Overview on

commodities
 Why commodities ?
 Commodities as an asset class have
traditionally low correlation with other
popular asset classes like equities and
debt.
 Studies have indicated that returns are
available due to both cyclical as well as
secular factors.
 What is the objective of
this project?
 Deals with creating a mutual fund
which would invest in commodities
so as to take advantage of the bull
run in the commodity prices
 Issues to be taken care
of
 Whether it would be an active or a
passively managed mutual fund?
 What are the advantages and the
disadvantages of the above
mechanism?
 The asset allocation decision of the
mutual funds and the criteria for
allocating the assets.
 How can mutual funds function
effectively given the constraints
imposed by SEBI and FMC?
 Method of study
 We would be initially analyzing the
liquidity of the commodities traded
on the various exchanges namely the
NMCE ,NCDEX and MCX and create a
universe of commodities which we
would be investing in.
 After the liquidity study we would be
analyzing the returns generated by
the commodities for the past 1 /2
years dependent on the availability
of data.
 Liquidity could be analyzed based on
the total volume /open interest or the
commercial open interest of the data
 The asset allocation decision would
be based on several criteria's like
a) Rupee value of contracts traded
b)The trading costs , bid ask spread
on various exchanges
 c) Option to execute spread contracts.
d) Prior to how many periods are the
contracts available for trading.
e) Which commodities have exhibited
positive roll returns in the past , the
frequency with which we would be rolling
the future contracts
Decision would be taken after studying the
best practices of the 6 indices namely the
DJ, DBLCI, S&P, GSCI, Rogers and CRB
index and the other funds like PIMCO and
the Oppenheimer Fund.
 Risk Management
 As the sophisticated tools like swaps
and options are not available to the
Indian investors, we would also need
to find out effective risk
management strategies and how can
funds possibly mitigate risks in a long
only strategy.
 Also we need to find out if money
could be made even in a bear market
by going short on commodites and
the kind of restrictions that SEBI
 What are the other asset
classes in the portfolio?
 Also decision needs to be taken as to
what percentage of the total portfolio
should be invested in commodities ,
whether it should be collateralized
investments etc
 Secular returns can be greatly
explained using the “Hicks theory of
normal backwardation”.
 We can maximize returns both by
predicting the trend ie directional
calls as well as buying those
commodities which have a positive
risk premium.
 Why not invest in commodity
firms instead of investing in
commodities?
 Most of the firms also hedge their
risks away by going into the futures
so the upward movement due to
price movements cannot be as large
as the direct investments.
 When a part of the portfolio,
commodity futures have the ability to
reduce the non diversifiable risk.
( reduces the beta of the portfolio)
 Comparative
performances of stocks ,
bonds and commodity
futures
 The roll process is generally governed by
rules. For example, the GSCI managers
shift positions out of the expiring month
during the fifth to ninth business days of
the month. In practical terms, this means
that in May, the GSCI’s WTI crude oil
futures contracts were rolled out of the
June contract month and into July, the next
deferred month. Under the GSCI’s rules,
20% of the position is rolled on each
business day within that five-day window.
 Need to track the correlations
between stocks and commodities
over various horizons.
 Longer the time horizon, lesser the
correlation.
 They earn above average returns
when stocks earn below average
returns.
Performance of commodity
and business cycles
Inde Number Frequency of Methodology Major Weakness
x of rebalancing commodities
commodi
GSCI ties
24 1 year , january World production 6 energy,5 Rebalances
tracked weighted, industrial, only once a
average value of 8 agriculture, year , so it is
production in the overweight on
3 livestock,2
last 5 years prices which
precious
are above their
metals
mean average
and
DJI 15 1 year, january Combination of underrweight
world production on those which
and trading are lower
volume ( 15%
cap and 2% floor
on commodities,
energy limited to
33%
DBLC 6 ( most 2- once a DBLCI MR adjusts Light sweet
I liquid in month, rest for those crude oil ,
their once a year commodities heating oil ,
sectors, ( contango) which are above gold ,
reduces their 5 year aluminum,
transacti average and corn , wheat
DBLC on costs) overweighs (annually)
I those which are
(MR) above their 5
year average
Index Numbe Freq Methodology Major Weaknes
r of uenc commodities s
commo y of
dities rebal
tracke ancin
d g
Rogers Tracks
Internat 35 month Based on monthly consumption , commodities
ional ly overseen by Jim rogers, the which are usually
composition has changed only 2 not tracked by
Commo
times since inception. This has led other indices like
dity
to higher returns zinc, nickel ,
index
wool , rubber ,
silk
Standar 17 Weight based on liquidity as Upstream
d and measured by open interest. Uses commodities
poor geometric mean compared to have a lower
Commo arithmetic mean which has led to weight age
dity lower volatility. compared to
Index downstream
commodities.
EXCLUDES
Reuters month Instead of assigning equal GOLD. Uses
CRB ly weightage like previously it now goementri
INDEX has four bands for weightage. ( need to check c instead
Prices would be derived from near this) of
month contracts instead of 6 arithmetic
months average , and it
understat
es the
performan
 How various indices are
calculated?
 S&P
Dependent on the commercial open
interest ( only hedged position) dollar
value
Price based on average of 2 near
month contracts.
Avoids double counting by giving
more importance to downstream
than upstream
  Some commodities perform well in
early recession but do not perform
well in late recession

