Commodity, A must asset class in your Portfolio

Portfolio

“Portfolio” is a collection of investments held by an institution or an individual. Holding a

portfolio is a part of an investment & diversification. By owning several assets, certain types of

risk can be reduced. A group of investments such as stocks, bonds and cash equivalents, mutual

funds, exchange-traded funds, and closed-end funds that are selected on the basis of an

investor's short-term or long-term investment goals. Prudence suggests that investors

should construct an investment portfolio in accordance with risk tolerance and investing

objectives.

In building up an investment portfolio a financial institution will typically conduct its own

investment analysis, while a private individual may make use of the services of a financial

advisor or a financial institution which offers portfolio management services.

Assets in Portfolio

1) Bank Accounts

2) Stocks

3) Bonds

4) Options

5) Warrants

6) Gold Certificates

7) Real Estates
8) Futures contracts

9) Production Facility

And any other item that is expected to retain its value.

Portfolio Management

Portfolio Management is the professional management of various securities (shares, bonds and

other securities) and assets (real estate) in order to meet specified investment goals for the

benefit of the investors. Investors may be institutions (insurance companies, pension funds,

corporations, charities, educational establishments etc.) or private investors. (both directly via

investment contracts and more commonly via collective investment schemes e.g. mutual

funds or exchange-traded funds).

It involves deciding what assets to include in the portfolio, given the goals and risk tolerance

of the portfolio owner. Selection involves deciding which assets to acquire/divest, how many to

acquire/divest, and when to acquire/divest them. These decisions always involve some sort of

performance measurement, most typically the expected return on the portfolio, and

the risk associated with this return). However, due to the almost-complete uncertainty of future

values, this performance measurement is often done on a casual qualitative basis, rather than a

precise quantitative basis (which would give a false sense of precision). Typically the expected

return from portfolios of different asset bundles are compared.

Traditional portfolio planning called for the selection of those securities that best fit the

personal needs and desires of the investors. Modern portfolio theory suggests that the

traditional approach to portfolio analysis, selection, and management may yield less than

optimum results, for that a more scientific approach is needed, based on estimates of risk and
 return of the portfolio and the attitudes of the investor toward a risk-return trade-off stemming

from the analysis of the individual securities.

Strategies For Portfolio Management

1) Equally weighted portfolio.

2) Capitalization weighted portfolio.

3) Price weighted portfolio.

4) Optimal portfolio.

Risks & returns

Returns

Return on a typical investment consists of two components, first is periodic cash receipts on the

investments, either in the form of interest or dividends. The second component is the change in

the price of the asset commonly called Capital gain or loss. This element of return is the

difference between the purchase price and the price at which the asset can be or is sold. Portfolio

returns can be calculated on a daily or long-term basis to serve as a method of assessing a

particular investment strategy.

Total return = Income + Price Change (+,-)

Return Measurement

The correct measurement must incorporate both income and price change into a total return.

Returns across time or from different securities can be measured and compared using the total
return concept. The total return for a given holding period relates all the cash flows received by

an investor during any designated time period to the amount of money invested in the asset.

Total return= Cash payment received + Price change over the period
Purchase price of the asset

Risks

Risk in holding securities is generally associated with the possibility that realized returns will be

less than the returns that expected. The source of such disappointment is the failure of dividend

and/or security price to materialize as expected.

Forces that contribute to variations in return- price or dividend- constitute element of risk. Some

influences are external to the firm, cannot be controlled, and affect large number of securities.

Other influences are internal to the firm and are controllable to a large degree. In investment,

those forces which are uncontrollable, external and broad in their effect are called sources of

systematic risk. Conversely, controllable, internal factors somewhat peculiar to industries and/or

firms are referred to as sources of unsystematic risk.

Systematic risk

1) Market risk: Market risk is the risk that the value of an investment will decrease due to

moves in market factors.

Volatility frequently refers to the standard deviation of the change in value of a financial

instrument with a specific time horizon. It is often used to quantify the risk of the

instrument over that time period. Volatility is typically expressed in annualized terms,

and it may either be an absolute number ($5) or a fraction of the initial value (5%).
 The four standard market risk factors are stock prices, interest rates, foreign exchange

rates, and commodity prices. The associated market risks are:

• Equity risk: the risk that stock prices and/or the implied volatility will change.

