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					COMMODITIES
  as an asset class




   Guru Raghavan
                          INDEX

•   Commodity characteristics
•   Commodity markets
•   Commodity pricing
•   Commodity risk analysis
•   Commodity hedging
•   Commodity indexes
•   Commodity investment
    Characteristics of commodities
    Commodities are physical goods, but not all physical goods are
    commodities. Commodities have certain characteristics that make it
    feasible to trade them in markets:

-   They can be stored for long periods or in some cases for unlimited
    periods
-
    Their value depends heavily on measurable physical attributes and on
    the physical location of the commodities

    Commodities with the same physical attributes and the same physical
    location are fungible. If a buyer has contracted to purchase petroleum
    of a certain density and sulphur content or wheat of a certain type
    and moisture content, it need not be concerned about which well
    pumped the oil or which farmer raised the wheat
Characteristics of commodity markets
        Nature of commodities

Commodities are real assets that are produced and consumed as it is
or for producing other finished goods. Where as the other asset
classes represent financial claims on different aspects of real assets.
This aspect of commodities has a number of dimensions

Consumption goods: Commodities are primarily consumption goods.
This means that their demand is not purely price dependent. Some
commodities display characteristics not normally found in financial
assets. For example, zero or negative price may occur in few
commodities due to excessive production or for which there is no
demand
Characteristics of commodity markets
        Nature of commodities..


Non standard structure: Commodities are generally non
standards. This is basically due to heterogeneous nature of
commodities in terms of quality or grade.

Cost of production: Commodity prices frequently gravitate
towards the cost of production. This is because market supply
and demand will adjust over time

Price behaviour: Commodity prices display seasonality.
Characteristics of commodity markets
            Market Structure


The commodity market has a number of distinctive structural
elements. The commodity market is global but also displays
jurisdiction specific factors.
                 Commodity markets
                    Participants
Producers and consumers

Producers have outright long positions and the consumers have
outright short positions. This inherent risk exposure drives the use
of commodity derivatives by producers and users. The producers
commodity derivatives are driven by pattern of cash flows.

Consumers hedging behaviour is more complex. Their desire to
undertake hedges is influenced by availability of substitute products
and the ability to pass on higher input costs.

The producers and consumers deal directly with each other and the
form of arrangement may include negotiated bilateral long term
supply or purchase contracts.
                 Commodity markets
                    Participants
Processors

These participants have limited outright price exposure. They have a
spread exposure to the price differential between the cost of the
input and the cost of output. The nature of exposure drives the type
of hedging activity and the instruments used.

Traders

Where involved the traders act as an agent or principal to secure the
sale / purchase of the commodity. Traders increasingly seek to add
value to a pure trading relationship by providing derivative / risk
management expertise. Traders also at times provide financing and
other services. Traders have complex hedging requirements. Acting
as an agent will have no price exposure. While acting as a principal,
will have outright commodity price risk that requires hedging.
              Commodity markets
                 Participants

Dealers and Financial institutions

Their participation in the markets is primarily as a provider of
finance or provider of risk management products. The dealers
role is similar to that in the derivative markets in other asset
classes.

Investors

They are financial investors seeking to invest in commodities
as a distinct and separate asset class of financial investment
               Commodity pricing

Commodity prices display volatility

The volatility of commodity prices is significant and (often) higher
than for equity portfolios.

Commodity prices exhibit a skew in returns over certain
periods of time. Commodities appear to exhibit a positive skew
more often than other financial assets. This is driven by the
fact that unexpected changes in price tend to be positive in
nature
               Commodity pricing

Commodity investments provide yield like returns. In the case of
physical commodities, this return can be generated by lending out the
commodities itself.

Commodities also display price returns. The price returns on
commodity assets are complex. The basic component of price
return is commodity price changes. This may be in the form of
changes in the price of the physical asset itself, or in the price
of the derivative contract that is driven by the underlying
commodity price.
              Commodity pricing
              How prices are set

The method for establishing the price of a contract is set in the
contract specifications. These state which currency the price is
quoted in and the unit for which the price is quoted. Prices for
agricultural futures traded in the United Sates are normally
quoted in cents and for some contracts in fractions of a cent.
Prices in most other countries and for US financial futures
contracts are quoted in decimals rather than fractions .
                  Commodity pricing
                   The quoted price

