Commodity Market.

COMMODITY INVESTING - BENEFITS

 Commodity prices are increasing over the years
 Inflation hedge
 Low correlation with the traditional investments

Good Diversification
 Good alternative to equity with Less volatility
COMMODITY MARKETS PARTICIPANTS
 Hedgers
 Taking an offsetting position in the market to reduce
the risk
 Long hedger (Buyer) and Short hedger (Seller)
 Speculators
 Risk takers
 No offsetting position in the market
 Arbitrageurs
 Benefits from Mispricing in the markets
 Cash and Carry Arbitrage is more common
 Cash and Carry Arbitrage example
Cash market price DHFL (as on 25th Oct Rs 422
2017) (S)
Dec Futures DHFL(Expiry on 29th Dec 2017) Rs 430
(F)
Contract size 3000
Fair value is measured by the formula F= S*(1+R)^n
Rate of Interest 9% (p.a.)
Time to expiry (n) 65 days
Amount borrowed Rs 12,66,000 (422*3000)
Cost of Borrowing {0.09*(65/365)} 1.6%
 Expected future price (F) = 422*(1+9%) ^(65/365)
 Therefore, in above case F= 428.53
 Current future price= 430
 Hence, we can see that there is an arbitrage opportunity.
 Risk free Arbitrage = Rs 1.47 (430-428.53)
 To take the advantage of this mis-pricing, an arbitrageur/ trader
may borrow Rs 12,66,000 at an interest rate of 9% p.a. and buy
3000 shares of DHFL in cash market at Rs 422 and sell 1 lot of
DHFL Futures contract at Rs 430.
 Cost of borrowing in Rs [(1266000)*(9%*(65/365))]= 20,291
 Gains from price difference between futures and spot= Rs 24,000
 This would result in to net arbitrage opportunity of Rs 24,000-
20291= Rs 3,709
Problem 2
 The spot price of copper is Rs. 427 per kg. The insurance cost
and storage cost is Re. 0.25 per kg per month. A dealer has
quoted RS. 433 as the price of a 3 month futures contract.
Assume the risk free return is 3 %, find

 (a) if there is any arbitrage opportunity?

 (b) how to exploit the opportunity (if it exist)
Commodity - CCA
The spot price of gold be $ 500 per ounce, storage costs be $ 5 per
ounce for a period of six months, payable at the end of six
months, the price of a futures contract for delivery of an ounce of
gold six months hence be $ 535. The risk free rate is 10%.
Whether arbitrage opportunity prevails?.
  Consider the case of an investor who can borrow at 10% per annum
 He can borrow $ 500 and buy an ounce of gold and simultaneously go short in a forward
contract
 Six months hence he can deliver the gold for $ 535
 His interest cost for six months will be $ 25 and the storage cost will be $ 5
 Thus the effective carrying cost will be $ 30
 The rate of return on investment is:
(535 – 500) = 0.07 ≡ 7%
--------------
500
 The effective carrying cost is:
(530 – 500) = 0.06 ≡ 6%
--------------
500
 Hence the cash and carry strategy is profitable
 It is so because F > S(1+r) + Z
Consider a three-month futures contract on a stock that does
not pay dividend. Assume that the price of the underlying stock
is Rs.40 and the three-month interest rate is 5% per annum.
 (a) Suppose that the futures price is relatively high at Rs.43.
 (b) Suppose that the futures price is relatively low at Rs.39.

 How arbitrager behave in two extreme situations?

KEY ASPECTS OF COMMODITY
 Storability
 Renewability
 Convenience yield
 Benefit of holding physical commodity than on futures long position
 Future prices and availability of commodity is the key factor
 Relationship

Commodity
Inventory
Future
level
prices

 Production Storable Inventory Cost Future Price C. yield

 Assume that a trader wishes to calculate the convenience
yield of crude oil for delivery in one year from today. Assume
that the annual borrowing rate is 2 percent, the spot price of
crude oil is $50.50 and the futures price of crude oil
contracts expiring one year from today is $45.50.
 12.43 percent, or

 0.02 - (1/1) * LN($45.50/$50.50)

CLASSIFICATION OF ASSETS AND
THEIR VALUATION BASES
 Capital Assets
 Generates continuous cash flow
 Can be valued by discounting the cash flows
 CAPM helps to get expected rate of return
 Consumable Assets
 Do not generate regular cash flow
 Valuation is based on Demand and Supply
 Store of Value
 Neither Capital nor Consumable
 Ex: Painting, Coins etc.,

 Which asset is suitable in all these categories?

