Commodity Markets - Emergence, Functioning & as Investment Vehicle

8/22/2019 Commodity Markets - Emergence, Functioning & as Investment Vehicle

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METS INSTITUTE OF MANAGEMENT

PART-TIME MASTERS DEGREE IN MANAGEMENT

MFM THIRD YEAR SEMESTER FIRST [2012-2013]

CERTIFICATE FROM GUIDE

This is to certify that the project entitled Commodities Markets Emergence,

Functioning & As An Investment Vehicle has been successfully completed by Mr. Ujval

Rajnikant Damania, under my guidance during the third year i.e. 2012-2013 in partial

fulfillment of his/her course, Master Degree in Finance management under the University of

Mumbai through the METs Institute of Management, General Arun Kumar Vaidya Chowk,

Bandra Reclamation, Bandra (W.), Mumbai 400 050.

Name of Project Guide: Prof. Nitin Kulkarni

Address of the Guide: ______________________________________

______________________________________

______________________________________

Telephone Number: ______________________________________

Date: ______________________________________

Signature of the

Project Guide: ______________________________________


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Acknowledgements

My sincere thanks to Prof. Nitin Kulkarni, for the guidance and support in helping me do this

project as a part of Masters in Finance Management (2010 2013).

I would like to thank METs Institute of Management, Mumbai for giving us this opportunity

of learning and providing us with the environment of learning, self-development and growth

for a better future.

I would also like to thank the people for sparing their valuable time and contributing their

views for this project.


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TABLE OF CONTENTS

Emergence of the Commodity Markets

1. Emergence of the Commodity Markets 11.1History of the Commodity Markets 11.2History of the Commodity Markets in India 21.3Present Commodity Market in India 3

2. International Commodity Exchanges 52.1Chicago Board of Trade (CBOT) 52.2Chicago Mercantile Exchange(CME) 52.3New York Mercantile Exchange(NYMEX) 62.4London Metal Exchange(LME) 62.5Tokyo Commodity Exchange(TOCOM) 7

Functioning of Commodity Markets

3. Functioning of Commodity Markets 83.1Introduction to Commodity Market Futures 8

3.1.1 Meaning & Objective 83.1.2 Pricing of Commodity Futures 93.1.3 Meaning of Basis and Spreads 12

3.1.3.1Basis 123.1.3.2Spread 12

4. Participants in the Commodity Derivatives 144.1Hedgers 144.2Speculators 144.3Arbitragers 14

5. Advanced Concept in Commodity Future 155.1Hedging 15

5.1.1 What is Hedging? 155.1.2 Hedge Ratio 155.1.3 Buying Hedge or Long Hedge 165.1.4 Selling Hedge or Short Hedge 165.1.5 Rolling over of Hedge Position 17


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5.1.6 Benefits & Limitations of Hedging 175.1.6.1Benefits of Hedging 175.1.6.2Limitations of Hedging 21

5.2Speculation 215.2.1 What is Speculation? 215.2.2 Long Position in Futures 225.2.3 Short Position in Futures 225.2.4 Meaning of Spread Trading 225.2.5 Buying a Spread 235.2.6 Selling a Spread 23

5.3Arbitrage 235.3.1 What is Arbitrage? 235.3.2 Cash and Carry Arbitrage 245.3.3 Reverse Cash and Carry Arbitrage 24

5.4Introduction to Option 245.4.1 Meaning & Types of Options 255.4.2 Common Terminologies Used in Options on Futures 255.4.3 Factors affecting Option Premium 29

6. Going Forward : Indian Commodity Markets 31

Commodity Market as an Investment Vehicle

7. Gold as a Commodity : An Introduction 337.1Factors influencing the Gold Market 337.2Total Investment Demand 337.3Historical Investment Data For Gold 347.4Top Gold Holders in the World 357.5Important World Markets 357.6Weight Conversion Table 36

8. Investment in Gold 379. Why Invest in Gold??? 38

9.1Portfolio Diversification 389.2Inflation Hedge 429.3Dollar Hedge 45


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9.4Risk Management 499.5Demand & Supply 51

10.Conclusion 5511.Reviews 5612.Bibliography 60

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Commodity Markets Emergence, Functioning & As An Investment Vehicle 2010-2013

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1. EMERGENCE OF THE COMMODITIES MARKETS1.1 History of Commodities MarketCommodities future trading evolved from need of assured continuous supply of seasonal

agricultural crops. The concept of organized trading in commodities evolved in Chicago, in

1848. However one can trace its roots to Japan. In Japan, merchants stored the rice in

warehouse for the future use. In order to raise cash, warehouse sold receipts against the held

rice. These were known as rice tickets. Eventually these rice tickets became accepted as a

general commercial currency.

In 19th century Chicago in United States had emerged as a major commercial hub, so that

wheat producers from Mid-west were attracted here to sell their produce to dealers &

distributors. Due to lack of organized storage facilities, absence of uniform weighing &

grading mechanisms producers often confined to the mercy of dealers discretion. These

situations lead to need of establishing a common meeting place for farmers and dealers to

transact in spot grain to deliver wheat and receive cash in return.

Gradually sellers & buyers started making commitments to exchange the produce for cash in

future and thus contract for futures trading evolved; Whereby the producer would agree to

sell his produce to the buyer at a future delivery date at an agreed upon price.

Trading of wheat futures became very profitable which encouraged the entry of other

commodities in futures market. This created a platform for establishment of a body to

regulate and supervise these contracts. Thus Chicago Board of Trade (CBOT) was

established in 1848. It was initially formed as a common location known both to buyers and

sellers to negotiate forward contracts. However, the popularity of the contracts and the

success of the CBOT on Chicago created interest in the other local markets catering to

specific commodities to establish trade bodies that would facilitate dealing in futures

contracts.

In 1870 and 1880s the New York Coffee, Cotton and Produce Exchanges were born.Agricultural commodities were mostly traded but as long as there are buyers and sellers, any

commodity can be traded. In 1872, a group of Manhattan dairy merchants got together to

bring chaotic condition in New York market to a system in terms of storage, pricing, and

transfer of agricultural products.