    The quoted price is not the price of a contract but of the
    specified unit. It must be multiplied by the number of units per
    contract to determine the price of one contract. Consider the
    International Petroleum Exchange’s Brent Crude contract,
    which is priced in US dollars even though it trades in London.
    The quoted price is for a single barrel of oil (42 American
    gallons or 159 litres). One contract provides for the future
    purchase or sale of 1,000 barrels of oil. If a given month’s
    Brent crude contract is trading at $100, one contract costs
    1,000X$100 or $100,000. A 10 cent drop in the posted price
    means a decrease of $100 in the value of a contract
.
                  Commodity pricing
                   Price movements

    Prices in the markets change constantly in response to supply
    and demand which are affected mainly by news from outside,
    although in a highly selective way. A fall in New York share
    prices will be felt immediately in the Chicago Mercantile
    Exchange pit where futures futures on the S&P’s 500 stock
    index are traded, but may not be noticed in the nearby cattle
    futures pits. Investors in commodity futures pay close
    attention to information that could affect the price of the
    underlying commodity. For example orange juice futures will
    soar on reports of frost that could damage the orange crop in
    Brazil. Investors in financial futures are concerned more with
    economic data that might signal interest rate changes
.
          Commodity pricing
       Limits on price movements

For some contracts the contract specifications limit the amount
that the price may rise or fall in a given day. A limit move
means that the contract has fluctuated as much as allowed on
that day. A contract that has risen the maximum allowable
amount is said to be limit up. One that has fallen the
permissible maximum is limit down. A locked market has
reached its price limit and trading may proceed only at current
prices or prices closer to the previous day’s settlement prices .
              Commodity pricing
                The spot price

The reference price for any futures contract is the spot price,
the amount required to go out and purchase those items
today. The difference between the spot price of an asset and
the price of a futures contract for the nearest delivery month is
the basis or the swap rate. As a contract approaches its
delivery date its price normally converges with the spot price.
The reasoning is intuitive. If the price of Japanese yen to be
delivered 30 days from now is far above the spot price, a
buyer could purchase yen now in the spot market and put
them in the bank for 30 days rather than buying futures
contract
              Commodity pricing
                Term factor

Most of the time the price of a contract rises as the delivery
month becomes more distant. This reflects both the greater
risk of big price changes over the life of a longer term contract
and the fact that the buyer of that contract has money tied up
for a longer period. If this price relationship exists, with each
delivery date for a particular contract having a higher price
than the previous delivery date, the market is called a normal
market, or is said to be in contango. If the near term contracts
cost more than more distant contracts, the market is said to
be inverted or in backwardness
          Commodity pricing
       Obtaining price information

The current price of a futures contract is simply the most
recent price at which a contract was exchanged. Active traders
and investors can subscribe to private information services. In
some cases, the information services are able to station
reporters on the exchange floor to report on transaction
prices; in other cases, the exchange supplies the services with
the information. But as prices for heavily traded contracts
change constantly, exchange members have an advantage.
Only they have the latest information about trades and orders,
gained either by being on the trading floor or by monitoring
the computer trading system
      Commodity risk analysis


Commodity hedging entails a high degree of
basis risk. This is driven by greater diversity
in the underlying commodities. This creates
significant opportunities for product design
and trading. The major types of basis risk
include
     Commodity risk analysis
    Basis risk – Quality / Grade

This refers to the basis risk involving product
specification (quality, grade and size). In
practice there are limited range of traded
commodities on which derivatives are
available. This requires the use of correlation
relationships to hedge/trade exposures. This
creates exposure to basis risk
      Commodity risk analysis
       Basis risk – Location

The underlying commodity must be physically
delivered at a specific location. Significant
price differences can exist between locations.
This reflects the supply demand condition in
the relevant location and the cost of
transportation of the commodity between
locations. The price differentials between
delivery locations can change rapidly
      Commodity risk analysis
        Basis risk – Time

Liquidity conditions may dictate use of hedges
with different maturity to the underlying
exposure. This limiting exposure can be
particularly important to commodities. This is
because sudden shifts in demand, supply or
transportation conditions can affect the
efficiency of the hedge
      Commodity risk analysis
          Event risk

This refers to significant events in individual
commodity markets that have significantly
affected prices. Examples of event risk
affecting commodity prices include the Gulf
War, Iraq War, the Hamanaka Copper scandal
and the decision by Central Banks to halt gold
sales
       Commodity hedging



Corporations  Financial risk management 
Commodity price risk management  Commodity
risk management  Commodity derivatives 
Commodity hedging
        Commodity hedging..


