You are on page 1of 19

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

bonds and other securities) and assets (real estate) in order to meet specified investment goals for the benefit of the investors. mutual funds or exchange-traded funds). rather than a precise quantitative basis (which would give a false sense of precision). and when to acquire/divest them.) or private investors. and management may yield less than optimum results. given the goals and risk tolerance of the portfolio owner. this performance measurement is often done on a casual qualitative basis. Typically the expected return from portfolios of different asset bundles are compared. based on estimates of risk and . Modern portfolio theory suggests that the traditional approach to portfolio analysis. charities. corporations. It involves deciding what assets to include in the portfolio. However. Portfolio Management Portfolio Management is the professional management of various securities (shares. Traditional portfolio planning called for the selection of those securities that best fit the personal needs and desires of the investors. most typically the expected return on the portfolio. Investors may be institutions (insurance companies. These decisions always involve some sort of performance measurement.g. pension funds. due to the almost-complete uncertainty of future values. selection. (both directly via investment contracts and more commonly via collective investment schemes e.8) Futures contracts 9) Production Facility And any other item that is expected to retain its value. how many to acquire/divest. and the risk associated with this return). for that a more scientific approach is needed. educational establishments etc. Selection involves deciding which assets to acquire/divest.

Strategies For Portfolio Management 1) Equally weighted portfolio. Portfolio returns can be calculated on a daily or long-term basis to serve as a method of assessing a particular investment strategy. either in the form of interest or dividends.-) Return Measurement The correct measurement must incorporate both income and price change into a total return. 4) Optimal portfolio. 2) Capitalization weighted portfolio. This element of return is the difference between the purchase price and the price at which the asset can be or is sold. Total return = Income + Price Change (+. Risks & returns Returns Return on a typical investment consists of two components. Returns across time or from different securities can be measured and compared using the total . The second component is the change in the price of the asset commonly called Capital gain or loss.return of the portfolio and the attitudes of the investor toward a risk-return trade-off stemming from the analysis of the individual securities. 3) Price weighted portfolio. first is periodic cash receipts on the investments.

Conversely.constitute element of risk. those forces which are uncontrollable.price or dividend. Volatility is typically expressed in annualized terms. and it may either be an absolute number ($5) or a fraction of the initial value (5%). cannot be controlled. 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. internal factors somewhat peculiar to industries and/or firms are referred to as sources of unsystematic risk. In investment.return concept. Systematic risk 1) Market risk: Market risk is the risk that the value of an investment will decrease due to moves in market factors. It is often used to quantify the risk of the instrument over that time period. . controllable. and affect large number of securities. Other influences are internal to the firm and are controllable to a large degree. 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. Volatility frequently refers to the standard deviation of the change in value of a financial instrument with a specific time horizon. external and broad in their effect are called sources of systematic risk. Some influences are external to the firm. Forces that contribute to variations in return. The source of such disappointment is the failure of dividend and/or security price to materialize as expected.

foreign exchange rates. prices on desired goods and services rise.g. the price of a fixed rate bond will fall. we can see that when a person purchases a stock. and commodity prices. Falling prices . • Currency risk: the risk that foreign exchange rates and/or the implied volatility will change. it refers to the impact of inflation and deflation on an investment. as rates rise. If we think of investment as the postponement of consumption. Interest rate risk: the risk that interest rates and/or the implied volatility will change. the investor actually loses purchasing power. such as a loan or a bond. 3) Purchasing power risk: it is the uncertainty of the purchasing power of the amounts to be received. 2) Interest rate risk: Interest rate risk is the risk (variability in value) borne by an interest- bearing asset. corn. Interest rate risk is commonly measured by the bond's duration. copper. In general. The associated market risks are: • • Equity risk: the risk that stock prices and/or the implied volatility will change. In more everyday terms. due to variability of interest rates.The four standard market risk factors are stock prices. If. interest rates. and vice versa. Rising prices of goods and services are normally associated with what is referred to as inflation. during the holding period. • Commodity risk: the risk that commodity prices (e. he has foregone the opportunity to buy some good or service for as long as he owns the stock. crude oil) and/or implied volatility will change.