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The largest commodity exchange in USA is Chicago Board of Trade, The Chicago

Mercantile Exchange, the New York Mercantile Exchange, the New York Commodity

Exchange and New York Coffee, Sugar and Cocoa Exchange. Worldwide there are major

futures trading exchanges in over twenty countries including Canada, England, India, France,

Singapore, Japan, Australia and New Zealand.

The various exchanges are constantly looking for new products in which futures contract can

be traded. In USA, futures trading is regulated by an agency of Department of Agriculture

called the Commodity Futures Trading Commission. It regulates the future exchanges,

brokerage firms, money managers and commodity advisors.

1.2 History of Commodity Market in India

The history of organized commodity derivatives in India goes back to the nineteenth century

when Cotton Trade Association started futures trading in 1875, about a decade after they

started in Chicago. Over the time derivatives market developed in several commodities in

India. Following the start of trading in cotton futures, derivatives trading started in oilseed in

Bombay (1900), raw jute and jute goods in Calcutta (1912), Wheat in Hapur (1913) and

Bullion in Bombay (1920).

However many feared that derivatives fuelled unnecessary speculation and were detrimental

to the healthy functioning of the market for the underlying commodities, resulting in to ban of

commodity options trading and cash settlement of commodities futures after independence in

1952. The parliament passed the Forward Contracts (Regulation) Act, 1952, which regulated

contracts in Commodities all over the India. The act prohibited options trading in goods along

with cash settlement of forward trades, rendering a crushing blow to the commodity

derivatives market. Under the act only those associations/exchanges, which are granted

reorganization from the Government, are allowed to organize forward trading in regulated

commodities.

The act envisages three tire regulations:

(i) Exchange which organizes forward trading in commodities can regulate trading

on day-to-day basis;

(ii) Forward Markets Commission provides regulatory oversight under the powers

delegated to it by the central Government;


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(iii) The Central Government- Department of Consumer Affairs, Ministry of

Consumer Affairs, Food and Public Distribution- is the ultimate regulatory authority.

After Liberalization and Globalization in 1990, the Government set up a committee (1993) to

examine the role of futures trading. The Committee (headed by Prof. K.N. Kabra)

recommended allowing futures trading in 17 commodity groups. It also recommended

strengthening Forward Markets Commission, and certain amendments to Forward Contracts

(Regulation) Act 1952, particularly allowing option trading in goods and registration of

brokers with Forward Markets Commission. The Government accepted most of these

recommendations and futures trading were permitted in all recommended commodities. It is

timely decision since internationally the commodity cycle is on upswing and the next decade

being touched as the decade of commodities.

Commodity exchange in India plays an important role where the prices of any commodity are

not fixed, in an organized way.

1.3 Present Commodity Market in India

INDIAN COMMODITY MARKET STRUCTURE

MINISTRY OF CONSUMER AFFAIR, FOOD &PUBLIC DISTRIBUTION

FORWARD MARKET COMISSION

INDIAN COMMODITY EXCHANGE

NATIONAL EXCHANGE

NCXDEX MCX NMCEIL ICEX

REGIONAL EXCHANGES

NBOT20 OTHER

REGIONALEXCHNAGES


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The Forward Markets Commission (FMC) headquartered at Mumbai, is the regulatory

authority for the commodity Derivatives Markets in India. It is the statutory body set up in

1953 under the Forward Contracts (Regulation) Act, 1952. FMC is in turn supervised by

Ministry of Consumer Affairs, Food and Public Distribution, Government of India.

There are four National level Commodity Exchanges in India

The four exchanges are:

(i) National Commodity & Derivatives Exchange Limited(NCDEX)Mumbai,

(ii) Multi Commodity Exchange of India Limited(MCX)Mumbai,

(iii) National Multi-Commodity Exchange of India Limited(NMCEIL)Ahmedabad

(iv) Indian Commodity Exchange Limited(ICEX), Gurgaon

There are 21 other regional commodity exchanges situated in different parts of India.

The functions of the Forward Markets Commission are as follows:

(a)To advise the Central Government in respect of the recognition or withdrawal ofrecognition from any association or in respect of any other matter arising out of the

administration of Forward Contracts (Regulation) Act 1952.

(b)To keep the forward markets under the observation and to take such action in relationto them, as it may consider necessary, in exercise of the powers assigned to it by or

under the Act.

(c) To collect and whenever the Commission feels necessary, to publish informationregarding the trading conditions in respect of goods to which any of the provisions of

the act is applicable, including information regarding supply, demand and prices, and

submit to the Central Government, periodical reports of the working of the forward

markets relating to such goods.

(d)To make recommendations generally with a view to improvising the organization andworking of forward markets.

(e)To undertake the inspection of the accounts and other documents of any recognizedassociation or registered association or any member of such association whenever it

considers it necessary.


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2. INTERNATIONAL COMMODITY EXCHANGESFutures trading is a direct consequence of the problem related to maintenance of a year-

round supply of commodities / products that are seasonal as is the case of agricultural

produce. Trading on the futures market platform provides the solution to these problems and

opens up new opportunities as well. The economic benefits of the exchange traded futures

and options include the ability to shift and manage the price risk exposure of the market and

tangible positions. With the liberalization in the international trade policies, there is a new

need felt in many countries for the price discovery and the existence of a future trading

mechanism. This need can be met through commodity exchanges.

There are at least a dozen major commodity exchanges that serve as a marketplace for

commodities worldwide. Each of these specializes in certain commodities, while others trade

in whole different set.

2.1 Chicago Board of Trade (CBOT)

The first commodity exchange established in the world was Chicago Board of Trade (CBOT)

during the year 1848 by a group of Chicago merchants who were keen to establish a central

market place for trade. It trades in financial and agricultural contracts.

In recent years, the CBOT has added electronic trading features, which is remarkably

different from the earlier open auction market.

Commodities traded: Corn, Soyabeans, Soyabean Oil, Soyabean meal, Wheat, Oats,

Ethanol, Rough Rice, Gold, Silver, etc.