The awareness of commodity price risk management
also coincides with increasing volatility in commodity
markets. The volatility in commodity markets is at
several levels

 - Structural volatility
 - Event risk
 - Resource intensity
          Commodity hedging..
          Structural volatility
The declining purchasing power of monetary assets increase the demand
for commodities, resulting in an increase in the prices of real goods
(including commodities) relating to financial assets.

In the 1970s, basic commodity price rose sharply, reflecting high rates of
inflation in the global economy. The major impact of this period was the
massive transfer of wealth from commodity users to commodity
producers, particularly oil producing countries.

High real interest rates in the late 1970s and the 1980s meant that the
relationship between commodity prices and financial assets changed
dramatically. As real interest rates rose, the opportunity costs of holding
inventories of commodities increased, resulting in a shift out of
commodities and into financial assets. The late 1980s and 1990s were
characterized by high real but low nominal interest rates and low
inflation. During this period, commodity prices fell in real terms.
         Commodity hedging..
            Event risk

This refers to significant events in individual commodity markets
that have significantly affected prices. Examples of event risk
affecting commodity prices include the Gulf war, Iraq war, the
Hamanaka copper scandal and the decision taken by central
banks to halt gold sales
         Commodity hedging..
          Resource intensity

This refers to changes in the fundamental level of demand.
Commodity prices are affected by the increasingly lower resource
intensity of certain industries. For example, the amount of metal
used in cars have reduced dramatically over time, reducing
demand. In contrast, the entry of certain communist countries into
global trade has created demand for other commodities such as
oil. It has also increased supply of other commodities, reflecting
the participation of these countries in international trade
               Commodity hedging..
Major drivers – Managing commodity price volatility




  Commodity hedging offers both producers and users the ability to
  lock in the price of commodity purchases or sales. For the
  producer, the benefit of hedging is the guarantee of revenue. This
  is of particular importance to high cost producers that sacrifice
  potential windfall gains of higher prices in order to obtain
  protection against the risk of lower prices. For consumers
  hedging guarantees prices for the purchase of essential raw
  materials, allowing profit margins on end products to be
  determined. Commodity hedging can be used by processors to
  manage both input price and output price exposure
             Commodity hedging..
    Major drivers – Additional financing flexibility



Commodity hedging can ensure certainty of revenue cash flows o allow
the organization to access finance. This is particularly important in the
case of commodity producers seeking financing (typically non recourse)
for resource and other projects. Commodity hedging can be integrated
into natural resource project financing, particularly for the resource
producers. The use of commodity hedging to manage the product price
risk on resource projects is increasing. This reflects the requirement of
project finance lenders that appropriate commodity price hedging action
is implemented. A major factor facilitating the use of such commodity
derivatives in the context of project financing is the increased
involvement of supranational bodies. These entities act as the counter
party to the commodity hedge. This is designed to allow entities of lower
credit quality access to commodity derivatives markets.
                 Commodity hedging..
                     Structure


    Key issues include

              - Basis risk

              - Value sources
.
                Commodity hedging..
                Structure - Basis risk

The major types of basis risk include:

              Quality / grade / size - involves specification. There
  are limited ranges of traded commodities on which derivatives
  are available. This requires the use of correlation relationships to
  hedge/trade exposures. This increases exposure to basis risk.
              Location – underlying commodity must be physically
  delivered at a specific location. Significant price differences can
  exist between locations reflecting supply demand condition and
  the cost of transportation between locations. The price
  differentials between delivery locations can change rapidly.
              Time – liquidity conditions may dictate use of hedges
  with different maturity to the underlying exposure. This timing
  exposure can be particularly important in commodities. because
  sudden shifts in demand, supply or transportation conditions can
  affect the efficiency of the hedge.
              Commodity hedging..
            Structure - Value sources
            Shape of forward curve – The forward curves frequently
display backwardation and often change shape - from backwardation to
contango. This allows one to extract additional value.
            Mean reversion / seasonality – the mean reverting and
seasonal behaviour of commodity prices allows producers, processors
and consumers with underlying positions to trade long run price cycles
in commodity price cycles.
            High volatility – creates trading opportunities. It also creates
opportunities for monetising volatility by the sale of options against
natural underlying positions
            Correlation – commodity users, processors or users often
have embedded correlation positions that can be used to generate value.
For example, Commodity users often have exposure to a range of
commodities that are imperfectly correlated. Commodity producers have
price exposures that are imperfectly correlated to exposures in other
asset classes (interest rates and currency). This allows correlation-based
hedges with lower costs.
               Commodity indexes

