 82% share in the
previous year. China and India have gained in importance in recent years with their emergence as
significant commodities consumers and producers. Over the past decade a number of large
exchanges have opened in China and India such as the Shanghai Futures Exchange, Zhengzhou
Commodity Exchange and the Dalian Commodity Exchange in China and the National
Commodity and Derivatives Exchange and MCX in India. Chinese exchanges accounted for morethan 60% of exchange-traded commodities in 2009, up on their 40% share in the previous year.
HISTORY OF COMMODITY MARKET
The first 'futures' contracts can be traced to the Yodoya rice market in Osaka, Japan around 1650.
In the mid-19th century, grain markets were established in US and a central marketplace was
created for farmers to bring their commodities and sell them either for immediate delivery (spot
trading) or for forward delivery. This saved many farmers from the loss of crops and helped
stabilize supply and prices in the off-season.
The world's oldest established futures exchange, the Chicago Board of Trade, was founded in
1848. Forward contracts on corn were introduced in 1851. The Chicago Mercantile Exchange wasfounded as the Chicago Butter and Egg Board in 1898. Most of the exchanges in the developing
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World were established in the 1980s and 1990s in response to government liberalization of
commodity markets. In the 21st century, online commodity trading has become increasingly
popular, and commodity brokers offer front-end interfaces to trade these electronic-based markets.
Today's commodity market is a diverse marketplace of farmers, exporters, importers,
manufacturers and speculators. Modern technology has transformed commodities into a global
marketplace where a Haryana farmer can match a bid from a buyer in EuropeIndian Commodity Markets have their presence in country for over 120 years. Trade in
commodities has been unorganised in regional markets & Local Mandis. Cotton Trade
Association started futures trading in 1875 Derivatives trading started in oilseeds in Bombay
(1900), raw jute and jute goods in Calcutta (1912), wheat in Hapur (1913) and in Bullion in
Bombay (1920)
After Independence, the Parliament passed Forward Contracts (Regulation) Act, 1952. The Act
envisages three-tier regulation: The Exchange which organizes forward trading in commodities
can regulate trading on a day-to-day basis; the Forward Markets Commission provides regulatory
oversight under the powers delegated to it by the central Government, and the CentralGovernment - Department of Consumer Affairs, Ministry of Consumer Affairs, Food and Public
Distribution is the ultimate regulatory authority. In 1960s, following several years of severe
draughts that forced many farmers to default on forward contracts (and even caused some
suicides), forward trading was banned in many commodities considered primary or essential.
Commodity derivatives and risk management commodity options were banned in India between
1952 and 2002. Commodity market restarted from 2003 onwards. Almost all stock exchanges
have commodity market segments apart from 3 national level electronic exchanges. Trading in
Futures Contracts has been permitted in over 120 commodities. Physical commodity market size
in India is estimated to be around 25 lakh crore per annum.
COMMODITY EXCHANGES IN INDIA
FUTURES
1. MCX (Multi Commodity Exchange)2. NCDEX (National Commodity & Derivative Exchange) &3. NMCE (National Multi-commodity Exchange)4. ICEX ( Indian Commodity Exchange)
SPOT
5.NSEL (SPOT)
6. NCDEX Spot Exchange Ltd. (NSPOT)
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NCDEX & MCX put together have a leadership position with >90% share of total trading through
exchanges in India
COMMODITY MARKET STRUCTURE
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COMMODITY ECOSYSTEM
Global commodity market and indias place in world
Business Potential
Commodities Size of Physical Market(Rs. Crore)
Conservative Multiplier
(Rs. Crore)
( In 3 years)
Global Multiplier
(Rs. Crore)
(In 35 Years)
Gold & Silver Rs. 43000 cr 20 Times
Rs. 8,30,000 cr
50 Times
Rs. 21,50,000 cr
Edible Oils Rs. 30000 cr 10 Times
Rs. 3,00,000 cr
20 Times
Rs. 6,00,000 cr
Metals Rs.11000 cr 10 Times
Rs. 1,10,000 cr
20 Times
Rs. 2,20,000 cr
Total Rs. 84,000 cr Rs. 12,40,000cr Rs. 29,70,000cr
COMMODITY INDIA WORLD SHARE RANK
RICE (PADDY) 240 2049 11.71 THIRD
WHEAT 74 599 12.35 SECOND
PULSES 13 55 23.64 FIRSTGROUNDNUT 6 35 17.14 SECOND
RAPESEED 6 40 15.00 THIRD
SUGARCANE 315 1278 24.65 SECOND
TEA 0.75 2.99 25.08 FIRST
COFFEE(GREEN) 0.28 7.28 3.85 EIGTH
JUTE AND JUTE FIBERS 1.74 4.02 43.30 SECOND
COTTON (LINT) 2.06 18.84 10.09 THIRD
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INDIAN COMMODITY MARKET- PRESENT SCENARIO
Despite intermittent curbs, Indias ten-year-old commodity futures market has seen a steady
stream of new entrants, drawn by the promise of richer rewards. The intense growth, even in the
absence of basic reforms, has attracted financial institutions, trading companies and banks to set
up large commodity bourse. Since, Indian Commodity Exchange (ICEX), promoted by India bulls
Financial Services Ltd in partnership with MMTC has started its operation in November 2009; ithas created a competition among national level commodity exchanges. Commodity derivatives
market of India is drawing attention from all over the world, albeit FMC had banned nine
commodities since early 2007, out of which 4 are still out of trade and even financial institutions
and foreign entities are barred from trading in the market.