MODES OF PARTICIPATING IN
COMMODITY MARKET
 Physical Commodity - Direct Purchase
 Storage and Maintenance cost involved
 Cash locked
 Shares of Commodity producing company
 "Earnings of metal companies have a 1.5-1.8x sensitivity to metal prices," says
Kishore Narne, Associate Director and Head, Commodity and Currency, Motilal
Oswal Commodities (September 2013, Business Today).
 “The relationship works both ways and this makes investing in commodity stocks
a double-edged sword” says Gopal Agarwal, Chief Investment Officer, Mirae
Asset Investment Managers.
 “Commodities and related stocks have a positive correlation, but other factors
also affect the market, says Vikas Jain, AVP, Retail Research, Religare Securities.
 “A lot of non-commodity factors such as valuation or price-earnings ratio, cost
or capital structure (debtequity ratio), hedging policy and government policy
driven tariffs or regulations can also affect the performance of stocks," says
Kishore Narne of Motilal Oswal Commodities.
 Historical returns are lesser than the physical commodity
 Commodity Mutual Fund
 Commodity Index Fund
 Commodity advisors use different strategies
 Low transaction cost but high diversifiable
 Awareness about the available funds and strategies are required.
http://www.businesstoday.in/moneytoday/stocks/ invest-i n-stocks -of-co mpanies- related-to-com modity-p rices/story/19 7992.html

 Commodity futures
 Initial deposit (Margin money)
 High Leverage
 Liquidity and Transaction cost
 Profit and Loss calculated based on Mark-to-Market
 Roll over
  To hedge against falling commodity prices, a wheat farmer takes a short
position in 10 wheat futures contracts on November 21, 2017. Since each
contract represents 5,000 kgs, the farmer is hedging against a price decline of
50,000 kgs of wheat. If the price of one contract is Rs.45 on November 21,
2017, the wheat farmer's account will be credited with Rs.45 x 50,000 kgs=
Rs.22,50,000.

Futures Change in Cumulative Account

Day Gain/Loss
Price Value Gain/Loss Balance
1 Rs.45.0 22,50,000
2 Rs.45.5
3 Rs.45.3
4 Rs.44.6
5 Rs.43.9
  To hedge against falling commodity prices, a wheat farmer takes a short
position in 10 wheat futures contracts on November 21, 2017. Since each
contract represents 5,000 kgs, the farmer is hedging against a price decline of
50,000 kgs of wheat. If the price of one contract is Rs.45 on November 21,
2017, the wheat farmer's account will be credited with Rs.45 x 50,000 kgs=
Rs.22,50,000.
Account
Cumulative Balance (6)
Futures Change in Gain/Loss
Day (1) Gain/Loss = Previous
Price (2) Value (3) (4)
(5) day (6) +
(4)
1 Rs.45.0 2250000
2 Rs.45.5 +0.5 -25000 -25000 2225000
3 Rs.45.3 -0.2 +10000 -15000 2235000
4 Rs.44.6 -0.7 +35000 +20000 2270000
5 Rs.43.9 -0.7 +35000 +55000 2305000
 To hedge against falling commodity prices, a wheat farmer takes a short
position in 10 wheat futures contracts on November 21, 2017. Since each
contract represents 5,000 kgs, the farmer is hedging against a price decline of
50,000 kgs of wheat. If the price of a kg is Rs.45 on November 21, 2017, the
wheat farmer's account will be credited with Rs.45 x 50,000 kgs=
Rs.22,50,000. Assume the farmer has to maintain a Initial margin of 20% and
maintenance margin of 15%
 Cumulat
Before After
Futures Change ive
Day Gain/Loss Margin Margin Margin
Price in Value Gain/Lo
payment payment
ss
1 Rs.45.0 450000 450000
2 Rs.45.5 +0.5 -25000 -25000 425000 0 425000
3 Rs.45.3 -0.2 +10000 -15000 435000 0 435000
4 Rs.44.6 -0.7 +35000 +20000 470000 0 470000
5 Rs.45.9 +1.3 -65000 -45000 405000 0 405000
6 Rs. 47 +1.1 -55000 -100000 350000 0 350000
7 Rs. 47.5 +0.5 -25000 -125000 325000 125000 450000
8 Rs. 50 +2.5 -125000 -250000 325000 125000 450000
9 Rs. 49 -1 +50000 -200000 500000 0 500000
10 Rs. 52 +3 -150000 -350000 350000 0 350000
 Investible Commodity Futures Indices
 TRMCXCMP, Goldman Sachs Commodity Index, Dow Jones
AIG Commodity Index
 6 indices in four different categories:
 Composite (TRMCXCMP)
 Base metals (TRMCXBSM)
 Indian bullion (TRMCXPRM)
 Individual commodities :
 Gold (TRMCXGOLD)
 Copper (TRMCXCOPP) and
 Crude Oil (TRMCXCROL)