Similar in concept to other indexes, including equity indexes, the
ability to provide diversified exposure to commodity prices in general
on a diversified basis has encouraged the advent of transactions
where the linkage is to an index. The benchmarking of commodity
portfolios to these indexes for the purpose of performance
measurement has also encouraged transactions based on the index.
             Commodity indexes
               Characteristics


A commodity index is essentially designed to represent and track
price changes in a basket of commodities or commodity futures
contracts. The underlying logic is that the returns on the index
approximate the returns to an investor holding an un leveraged
position in the assets underlying the basket.
              Commodity indexes
                  Drivers

The essential drivers of commodity indexes are:

   - Indexes allow diversified exposure to commodities to be
engineered
    - The index can be used as a performance benchmark for
commodity investments

In practice, commodity indexes are important in commodity markets
as derivative transactions (futures contracts as well as forwards and
options) and structured notes based on the index rather than specific
commodities have become increasingly popular.
           Commodity indexes
       Differences between indexes
Composition – commodity indexes are either narrow or broad based.
Narrowly based indexes typically cover major commodities, primarily
energy and metals. Broad based indexes cover these commodities, but extend
their coverage to a large variety of other commodities including ‘softs’
(grains, livestock and other agricultural products). Narrowly based indexes
aim to be sector specific and focus on liquid commodities with a direct link
to industrial production and GDP. Narrowly based indexes also seek to avoid
exposure to factors such as weather conditions. Broad based indexes are
focused on a widely based exposure to all commodities that are economically
significant. Broad based indexes, while more difficult to replicate, will
generally provide more accurate protection against inflation and exposure to
the low cross correlations between commodities. The underlying assets in a
commodity basket may also vary. Some indexes use physical commodities
while others use futures contracts on the commodity. The difference is driven
by the relative liquidity and price transparency of the relevant commodity
markets
           Commodity indexes
       Differences between indexes
Weight

Index weight may be based on

Economic weights – based on fundamental economic data (such as
world production quantities or values)

Equal weights – based on fixed weights

Market weights – based on relative trading volumes in futures
markets (on futures contracts on the commodity)

Optimised weights – based on econometric models which seek to
optimize nominated criteria (such as level of returns, volatility of
returns, correlations to inflation etc) over the selected time period
           Commodity indexes
       Differences between indexes
Rebalancing – index rebalancing entails two separate factors – the
mechanics of rolling futures contracts and rebalancing the portfolio
weighting. Where the commodity index is based on commodity
futures contracts, the futures contract will mature and must then be
rolled into a more distant maturity. This rolling process is the
mechanism that allows capture of the convenience yield in the
commodity markets. The other element of index rebalancing
necessitates adjusting the positions in individual commodities (for
example, electricity or telecommunications capacity). There are two
approaches:

      fixed weights – consistent exposure is maintained based on
fixed quantities of commodities in the basket

       value weights – this     requires constant rebalancing with
investors effectively selling (buying) commodities that have risen
(fallen) in value
          Commodity indexes
      Differences between indexes


Return calculations – return may be calculated on an
arithmetic or geometric basis. The use of geometric returns
prevents domination of index value changes by higher priced
commodities.
           Commodity indexes
       Differences between indexes

Leveraged versus un leveraged returns – a leveraged
commodity index is typically based on future contracts. This reflects
the fact that trading in futures requires minimal commitment of
capital (the initial and variation margin). This will have the effect of
enhancing the returns, as price changes will be relative to low levels
of employed investment capital. Un leveraged indexes assume either

     Investment in cash or physical commodity assets

     Investment in future contracts, but with fully matched
     cash investment equal to the underlying value of the contract
     (the cash earns risk free returns) .
         Commodity indexes
     Differences between indexes


Total return versus excess returns – the commodity index
returns are calculated in two ways

    total return – representing the total rate of return of the
    index

    excess return – representing the total returns minus the
    return on treasury bills
            Commodity indexes
             Various indexes


CPCI - Chase Physical Commodity Index,
CRBI - Commodity Research Bureau Index,
DJ-AIGCI - Dow Jones AIG Commodity Index,
GSCI - Goldman Sachs Commodity Index
                 Commodity indexes
                   Comparison
Index           CRBI             CPCI             GSCI             DJ-AIGCI