Even, industry players are of the view that commodity market regulator (FMC) should permit
banks and financial institutions to trade in commodity futures, allow options, exchange-traded
indices and some more powers to the market regulator from Ministry of Consumer Affairs to
develop the market.
Unlike developed markets, participation in Indian market is more retail & individual and notinstitutional.
Commodity Futures Trading in India had long tradition; market now being revived; paradigm
shift in thinking with huge appetite for speculation is seen; equity players expand into
commodities with more liquidity.
New Developments Banks, MFs, FIIs may be allowed to trade commodities; huge fund flow
expected; volatility will create market opportunities for investors; Gold ETF has all ready
launched. A gold exchange-traded fund (or GETF) is an exchange-traded fund (ETF) that aims to
track the price of gold. Gold exchange-traded funds are traded on the major stock exchanges
including Zurich, Mumbai, London, Paris and New. All exchange-traded instruments, including
those that hold physical gold for the benefit of the investor, carry risks beyond those inherent in
the precious metal itself. The most popular gold ETF (SPDR Gold Trust, symbol GLD) has been
compared with mortgage-backed securities and collateralised debt obligations due to its
complexity. The extensive analysis and criticism received by GLD is instructive for reviewing all
gold ETF's, many of which are similarly complex and have received little scrutiny.
Usually derivatives markets are much larger than the spot markets. In India itself, the derivatives
markets in equity instruments are at least 2 to 3 times the size of the spot markets. With similar
assumptions, one can expect daily volumes of Rs. 1,00,000 crores in the commodity derivatives
markets.
The futures market is a centralized market place for buyers and sellers from around the world who
meet and enter into commodity futures contracts. Pricing mostly is based on an open cry system,
or bids and offers that can be matched electronically. The commodity contract will state the price
that will be paid and the date of delivery. Almost all futures contracts end without the actual
physical delivery of the commodity.
HOW TO INVEST IN COMMODITIES
We list here five ways in which investors can gain exposure to commodities, describing some of
the benefits as well as potential risks and costs in each case. Exhibit 14 summarises the pros and
cons of these various investment vehicles.
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14
The most direct way to invest in commodities is to purchase physical commodities directly. The
main advantage of this approach is that direct physical ownership gives an investor the most
control over the asset. By definition, this strategy also provides the best opportunity to maximise
spot performance. On the other hand, taking delivery of commodities entails storage as well as
transportation costs. Also, it is usually not easy to sell these commodities on short notice without
incurring extra costs, so direct ownership is a very illiquid way of gaining exposure to the asset
class. Moreover, purchasing commodities directly is not always possible for every type of
investor.
A common alternative to direct physical ownership is an investment in commodity futures. A
commodities futures contract is an agreement to buy or sell a set amount of a commodity at a
predetermined price and date. Buyers purchase such contracts to avoid the risks of commodity
price fluctuations, and sellers use them to set prices for their products. Futures are highly liquid,
unlike physical ownership of the underlying commodities. The main risk to investors is that even
a very small move in the price of a commodity could result in large gains or losses. Unlike
options, futures imply an obligation to buy and sell the underlying commodities at the set price. Ifthe contract is not rolled over, investors face the risk of having to take delivery of the underlying
commodities, which entails storage and transportation costs.