Like any other commodity exchange, the primary role of CBOT is to provide transparency

and liquidity in its contracts to its members, clients and market participants like farmers,

corporate, small businessmen, financial service providers, international trading firms and

speculators for price discovery, risk management and investment.

2.2 Chicago Mercantile Exchange (CME)

Popularly known as CME, has been in business for over a hundred years, is the largest futures

exchange in US and the largest futures clearing house in the world for futures and options

trading. Formed in 1898 primarily to trade in agricultural commodities, the CME introduced


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the worlds first financial futures more than 30 years ago. Today it trades heavily in interest

rate futures, stock indices, and foreign exchange futures.

The commodity futures profile of CME consists of livestock, dairy and forest products and

enables small family farms to large agri-business to manage their price risks.

Commodity traded: Butter, Milk, Diammonium, Phosphate, Feeder cattle, Frozen Pork

bellies, Lean Hogs, Live Cattle, Non-Fat dry milk, Urea, Urea Ammonium Nitrate, etc.

2.3 New York Mercantile Exchange (NYMEX)

The New York Mercantile Exchange is the worlds biggest exchange for trading in physical

commodity. It is the primary trading forum for energy products and precious metals. The

exchange has been in existence for 132 years and performs trades through two divisions, the

NYMEX division, which deals in energy and platinum and the COMEX division, which

trades in all the other metals. The exchange also clears the trade for market participants who

wish to avoid counter-party credit risk by using standardized contracts for Natural Gas, Crude

Oil, Refined Products and Electricity.

Commodities Traded: Light Sweet Crude Oil, Natural Gas, Heating Oil, Gasoline, RBOB

Gasoline, Electricity, Propane, Gold, Silver, Copper, Aluminum, Platinum, Palladium, etc.

2.4 London Metal Exchange (LME)

The London Metal Exchange (LME) is the worlds premier non-ferrous market, with highly

liquid contracts. It is the innovative exchange that has maintained its traditional strengths in

modern business environment by remaining close to its core users by ensuring that its

contracts continue to meet the high expectation of the demanding industry.

The exchange was formed in 1877 as a direct consequence of the industrial revolution

witnessed in Britain in the 19th

century. The primary focus of LME is in providing a market

for participants from the non-ferrous base metals related industry to safeguard against risk

due to movement in the base metals prices and also arrive at a price that sets benchmark

globally.

Commodities traded: Aluminum, Copper, Nickel, Lead, Tin, Zinc, Aluminum Alloy, North

American Special Aluminum Alloy (NASAAC), Polypropylene, Linear Low Density

Polyethylene, etc.


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The LME metal futures contracts run on a daily basis for a period of three months, unlike

others commodity markets that are primarily based on monthly prompt dates. The exchange

thus combines the convenience of the settlement dates tailored to individual needs with the

security of a clearing house for its clearing members.

2.5 Tokyo Commodity Exchange (TOCOM)

The Tokyo Commodity Exchange (TOCOM) is the second largest commodity futures

exchange in the world with trade in metals and energy contracts. It has made rapid

advancement in commodity trading globally since the inception. One of the biggest reasons

for this is the initiative TOCOM took towards establishing Asia as the benchmark for price

discovery and risk management in commodities like the Middle East Crude Oil. TOCOMs

recent tie-up with MCX to explore cooperation and business opportunities is seen as the one

of the steps towards providing a platform for the futures price discovery in Asia for Asian

players in Crude Oil since the demand-supply situation in U.S. that drives the NYMEX is

different from the demand-supply situation in Asia.

In January 2003, in a major overhaul of its computerized trading system, TOCOM fortified

its clearing system in June by being the first commodity exchange in Japan to introduce an in-

house clearing system. TOCOM launched its option on gold future, the first option contract in

Japanese market in May 2004.

Commodities Traded: Gasoline, Kerosene, Crude Oil, Gold, Silver, Platinum, Palladium,

Aluminum, Rubber, etc.

As you can see, commodity exchanges are very readily available all over the world. There are

not only commodity exchanges that specialize in certain kinds of trades; there are ones that

will trade in a wide variety of products as well. These exchanges can trade in everything from

the mundane, to the wacky. Hopefully this summary has piqued your interest regarding the

world of commodities trading.


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3. FUNCTIONING OF THE COMMODITY MARKETS3.1Introduction to Commodity Markets Futures3.1.1 Meaning & Objective of Commodity FuturesA commodity futures contract is a contractual agreement between two parties to buy or sell a

specified quantity and quality of commodity at a certain time in future at a certain price

agreed at the time of entering into the contract on the commodity futures exchange.

Objectives and benefits:-

Hedging- Price Risk Management by risk mitigation Speculation- take advantage a favorable price movements Leverage- pay low margin and enjoy large exposure

Liquidity- eases of entry and exit of market Price discovery- for taking farm and business decision Price stabilization along with balancing demand and supply position Facilitates integrated price structure Flexibility, certainty and transparency in purchasing commodities facilitate bank

financing

Facilitates informed lending by the banksThe primary objectives for any futures exchange are effective price discovery and efficient

price risk management. In commodity futures, it is necessary to distinguish between

investment commodities and consumption commodities. An investment commodity is

generally held for investment purposes whereas consumption commodities are held mainly

for consumption purposes. Gold and Silver can be classified as investment commodities

whereas oil, steel and other commodities can be classified as consumption commodities.

Difference between cash and futures market

Cash market is the market for buying and selling physical commodity at a negotiated price.

Delivery of a commodity takes place immediately.

Futures market is the market for buying and selling standardized contract of the commodity at

a pre-determined price. Delivery of the commodity takes place during a future delivery period

of the contract if the option of delivery is exercised.


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Difference between Future and Forward contract

Future contract is an agreement between two parties to buy or sell a specified quantity and

quality of asset at a certain time in future at a certain price agreed at the time of entering into

the contract on the futures exchange.

Forward contract is an agreement entered between two parties to buy or sell an asset at a

future date for an agreed price. Forward contract is not traded on an exchange.

Size of the contract: Futures contract is standardized in terms of quality and quantity as

specified by the exchange. Size of the contract is customized as per the terms of the

agreement between the buyer and the seller.