Early Late Recession

Energy Recession
15.7% -2.8%
Metals 29.4% -8.7%
Non- 2.3% 1.4%
Energy
 It has been empirically proved that
commodities have generated positive
returns when the equities have
generated negative returns ( even in
the worst performing months)
 As the commodity prices rise during
periods of inflation , commodities
play a role of a natural hedge against
inflation.
 Their value is enhanced more during
periods of “UNANTICIPATED” inflation
 Which commodities to
choose?
 Commodities which have prohibitive
storage costs or those which are
difficult to store have over performed
 Crude oil , base metals and live stock
have traditionally exhibited positive
risk premiums
 How will investors earn
money?
 If future prices are set to indicate
the current spot prices, then how
would investors earn their money?
 This would be by capturing the
unexpected moves/ due to the
inherent risk premium
Total payoff = risk premium +
unexpected deviation
 Methodologies for selection
1) Liquidity ( Dow Jones, S&P) –
storable commodities like gold ,
silver
2) World Wide production data- non
storable commodites like crude oil,
natural gas
(Volume in 2004 CHANA
2005 2006
lac tons) (Till April)
Total Traded MCX 0.8 33 38
volume
NCDEX 64 850 430

Total in lac 50 50 50
consumption tons
/annum
Leverage 4 16 30
factors

Total value MCX 120 6300 5500

(in crores)
NCDEX 10200 160000 87000
(Volume in 2004
URAD
2005 2006
lac tons) (Till April)
Total MCX 1.35 33 49
Traded
volume
NCDEX 26.8 850 440

Total 14.5-16 16 16
consumption
in lac
/annum
tons
Leverage 5.3 36 89
factors
Total value MCX 120 6300 5500
(in crores)
NCDEX 10200 160000 87000
 Refined Soya Oil
(Volume in 2004 2005 2006
lac tons) (Till April)
Total MCX 13 85 21
Traded
volume
NCDEX 19 103 21

Total 25(1+1.5 25 (1+1.5 25 (1+1.5

consumption Import) Import) Import)
in lac
/annum
tons
Leverage 1.4 7.6 5.04
factors
Total traded MCX 120 30000 8100
value
(in crores) NCDEX 10200 39000 8100
 Guar Seed
(Volume in 2004 2005 2006
lac tons) (Till April)
Total MCX 98 60
Traded
volume
NCDEX 450 1860 300
Total 4 4 2-6
consumption (dependent
in lac
/annum on
tons
monsoon)
Leverage 11 500 ( app) 216
factors
Total traded MCX 120 15800 48000
value
(in crores) NCDEX 80000 316000 48000
 Wheat
(Volume in 2004 2005 2006
lac tons) (Till April)
Total MCX - -
Traded (low
volume volumes)
NCDEX - 113 127
Total - 700 700
consumption
in lac
/annum
tons
Leverage 0.161 0.545
factors
Total traded MCX - - -
value
(in crores) NCDEX 8900 11000
 Sugar
(Volume in 2004 2005 2006
lac tons) (Till April)
Total MCX - -
Traded
NCDEX 8.4 110 68
volume
Total 180 180
consumption
in lac
/annum
tons 140 130
(produced) (produced)

Leverage 0.6 1.1

factors
Total traded MCX - - -
value
(in crores) NCDEX - 20000 13000
 Chilly
(Volume in 2004 2005 2006
lac tons) (Till April)
Total MCX
Traded
NCDEX 15 14
volume
Total 11 10.9 10-11
consumption
in lac
/annum
tons
Leverage 1.37 4.2
factors
Total traded MCX - - -
value
(in crores) NCDEX - 3900 5602
 Rubber
(Volume in 2004 2005 2006
lac tons) (Till April)
Total NCDEX
Traded NMCE 2.83 4.27 2.02
volume
Total 7 7 7-7.5
consumption
in lac
/annum
tons
Leverage .6 .857
factors
Total traded NCDEX - - -
value
(in crores) NMCE - 2600 1690
 GOLD
(Volume in 2004 2005 2006
tons) (Till April)
Total NCDEX 304 425
Traded MCX 2286 2785
volume
Total 800 800 800-825
consumption
(in tons)
/annum