• Interest rate risk: the risk that interest rates and/or the implied volatility will

change.

• Currency risk: the risk that foreign exchange rates and/or the implied volatility

will change.

• Commodity risk: the risk that commodity prices (e.g. corn, copper, crude oil)

and/or implied volatility will change.

2) Interest rate risk: Interest rate risk is the risk (variability in value) borne by an interest-

bearing asset, such as a loan or a bond, due to variability of interest rates. In general, as

rates rise, the price of a fixed rate bond will fall, and vice versa. Interest rate risk is

commonly measured by the bond's duration.

3) Purchasing power risk: it is the uncertainty of the purchasing power of the amounts to be

received. In more everyday terms, it refers to the impact of inflation and deflation on an

investment.

If we think of investment as the postponement of consumption, we can see that when a

person purchases a stock, he has foregone the opportunity to buy some good or service

for as long as he owns the stock. If, during the holding period, prices on desired goods

and services rise, the investor actually loses purchasing power. Rising prices of goods

and services are normally associated with what is referred to as inflation. Falling prices
 on goods and services are termed deflation. Both inflation and deflation are covered in

the all-encompassing term purchasing-power risk.

Unsystematic risk

1) Business risk: The risk that a business will experience a period of poor earnings and

resultant failure. Business risk is greatest for firms in cyclical or relatively new

industries. Business risk affects holders of stocks and bonds, since a firm may be

unable to pay dividends and interest.

Business risk can be divided into two broad categories: external and internal. Internal

business risk is largely associated with the efficiency with which a firm conducts its

operations within the broader operating environment imposed upon it. Each firm has

its own set of internal risks, and degree to which it is successful in coping with them

is reflected in operating efficiency.

External business risk is the result of operating conditions imposes upon the firm by

circumstances beyond its control. Each film also faces its own set of external risks,

depending upon the specific operating environmental factors which it must deal.the

external factors, from cost of money to defense budget cuts to higher tariffs to a

downswing in the business cycle, are far too numerous to list in detail, but the most

pervasive external risk factor is probably the business cycle.

2) Financial risk: Financial risk is associated with the way in which a company finances

its activities. We usually gauge financial risk by looking at the capital structure of a

firm. The presence of borrowed money or debt in the capital structure creates fixed

payments in the form of interest that must be sustained by the firm. The presence of
 these interest commitments (fixed interest payments due to debt or fixed dividend

payments on preferred stock) causes the amount of residual earnings available for

common stock dividends to be more variable than if no interest payments were

required. Financial risk is avoidable risk to the extent that managements have the

freedom to decide to borrow or not to borrow funds. A firm with no debt financing

has no financial risk.

Commodity

“Commodity” refers to any good that possesses a physical attribute. It is a thing of value, with

uniform quality, produced in large quantities by many different producers. The commodity can

be produced by different producers, but will still be considered equivalent. It is a physical

substance such as food, metal and grains which is interchangeable with another product of the

same type. Commodities are most often used as inputs in the production of other goods and

services. The price of commodity is subject to the demand and supply of that commodity in

market.

Anything which is supplied across markets without any product differentiation, and for which

the demand exists is a commodity. Crude is a commodity, and it has one price around the world,

that price being determined daily based on global supply and demand. Cement, on the other hand

is determined through branding, and is not a commodity. In general, better grades of cement will

sell for more.

So a commodity is understood to mean a good that has the following properties:

• Is usually produced and/or sold by many different producers

• Is uniform in quality between producers that produce and sell it

 • Is traded at a price resulting from its demand and supply

Commodity Risks

Commodity risk refers to the uncertainties of future market values and of the size of the

future income, caused by the fluctuation in the prices of commodities. These commodities may

be grains, metals, gas, electricity etc. A commodity enterprise needs to deal with the following

kinds of risks:

• Price risk: Risk arising out of adverse movements in the world prices, exchange rates,

basis between local and world prices. It also includes the risk comes about due to the

unpredictability of cost at which production inputs can be obtained in the future, or the

price of the final produce can be sold, in the future.