Liquidity: Future contract is more liquid as it is traded on the exchange. Forward contract is

less liquid due to its customized nature and mutual trade.

Counter party Risk: In futures contract the clearing houses becomes a counter party to each

transaction, which is called novation, making counter party risk nil. In forward contracts,

counter party risk is high due to decentralized nature of the transaction.

Regulations: Futures contract is regulated by a government regulatory authority and the

Exchange. Forward contract is not regulated by any authority or exchange.

Settlement: Futures contract can be settled by cash or physical delivery depending on the

commodity futures contract specification. Forward contract is generally settled by physical

delivery.

3.1.2 Pricing the commodity futures

Meaning & factors affecting cost of carry

The relationship between cash price and futures price can be explained in terms of cost of

carry. Cost of carry is an important element in determining pricing relationship between spot

and futures prices as well as between prices of futures contracts of different expiry months.

According to the cost of carry model, futures price depend on the spot prices of a commodity

and the cost of storing the commodity from the date of spot prices to the date of delivery of

the futures contract. Cost of storage and insurance and cost of financing constitute cost of

carry. Estimated cost of futures price is also called Full carry futures price


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Cost of carry model: The cost of carry model can be defined as:

F = S + C

Where,

F = Futures Price

S = Spot Price

C = Cost of carry

For example: If the cost of 100 grams of gold in spot market is Rs. 80,000 & cost of carry is

12% per annum, the fair value of a 4 month futures contract will be:

F = S + C

F = 80,000 + (80,000 * 12% * 4/12)

F = 80,000 + 3,200

F = Rs. 83,200

The fair value of a futures contract is a theoretical value of where a future contract should be

positioned, given the current spot price, cost of financing & the time to expiration. Fair value

of a futures contract can be calculated using the following:

F = S (1 + r)n

Where

S = Spot Price

F = Futures Price

r = % cost of financing (annually compounded)

n = Time till expiration of the contract

If the value of r is compounded m times in a year, the formula to calculate the fair value will

be

F = S (1 + r/m)mn

Where

m = number of times compounded in a year


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For example : The cost of 100 grams of gold in spot market is Rs. 80,000 & cost of financing

is 12% per annum, compounded monthly, the fair value of a 4 month futures contract will be

F = S (1 + r/m)mn

F = 80,000 (1 + 0.12 / 12)12 * 4/12

F = 80,000 (1.01)4

F = 80,000 * 1.0406

F = Rs. 83,248

The fair value of a futures contract with continuous / daily compounding can be expressed as:

F = Sern

Where

F = Futures price

S = Spot Price

r = % cost of financing

n = Time till expiration of the contract

e = 2.71828

The above formula is used to calculate the futures price of a commodity when no storage cost

are involved.

The futures price is equal to the sum of money S invested at a rate of interest r for a period

of n years.

For example : If the cost of 100 grams of gold in spot market is Rs. 80,000 & cost of

financing is 12% per annum, the fair value of a 4 month futures contract will be

F = Sern

F = 80,000 * e(0.12 * 0.333)

F = 80,000 * 2.71828(0.0399)

F = 80,000 * 1.04077

F = Rs. 83,261


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3.1.3 Meaning of Basis and Spread3.1.3.1BasisBasis is the difference between the cash price of an asset and the future price of the

underlying asset. Basis can be negative or positive depending on the prices prevailing in the

cash and futures market. If the cash price is less than the futures price, basis is negative and if

the cash price is more than the futures price, basis is positive.

When the cash price of the an asset increases at a rate faster than the futures price of the

underlying asset, it is usually referred to as a strengthening of basis; when the futures price of

the underlying asset increases at a rate faster than the cash price of the asset, it is usually

referred to as weakening of the basis.

If the spot price of the asset is less than the futures price of the underlying asset, the market is

said to be in contango. Future price converges close to the spot price of the underlying asset

during the delivery month of the futures contract. As the futures contract approaches the

expiry, it converges with the spot price.

A strong basis is indicative of a short supply in the spot market. As soon as supply needs are

met, basis levels will weaken. A crop year when short supply is anticipated or forecast will

result in strong basis until supply needs in the spot market are met.

A large supply in indicated by a weak basis. A crop year when supplies are forecast to be

ample is indicative that basis level will weaken.

If the spot price of an asset is less than the futures price of the underlying asset, the market is

said to be in contango. When the futures contract approaches the expiry, the spot price and

the future price converge with each other

If the spot price of an asset is more than the futures price of the underlying asset, the market

is said to be in backwardation. When the futures contract approaches expiry, the spot price

and future price converge with each other.

3.1.3.2 Spread

Spread is the difference in prices of two futures contracts. Futures market can be normal

market or the inverted market. If the price of the far month futures contract is higher than the

near month futures contract, then it is referred as normal market. If the price of the far month


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futures contract is lower than the near month futures contract, then it is referred to as an

inverted market. Spreads can be classified as intra commodity spreads and inter commodity

spreads. An intra-commodity spread is the difference in prices between the two futures

contracts of the same commodity having different expiry months. Inter commodity spread is

the difference in prices of two commodities having the same expiry month.


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4. PARTICIPANTS IN COMMODITY DERIVATIVES4.1 Hedgers

Hedgers are interested in transferring risk associated with transacting or carrying underlying

physical asset. Hedging is an insurance used to avoid or reduce price risks associated with

any kind of futures transaction. A hedge involves the establishing a position in the futures

market that is equal and opposite to a position in the physical market. Hedging works because

cash and future prices tend to move in tandem, converging as the futures contract reached

expiration.

4.2SpeculatorsSpeculators are interested in making money by taking a view on future price movements.

Commodity futures allow speculators to create high leveraged positions to undertake

calculative risk, with the objective of correctly predicting the market movement. A speculator

is an additional buyer of commodities whenever it seems that market prices are lower than it

should be. Conversely, when it appears that prices are too high, a speculator becomes an

active seller.