Leverage 3.25 12
factors
Total traded NCDEX - 21000 35000
value
(in crores) MCX - 157000 225000
 Silver
(Volume in 2004 2005 2006
tons) (Till April)
Total MCX 130000 84000
Traded NCDEX 18330 69000 23000
volume
Total 4000 4500 4250-4750
consumption
in tons
/annum

Leverage 4.5 44.4 75

factors
Total traded MCX - 150000 90000
value
(in crores) NCDEX - 69000 24000
 Crude oil
(Volume in 2004 2005 2006
lac barrels) (Till April)
Total MCX 1300 200
Traded NCDEX 125 72
volume
Total 6800 7500 8000
consumption
in lac
/annum
barrels
Leverage 4.5 .19 .012
factors
Total MCX - 35000 5775
traded
value
NCDEX - 3461 2079
(in crores)
 2005

Total Traded Total Leverage Total Value in crores

Commodity Volume Consumptio Factors
n
MCX NCDEX MCX NCDEX

Chana 50 16
33 850 6300 16000

Refined Soya 85 103 2.5 ( 1 76 30000 39000

oil produced)
Guar Seed 98 1860 4 460 15800 316000

Sugar 110 180 20000

(130
Rubber 4.27 produced)
7 .75 2700
(NMCE
Chilly )15 10.9 1.37 3900

Urad 20 560 16 36 3890 110000

Wheat -------- 113 70 1.61 8900

 2005

Total Traded Total Leverag Total Value in crores

Commodity Volume Consumpti e
on Factors
MCX NCDEX MCX NCDEX

Crude Oil 1300 125 7500 .19 35000 3461

( in lac
barrels)
Silver 13000 69000 4500 44.44 150000 69000
0
Gold 2286 304 800 3.25 157000 21000

Pepper 55000 65000 8

0
Cardamom 13400 11000 12
0
Castor Seed
Mentha oil 6142 15000 0.4
produced
(1000
exported)
 2006 data

Total Traded Total Leverag Total Value in crores

Commodity Volume Consumpti e
on Factors
MCX NCDEX MCX NCDEX

Chana 38 430 50 30 5500 87000

Refined 21 21 2.5 ( 1 1.6 8100 8100

Soya oil produced)
Guar Seed 60 300 4 216 10000 52000

Sugar 68 180 1.1 13000

(130
produced)
Rubber 2.02 7 1.5 1690
(NMCE
)
Chilly 14 10.9 4.2 5600

Urad 49 440 16 89 5500 87000

Wheat 127 70 5.45 11000
 2006

Total Traded Total Leverag Total Value in crores

Commodity Volume Consumpti e
on Factors
MCX NCDEX MCX NCDEX

Crude Oil 200 72 7500 .0.12 5775 2079

( in lac
barrels)
Silver 84000 23000 4500 75 90000 24000
Gold 425 2785 800 12 225000 35000
Pepper 85000 65000 4
Cardamom 50000 11000 16
Castor Seed 6-9 lac
Mentha oil tons
15000
produced
(1000
exported)
 Average Standard Average Average
Prices in deviation Range /day Range as Margins
Commodity (per month) percentage
2005 2006 2005 06 2005 06 05 06 NCD MCX

Channa 1748 1901 178 285 24 35 1.8 1.38 5%

Wheat 769 858 61 27 4.88 16 0.62 1.88 5%

Soya oil 370 373 13.81 22 3.38 4.12 .91 1.09 5%

Rubber 6127 8296 508 507 81 99 .62 1.88 6%

(
nm
Urad 1944 2908 393 335 39 86 1.86 2.88 ce)

Chilly 2479 3426 376 283 56 86 2.04 2.62

 Average Standard Average Average
Prices in deviation Range Range as Margins
Commodity (per /day percentag
month) e
05 06 05 06 05 06 05 06 NCD MCX