• Yield risk: Risk occurs because agriculture is affected by many uncontrollable events that

are often related to weather, including excessive or insufficient rainfall, extreme

temperatures, hail, insects and diseases. For many other producers, the threat of

obsolence of machinery can cause a risk.

• Political risk: Political risk refers to the complications producers may face as a result of

what are commonly referred to as political decisions—or “any political change that alters

the expected outcome and value of a given economic action by changing the probability

of achieving business objectives.”

Commodity Derivatives

Derivatives are investment tools that allow investors to profit from certain

items without possessing them. This type of investing dates back to 1848
when the Chicago Board of Trade was established. Initially, the idea behind

commodity derivatives was to provide a means of risk protection for farmers.

They could promise to sell crops in the future for a pre-arranged price.

Modern commodity derivatives trading is most popular with people outside of the commodities

industry. The majority of people who use this investment tool tend to be price speculators. These

people usually focus on supply and demand and try to predict whether prices will go up or down.

When the prices of a certain commodity move in their favor, they make money. If price moves in

the opposite direction, then they lose money.

The buyer of a derivative contract buys the right to exchange a commodity for a certain price at a

future date. Although this person is a contract buyer, he may be buying or selling the commodity.

He does not have to pay the full value of amount of the commodity that he is investing in. He

only needs to pay a small percentage, known as the margin price.

The contract seller is the person who accepts a margin. He agrees that on a certain date he will

buy or sell the commodity stated in the contract at a certain price. Both parties are generally

required to honor the agreement despite losses.

For example, an investor may buy a contract from the seller that gives him rights to one ton of

coffee beans for $1000 US Dollars (USD) on July 1st. Although the value of the contract is

$1000 USD, the buyer may only be required to pay $100 USD. On July 1st, the seller will

transfer the rights of one ton of coffee beans to the buyer.If the current value of a ton of coffee

beans on July 1st is $1,500 USD, the buyer can sell to the market and make a $500 USD profit.

If the value of coffee beans on that day is only $800 USD, this person will have purchased at a

loss. He can choose to take possession of the coffee beans, which is rare. He can sell to the

market at a loss. In most cases, he will become the seller and attempt to find a buyer.
Commodity exchange

A commodities exchange is an exchange where various commodities and derivatives products

are traded. Most commodity markets across the world trade in agricultural products and

other raw materials (like wheat, barley, sugar, maize, cotton, cocoa, coffee, pork

bellies, oil, metals, etc.) and contracts based on them. A commodity exchange offers a central

meeting place where buyers and sellers meet to do business, and where various commodities are

traded. The contracts traded on commodity exchanges can include spot

prices, forwards, futures and options on futures contracts. The exchange only facilitates where

buying and selling can take place. The exchange itself does not buy or sell commodities or

contracts, nor does it set or establish prices. A commodity exchange performs three main

functions. Firstly, it sets rules and regulations to standardise the practices of buying and selling

in the market. Secondly, the commodity exchange provides the mechanism for resolution of

business disputes. Finally, and very importantly, commodity exchange helps to generate and

disseminate valuable signals relating to price and market information to exchange members, their

customers and other interested market participants on a real time basis.

The sale and purchase of commodities usually carried out through future contracts on exchanges

that standardize the quantity and minimum quality of the commodity being traded.

There are mainly 3 national level commodity exchanges in India:-

1) National Commodity & Derivative Exchange Limited (LCDEX)

2) Multi Commodity Exchange of India Limited (MCX)

3) National Multi Commodity Exchange of India Limited (NMCEIL)

 The commodities which are traded under these exchanges are shown in Fig.1

Fig: 1 Commodities in Indian commodity market

Trading Systems on commodity exchanges

There are two ways that contracts can be traded on an exchange.

1) Open-outcry: as the name suggests, this method involves the use of shouting and hand

signals by traders on the exchange trading floor to transfer information information about

buy and sell orders. The part of the trading floor where this takes place is called the

pit( or ring). The trading floor serves as a trading venue, or a place where traders meet in

order to buy and contracts. Example of exchanges which still have this system in use,

though to a limited extent, are the New York Mercantile Exchange. The Chicago

Mercantile Exchange. In UK, the London Metal Exchange also makes use of open-

outcry.

