Research Approach to investment in

commodity markets

S.Venkataraghavan
Vice President –Research
www.altostrade.com
Disclaimer

! The views expressed in this presentation are personal. They are not a
solicitation to buy or sell instruments.

! Altos Advisory Services Ltd., altostrade.com, Ten Ford Rich Ventures

Ltd., Gibraltar, Spain – the companies that I represent are not
responsible for any desired or undesired outcome of this presentation.

! Investment in derivatives bears considerable risk-reward tradeoffs.

! There is a risk of loss when trading in derivatives.

Disclosure

Investments: Commodities & Derivatives.

Proprietary Positions No
Family and Friends Yes
Clients Yes
Other Conflicts Maybe
Dedicated to the Greatest Cartoonist of
all times R.K.Lakshman
In Spain a very interesting sport of valor is played the MATADOR here
I try to draw an analogy from that sport to the recent moves in financial markets.

We are in a secular bull market for Commodities silver, gold, and

many other metals here is an explanation for the recent sell offs,
In Spain there is a game with the bull "MATADOR "
an average guys who tries to ride the bull typically last only
about 5 seconds before getting bucked off.
That's the job of a bull, to buck off those who attempt to ride it.
Bulls also gore people with their horns, and use their horns to
throw those bull riders into the air.
The spike you see on the gold and silver price charts that
looks is a bull's horn. It just gored and killed all those who tried
to use borrowed money to try to take advantage of the bull.
IS there an asset bubble ?
Equity markets at 9 % Volatility ?
housing and real estate asset market is it over valued ?
Commodity Markets- Role of investor
buying outweighed by fundamentals……
Investor buying is one factor that has added upside to
commodity markets.
Asset diversification as a concept a must ‘just being
reinforced’
Inspite of the Recent Falls, The Commodity Indices like Roger
Index an out performer year to date.
However of greater significance are the fundamental factors
that will support higher commodities prices over the rest of
this decade:
Fundamental Factors that influences commodity prices.
MONETARY MACRO GEO CLIMATIC LOCAL
ECONOMICS POLITICAL
Precious Metals: Gold Silver Platinum Palladium

Base Metals: Al ,Cu,Zn,Pb,Tin

Forestry Products : Rubber,Lead&

Paper Pulp

Energy Products: Crude Oil,Gasoline,Heating Oil

Softs: Cocoa,coffee,Sugar Orange Juice

Soybean,Rapeseed oil

Grains Wheat & Corn

Fibers : cotton & wool

Meats & Live Stocks

Electricity
Example of Monetary Factors
-Precious Metals Prices
Example of Geo political & Macro Economic Factors
Iran tension drives markets whereas India's nuclear Plans to drive the
‘Economy’ back ?
Example of Geo political – ‘The terror premium’
Example of Climatic Factors
Example of Disruptive Demand Shift – Fuels to Bio Fuels
Example of Local Factors-Bird flu and Mad Cow on Meat Prices & soy feed
Don’t know whether to call this monetary,macro economic or geo political or Local!~~!
Skeptics who say commodities demand drive in China Exaggerated?
Above-trend growth in raw materials demand
• Chinese industrialization, urbanization and income growth as a
key driver.
• Below-trend growth in supply
• lack of investment, increased environmental & political risks,
&lack of large mineral deposits and very low levels of spare
crude oil and refining capacity.
• Low inventory levels
• commodity prices are fundamentally justified as stocks are near
“critically-low”levels. Weaker US dollar
• Resource misallocation risk is small
• Unlike the tech. bubble of the late 1990s high commodity prices
are required to encourage much needed investment to take place.
 In an honest survey of ‘new entrants’ to
trading in commodity markets
I want to make more money 55%
I want to diversify my assets 40%
I don’t want to watch saas bhi 5%
kabhi bahu thi and I prefer
to sit in front of a trading
screen in the evenings
Research Approach of Participants in the commodity
markets

• Investor & Financiers.