Each film also faces its own set of external risks. Business risk affects holders of stocks and bonds. from cost of money to defense budget cuts to higher tariffs to a downswing in the business cycle. Each firm has its own set of internal risks.on goods and services are termed deflation. but the most pervasive external risk factor is probably the business cycle.the external factors. and degree to which it is successful in coping with them is reflected in operating efficiency. depending upon the specific operating environmental factors which it must deal. We usually gauge financial risk by looking at the capital structure of a firm. External business risk is the result of operating conditions imposes upon the firm by circumstances beyond its control. 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. 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. Business risk is greatest for firms in cyclical or relatively new industries. The presence of . Internal business risk is largely associated with the efficiency with which a firm conducts its operations within the broader operating environment imposed upon it. since a firm may be unable to pay dividends and interest. 2) Financial risk: Financial risk is associated with the way in which a company finances its activities. are far too numerous to list in detail. Business risk can be divided into two broad categories: external and internal.

and it has one price around the world. The commodity can be produced by different producers. Anything which is supplied across markets without any product differentiation. but will still be considered equivalent. In general. with uniform quality. that price being determined daily based on global supply and demand. Commodity “Commodity” refers to any good that possesses a physical attribute. The price of commodity is subject to the demand and supply of that commodity in market. Financial risk is avoidable risk to the extent that managements have the freedom to decide to borrow or not to borrow funds. It is a physical substance such as food. It is a thing of value.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. Crude is a commodity. on the other hand is determined through branding. better grades of cement will sell for more. Cement. and for which the demand exists is a commodity. and is not a commodity. A firm with no debt financing has no financial risk. 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 . Commodities are most often used as inputs in the production of other goods and services. metal and grains which is interchangeable with another product of the same type. produced in large quantities by many different producers.

• Yield risk: Risk occurs because agriculture is affected by many uncontrollable events that are often related to weather. This type of investing dates back to 1848 . These commodities may be grains.• 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.” Commodity Derivatives Derivatives are investment tools that allow investors to profit from certain items without possessing them. extreme temperatures. For many other producers. gas. • 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. including excessive or insufficient rainfall. or the price of the final produce can be sold. hail. basis between local and world prices. metals. A commodity enterprise needs to deal with the following kinds of risks: • Price risk: Risk arising out of adverse movements in the world prices. caused by the fluctuation in the prices of commodities. the threat of obsolence of machinery can cause a risk. It also includes the risk comes about due to the unpredictability of cost at which production inputs can be obtained in the future. exchange rates. electricity etc. insects and diseases. in the future.

He agrees that on a certain date he will buy or sell the commodity stated in the contract at a certain price. He can sell to the market at a loss. If the value of coffee beans on that day is only $800 USD. The majority of people who use this investment tool tend to be price speculators.when the Chicago Board of Trade was established. the buyer may only be required to pay $100 USD. they make money. he may be buying or selling the commodity. he will become the seller and attempt to find a buyer. Initially. In most cases. . He can choose to take possession of the coffee beans. which is rare. 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. the buyer can sell to the market and make a $500 USD profit. For example. 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. the seller will transfer the rights of one ton of coffee beans to the buyer. Modern commodity derivatives trading is most popular with people outside of the commodities industry.500 USD. Although the value of the contract is $1000 USD. 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.If the current value of a ton of coffee beans on July 1st is $1. He does not have to pay the full value of amount of the commodity that he is investing in. If price moves in the opposite direction. On July 1st. He only needs to pay a small percentage. Both parties are generally required to honor the agreement despite losses. 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. this person will have purchased at a loss. then they lose money. The contract seller is the person who accepts a margin. known as the margin price.

