1.Introduction & Growth of Commodities as an Asset Class

8/3/2019 1.Introduction & Growth of Commodities as an Asset Class

1/27

(c) Nupur Pavan Bang 1

Introduction & Growth ofCommodities as an asset class

Commodities and Commodity Derivatives@MANAGE

Dr. Nupur Pavan Bang


2/27


If stocks, bonds and commodities were part of the same

family, commodities would be the sibling who never

measured up, the black sheepthe brother-in-law, perhaps,

who got wiped out in soybeans. Commodities have nevergot the respect that they deserve, and its been something

of a mystery to me why.

-Jim Rogers, Commodity Investment Expert & Creator of

Rogers International Commodities Index.


3/27


Why Commodities?

Futures / (Cash + Futures) = 86%

Turnover of (Commodity + Stock) Futures up 60% in

2010-11 (close to Rs150 trillion)

Commodity futures up 70% as opposed to 53.7% of

stocks and index futures

Among the five major exchanges that allow futures

trading, NSE accounts for 67%, MCX 20%, NCDEX

10.5%, BSE 0.5% and NMCE 2%.


4/27


The three major commodity exchanges had a combined

turnover of Rs.54 trillion during the financial year.

A trader is required to pay upfront margins of 15% of the

market value of index futures, about 25% of the marketvalues of stock futures, around 8-10% of agro commodity

futures, and up to 6% of non-agro commodities.

Why Commodities?


5/27


Commodities

Definition

FCRA, Economists, Bankers, Ecologist, Academicians, Oil

Producing nations

Markets

Spot and Derivatives

Evolution

Agricultural-Metals-Energy-Carbon Credits Barter-Forward Contracting-Futures Markets

Plain Vanilla-Exotic Options-Structured Products


6/27


Derivatives Markets

MCX

NCDEX

NCME

21 Regional Exchanges (approved by FMC)


7/27


Commodity Market Beneficiaries

Farmers/Producers;

Processors;

Traders;

Manufacturers;

Wholesalers;

Retailers and end-users.

All these participants in the commodities trade are benefited to

a large extent due to changes in technology, communication

networks and a number of value-added services provided by

multi-commodity exchanges.


8/27


Commodity Future

Increasing Farmer Participation

In India, 60% of the population dependent upon agriculture.

Farmers are now assured better price for their produce (fair price

discovery). Hence, they are no longer required to sell below cost

of production in distress. Market determined price information available to the farmers

enabling them to plan their production schedule.

Inculcates competitive spirit among farmers to cultivate quality

produce and among the traders for quality production and output.


9/27


Commodities Futures MarketOther Benefits

Price risk management through hedging strategy, wherein, price risk

that is inherent in a spot market is offset by taking an equal but

opposite position in futures market.

Enable the exporters to hedge their price risks (risk arising from

volatility in foreign exchange rate movements) and improve

competitiveness. In fact, with rupee strengthening against the dollar,export firms can now go in for more proactive hedging strategies,

such as entering into forward and option contracts or exotic

derivative products.

Enables manufacturers to predict domestic prices that are likely to

prevail in future, so that they can ensure that their market share isprotected even with free entry of imports.

Hedging would cut down the discount rate in commodity lending

thereby enabling commodity traders to get easy access to credit.


10/27


Future of Commodity Markets

National online exchanges started operating since 2003. Future trading in commodities permitted from 2003 &

thereafter remarkable growth in volumes traded in thecommodity market.

Just passed nascent stages of their growth story. Phenomenal turnover achieved by commodity derivative

exchanges in India.

Increase in volume to Rs.53trillion for 2008-2009 periodwithin just five years.

Investor community in India has finally started taking notice ofcommodity markets.

Bright future aheademerging as a new hot market for thefuture.


11/27


Facts and Fantasies About Commodity Futures

The study carried out by Yale School ofManagements Centre

for International Finance (2004) published the following results:

Since 1959, commodity futures have produced better annual

returns than stocks and outperformed bonds even more.

Commodities have had lesser risk than stocks and bonds, as

well as better returns.

During the 1970s, commodity futures outperformed stocks;

during the 1980s the exact opposite was true evidence of

the negative correlation between stocks and commoditiesthat is often noticed. Bull markets in commodities are

accompanied by bear markets in stocks, and vice versa.


12/27


The volatility of the returns of commodity futures for a 43

year period was slightly below the volatility of the S&P 500

for the same period.

