Introduction & Growth of Commodities as an asset class

Commodities and Commodity Derivatives @MANAGE Dr. Nupur Pavan Bang

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If stocks, bonds and commodities were part of the same family, commodities would be the sibling who never measured up, the black sheep the brother-in-law, perhaps, who got wiped out in soybeans. Commodities have never got the respect that they deserve, and its been something of a mystery to me why. - Jim Rogers, Commodity Investment Expert & Creator of
Rogers International Commodities Index.

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Why Commodities?

Futures / (Cash + Futures) = 86% Turnover of (Commodity + Stock) Futures up 60% in 2010-11 (close to Rs150 trillion) Commodity futures up 70% as opposed to 53.7% of stocks and index futures Among the five major exchanges that allow futures trading, NSE accounts for 67%, MCX 20%, NCDEX 10.5%, BSE 0.5% and NMCE 2%.

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Why Commodities?

The three major commodity exchanges had a combined turnover of Rs.54 trillion during the financial year. A trader is required to pay upfront margins of 15% of the market value of index futures, about 25% of the market values of stock futures, around 8-10% of agro commodity futures, and up to 6% of non-agro commodities.

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Commodities

Definition

FCRA, Economists, Bankers, Ecologist, Academicians, Oil Producing nations Spot and Derivatives Agricultural-Metals-Energy-Carbon Credits Barter-Forward Contracting-Futures Markets Plain Vanilla-Exotic Options-Structured Products
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Markets

Evolution

Derivatives Markets

MCX NCDEX NCME 21 Regional Exchanges (approved by FMC)

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Commodity Market Beneficiaries

Farmers/Producers; Processors; Traders; Manufacturers; Wholesalers; Retailers and end-users. All these participants in the commodities trade are benefited to a large extent due to changes in technology, communication networks and a number of value-added services provided by multi-commodity exchanges.
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Commodity Future Increasing Farmer Participation

In India, 60% of the population dependent upon agriculture. Farmers are now assured better price for their produce (fair price discovery). Hence, they are no longer required to sell below cost of production in distress. Market determined price information available to the farmers enabling them to plan their production schedule. Inculcates competitive spirit among farmers to cultivate quality produce and among the traders for quality production and output.

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Commodities Futures Market Other Benefits

Price risk management through hedging strategy, wherein, price risk that is inherent in a spot market is offset by taking an equal but opposite position in futures market. Enable the exporters to hedge their price risks (risk arising from volatility in foreign exchange rate movements) and improve competitiveness. In fact, with rupee strengthening against the dollar, export firms can now go in for more proactive hedging strategies, such as entering into forward and option contracts or exotic derivative products. Enables manufacturers to predict domestic prices that are likely to prevail in future, so that they can ensure that their market share is protected even with free entry of imports. Hedging would cut down the discount rate in commodity lending thereby enabling commodity traders to get easy access to credit.
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Future of Commodity Markets

National online exchanges started operating since 2003. Future trading in commodities permitted from 2003 & thereafter remarkable growth in volumes traded in the commodity market. Just passed nascent stages of their growth story. Phenomenal turnover achieved by commodity derivative exchanges in India. Increase in volume to Rs.53trillion for 2008-2009 period within just five years. Investor community in India has finally started taking notice of commodity markets. Bright future ahead emerging as a new hot market for the future.
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Facts and Fantasies About Commodity Futures

The study carried out by Yale School of Managements Centre for International Finance (2004) published the following results: Since 1959, commodity futures have produced better annual returns than stocks and outperformed bonds even more. Commodities have had lesser risk than stocks and bonds, as well as better returns. During the 1970s, commodity futures outperformed stocks; during the 1980s the exact opposite was true evidence of the negative correlation between stocks and commodities that is often noticed. Bull markets in commodities are accompanied by bear markets in stocks, and vice versa.
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Facts and Fantasies About Commodity Futures

The volatility of the returns of commodity futures for a 43 year period was slightly below the volatility of the S&P 500 for the same period. While investing in commodity stocks is one rational way to play a commodity bull market, it is not necessarily the best. The returns of commodity futures examined in the study were triple the returns for stocks in companies that produced those commodities.