4.3ArbitragersArbitragers are interested in locking in a minimum risk profit by simultaneously entering into

transactions in two or more markets. Arbitragers lock in profit when they spot cash and carry

arbitrage opportunity; or reverse cash and carry arbitrage opportunity.


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5. ADVANCED CONCEPT IN COMMODITY FUTURES5.1Hedging5.1.1 What is Hedging?

Hedging means taking a position in futures market that is opposite to a position in the

physical market with the objective of reducing or limiting risks associated with the price

changes.

5.1.2 Hedge Ratio

Hedge Ratio is the ratio of the number of futures contracts to be purchased or sold to the

quantity of the cash asset that is required to be hedged.

CP Change in cash price

FP Change in futures price

CP Standard deviation ofCP

FP Standard deviation ofFP

Coefficient of correlation between CP & FP

HR Hedge Ratio

Hedge Ratio (HR) that minimize the variance is

HR = * (CP /FP)

Hypothetical Example

On 3rd

March 3012, Mr. Sagar, a Mumbai based gold jeweler buys a 8 kg of gold in cash

market as a raw material to make jewellery from it. Mr. Vinod wants to protect himself from

a decline in the prices of gold till the jewellery is ready for sale in 15 days. He decides to

hedge by selling futures contract of gold. The standard deviations of the change in the cash

price of gold and change in futures price of gold over the 15 day period is 1.17 and 0.62

respectively. The coefficient of correlation between the cash price of gold and the futures

price of gold for 15 days is 0.60. Standardized futures contract size is 1 kg.

The optimal hedge ratio is 0.60 * 1.17 / 0.62 = 1.13


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Mr. Sagar should sell 1.13 * 8 / 1 = 9.04 or sell 9 (rounded off) gold futures contracts to

hedge the physical exposure of 8 kg of gold.

5.1.3 Buying Hedge or Long Hedge

Buying Hedge is also called the Long Hedge. Buying Hedge means buying the futures

contracts to hedge a cash position. Buying Hedge strategy is used by dealers, consumers,

fabricators, etc. who have taken or will be taking exposure in the physical market.

Uses of Buying hedge strategy

To protect increase in the cost of raw material To replace the inventory at lower prevailing cost To protect uncovered forward sale of finished goods

Buying hedge is done with the purpose of protecting against price increase in the spot market

of a commodity that has already been sold at a specific price but not purchased yet. It is very

common among exporters and importers to sell commodities at an agreed-upon price for

forward delivery. If the commodity is not yet in possession, the forward delivery is

considered uncovered.

5.1.4 Selling Hedge or Short Hedge

Selling hedge is also called Short Hedge. Selling hedge means selling a futures contract tohedge a cash position. Selling hedge strategy is used by the dealers, consumers, fabricators,

etc. who have taken or will be taking exposure in the physical market.

Uses of Selling hedge strategy

To protect the price of finished products To protect inventory not covered by forward sales To protect the prices of estimated production of finished product

Short Hedgers are merchants and producers who acquire inventories of the commodity in the

spot market and who simultaneously sell an equivalent amount or less in the futures market.

The hedgers in this case are said to be long in the spot transaction and short in the futures

transactions.


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5.1.5 Rolling over of Hedge Position

If the time period required for a hedge position is later than the expiration date of the current

futures contract, the hedger can roll over the hedge position. Rollin over the hedge position

means closing out the existing position in one futures contract and simultaneously taking a

new position in a futures contract with a later expiration date. If a person wants to reduce or

limit the risk due to fall in prices of the finished material to be sold after 6 months and if the

futures contracts up to 2 months are liquid, then he can rollover the short hedge position three

times till the date when the actual physical sale takes place. Every time the hedge position is

rolled over, it limits or reduces the price risk.

5.1.6 Benefits & Limitation of Hedging

5.1.6.1 Benefits of Hedging

1. Hedging reduces or limits the price risk associated with the physical commodity2. Hedging is used to protect the price risk of a commodity for long periods by rolling

over contracts

3. Hedging makes business planning more flexible without interfering with routinebusiness operations

4. Hedging can facilitate low cost financingHedging is the most common method of price risk management. It is the strategy of offsetting

price risk that is inherent in a spot market by taking an equal but opposite position in the

futures market. Futures markets are used as a mode by hedgers to protect their businesses

from adverse price changes, which could dent the profitability of their business. Hedging

benefits all participants who are involved in trading of commodities like farmers, processors,

merchandisers, manufacturers, exporters, importers, etc.

The following are 2 hypothetical illustrations of the benefits of hedging:

Hypothetical Illustration 1:

A wheat miller enters into a contract to sell flour to a bread manufacturer four months from

now. The price is agreed upon today though the flour would only be delivered after four

months. The miller is worried about the rise in the price of wheat during the course of next

four months. A rise in the price of wheat would result in losses on the contract to the miller.

To safeguard against the risk of increasing prices of wheat, the miller buys wheat futures


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contracts that call for the delivery of wheat in four months time. After the expiry of four

months, as feared by the miller, the price of wheat may have risen. The miller then purchases

the wheat in the spot market at a higher price. However, since he has hedged in the futures

market, he can now sell his contract in the futures market at a gain since there is an increase

in the futures price as well. He thus offsets his purchase of wheat at a higher cost by selling

the futures contract thereby protecting his profit on the sale of the flour. Thus, the wheat

miller hedges against exposure to price risk.

Mechanics of Hedging as explained in Illustration 1


An automobile manufacturer purchases huge quantities of steel as raw material for

automobile production. The automobile manufacturer enters into a contractual agreement to

export automobiles 3 months hence to dealers in East European market. This presupposes that

the contractual obligation has been fixed at the time of signing the contractual agreement for

exports. The automobile manufacturer is now exposed to risk in the form of increasing steel

prices. In order to hedge against price risk, the automobile manufacturer can buy Steel futurescontracts, which would mature 3 months hence. In case of increasing or decreasing steel

prices, the automobile manufacturer is protected. Let us analyze the different scenarios:

APRIL

JULY

WHEAT MILLER

Agrees to sell flour to bread

manufacturer

Buy Wheat Futures Contract

Sell Wheat Futures Contracts

Buy Wheat in the Physical Market for

delivery of flour to Bread Manufacturer


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Scenario 1: Increasing Steel Prices

If steel prices increase, this would result in increase in the value of the Futures contracts,

which the automobile manufacturer has bought. Hence, he makes profit in the futures

transaction. But the automobile manufacturer needs to buy Steel in the physical market to

meet his export obligation. This means that he faces a corresponding loss in the physical

market. But this loss is offset by his gains in the futures market. Finally, at the time of

purchasing steel in the physical market, the automobile manufacturer can square off his

position in the futures market by selling the Steel Futures contract, for which he has an open

position.