While investing in commodity stocks is one rational way to

play a commodity bull market, it is not necessarily the best.

The returns of commodity futures examined in the study were

triple the returns for stocks in companies that produced those

commodities.

Facts and Fantasies About Commodity Futures


13/27


Alternative investment class in 21st century

Viable alternative to equity, real estate and other traditional

forms of investments owing to

Better returns

Less risky Less price volatility due to few factors influencing

commodity prices

Less sluggish than bonds

Good way to diversify a portfolio of stock & bonds


14/27


Twentieth century was witness to three long commodity bulls

(1906-1923, 1933-1953, 1968-1982), each lasting an average

of seventeen years and we are living in the middle of another

such bull period which started in 1999. By nature, commoditybull markets last for a longer period than stock market bull

periods. This presents all the more reason to be excited about

the real things

- Jim Rogers (Hot Commodities).


15/27


Interesting facts

The world is adding to its population at the rate of the

country of Mexico every year-thats more than 80

million.

Out of every 100 people, 14 are from the WesternHemisphere

27 would be from Africa, Australia, Europe, and the

Middle East combined.

57 would be Asians (38 from China and India)


16/27


The Commodity Hunger of China and India

Oil

Today, US consumes approx. 25% of all oil produced i.e 25barrels per capita per year.

When Japan accelerated its economic growth (from 1950 to1970), Japanese consumption rose from 1 barrel to 17 barrelsper capita per year.

China and India are currently consuming just over 1 barrel percapita per year.

China and Indias combined population is 18 times that ofJapan.


17/27


Commodity Markets- Key Characteristics

Consumption goods

Non standard structure

Cost of production

Price behavior (seasonality)

Limits on supply and consumption

Time delays in production and consumption

Direct exposure to a variety of exogenous functions Substitution potential between different commodities in

the production or consumption process.


18/27


Needs for physical access or possession of thecommodity that introduces issues such as location andtransportation.

Additional costs including storage costs, insurance,wastage and possession value.

Inability to readily store certain commodities (such aselectricity).

Complicated value/processing chains in commoditymarkets.

Opportunities to generate significant value from theshape and behavior of commodity forward curves.

High volatility of (some) commodity prices.

Commodity Markets- Key Characteristics


19/27


A crucial difference between securities and commodities

is the physical delivery attached to spot, forward contracts

and futures positions not closed prior to maturity and

translate into good transfer, with the correspondingconstraints for both parties in terms of shipping

arrangements, warehousing and so forth.


20/27


Another key difference between security and commodity

markets is the existence, in the latter case, of quantity

risk. Investors owing stocks or bonds are only concerned

by equity markets going down or interest rates going up(i.e., by the price risk attached to the instruments they are

holding).

Similarly, the concept ofvarying quality of assetdoes not

really exist as far as financial underlyings are concerned.However in the case of commodities, the quality of the

asset underlying a contract can vary largely. This

becomes an important issue to be managed.


21/27


Physical Settlement

Accredited warehouses

There are limits on storage facilities in different states.

There are restrictions on interstate movement of

commodities.

Besides state level control and duties have an impact on

the cost of movement of goods across locations.

Delivery NoticeSeller, warehousing receipt (proof of

quantity and quality)

Assignment - Exchange


22/27


Quality Standards

Commodity derivatives demand good standards and quality

assurance/ certification procedures. A good grading system

allows commodities to be traded by specification.

Currently there are various agencies that are responsible forspecifying grades for commodities. For example, the Bureau

of Indian Standards (BIS) under Ministry of Consumer Affairs

specifies standards for processed agricultural commodities

whereas AGMARK under the department of rural

development under Ministry of Agriculture is responsible for

promulgating standards for basic agricultural commodities.

Apart from these, there are other agencies like EIA, which

specify standards for export oriented commodities.


23/27

(c) Nupur Pavan Bang

Derivative Contracts and Exchanges

Over the Counter (OTC)

Customized

Exchange traded

Standardized

Financial Derivatives are all automated exchange traded

contracts.

Commodities Derivatives are still follow an open-outcry

method on many exchanges.

23


24/27


NYMEX

24


25/27


Trading Pit

25


26/27


Trading Pit

26


27/27


Automated Trading

27

1.Introduction & Growth of Commodities as an Asset Class

Documents

Transcript of 1.Introduction & Growth of Commodities as an Asset Class