An alternative is to invest in a commodity index, such as the S&P GSCI or the Dow Jones
Commodity Index. An index tracks the performance of a basket of commodities. These indices
are often traded on exchanges, allowing investors to gain easier access to commodities without
having to enter the futures market. The value of these indices depends on the commodities which
constitute the index, and this value can be traded on an exchange in a similar fashion to stock
index futures. An advantage of trading a commodity index is that, unlike trading the commodities
directly, it is a very liquid investment. It is also accessible to many investors by virtue of being
traded on an exchange. On the other hand, it is by definition a passive investment, so any returns
will be purely beta driven. What is more, the carry on an index is often negative.
Another, though more indirect way, to invest in commodities is by investing in commodity
producing companies equity. Of course, this is by nature more of an equity investment than a
commodities investment, at least in terms of asset class allocations. Their main advantages
include the fact that they are highly liquid as publicly traded investments and that they may offer
dividends. On the other hand, stocks of commodities companies carry equity risk, and as with
any equity investment, also incorporate stock-specific risk.
Alternatives to these investment vehicles involve entering into the realm of actively managed
investments. One example of this involves a Commodity Trading Advisor, or CTA, which is
either a person or a firm paid to provide specialised advice on the trading of commodity-related
investments. A CTA will typically trade liquid commodity futures and bring all the benefits of
active management to the investment. Investors should be aware, however, that CTAs tend to base
their trading strategies on trends, and their bets are not necessarily confined to commodities: their
decisions can typically also involve other investments, such as foreign exchange positions.
Commodity specialist hedge funds are another way to gain actively managed exposure to
commodities. Their experience is specific to individual commodities or groups of commodities.
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While their expertise can bring higher returns for individual commodity investments, they are
typically less diversified across commodity sectors.
CHARACTERISTICS OF COMMODITY MARKET
Commodity futures market, the calculation of profit and loss will be slightly different than on a
normal stock exchange. The main concepts in commodity market are:
Margins
In the futures market, margin refers to the initial deposit of good faith made into an account in
order to enter into a futures contract. This margin is referred to as good faith because it is this
money that is used to debit any losses.
The initial margin is the minimum amount required to enter into a new futures contract, but the
maintenance margin is the lowest amount an account can reach before needing to be replenished.
Leverage
Leverage refers to having control over large cash amounts of a commodity with comparatively
small levels of capital. In other words, with a relatively small amount of cash, one can enter into a
futures contract that is worth much more than one initially has to pay (deposit into ones margin
account). It is said that in the futures market, more than any other form of investment, price
changes are highly leveraged, meaning a small change in a futures price can translate into a huge
gain or loss.
Futures positions are highly leveraged because the initial margins that are set by the exchanges are
relatively small compared to the cash value of the contracts in question (which is part of the
reason why the futures market is useful but also very risky)..
Due to leverage, if the price of the futures contract moves up even slightly, the profit gain will belarge in comparison to the initial margin. However, if the price just inches downwards, that same
high leverage will yield huge losses in comparison to the initial margin deposit.
Pricing and Limits
Contracts in the Commodity futures market are a result of competitive price discovery. Prices are
quoted as they would be in the cash market: in dollars and cents or per unit (gold ounces, bushels,
barrels, index points, percentages and so on).
Prices on futures contracts, however, have a minimum amount that they can move. These
minimums are established by the futures exchanges and are known as ticks.Futures prices also have a price change limit that determines the prices between which the
contracts can trade on a daily basis. The price change limit is added to and subtracted from the
previous day's close, and the results remain the upper and lower price boundary for the day.
The exchange can revise this price limit if it feels it's necessary. It's not uncommon for the
exchange to abolish daily price limits in the month that the contract expires (delivery or spot
month). This is because trading is often volatile during this month, as sellers and buyers try to
obtain the best price possible before the expiration of the contract.
In order to avoid any unfair advantages, the CTFC and the Commodity futures exchanges impose
limits on the total amount of contracts or units of a commodity in which any single person can
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invest. These are known as position limits and they ensure that no one person can control the
market price for a particular commodity.
STRATEGIES FOR TRADING IN COMMODITIES AND FUTURES
Futures contracts try to predict what the value of an index or commodity will be at some date in
the future. Speculators in the futures market can use different strategies to take advantage of rising
and declining prices. The most common strategies are known as going long, going short andspreads.