https://www.business-standard.com/articl e/mark ets/long-wait-before-tra ding-in- commo dity-ind ex-derivatives-ta kes-off- 118081 000488 _1.html
 ETF on Commodity Index
 Less Transaction Cost
 Credit risk of the issuer is not a concern
 Composition of Index is important
 Commodity Index Certificate
 Issued by bank
 Credit risk
CONTANGO AND BACKWARDATION
 Contango
 FP>SP
 Rising trend in the commodity term structure
 Most commodity users use Long hedging
 Backwardation
 FP<SP
 Falling trend in the commodity term structure
 Most commodity producers use Short hedging
 FP0 = S0 * e(r+S-CY)T
FP0 ≈ S0 (1 + r)^T + Storage costs – Convenience yield

FP0 = (S0 + S - CY)e^rT

1. The spot price of gold is Rs.17000 per 10 gms. If the cost of
financing is 15% annually, (a)what should be the futures price
of 10 gms of gold one month down the line (b) If the contract
was for a three-month period ?
1. The spot price of gold is Rs.17000 per 10 gms. If the cost of
financing is 15% annually, (a)what should be the futures price
of 10 gms of gold one month down the line (b) If the contract
was for a three-month period ?

 F = Se^rT = 17000e^(0.15 x 30/365) = Rs.17,210.89

 F = Se^rT = 17000e^(0.15 x 90/365) =
 2. Suppose the fixed charge is Rs.310 per deposit and the
variable storage costs are Rs.52.50 per week, it costs
Rs.3040 to store one kg of gold for a year (52 weeks).
Assume that the payment is made at the beginning of the
year. Assume further that the spot gold price is Rs.17000 per
10 grams and the risk-free rate is 7% per annum. What
would the price of one year gold futures be if the delivery
unit is one kg?
 2. Suppose the fixed charge is Rs.310 per deposit and the
variable storage costs are Rs.52.50 per week, it costs
Rs.3040 to store one kg of gold for a year (52 weeks).
Assume that the payment is made at the beginning of the
year. Assume further that the spot gold price is Rs.17000 per
10 grams and the risk-free rate is 7% per annum. What
would the price of one year gold futures be if the delivery
unit is one kg?
 F = (S + U)e^rt

 (1700000 + 310 + 2730)e^(0.07 x 1) =

3. Consider a one-year futures contract on crude oil. Assume
that (a) it costs 2% of the price of crude oil to store a barrel of
oil and the payment is made at the end of the year; (b) the
current price of oil is $50; and (c) the risk-free rate of interest
is 6%. Then the future value of a one-year crude oil futures
contract is
3.Consider a one-year futures contract on crude oil. Assume
that (1) it costs 2% of the price of crude oil to store a barrel of
oil and the payment is made at the end of the year; (2) the
current price of oil is $50; and (3) the risk-free rate of interest
is 6%. Then the future value of a one-year crude oil futures
contract is
 F = $50e^(0.06+0.02) = $54.16
4. Assume that a commodity's spot price is Rs1,000. There is a
one-year contract available, the risk-free rate is 2%, the storage
cost is 0.5%, and the convenience yield is 0.25%. Find the
future price of the commodity and its cost of carry.
4. Assume that a commodity's spot price is Rs1,000. There is a one-
year contract available, the risk-free rate is 2%, the storage cost is
0.5%, and the convenience yield is 0.25%. Find the future price of
the commodity and its cost of carry.

 F = Rs.1,000 x e ^ ((2% + 0.5% - 0.25%) x 1) = Rs.1,000 x

1.0228 = Rs.1,022.80.

The future price of Rs.1,022.80 shows that the cost of carry in

this situation is 2.28% i.e. (1,022.80 / 1,000) - 1.

Futures Price = Spot Price + Cost of Carry

 5. The current price of an ounce of gold is $400, the risk-free
rate is 6%, the cost of storage is 2% of the purchase price,
and the lease rate to lend gold is 1%. A six-month futures
contract on gold will be
 5. The current price of an ounce of gold is $400, the risk-free
rate is 6%, the cost of storage is 2% of the purchase price,
and the lease rate to lend gold is 1%. A six-month futures
contract on gold will be

 F = $400 x e ^ ((0.06+ 0.02 - 0.01) x 0.5) =

EX:
 Spot rate = Rs. 10
 Riskless rate rf = 3%
 Period of future contract = 1 year
 Storage cost = 2%
 Commodity beta = 0.7
 Expected market return = 12%
 Convenience yield = 0%
 Expected growth rate of commodity g = Minimum expected
return of the commodity (Disc rate r) + Storage cost
 Minimum expected return of the commodity (Disc rate r)
= CAPM model
 Discount rate r = 9.3%
 g = 11.3

 Theoretical future prices (F1)= ?