cotton. futures and options on futures contracts. it sets rules and regulations to standardise the practices of buying and selling in the market. The contracts traded on commodity exchanges can include spot prices. 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.Commodity exchange A commodities exchange is an exchange where various commodities and derivatives products are traded. oil.) and contracts based on them. the commodity exchange provides the mechanism for resolution of business disputes. their customers and other interested market participants on a real time basis. metals. cocoa. 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) . commodity exchange helps to generate and disseminate valuable signals relating to price and market information to exchange members. Secondly. Finally. etc. coffee. Firstly. Most commodity markets across the world trade in agricultural products and other raw materials (like wheat. A commodity exchange offers a central meeting place where buyers and sellers meet to do business. forwards. maize. A commodity exchange performs three main functions. barley. pork bellies. sugar. and very importantly. and where various commodities are traded. nor does it set or establish prices. The exchange only facilitates where buying and selling can take place. The exchange itself does not buy or sell commodities or contracts.

In UK.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. The trading floor serves as a trading venue. Example of exchanges which still have this system in use. or a place where traders meet in order to buy and contracts. are the New York Mercantile Exchange. 2) Electronic Trading: Electronic trading. The Chicago Mercantile Exchange. as contrasted to the floor-based open-outcry method. It uses information .The commodities which are traded under these exchanges are shown in Fig. 1) Open-outcry: as the name suggests. or e-trading. The part of the trading floor where this takes place is called the pit( or ring). the London Metal Exchange also makes use of openoutcry. is a screen based method of trading electronically. though to a limited extent. 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.

technology to bring together buyers and sellers through electronic media to create a virtual marketplace. Participants in Commodity Markets There are primarily three classes of participants in the commodity market. So. The sellers of the commodity. Electronic trading systems. who has an underlying risk in a commodity. They are also hedgers. 1) Hedger: Hedging is buying and selling future contracts to offset the risks of changing underlying market prices. are trying to secure as low a price as possible. MCX and NCDEX are examples of electronic marketplaces. 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. The objective is to reduce the risk associated with exposures in underlying market by taking counter-positions in the future markets. are less prone to manipulation by market makers and brokers/dealers. and are called hedgers. will want to secure as high a price as possible. 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. but with a different direction of risk as compare to the buyers. a seller or a buyer. 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. a hedger can essentially be anyone. The buyers of the commodity. By means of derivatives contracts. besides being faster. cheaper and more efficient to use. which are consumers like refineries or food processing companies. .

the arbitrageur.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 a commodity market. by taking a long position in one market and a short position in another market. if any. If he sees the future price of a commodity getting out of sync with its spot price with regard to its basis. in order to benefit from the inherently risky nature of the commodity market. The arbitrageur looks for non speculative profits by operating in two or more markets simultaneously. In the process. Rather. 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 . 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. he will take offsetting position in the two markets to lock in a profit. Unlike the hedger. by his actions. uses his knowledge to take positions in the cash and futures markets. in either the cash or futures markets. and aligns the prices through operating in both markets. he will enter the market seeking profits by offsetting rising and declining prices through the buying and selling of contracts. The aim of a speculator is to profit from the very price change that the hedger seeks protection from. serves to remove mispricing. the speculator does not actually seek to own the commodity in question. financial organisations around the world are devising methods and instruments to contain the price risk that these uncertainties bring. Need In the wake of globalisation and surge in the global uncertainties. 3) Arbitrageur: An arbitrageur is one who predicts the basis.

Besides. 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. which are aggravated by the high income and low price elasticity of demand and the shifts in such elasticity overtime. complex production decisions. with the recent measures of liberalisation. A strong. the lack of which has currently impeded the flow of agricultural credit. these markets also contribute in scaling down the downside risks associated with agricultural lending and thereby facilitate the flow of credit to agriculture. These markets while enabling price discovery and better price risk management engender inter-temporal price equilibrium and horizontal and vertical price integration. which can not only yield adequate returns to its producers but also ensure timely supply at desired prices to the consumers. Planned and sustained growth of any sector coupled with a prudent demand and supply management calls for a system. 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. healthy.history. these markets through the use of warehouse receipts obviate the need for collaterals. Derivatives markets hold an immense potential for the economy as they stabilize the amplitude of price variations. the sector has witnessed a massive boom in the country. act as a price barometer to the farmers and the traders besides encouraging competition. bring a balance between demand and supply. 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 . facilitate lengthy. While ensuring price risk mitigation and remunerative returns.