Scenario 2: Decreasing Steel Prices

If steel prices decrease, this would result in decrease in the value of the Futures contracts,

which the automobile manufacturer has bought. Hence, he makes losses in the futures

transaction. But the automobile manufacturer needs to buy Steel in the physical market to

meet his export obligation. This means that he faces a corresponding gain in the physical

market. The loss in the futures market is offset by his gains in the physical market. Finally, at

the time of purchasing steel in the physical market, the automobile manufacturer can square

off his position in the futures market by selling the Steel Futures contract, for which he has an

open position. This results in a perfect hedge to lock the profits and protect from increase or

decrease in raw material prices. This also provides the added advantage of Just in TimeInventory management for the automobile manufacturer.


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Mechanics of Hedging as explained in Illustration 2


A farmer plans to harvest Guar seed crop in the month of November. But in the harvesting

season (November), the Guar seed prices usually decline due to excess supply in the market.

This usually forces the farmer, who requires income for the next subsequent harvesting

season, to sell his harvest at a discount.

The farmer has two options to counter this risk he is exposed due to price fluctuations:

Option A: Store the Guar seed, which has been harvested for few months and subsequently

sell the Guar seed when the prices increases (in the non-harvest) season). But, this would not

be possible if the farmer requires the proceeds from the sale of this harvest to finance the next

crop season. Also, the farmer would require adequate storage space and would require

following preservation techniques to ensure that the stored harvest would not be destroyed

due to infestation.

Option B: Alternatively, the farmer can hedge himself by selling November Guar seed

Futures contract in the month of September. Any decline on the spot prices in the month of

November would result in decline in the futures prices, which he has already sold at higher

JUNE

SEPTEMBER

AUTOMOBILE

MANUFACTIURER

Export Contract to sell (export)Automobiles in October

Buy Steel Futures Contracts

Sell Steel Futures Contracts Buy Steel from Physical Market to meet

export requirement


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price. Upon harvest, the farmer would offset his futures transaction by buying Guar seed

November futures contract and simultaneously sell his Guar seed crop harvest in the physical

market. This ensures that the farmer is protected against any decline in the prices in the

physical market.

Mechanics of Hedging As explained in Illustration 3

5.1.6.2 Limitations of Hedging

1. Hedging cannot eliminate the price risk associated with the physical commodity intotality due to the standardized nature of futures contracts

2. Because of the basis risk, hedging may not provide full protection against the adverseprice changes

3. Hedging involves transaction costs4. Hedging may require closing out a futures position before it enters into the delivery

period

5.2Speculation5.2.1 What is Speculation?

Speculation means anticipating future price movements to make profits from it. The main

objective of speculation in a commodity futures market is to take risks & profit from

anticipated price changes in the futures price of an asset.

SEPTEMBER

NOVEMBER

FARMER

Sell Guar seed November Futures

Buy Guar seed November Futures to

square-off transaction

Sell Guar seed Harvest


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5.2.2 Long position in futures

Long position in commodity futures contract without any exposure in the cash market is

called speculative transaction. Long position in futures for speculative purpose means buying

a futures contract in anticipation of increase in the prices before the expiry of the contract. If

the prices of the futures contracts increase before the expiry of the contract then the trader

makes the profit by squaring off the position and if the prices of the futures contract decrease

then the trader makes losses.

5.2.3 Short position in futures

Short position in a commodity futures contract without any exposure in the cash market of

the commodity means a speculative transaction. Short position in futures for speculative

purpose means selling a future contract in anticipation of decrease before expiry of the

contract then the trader makes profit on squaring off the position and if prices of the futures

contract increase then the trader makes losses.

5.2.4 Meaning of Spread Trading

Spread refers to difference in prices of two futures contracts. An understanding of spread in

relationship in terms of fair spread is essential to earn a speculative profit. Considerable

knowledge of a particular commodity is also necessary to enable the trader to use the spread

trading strategy.

When actual spread between two futures contracts of the same commodity widens, buy the

near month contract because it is under-priced and sell the far month contract because it is

over-priced. When actual spread between two futures contract of the same commodity

narrows, sell the near month contract because it is over-priced and buy a far month contract

because it is under-priced.

A calendar spread is a spread between the same variable at two points in time.

An intra-commodity spread consists of one long future and one short. Both have the same

underlying, but different maturities.

An inter-commodity spread consists of a long-short position in futures on different

underlying commodities. Both typically have the same maturities.


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Spreads can also be constructed with the futures traded on different exchanges. Typically this

is done using the futures on the same underlying, either to earn arbitrage profits or, in case of

the underlying commodity, to create an exposure to price spreads between two

geographically separate delivery points.

5.2.5 Buying a Spread

Buying a spread is an intra-commodity spread strategy. It means buying a near month

contracts and simultaneously selling a far month contract. This strategy is adopted when the

near month contract is underpriced or the far month contract is overpriced. A trader of the

above strategy buys the near month contract and sells the far month contract when the spread

is not fair and squares off the positions when the spread corrects and the contract are traded at

a fair price.

5.2.6 Selling a spread

Selling a spread is also an intra-commodity spread strategy. It means selling a near month

contract and simultaneously buying a far month contract. This strategy is adopted when the

near month is overpriced or far month contract is underpriced. A trader of the above strategy

sells near month contract and buys the far month contract when the spread is not fair and

squares off the positions when the spread corrects and contracts are traded at fair spread.

5.3Arbitrage5.3.1 What is Arbitrage?