• Speculators/traders
• Hedgers
• Arbitrageurs
 Research Approach of Investors
• An Investor has committed ‘x’ amount of money with an
intention of pulling out ‘x’+Delta ‘x’ , he has the capacity
to hold since he believes that an intrinsic value of any
commodity cannot become zero.
• He never takes unlimited risks in the market and as a rule is
never leveraged and is wholly collateralized.(meaning in
futures as margin and remaining value of asset as T-bills or
bank sweeps)
Total Yield for Investors ( futures) = Increase or
Decrease in value of his positions in futures +
Collateralized yield-cost of roll over.
 Research Approach of The Financier
• The ‘Cash’ Financier in a contango situation
Buys Current/Spot " Takes delivery (demat a more transparent option)
Simultaneously sells futures"
Enjoys this cost of financing the contango market.
Eg.(on 14th June 2006) MCX
05 JUL 2006 SILVER Rs. 15295 per Kg 30 Kgs Contract
05 SEP 2006 SILVER Rs. 15725 per Kg 30 Kgs Contract
Differential = Rs. 430

financier earns= 430* 30= Rs. 12,900

Financiers commitment = 30*15295+5% 30*16725
Total Yield for financier = 430/16131.25
=2.66 % or
annualized 15.96 % Risk Free
(*) Assuming Margin to be 5 % on futures
 Research Approach of The Financier Contd
• The ‘Stock’ financier in backwerdation.
Sells Current/Spot " Gives delivery (demat a more transparent option)
Simultaneously Buy futures" Takes delivery

Enjoys this cost of loaning his stock to the market.

Eg 14th June URAD MCX
20 JUN 2006 URAD 3151 Rs.
18 AUGUST URAD 2875 Rs.

Stock financier earns # Rs. 276 on the difference +

risk free rate on 95% of the money he has got by giving
delivery for a month(since about 5% would go for margin on
this futures position)
Financiers commitment = Stock
Total Yield for financier = Infinite since money
committed into transaction is zero and it is only as stock.
 Research Approach of Hedgers

• Hedging Defined When two risks offset each other, one is said to be a
hedge for the other. A hedged position has less risk than its separate
components.
• A Commodity Hedging Example A farmer who has wheat in the ground
risks that the price of wheat will fall before the July harvest.
• A baker who must buy flour in July risks that the price of wheat will rise
before July.
• A natural hedge appears possible because these two risks are
complementary.
• The Hedge If the baker buys a wheat futures contract from the farmer,
both will reduce their net risk exposure.
• Although the futures contract by itself may be very risky, when used in
these hedges, it reduces overall risk.
• The contract need not be delivered.
• The Farmer’s Hedge :The farmer hedges her long position
(wheat in the ground) with a short position in wheat futures.

If wheat prices fall, the farmer loses on her harvest but gains on
her futures position, and vice versa. (What if hail destroys her
crop?)
• The Baker’s Hedge The baker hedges his short position (must
buy flour) with a long position in wheat futures.
If wheat prices rise, the baker loses on his flour purchase but
gains on his futures position, and vice versa. (What if he loses a
contract to deliver bread in July?).
• Hedging Summary : Hedging involves the exchange of risks
but not necessarily assets.
• Many futures, swaps, and options contracts have been
developed to facilitate hedgers
Research Approach of Arbitrageurs

• Arbitrageurs use fundamental and technical models to

estimate relative differences in fundamental values.
• They trade when the relation between two (or more) prices
differs from the relation predicted by their models.
• The effect of their trading is to remove these differences.
 Research Approach of Traders
• Value-motivated traders estimate fundamental values.Value-motivated
traders use economic models to estimate security values.
– Forecast cash flows.
– Analyze discount rates.
– Value-motivated traders must be very disciplined about their assumptions.
– Organizations that pursue value-motivated strategies tend to be shaped like
pyramids.
• News traders estimate changes in fundamental values.
– News traders follow news carefully.
– They trade on events that they expect to change prices.
– News traders must act quickly.
– Organizations that pursue news trading strategies tend to be flat.
• Technical traders try to identify price patterns that are inconsistent with
prices that reflect fundamental values.
– Informational efficient prices should not have forecast able changes.
– Technical traders try to forecast prices from past prices and other market data.
– Their trading removes predictable price patterns.
– Technical traders profit when other traders make mistakes.
– They scavenge for the tidbits that other traders leave on the table.
 Speculators
• Informed traders compete to acquire and
profit from expensive information.
• Informed traders enter and exit.
• Only efficient informed traders make
profits.
• Price informative ness depends on the costs
of acquiring information.
 Acknowledgements
• Google.com
• Cagle.slate.msn.com for all the cartoons.
• Reuters –RTC for commodities
• Active 8- Telerate.
• My Research department for their support and
analysts at altos for their consensus estimate.
• MATS