Gold is one single commodity Indians trust more than their spouse. 3) Commodities can allow you to gain exposure to a specific area in order to take advantage of opportunities – e. The 4 fundamental reasons why commodities should be part of a well diversified portfolio. 2) Commodity prices tend not to move in same direction as other asset classes. value and volume. . gold in times of uncertainty. And believe it or not. If one billion plus population of India had the capacity.become imperative particularly. whether it is a household woman or a trader with substantial wealth.g. 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. they would have built their toilets in Gold. commodities have been a good hedge against inflation. 1) Having a holding in commodities helps to spread your portfolio risk by diversifying your assets. Addiction with Gold never ceases round the year. 4) Historically. Here are they: Gold: One of the favourites in Indian sub continent. in the aftermath of WTO regime to face the challenges in terms of exposure to the vicissitudes of world commodity prices and heightened competition. Top 5 commodities demanded in india The top five commodities in Indian in terms of popularity. India is the largest consumer of Gold.

Gold trading on MCX Silver: Known as a poor cousin to Gold. the annual production of Silver has been much less than the annual consumption. In terms of utility.Such is the fascination for Gold that it has become the sole representative of value addition. It is also used in the production of . Silver is more precious than Gold as it is used heavily in manufacturing sector. the white super metal has given investors more than what Gold has given. In advisory business. The other reason being increased investment demand against the backdrop of uncertain economy and growing fears of higher inflation. Supply and demand scenario has put Silver in high pedestal for investors. Gold advisories sell the maximum. But pure economics points out that in the last decade. silver is used to produce batteries. A good conductor of electricity. The unprecedented rise of Silver has surprised the pundits but investors in Silver laughed all the way to the bank this year. traders and investors stick to Gold. while the anti-bacterial properties of silver ions are often employed to make water purifiers. Irrespective of the return it gives.

electrical. used a silver engine – that gave more efficiency than any other engines. Copper is more traded by the business community to hedge their positions. Zen from Maruti stable.photovoltaic cells. Copper trading on MCX . The once famous model.000 pounds of copper. Due to its wide variety of usage. it is one of the most versatile and volatile commodities traded in the commodity exchanges. 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. air conditioning & commercial refrigeration. the most common type of solar cells and even in Jet engines. Imagine even a Boeing 727 airplane uses 9. Silver is suddenly the darling of investors. More than 16 per cent of total Copper available is used for building wire followed by plumbing and heating. 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. electronics and various other uses. It is also used in automative industry.

the Crude price controlling authority should answer. in the food we eat and in products we use daily whether it is . in every cell of the human body. But being a commodity without which the world cant move. Thereafter. Some earned while a majority lost their trust in Crude. many are said to have taken the extreme step of killing themselves after seeing their wealth melt like ice.Crude: One of the most essential commodities in today’s world. was one major reason. Crude trading on MCX Zinc: Not everyone knows that Zinc is found everywhere in daily life. in the earth. Crude ditched thousands of investors when the prices nosedived from over $147 a barrel in July 2008 to less than 34 in Jan 2009. Crude is still in the top five. Prices just exploded in a natural progression of demand and supply. Many investors went bankrupt and in India. Why this happened is something that OPEC. many in India turned to Gold as a safe investment haven. But the fact that speculators in tandem with OPEC made the price extraordinary and unrealistically high.

Zinc trading on MCX . it is yet another commodity used to gain wealth.000 tonnes in the first eight months of 2010. But its inventories piled up resulting in more than 11% drop in prices at MCX. But for a trader. or food we eat. According to Portugal-based International Lead and Zinc study group Zinc production declined by 44% to 166.vehicles appliances. For industry it is a corrosion resistant metal.