Commodity as An Asset Class
FINANCIAL MARKETS
CAPITAL MARKET
MUTUAL FUNDS
FOREX MARKET
COMMODITY MARKET
DEBT MARKET
MONEY MARKET
Overview of Presentation
• Supply/Demand and the ‘New consumers’Supply/Demand and the ‘New consumers’
• Other Factors too:Other Factors too:- The US Dollar – outlook - The US Dollar – outlook - Real Interest Rates – not rising …- Real Interest Rates – not rising …- The Commodity Cycle - lasts years …- The Commodity Cycle - lasts years …- Massive Reserves - Developmental demand - Massive Reserves - Developmental demand - The Economic Cycle - The Economic Cycle
• Portfolio Diversification With CommoditiesPortfolio Diversification With Commodities- Better Returns- Better Returns- Diversification benefits- Diversification benefits- Hedge Against Inflation- Hedge Against Inflation- Scenario Analysis- Scenario Analysis
• India StoryIndia Story
Supply & Demand /New Customers
World Demand – New ConsumersAluminum: pounds per capita consumption
Source – World Meta Bureau
World Demand – New ConsumersSteels: pounds per capita consumption
Source – World Meta Bureau
• If supply cannot expand at the rate of intended demand, the price of commodities MUST rise in order to squeeze demand back to the available supply.
• In the true sense; a rising price is the market’s way of rationing demand.
• Accordingly, central banks run serious risks by tightening monetary policy in hopes of suppressing the rise in commodity prices.
We could say…
Other Factors
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Q Dollar broke down in 2002
Dollar Index: Euro, Yen,Pound, CDN Dollar
US DOLLAR INDEX CONTINUOUS [FINEX] (72.9500, 74.3200, 72.1700, 74.1700, +1.22000)
Other Factors: the US DollarThe Dollar broke down in 2002 …
Created Using Metastock
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Gold(US$/oz)
GOLD USD/Oz
USD Index
Gold, USD INDEX
Other Factors: the US DollarIn fact, the gold price often turns with US$ …
Created Using Metastock
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S&P Commodity Index, USD INDEX
Commodity Prices and US$So does S&P commodity price index …
USD Index
S&P Commodity Index
Created Using Metastock
The Outlook for the US DollarThe RMB and Asian currencies must rise!
Source - IMF
• When the dollar declines against the Asian currencies:
Local demand picks up
Local prices eventually start rising …
• But since Asian consumers are driving commodity prices, the dollar’s decline against
Asian currencies is far more important for commodities than other factors such as the
dollar’s relationship with say the Euro!
• 2010 Phenomenon: Gold & Euro:
Sudden payment crisis in some EC countries (Greece/Portugal/Spain/Ireland) caused a
loss of confidence in the Euro
We could say…
Commodity Prices and Interest Rates… with the S&P Commodity Index …
News: 15th November 2010
• Gold gained half a % on Monday, after falling three % in the previous session on talk of an imminent interest rate hike by China that triggered a broad commodities decline.
• Copper fell on Friday, receding from the previous session's record high to hit a one-week low on talk of an interest rate hike in top consumer China, but analysts said good fundamentals supported the metal longer-term.
• Oil prices slumped more than 3 % on Friday, retreating from a 25-month high, amid a broad commodities rout on fears that China may raise interest rates to brake its economy and concerns about euro zone debt.
• When real interest rates (inflation-adjusted) decline, demand for goods and services generally responds positively
• This demand is reflected in the demand for raw material in general and key commodity prices specifically
• In fact, the data shows that both the Dollar and real interest rates are negatively correlated with commodity prices
We could say…
The Commodity CycleThe shortest copper cycle lasted 16 years
50 day Moving Average
COMEX Copper Prices from Jan 1988- Oct 2010
TubeSheetsWires
The Gold CycleThe shortest gold cycle lasted for 10 years…
The Commodity CycleThe shortest gold cycle lasted for 10 years…
50 day Moving Average
COMEX Gold Prices from Jan 1979- July2010
The Wheat CycleThe shortest wheat cycle lasted 16 years
The Commodity Cycle
Subprime crisis
Iraq War
Gulf war
NYMEX Crude Oil Prices from Jan 1980- July2010
50 day Moving Average
Reserves
Foreign Exchange Reserve (Sept 2010)
Country Mn $ Country Mn $
China 2648300 Singapore 214,662
Japan 1050235 Switzerland 255,522
Euro system 726850 Germany 197107
Russia 501100 Algeria 150000
Saudi Arabia 410300 Thailand 182691
Republic of China 380505 France 142834
India 295792 Italy 144287
South Korea 289780 United States 128,601
Hong Kong 266100
Brazil 282921
Total Sum of all Countries 10008392
Source - IMF
Investment Demand in CommoditiesCommodity “asset class” room to grow!
• The value of managed assets in the world is about $55 trillion …
• Estimates suggest that only $175-200 billion of this is invested in commodities
• Assuming that the “commodity asset class” will grow to about 3% of all assets …
• There could be an 8-fold increase in commodity investments!
Opportunities in CommoditiesCommodity “asset class” room to grow!