Going Long
When an investor goes long, that is, enters a contract by agreeing to buy and receive delivery of
the underlying at a set price, it means that he or she is trying to profit from an anticipated future
price increase.
Going Short
A speculator who goes short, that is, enters into a futures contract by agreeing to sell and deliver
the underlying at a set price, is looking to make a profit from declining price levels. By selling
high now, the contract can be repurchased in the future at a lower price, thus generating a profit
for the speculator.
Spreads
As going long and going short, are positions that basically involve the buying or selling of a
contract now in order to take advantage of rising or declining prices in the future. Another
common strategy used by commodity traders is called spreads. Spreads involve advantage of the
price difference between two different contracts of the same commodity. Spreading is considered
to be one of the most conservative forms of trading in the futures market because it is much safer
than the trading of long / short (naked) futures contracts.
There are many different types of spreads, including:
Calendar spread - This involves the simultaneous purchase and sale of two futures of the same
type, having the same price, but different delivery dates.
Inter-Market spread - Here the investor, with contracts of the same month, goes long in one
market and short in another market. For example, the investor may take Short June Wheat and
Long June Pork Bellies.
Inter-Exchange spread - This is any type of spread in which each position is created in different
futures exchanges. For example, the investor may create a position in the Chicago Board of Trade,CBOT and the London International Financial Futures and Options Exchange, LIFFE.
WAYS TO TRADE IN COMMODITY MARKET
One can invest in the futures market in a number of different ways, but before taking the plunge,
one must be sure of the amount of risk he is willing to take. As a futures trader, one should have
a solid understanding of how the market works and contracts function. It is also needed to
determine how much time, attention, and research one can dedicate to the investment. Talk to the
broker and ask questions before opening a futures account.
Unlike traditional equity traders, futures traders are advised to only use funds that have been
earmarked as risk capital. Once the initial decision is made to enter the market, the next question
should be, how? Here are three different approaches to consider:
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Self Directed Full Service Commodity pool
Self Directed: - As an investor, one can trade ones own account, without the aid or advice of a
Commodity broker. This involves the most risk because one become responsible for managing
funds, ordering trades, maintaining margins, acquiring research, and coming up with ones own
analysis of how the market will move in relation to the commodity in which one has invested. It
requires time and complete attention to the market.
Full Service: - Another way to participate in the market is by opening a managed account, similar
to an equity account. A broker would have the power to trade on any ones behalf, following
conditions agreed upon when the account was opened. This method could lessen ones financial
risk, because a professional broker would be assisting, or making informed decisions on ones
behalf. However, one would still be responsible for any losses incurred and margin calls.
Commodity Pool: - A third way to enter the market, and one that offers the smallest risk, is tojoin a commodity pool. Like a mutual fund, the commodity pool is a group of commodities which
can be invested in. No one person has an individual account; funds are combined with others and
traded as one. The profits and losses are directly proportionate to the amount of money invested.
By entering a commodity pool, one gains the opportunity to invest in diverse types of
commodities. One is also not subject to margin calls. However, it is essential that the pool be
managed by a skilled broker, for the risks of the futures market are still present in the commodity
pool.
DIFFERENT SEGMENTS IN COMMODITIES MARKET
The commodities market exits in two distinct forms namely the Over the Counter (OTC) market
and the Exchange based market. Also, as in equities, there exists the spot and the derivatives
segment. The spot markets are essentially over the counter markets and the participation is
restricted to people who are involved with that commodity say the farmer, processor, wholesaler
etc. Derivative trading takes place through exchange-based markets with standardized contracts,
settlements etc.
Market share of commodity exchanges in India (APPROX)
% of market share of exchange
MCX, 74%
NCDEX, 22%
NMCE, 1% NBOT, 2% OTHERS, 1%
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RISK ASSOCIATED WITH COMMODITIES MARKET
No risk can be eliminated, but the same can be transferred to someone who can handle it better or
to someone who has the appetite for risk. Commodity enterprises primarily face the following
classes of risk. Namely: The price Risk, the quantity risk, the yield/output risk and the political
risk, talking about the nationwide commodity exchanges, the risk of the counter party not
fulfilling his obligations on due date or at any time therefore is the most common risk.This risk is mitigated by collection of the following margins:-
Initial margins Exposure margins Mark to Market on daily positions Surveillance
TREND OF GLOBAL COMMODITY PRICE MOVEMENT
While not all commodity prices move in lock-step, throughout history there have been markedperiods of generalised spikes and swoons. In the 1970s, prices of many commodities trended
higher, but by the 1990s prices typically weakened. Decade of weak price signals left a legacy of
under-investment and dwindling supplies. From 2000 onward, however, demand picked up for all
types of commodities. A bull market that kicked off in 2006 pushed some prices to record levels.