2) Electronic Trading: Electronic trading, or e-trading, is a screen based method of trading

electronically, as contrasted to the floor-based open-outcry method. It uses information

 technology to bring together buyers and sellers through electronic media to create a

virtual marketplace. MCX and NCDEX are examples of electronic marketplaces.

Electronic trading systems, besides being faster, cheaper and more efficient to use, are

less prone to manipulation by market makers and brokers/dealers.

Participants in Commodity Markets

There are primarily three classes of participants in the commodity market.

1) Hedger: Hedging is buying and selling future contracts to offset the risks of changing

underlying market prices. The objective is to reduce the risk associated with exposures in

underlying market by taking counter-positions in the future markets. The buyers of the

commodity, which are consumers like refineries or food processing companies, are trying

to secure as low a price as possible, and are called hedgers. The sellers of the commodity,

which could be producers or farmers who want to mitigate the risk of prices declining by

the time they actually bring their commodity for sale in the market, will want to secure as

high a price as possible. They are also hedgers, but with a different direction of risk as

compare to the buyers.

So, a hedger can essentially be anyone, a seller or a buyer, who has an underlying risk in

a commodity, and wants to transfer the price-risk onto the market. The commodity

derivatives contract provides a definite price certainty which reduces the risk associated

with price volatility for both parties. By means of derivatives 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.

 2) Speculator: A speculator is a risk taker who trades commodities with higher than average

risk in for return higher than average profit potential, in order to benefit from the

inherently risky nature of the commodity market. The aim of a speculator is to profit from

the very price change that the hedger seeks protection from. In a commodity market, a

speculator buying 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 will enter the market seeking profits by offsetting

rising and declining prices through the buying and selling of contracts.

3) Arbitrageur: An arbitrageur is one who predicts the basis, uses his knowledge to take

positions in the cash and futures markets. The arbitrageur looks for non speculative

profits by operating in two or more markets simultaneously, by taking a long position in

one market and a short position in another market. If he sees the future price of a

commodity getting out of sync with its spot price with regard to its basis, he will take

offsetting position in the two markets to lock in a profit. In the process, the arbitrageur,

by his actions, serves to remove mispricing, if any, in either the cash or futures markets,

and aligns the prices through operating in both markets.

Need

In the wake of globalisation and surge in the global uncertainties, financial organisations

around the world are devising methods and instruments to contain the price risk that these

uncertainties bring. Commodity derivatives are such instruments that have been devised

to achieve price risk management by basing the value of a security on the value of an

underlying commodity. Commodity derivatives trading although has witnessed a long

history, with the recent measures of liberalisation, the sector has witnessed a massive

boom in the country.

Planned and sustained growth of any sector coupled with a prudent demand and supply

management calls for a system, which can not only yield adequate returns to its producers

but also ensure timely supply at desired prices to the consumers. Commodity derivatives

or futures markets hold a key in insulating the producers and the trade functionaries from

the seasonal and cyclical oscillations in the prices of commodities, which are aggravated

by the high income and low price elasticity of demand and the shifts in such elasticity

overtime. Derivatives markets hold an immense potential for the economy as they

stabilize the amplitude of price variations, facilitate lengthy, complex production

decisions, bring a balance between demand and supply, act as a price barometer to the

farmers and the traders besides encouraging competition. These markets while enabling

price discovery and better price risk management engender inter-temporal price

equilibrium and horizontal and vertical price integration. While ensuring price risk

mitigation and remunerative returns, these markets also contribute in scaling down the

downside risks associated with agricultural lending and thereby facilitate the flow of

credit to agriculture. Besides, these markets through the use of warehouse receipts

obviate the need for collaterals, the lack of which has currently impeded the flow of

agricultural credit. They also hold a key role not only in reinvigorating the spot markets

but also triggering the diversified growth of Indian agriculture in line with the

consumption pattern. A strong, healthy, vibrant and well developed commodity

exchanges can play a pivotal role in the globalisation of international trade by imparting a

competitive pricing efficiency to exports. The promotion of derivatives trading has

 become imperative particularly, in the aftermath of WTO regime to face the challenges in

terms of exposure to the vicissitudes of world commodity prices and heightened

competition.