The Economic Cycle… and generally decline during/after recessions
The Economic Cycle
Goldman Sachs Index
Recessionary phase
Agri commodity prices
Commodity Prices
Source: IMF
• The dollar has a major impact on commodity prices
…
• So do real interest rates …
• The commodity cycle generally lasts for years
• The Commodity complex has become an “investment
class”
• Recessions damage commodity prices
• Recovery pushes up prices
Conclusion…
Portfolio Diversification
Commodity Delivers Better Returns…absolute and risk adjusted returns…
Stocks Bonds Commodity Futures
Mean Return 11.02% 7.71% 11.02%
Std. Dev 14.90% 8.47% 12.12%
The average historical risk premium of Commodity Futures has been about 5% per annum during the period from 1959 to 2010.
Commodity Futures Stocks Bonds
Average 5.23 5.65 2.22
Standard Deviation 12.1 14.85 8.47
Sharpe Ratio 0.43 0.38 0.26
Quarter Commodities Equities Comments
Q2 1970 3.6% -16.9%
Q4 1973 10.1% -12.6% 1973 Oil Crisis
Q2 1974 6.0% -8.3% US Recession
Q3 1974 32.0% -22.6% UK Recession
Q3 1975 19.5% -10.6%
Q3 1981 1.0% -10.6% US Recession
Q1 1982 9.5% -9.7% US Recession
Q2 1984 -0.6% -6.9%
Q4 1987 -1.8% -15.4% Black Monday
Q1 1990 0.0% -14.2%
Q3 1990 55.2% -18.1% Gulf War
Q1 1992 2.8% -8.0% Gulf War
Q3 1998 -4.4% -11.9% Asian/ Russian Crises
Q4 2000 7.2% -6.1% Dot Com Crash
Q1 2001 -10.3% -12.8% Dot Com Crash
Q3 2001 -9.9% -14.3% 9/ 11 Crash
Q2 2002 0.0% -9.0% Dot Com Collapse
Q3 2002 11.5% -18.3% Dot Com Collapse
Q1 2008 11.2% -8.1% Credit Crisis
Commodity prices and prices for stock and bonds respond differently to changes in market and economic conditions. The difference in how they respond to global events and the timing to these responses can provides commodities with valuable benefits when combined with other financial assets.
Diversification Benefits …when other disappoint, commodities stands!!!
Source – DataStream
Diversification Benefits …the importance of negative correlation…
Portfolio I
Consider a position consisting of a USD 1,000,000 investment in S&P 500. The daily volatility for S&P 500 is 1.37% (2nd Jan, 2009 to 30th May, 2009).
VaR for S&P 500
Since size of the position is USD 1 million, the standard deviation of daily changes in the value of the position is 1.37% of USD 1 million or USD 13700. The 1-day 99% VaR of a USD 1 million position in S&P is
2.33*13700 = USD 31921
Portfolio II
Position consisting of a USD 1,000,000 investment in Gold. The daily volatility for Gold is 1.44% (2nd Jan, 2009 to 30th May, 2009)
VaR for Gold
Since size of the position is USD 1 million, the standard deviation of daily changes in the value of the position is 1.44% of USD 1 million or USD 14400. The 1-day 99% VaR of a USD 1 million position in S&P is
2.33*14400 = USD 33552
Diversification Benefits …the importance of negative correlation…
So if we combine these two Single-Asset Case portfolio and form a new Two-Asset Case portfolio the VaR for the portfolio should be???
Simple – Sum of the VaR for the two portfolio’s, Right??? Therefore VaR for this portfolio is
USD 31921 + USD 33552 = USD 65473
No !! Correlation gets involved here. If S&P 500 and gold were perfectly correlated (+1), the VaR for the portfolio would equal the VaR for the S&P 500 plus the VaR for the gold (31921+33552 = 65473).
Less than perfect correlation leads to some of the risk being “diversified”.
IF Correlation between both the asset classes during the given time period is -0.71
Diversification Benefits …the importance of negative correlation…
VaR for the portfolio
The standard deviation of the change in the value of the portfolio consisting of both stocks over a one-day period is therefore
SQRT (13700^2 + 14400^2 + (2*-0.71*13700*14400)) = USD 10719
The 1-day 99% VaR for the portfolio is therefore
2.33*10719 = USD 24977
The amount (31921 + 33552) – 24977 = USD 40496 represents the benefits of diversification.
IMPORTANTLY COMMODITY HAS HISTORICALLY PROVIDED IMPORTANTLY COMMODITY HAS HISTORICALLY PROVIDED DIVERSIFICATION DUE TO LOW OR NEGATIVE CORRELATION WITH DIVERSIFICATION DUE TO LOW OR NEGATIVE CORRELATION WITH
OTHER ASSET CLASSES!!!OTHER ASSET CLASSES!!!
Diversification Benefits …the importance of negative correlation…
In Summary, Commodities Offer:
•Positive Expected Risk Premium
•Strong Diversification Effects
•Unique Risk Hedging
•Benchmark Choices
•Variety of Investment Vehicles
DISCLAIMER: The Information in the presentation is solely for informational purpose and should not be regarded as a recommendation by FTKMC. All information in the presentation is obtained from the sources believed to be reliable and FTKMC or any of the associate entities make no representation as to its completeness or accuracy. FTKMC accepts no obligation to correct or update the information or opinion. No member of FTKMC or its associate entities accept any liability whatsoever, or other loses arising from the use of the material in the presentation and or further communication in relation to this presentation.
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