The reasons for this were manifold, but perhaps the chief driving force was a sharp rise in demand
from emerging economies. In the wake of the financial crisis in 2008, global demand dropped as a
result of negative GDP growth in most of the developed world and lower growth in many
developing economies. But prices for many commodities have rebounded over the past two years
as demand has recovered, especially in emerging economies.
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PERFORMANCE OF COMMODITY DERIVATIVES & MACRO-ECONOMY
In the wake of the 2008 credit crisis and subsequent unprecedented injections of liquidity into
world markets, a major concern for many investors is the prospect for higher rates of inflation in
the future. At the same time, with growth in developed economies still well below trend, deflation
is also a significant concern as it may be a more immediate threat.
Both pricing regimes inflation and deflation present challenges to investors seeking to maximisethe purchasing power of their portfolio assets over the mid-to-long term. While real assets such as
commercial real estate have historically tended to perform best during periods of high inflation
and fixed income investments have been a safe harbour amid deflation, the role of commodities in
these pricing environments is perhaps less well understood. Can a strategic allocation to
commodities act as a hedge in either caseor both?
In order to understand the relationship between inflation and asset returns, including commodity
returns, JP Morgan conducted an empirical analysis in which they sought to isolate the impact of
inflation on various asset prices, taking into account the fact that asset returns are also driven by
other factors such as prospects for economic growth, interest rates, capital flows, currencyvaluation, financial regulation, government policy (including taxes) and changes to investor risk
appetite, to name but a few variables.
Results of analysis suggest that inflation detracts from equity performance, as profit margins are
depressed and both higher variable input costs as well as labour costs tend to impede earnings
growth. Fixed income (in the form of government-issued securities), meanwhile, is negatively
affected by strong GDP growth as well as by a higher unemployment rate. Corporate bonds,
which have both equity15 and fixed income qualities, suffer in a high inflationary environment
because that is when their fixed income characteristics tend to dominate. Long positions in
commodities are perhaps the closest thing to a pure inflation hedge relative to the other liquid
asset classes considered in this analysis. That is because, as our results show, unlike equities or
fixed income, commodities exhibit a significant positive return in inflationary environments. In
other words, inflation and commodity returns have strong positive correlations.
Given the current slack in economies around the world, investors are also concerned about the
potential for deflation. In this section, we define deflation as a decrease in the general price level
of goods and services. Deflation occurs when the annual inflation rate becomes negative, resulting
in an increase in the real value of money.
It is found that the immediate impact of deflation on equities is to depress prices, but that
moderates over a three-year time frame. As for fixed income, it reacts positively in deflationary
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cycles, but this effect dissipates over time. Credit, however, benefits in both short-and mid-term
deflationary scenarios. Commodities, on the other hand, display an unambiguously negative
response to deflation. But that is not necessarily a disincentive for an investor because that strong
correlation
According to modern financial theory as it was pioneered by Harry Markowitz in 1952, the risk
associated with asset returns is divided into two components: the asset-specific risk and the
market risk. In theory, it is not possible to avoid market risk by portfolio diversification, as only
asset-specific risk may be reduced in this way. For example, because commodity returns and
equity returns are negatively correlated, holding both these asset classes can reduce the asset-
specific risk taken by sharing it between the two assets. The market risk, however, is un-
diversifiable.
If we take into account the cyclical nature of economic growth, however, we find that an
investment in commodities can, in fact, help reduce the systematic, market risk taken by a port-folio. Indeed, if we can identify patterns between asset class returns and economic cycles, an
investor employing sophisticated hedging techniques may be able to exploit them.
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In particular, commodities tend to perform well in the early stages of a recession, a time when
stock returns generally deteriorate. In later stages of recessions, commodity returns also start to
deteriorate, but this is typically when equities begin to outperform. An investor employing
sophisticated hedging techniques may therefore be able to take advantage of this apparent pattern
in asset class returns and economic cycles.