The 4 fundamental reasons why commodities should be part of a well diversified

portfolio.

1) Having a holding in commodities helps to spread your portfolio risk by

diversifying your assets.

2) Commodity prices tend not to move in same direction as other asset classes.

3) Commodities can allow you to gain exposure to a specific area in order to take

advantage of opportunities – e.g. gold in times of uncertainty.

4) Historically, commodities have been a good hedge against inflation.

Top 5 commodities demanded in india

The top five commodities in Indian in terms of popularity, value and volume.

Here are they:

Gold: One of the favourites in Indian sub continent. Addiction with Gold never

ceases round the year, whether it is a household woman or a trader with

substantial wealth. Gold is one single commodity Indians trust more than their

spouse. And believe it or not, the yellow commodity has always been faithful to

the owner – much more than many high society individuals to their spouses or

dogs to their masters. India is the largest consumer of Gold. If one billion plus

population of India had the capacity, they would have built their toilets in Gold.
 Such is the fascination for Gold that it has become the sole representative of value

addition. In advisory business, Gold advisories sell the maximum. Irrespective of

the return it gives, traders and investors stick to Gold.

Gold trading on MCX

Silver: Known as a poor cousin to Gold, the white super metal has given investors more

than what Gold has given. The unprecedented rise of Silver has surprised the pundits but

investors in Silver laughed all the way to the bank this year. But pure economics points

out that in the last decade, the annual production of Silver has been much less than the

annual consumption. Supply and demand scenario has put Silver in high pedestal for

investors. The other reason being increased investment demand against the backdrop of

uncertain economy and growing fears of higher inflation. In terms of utility, Silver is

more precious than Gold as it is used heavily in manufacturing sector. A good conductor

of electricity, silver is used to produce batteries, while the anti-bacterial properties of

silver ions are often employed to make water purifiers. It is also used in the production of
 photovoltaic cells, the most common type of solar cells and even in Jet engines. The once

famous model, Zen from Maruti stable, used a silver engine – that gave more efficiency

than any other engines. Silver is suddenly the darling of investors.

Silver trading on MCX

Copper: The first metal man extracted from earth was more used in utensils in ancient

era before ceramic and stainless steel plates were introduced. Due to its wide variety of

usage, it is one of the most versatile and volatile commodities traded in the commodity

exchanges. Copper is more traded by the business community to hedge their positions.

More than 16 per cent of total Copper available is used for building wire followed by

plumbing and heating. It is also used in automative industry, electrical, air conditioning &

commercial refrigeration, electronics and various other uses. The copper usage has

increased to such an extent that thirty years ago a car used about 35 pounds of copper as

against 50 to 80 pounds of copper now. Imagine even a Boeing 727 airplane uses 9,000

pounds of copper.

Copper trading on MCX

 Crude: One of the most essential commodities in today’s world. Crude ditched

thousands of investors when the prices nosedived from over $147 a barrel in July 2008 to

less than 34 in Jan 2009. Many investors went bankrupt and in India, many are said to

have taken the extreme step of killing themselves after seeing their wealth melt like ice.

Why this happened is something that OPEC, the Crude price controlling authority should

answer. But the fact that speculators in tandem with OPEC made the price extraordinary

and unrealistically high, was one major reason. Prices just exploded in a natural

progression of demand and supply. Some earned while a majority lost their trust in

Crude. Thereafter, many in India turned to Gold as a safe investment haven. But being a

commodity without which the world cant move, Crude is still in the top five.

Crude trading on MCX

Zinc: Not everyone knows that Zinc is found everywhere in daily life, in every cell of the

human body, in the earth, in the food we eat and in products we use daily whether it is
 vehicles appliances, or food we eat. For industry it is a corrosion resistant metal. But for a

trader, it is yet another commodity used to gain wealth. According to Portugal-based

International Lead and Zinc study group Zinc production declined by 44% to 166,000

tonnes in the first eight months of 2010. But its inventories piled up resulting in more

than 11% drop in prices at MCX.

Zinc trading on MCX