Arbitrage means locking in profit by simultaneously entering into transactions in two or more

markets. If the relationship between spot prices and the future prices in terms of basis or

between prices of the two futures contracts in terms of spread changes, it gives rise to

arbitrage opportunities. Difference in the equilibrium price determined by the demand and

supply at two different markets also gives opportunities to arbitrage. The futures price must

be equal to the spot prices plus cost of carrying the commodity to the futures delivery dateelse arbitrage opportunity arises.

Mathematically, it can be expressed as F (o, n) = S0 (1+ c)

F (o, n) = Futures price of the commodity at t = 0 for the expiry at t = n

S0 = Spot price of the commodity at t = 0


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c = Cost of carry from t = 0 (present) to t = n (expiry date of futures) expressed as a

percentage of the spot price

Cost of carry relationship also applies to price relationship that should exist between futures

contracts of the same commodity with different expiry dates. The far month futures price

must be equal to the near month future price plus cost of carrying the commodity from the

near month to the far month expiry date else arbitrage opportunities arise.

Arbitrage provides market efficiency in commodity futures and hence prices are quoted at

their fair value most of the times.

5.3.2 Cash and Carry Arbitrage

Cash and Carry arbitrage between spot and futures prices means buying the physical

commodity borrowed funds and simultaneously selling in the futures contract in the first

transaction and closing the futures contract by delivering the physical commodity on maturity

in the second transaction. Cash and carry arbitrage opportunity arises when the futures price

of the asset is more than the spot price of the asset plus cost of carrying the asset to the

futures expiry date.

5.3.3 Reverse Cash and Carry Arbitrage

Reverse cash and carry arbitrage between spot and futures prices means lending funds

realised from selling the physical commodity and simultaneously buying the futures contract

in the first transaction and closing out the futures contract by taking the delivery of the

physical commodity on maturity in second transaction. Reverse cash and carry arbitrage

opportunity arises when the futures price of the asset is less than the spot price of the asset

plus cost of carrying the asset to the futures expiry date.


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5.4 Introduction to Options

5.4.1 Meaning & Types of Options

An Option on futures gives the right but not the obligation on the part of the holder to buy or

sell the underlying futures contract by a certain date at a certain price.

Two types of options

A Call Option is contract that gives the owner of the call option the right, but not obligation

to buy the underlying asset by a specified date and at a specified price.

A Put Option is a contract that gives the owner of the put option, the right, but not the

obligation to sell the underlying asset by a specified date and at a specified price.

A Commodity Option gives the owner the right to buy or sell a commodity at a specified

price and before a specified time.

Base on the exercise mode, there are two types of options that are currently being traded.

American Style Options

In an American option, the buyer of the option can choose to exercise his option at any given

period of time between the purchase date & the expiry date of the underlying futures contract.

European Style Option

In a European option, the buyer of the option can choose to exercise his option only on the

date of expiration of the underlying futures contract.

Since the American option provides greater degree of flexibility to the investor, the premium

paid to buy an American style option is equal to or greater than the European style option.

5.4.2 Common Terminologies used in options on futures

In the money

A call option is said to be in the money if the price of the underlying futures contract is above

the strike price.

A put option is said to be in the money if the price of the underlying futures contract is below

the strike price.


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At the money

A call option is said to be at the money if the underlying futures contract is equal to the strike

price.

A put option is said to be at the money if the underlying futures contract is equal to the strike

price.

Out of the money

A call option is said to be out of the money if the underlying futures contract is below the

strike price.

A put option is said to be out of the money if the underlying futures contract is above the

strike price.

Deep in the money

An option contract that is so far in the money that it is unlikely to go out of money prior to

expiration.

Close to the money

An option contract whose strike price is close to the futures price of the underlying.

Deep out of money

An option contract that is so far out of the money that it is unlikely to go in the money prior

to expiration.

Underlying Futures contract

It is the corresponding futures contract that can be either bought or sold by exercising the

option.

Exercise

Action taken by the buyer of the option whose intention is to deliver / take delivery of the

underlying futures contract.


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Only the buyer of an option contract has the right to exercise the option. The seller of the

option (option writer) is obligated to deliver / take delivery of the underlying futures contract

as & when the buyer wishes to exercise his option.

Exercise price

It is also called the strike price & is the price at which the buyer / seller of the option may buy

or sell the underlying futures contract respectively.

Expiration Date

Is the last day on which an option can be either exercised or offset.

In the case of a call option, exercising would generate a long futures position.

In the case of a put option, exercising would generate a short futures position.

Premium

It is the cost paid to buy an option at a specific strike price / exercise price. The premium to

be paid depends upon the strike price relative to the futures price, time till expiration &

market volatility.

Delta

Delta is the first derivative in the option-pricing model. It is also called the hedge ratio.

Delta is defined as the change in price of the option premium corresponding to the change in

price of the underlying futures contract. Since options premiums do not always move as

much as the underlying futures price, the delta factor is used. Generally, a change in the

futures price of the underlying will result in a smaller change in the price of the option

premium.

Delta is expressed in percentage terms & ranges from 0% for deep out of money options to

100% for deep in the money options. Delta or at the money options is usually 50% or 0.5.

The value of delta decreases when the futures price moves from in the money to at the money

to out of money. Similarly, the value of delta increases when the futures price moves from

out of money to at the money to in the money.


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Gamma

The change in value of delta corresponding to ta change in the underlying futures price is

called Gamma. It is also called the curvature of the option.

The changes in Gamma are dynamic i.e. the value of Gamma moves up or down as the

futures price of the underlying changes.

Theta

Theta is the measure of the change in option premium corresponding to a one day change in

its time to expiration.

It is also called the time decay.

Vega

Vega is the change in the option premium corresponding to a 1% change in volatility in the

futures price of the underlying.

Vega is a measure of the sensitivity of options to market volatility.

Rho

The rho of a portfolio is a measure of the portfolios linear exposure to changes in the risk-

free interest rate. It measures the sensitivity of the portfolio to interest rates.

Intrinsic Value

The amount by which an option is in the money is called intrinsic value of the option.