The above graph depicts a classic business cycle in stylized form identifying the peak and
troughas determined by the US National Bureau of Economic Research (NBER). The
corresponding cycles are divided into phases, which are calculated by dividing the number of
months from peak-to-trough (or trough-to-peak) into equal halves to indicate Early Recession and
Late Recession (and then Early Expansion and Late Expansion). In this way, the Early and Late
Expansion phases correspond to an economic expansion, while the Early and Late Recession
phases correspond to an economic contraction.
Each of the four stages in the exhibit have been defined as a combination of the level of the output
gap (i.e., the difference between actual output and potential output) and the rate of economicgrowth. In Stage No. 1, the economy is in a late expansionary phase characterized by fast growth
and above-trend output, so capacity constraints begin to come into play and commodity prices
rise. In Stage No. 2, labeled Early Recession in the diagram, output is still above-trend but it starts
to slow as capacity constraints lead to a rise in unemployment. Eventually, output drops below its
trend average and the economy enters a Late Recession phase. Thus, in Stage No. 3, output
continues to decline, unemployment levels peak and capacity utilisation bottoms out. Finally, in
Stage No. 4, the Early Expansion, the economy emerges from recession with rising, but still
below trend, output and moderating unemployment levels.
The obvious question for the long-term investor is: How well do major asset classes performacross each of the four stages of an economic cycle? To answer that, we looked at average
annualised quarterly returns and volatility (via standard deviation) for four major asset classes
during the four stages of a complete cycle.
From this simple analysis, we can see that commodities tend to perform better than the other three
asset classes when the economy is in a late expansionary phase, with average returns of 19.97%
and relatively low volatility. As the economy enters recession, this analysis shows that
commodity returns are still higher than the returns to the other asset classes, but that bonds and
bills are on the rise and equities underperform. In the latter part of a recession, we have
determined that equities and bonds seem to outperform, while in an early expansion, commoditiesregain the upper hand. In this respect, historically speaking, a tactical allocation to equity
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investments would have been optimal just when the economy was at its worst, while an
opportunistic allocation to commodities would seem to have been most logical just as an
economic recovery got underway.
It should be emphasised that these results are purely descriptive and are not meant to imply a
trading strategy since the business cycles used are dated ex-post facto. However, one key
takeaway that emerges from this analysis is that equities, bonds, and treasuries display similar riskcharacteristics relative to the economic cycle. Commodities, in contrast, behave very differently
from other asset classes, offering potential for lowly correlated macroeconomic diversification
within an investment portfolio.
CONCLUSION
The commodity Market is poised to play an important role of price discovery and risk
management for the development of agricultural and other sectors in the supply chain. New issue
and problems Govt. regulators and other share holders will need to proactive and quick in their
response to new developments. WTO regime makes it all the more urgent to develop these
markets to enable our economy, especially agriculture to meet the challenge of new regime and
benefits from the opportunities unfolding before U.S. with risks not belong absorbed any more the
idea is to transfer it as the focus is shifting to Manage price change rather than change prices
the commodity markets will play a key role for the same.
Our overall conclusion is that the risk/return case for including commodities as one component of
a diversified portfolio has become stronger in the wake of the 2008 financial crisis and amid the
economic ascendancy of China. In particular, there are significant supply constraints on
commodities amid burgeoning demand for them, not only among developed nations and China
but also from a broader swath of the developing world. This includes emerging economies in
places as far afield as Africa, Asia and South America, many of which, up until recently, have
been characterized as commodity exporters as opposed to commodity consumers. Empirical
research indicates that commodities may offer protection in moderately inflationary as well as in
deflationary environments because of the way in which commodities behave across the business
cycle. Commodities may offer protection against inflation and provide other diversification
benefits across the business cycle. Even in a deflationary environment, for example, investors
could be poised to benefit from short positions. There is prospect for achieving higher returns
through active management.
Commodities present a combination of challenges and opportunities unlike any other asset class
and therefore must be assessed differently from more traditional investment options such as equity
and fixed income. An allocation to commodities as part of a balanced portfolio may help diversify
and potentially bolster performance in a number of different macroeconomic environments
especially if top quartile actively managed strategies are considered. To be sure, commodities
involve higher risk profiles and may be best utilised to complement larger allocations to other
asset classes. However, it is obvious that, they do deserve a place in the pantheon of portfolio
choices. Linkages between and among commodities could potentially be exploited by an active
manager with a flexible approach so as to outperform an index-based strategy tied to a fixed
basket of commodities.
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