 Expected Spot price E(S) = ?

 If E(S) > F1, then it is Normal Backwardation otherwise vice

versa
COMMODITY FUTURE INVESTMENT –
COMPONENT OF RETURNS
 Spot return
 % change in the price of the commodity
 Reasons for the change in the price is due to _____
 Roll return
 Return because of closing current maturity futures and opening new
futures contract
 [(Spot price on the maturity date – next futures contract price)/spot
price on the maturity date] x Percentage of the position in the futures
contract being rolled
 Increases in backwardation and decreases in contango state
 Collateral return
 Interest or return% on the cash investment
 Generally T-bill rate is taken
 Total return>Excess return
 Rebalancing return in case of portfolio
 Especially for Value Weighted PF.
 Futures contracts whose value are increase are sold and whose
values are decrease are purchased.
Roll over example
 Assume an investor has £110 of exposure in wheat futures and the
near contract is worth £10 of exposure but the far (i.e., longer
expiration date) contract is worth only £9 of exposure. Explain
the roll over position of the investor.

 The investor has £110 exposure divided by £10 per contract, or

11 contracts.
 Therefore, for the investor to roll forward his contracts and
maintain a constant level of exposure, he needs to roll the 11
contracts
 Also buy an additional 1 contract to keep the post-roll exposure
close to the pre-roll exposure (£110 exposure divided by £9 per
contract equals 12.2, or 12 contracts rounded).
 Assume an investor has £108 of exposure in regular gasoline
(or petrol) futures and the near contract is worth £9 of
exposure but the far contract is worth £10 of exposure.
Explain the roll over position of the investor.
An investor has a Rs10,000 position in long futures contracts for
soybeans that he wants to roll forward. The current contracts, which
are close to expiration, are priced at Rs4.00 per bushel whereas the
longer term contract he wants to roll into is priced at Rs2.50 per
bushel. What are the transactions—in terms of buying and selling
new contracts—he needs to execute in order to maintain his current
exposure?
 A. Close out (sell) 2,500 near-term contracts and initiate (buy)
4,000 of the longer-term contracts.
 B. Close out (buy) 2,500 near-term contracts and initiate (sell)
4,000 of the longer term contracts.
 C. Let the 2,500 near-term contracts expire and use any proceeds
to purchase an additional 2,500 of the longer-term contracts.
Roll return example
 Consider the roll from the March contract to the April
contract for Crude Oil on 7 February 2014 using the S&P
GSCI (formerly the Goldman Sachs Commodity Index)
methodology, which rolls its positions over a five-day period
(so 1/5 = 20% per day):
March contract closing price: $99.88/barrel
April contract closing price: $99.35/barrel
Calculate roll return
 ($99.88 – $99.35)/$99.88 = 0.53% gross roll return ×
20% rollover portion
 = 0.11% net roll return
An investor has realized a 5% price return on a commodity
futures contract position and a 2.5% roll return after all her
contracts were rolled forward. She had held this position for
one year with required initial collateral of 10% of the position
at a risk-free rate of 2% per year. Her total return on this
position was:
 A. 2.7%.
 B. 7.3%.
 C. 7.7%.
 Total return = Price return + Roll return + Collateral
return
 In this case, she held the contracts for one year, so the price
return of 5% is an annualized figure.
 In addition, the roll return is also an annual 2.5%. Her
collateral return equals 2% per year × 10% initial collateral
investment = 0.2%.
 So, her total return (annualized) is
 Total return = 5% + 2.5% + 0.2% = 7.7%
MODELS FOR EXPECTED RETURN
 Insurance Perspective
 Commodity sellers always go for Short Hedging to hedge the risk.
 A premium is paid to speculators for absorbing the risk
 FP<E(SP)
 When price rises Speculators Long position will generate profit.
 Hedging Pressure Hypothesis
 Consumers of commodity always go for Long Hedging to hedge the
risk.
 More Long hedges FP>E(SP)
 Short or Long position can make profit depending on who are more
 Theory of Storage
 Difference between FP and SP is depends on Storage cost and
Convenience yield

 What is the relationship between Storage Cost and

Convenience yield?