Composition     Broad            Broad            Broad            Broad
Major sectors   Energy, Live     Energy, Live     Energy, Live     Energy, Live
                stock, grains,   stock, grains,   stock, grains,   stock, grains,
                industrial       industrial       industrial       industrial
                metals,          metals,          metals,          metals,
                precious         precious         precious         precious
                metals and       metals and       metals and       metals and
                softs            softs            softs            softs
Weighting       Equal            Economic         Economic         Liquidity,
                                                                   economic
Rebalancing     Value: static    Value:           Quantity;        Value:
                                 dynamic          dynamic          dynamic
Returns         Geometric        Arithmetic       Arithmetic       Arithmetic
          Commodity investment


The market has witnessed a rapid growth in demand for
commodity linked investment instruments. The growth in this
source of commodity demand is evidenced by the fact that a
significant portion of commodity trading is now investor driven
             Commodity investment

Financial and portfolio investors face substantial difficulties in effecting
commodity investments. These include storage and related (insurance,
transport, etc) costs and difficulties in leasing or lending out the commodity
holding. These factors have encouraged the development of a paper
commodity market that strongly emphasizes commodity-linked notes (or
pure off balance sheet structures) as the mechanism for creating the required
exposure to commodity prices. The investment demand for commodity-
linked products has been met from two sources: firstly, issue of commodity
linked debt from commodity producers (and, less frequently, commodity
users); and secondly, structured notes with commodity price linkages. In
practice commodity linked structured notes are the principal method of
providing commodity exposure for investors
           Commodity investment


Commodity investment by traditional financial investors has become
a significant factor in commodity markets. Commodity investment is
driven by different factors to that driving investment in other
financial assets.
            Commodity investment
The demand for financial investment in commodities was originally
driven by the following factors.
Speculation: Investors seeking to speculate on future price
movements of the underlying commodity
Inflation protection: Investors seeking inflation proof investments
in an attempt to preserve the purchasing power of their monetary
asset particularly under conditions of high inflation
Pure commodity exposure – Investors seeking pure commodity
exposure that is not obtainable efficiently through equity investments
(that filter the direct commodity exposure)
Commodity as a separate asset class: Investors seeking exposure to
commodities in a diversified portfolio where commodity assets are
treated as a unique asset class
            Commodity investment
                 Speculative purposes


The demand for commodity investment for speculative purposes is a
constant feature of commodity markets. This interest derives from
both retail and institutional investors. Retail interest is widespread, in
areas where commodities (precious) metals are seen as a type of
savings. This is particularly evident in Asia, the Middle East and
Latin America
            Commodity investment
                  Inflation protection
During the inflationary period of the 1970s and 1980s, a variety of
commodity linked structures evolved in response to the demand for
effectively priced inflation linked securities. These investments were
designed to protect the value of investment capital in real terms.
Interest in commodities as a mechanism for preservation of
purchasing power has become less important as the price inflation
pressures have reduced in the 1990s.

However, these pressures have resumed in the 2000s, with the oil
taking its onward march very steeply; additionally the Chinese
demand for more commodities have seen the prices of many metals
going up to unheard levels so far. Moreover, the present economic
predicament in which US economy is placed is also putting upward
pressure
            Commodity investment
            Pure commodity exposure
The traditional format for commodity investment is investment in the
stocks of companies involved in resources (commodity producers
and users). Increasingly direct investment in the commodity itself has
emerged as the favoured form of creating the price exposure. This
reflects increased awareness that resource based stock’s price
movements are strongly correlated to movements in equity prices
generally. This means that the commodity price exposures obtained
through stock investment is imperfect. The fact that the commodity
firm may have investments in a range of (unrelated) commodities
may also make it difficult to obtain pure price exposure to a single
commodity.
             Commodity investment
                    Separate asset class
The concept of an asset class relates to a set of investments that exhibit
similar and distinctive investment characteristics (primarily return, volatility
of return and relationship of return to returns from other investment assets)

The typical characteristics of an asset class include
      Yield
      Price return
      Volatility
      Liquidity

It is important to differentiate between physical commodity investments
(investment in commodity assets) and paper commodities. In practice, all
commodities, particularly paper commodity assets, display all of the requisite
characteristics identified above

				
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