Crude oil 1748 1901 178 285 24 35 1.8 1.38 5%

Silver 16663 640 3.5 5%

Gold 83 1.09 5%
 Some risk measurement
techiniques
 Risk management at a strategic level
Tools to use
a) Value at Risk
b) Worst case scenario , take the
previous worst loss under a similar
scenario
c) changes in the structural
component ( eg heating oil versus
gasoline
 Risk management at a
portfolio level
 Corrleations between different
commodites are very low but a
scenario analysis needs to be done
for different time periods and try to
find out whether if there is a
particular event /time period when
correlation is high and exposures
have to be adjusted accordingly.
 Some commodites tend to perform
low when they have equities in their
portfolios and they have a small
 The disadvantage of using
a mean variance framework
 Commodities returns are not
normally distributed
 Commodities positively skewed and
they have less kurtosis compared to
equities ( Till)
 Also commodites are a very
hetrogenous group and they are not
affected by common events
 Another assumption in using
variance as a measure of risk is that
investor have a quadratic prefernce (
The first step to rehabilitate active
asset allocation in the investment
process is found in a paper of Amenc
and Martellini (2001). Since expected
returns are very difficult to forecast,
the two authors focus rather on the
minimum variance portfolio, whose
determination only
requires estimating the covariance of
hedge fund returns.
 The traditional markowitz
approach
 Allocate assets based on the
estimated means and variances and
choose assets which have the
highest return for a given variance.
 It is not used nowdays for 2 reasons
a) estimated proportions sensitive
due to their
expected /predicted values.
b) the one which has the largest
estimation error is chosen.
 “High Sharpe ratios tend to go
together with negative skewness and
high kurtosis. This
 means that the relatively high mean
and low standard deviation offered
by hedge fund
 indices is no free lunch.”
 Shortcomings of sharpe
ratio
 Illiquid stocks are preferred over
liquid stocks as the sharpe ratio does
not consuder liquidity
 As commodities have a fatter tail we
need to use a VaR approach to using
them and not simply the mean
variance framework.
Tactical Asset allocation
 Tactical Asset Allocation (TAA)
broadly refers to active strategies
that seek to enhance
portfolio performance by
opportunistically shifting the asset
mix in a portfolio in
response to the changing patterns
of return and risk
 Roughly speaking, the prescriptions of
these models are that investors should
increase their
allocation to risky assets in periods of
high expected returns (market timing) and
decrease
their allocation in periods of high volatility
(volatility timing). Steps in tactical asset
allocation
 · Step 1: forecast asset returns by asset
classes
 Workaround for the
Efficient frontier model..
 A number of remedies have been
proposed, among others, additional
constraints on the deviation from a
benchmark such as ranges for the asset
weighs in the portfolio. More refined ways,
such as sophisticated models for
covariance matrix (like Garch
specifications), penalizations of the
«volatility» of the
volatility, or some sort of Bayesian
approach to the input (Stein, 1995) have
been tried. At the end of the day, a lot of
 Issues with TAA
 The cost of transactions tend to be
very high
both qualitative and quantitative
model can be used for asset
allocation

Shifting between asset classes based

on asset returns predicted.
 Using a satellite core
model
 There is a demarcation between the core
and the satellite with different modes of
investing for both of them.
 The satellite provides alpha or excessive
returns
Issues to be noted whether there is a
positive deviation or a negative deviation
The dynamic allocation is between risky and
riskless portfolio ( the riskless is the index)
and the risky is the satellite so that we are
able to limit the downturn and perfom in
line with the index. (index performance is
the benchmark)
 Some risk measurement
strategies
 Sultzer index : rewards those
portfolios which perform higher than
benchmark and punishes those
which have negative skewness.
 Gain loss ratio : Expected gain
/expected loss
 Commodities as an asset class are
volatile but when they are a part of
the portfolio volatility decreases to a
great extent.
 Main classifications – energy , base
metals, precious metals, agricultural
products.
 Sources of alpha
 Relative value strategies, timing
strategies, and event-driven
strategies.
 We need to determine how much
alpha is required and assets have to
be allocated proportionately.
 Strategies to adopt
 Cash and carry arbitrage – not
possible
 Calender spread ( backwardation and
contango)
 Inter exchange arbitrage ( is it
possible???)
 Directional call
How can you do a risk management
without proper contracts?
spread strategy is one way to allocate
assets
What kind of commodities should
spread strategy be adopted?
 80 commodities traded in India but
spread trading might not be viable
for spread trading.
 How to trade in the recent meltdown
in commodities. The commodity
prices have crashed by more than
20% , how will the impact of interest
rate affect the commodity prices.
 The commodity fund management
has nearly tripled in the last 2 years
 Portable alpha
 Desired market exposure ( beta)
 Cost of obtaining the desired market
exposure
 The cash strategy should be used to
generate the excess returns
 Portable alpha