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Alternative investment class in 21st century

Viable alternative to equity, real estate and other traditional forms of investments owing to Better returns Less risky Less price volatility due to few factors influencing commodity prices Less sluggish than bonds Good way to diversify a portfolio of stock & bonds

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Twentieth century was witness to three long commodity bulls (1906-1923, 1933-1953, 1968-1982), each lasting an average of seventeen years and we are living in the middle of another such bull period which started in 1999. By nature, commodity bull markets last for a longer period than stock market bull periods. This presents all the more reason to be excited about the real things
- Jim Rogers (Hot Commodities).

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Interesting facts

The world is adding to its population at the rate of the country of Mexico every year-thats more than 80 million. Out of every 100 people, 14 are from the Western Hemisphere 27 would be from Africa, Australia, Europe, and the Middle East combined. 57 would be Asians (38 from China and India)

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The Commodity Hunger of China and India

Oil

Today, US consumes approx. 25% of all oil produced i.e 25 barrels per capita per year. When Japan accelerated its economic growth (from 1950 to 1970), Japanese consumption rose from 1 barrel to 17 barrels per capita per year. China and India are currently consuming just over 1 barrel per capita per year. China and Indias combined population is 18 times that of Japan.

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Commodity Markets- Key Characteristics

Consumption goods Non standard structure Cost of production Price behavior (seasonality) Limits on supply and consumption Time delays in production and consumption Direct exposure to a variety of exogenous functions Substitution potential between different commodities in the production or consumption process.
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Commodity Markets- Key Characteristics

Needs for physical access or possession of the commodity that introduces issues such as location and transportation. Additional costs including storage costs, insurance, wastage and possession value. Inability to readily store certain commodities (such as electricity). Complicated value/processing chains in commodity markets. Opportunities to generate significant value from the shape and behavior of commodity forward curves. High volatility of (some) commodity prices.
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A crucial difference between securities and commodities is the physical delivery attached to spot, forward contracts and futures positions not closed prior to maturity and translate into good transfer, with the corresponding constraints for both parties in terms of shipping arrangements, warehousing and so forth.

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Another key difference between security and commodity markets is the existence, in the latter case, of quantity risk. Investors owing stocks or bonds are only concerned by equity markets going down or interest rates going up (i.e., by the price risk attached to the instruments they are holding). Similarly, the concept of varying quality of asset does not really exist as far as financial underlyings are concerned. However in the case of commodities, the quality of the asset underlying a contract can vary largely. This becomes an important issue to be managed.
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Physical Settlement

Accredited warehouses There are limits on storage facilities in different states. There are restrictions on interstate movement of commodities. Besides state level control and duties have an impact on the cost of movement of goods across locations. Delivery Notice Seller, warehousing receipt (proof of quantity and quality) Assignment - Exchange
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Quality Standards

Commodity derivatives demand good standards and quality assurance/ certification procedures. A good grading system allows commodities to be traded by specification. Currently there are various agencies that are responsible for specifying grades for commodities. For example, the Bureau of Indian Standards (BIS) under Ministry of Consumer Affairs specifies standards for processed agricultural commodities whereas AGMARK under the department of rural development under Ministry of Agriculture is responsible for promulgating standards for basic agricultural commodities. Apart from these, there are other agencies like EIA, which specify standards for export oriented commodities.
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Derivative Contracts and Exchanges

Over the Counter (OTC)

Customized Standardized

Exchange traded

Financial Derivatives are all automated exchange traded contracts. Commodities Derivatives are still follow an open-outcry method on many exchanges.

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NYMEX

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Trading Pit

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Trading Pit

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Automated Trading

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