Intrinsic value is calculated by taking the difference between the strike price and the current

price of the underlying.

Intrinsic value for a CALL OPTION is calculated as

INTRINSIC

VALUE

CURRENT PRICE OF

UNDERLYING FUTURES

CONTRACTS

STRIKE

PRICE


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Intrinsic value for a PUT OPTION is calculated as

Time value is the amount an investor is willing to pay for an option above its intrinsic value

in the hope that some time before the expiration of the contract, the value of the underlying

will generate positive cash flows.

The time value of an option contract decreases as the underlying futures contract approaches

the expiry.

5.4.3 Factors affecting Option premium

There are six major factors that influence option premiums. They are

a) Changes in the price of the underlying futures contractb) Strike pricec) Time until expirationd) Volatility of the underlying futures contracte) Dividendsf) Risk free interest rates

Changes in the price of the underlying futures contract can increase or decrease the value of

an option. The price changes have opposite effect on call and puts. For instance, as the value

of the underlying futures contract rises, the value of the call option will increase and the value

of the put option will decrease. A decrease in the price of the underlying futures contract will

have the opposite effect.

INTRINSIC

VALUE

CURRENT PRICE OF

UNDERLYING FUTURES

CONTRACTS

STRIKE

PRICE

TIME

VALUEPREMIUM

INTRINSIC

VALUE


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The strike price determines whether or not an option had an intrinsic value. An options

premium generally increases as the option becomes further in the money, and decreases as

the option becomes more deeply out of money.

Time until expiration affects the time value component of an options premium. Generally, as

expiration approaches, the level of an options time value for both puts and calls decreases.

The effect is mostly noticed with the at-the-money options.

The effect of volatility can have a significant impact on the time value portion of an options

premium. Volatility is simply a measure of risk (uncertainty), or variability in the price of the

underlying futures contract. Higher volatility estimates reflect greater expected fluctuation (in

either direction) in the price levels of the underlying. This expectation generally results in

higher option premium for the puts and calls alike, and is most noticeable with at-the-money

options.

The effect of an option premium on the underlying securitys dividend and the current risk-

free interest rate has a small but measurable effect. This effect the cost of carry of the

shares in an underlying security the interest that might be paid for margin or received from

an alternative investments (such as a Treasury bill), and the dividends that would be received

by owning shares outright.


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6. GOING FORWARD: INDIAN COMMODITY MARKETSEver since the first national level commodity exchange was introduced in 2003, commodity

exchanges have seen an exponential growth. In the last fiscal turnover in Indias commodity

exchanges rose 52% to Rs. 181, 26,103 crores in 2011-12 as against 119, 48,942.35 crores in

2010-11 amidst high volatility, according to data released by Forward Markets Commission.

The turnover on the Indian commodity bourses has increased 120 times after electronic

trading was introduced in 2003, according to the Forward Markets Commission (FMC), the

commodities market regulator.The MCX is the world's largest exchange in silver, the secondlargest in gold, copper and natural gas and the third largest in crude oil futures. However, as a

whole, exchange-traded commodities account for only a fifth of the total volume of

commodities traded in India. Globally, the futures market in commodities is 30-40 times the

size of the underlying physical commodity trade.

The commodity markets are at a juncture where investment in education and research is

important to sustain their growth. The MCX has been taking various initiatives to

systematically develop markets through continuous innovation, education and research

focused on spreading awareness of the modern trading mechanisms facilitated by commodity

exchanges.

To widen and deepen our commodities market for the future, policymakers need to strengthen

the institutional infrastructure through market-friendly policies on taxation, enabling of

institutions, such as banks and mutual funds, to participate in the commodity futures market,

and the provision to initiate trading in options and intangible commodities.

Following are the bold and the revolutionary steps taken by Forward Markets Commission &

NCDEX the largest Agriculture Exchange to strengthen the futures market.

1. Staggered Delivery:Most of the agricultural commodities traded on the domestic exchanges are under the

Compulsory Delivery system wherein it is mandatory for sellers to deliver goods upon the

expiry of the contract. In a move which gives the seller an option to tender delivery much

before the expiry of the contract, the Regulator has introduced a system of staggered delivery

in Compulsory Delivery contracts which could go a long way towards easing pressures

towards the expiry of the contract and facilitate convergence in the futures and underlying

physical markets..


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2. Reduction in Delivery Default Penalty:In scenarios of shortage of goods in the Exchange accredited warehouses, when sellers were

not in a position to effect delivery this led default penalty being priced into the futures prices.

The penalty has been reduced from 3% to 1.5 % plus the difference in the Settlement Price

and the average of three of the highest spot prices during five days after expiry of the contract

in select commodities. Relaxing the penalty percentage would reduce the probability of non-

convergence between spot and future prices and ensure more orderly expiries of the contracts.

3. Change in Validity Structure:Agricultural commodities have a fixed validity period during which they are eligible to be

delivered on the exchange platform. This validity period is in general governed by the shelf

life of the commodity. Taking into consideration the low availability and high demand for

select commodities in the current season, the Exchange proactively has reduced the validity

period of in respect of agricultural commodities like Mustard Seed, Pepper, Soya Bean and

Chana. This would result in stocks being moved out of the warehouse at regular intervals

during the year which is beneficial in years of shortages.

Given the above, a greater adoption of hedging instruments available on commodity

exchanges can help commodity value chain participants and also end users mitigate price risk

which will be in the larger interest participant in the exchange.

The above steps are designed to further strengthen the commodities futures market in India.


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7. Gold as a Commodity: An Introduction

Gold is primarily a monetary asset and partly a commodity. More than two thirds of Golds

total accumulated holdings, relating to the value of investment is with the central banks

reserves, private players and high karat jewelry.

Gold is highly liquid. Gold held in central banks, other than major institutions, and retail

jewelry is reinvested in the market. Due to a large stock of gold, against its demand, it is

argued that the core driver of the real price of gold is stock equilibrium rather than flow

equilibrium.

7.1 Factors Influencing the Gold Market:

Above ground supply from sales by central banks, reclaimed scrap, and official goldloans

Producer/ mining hedging interest World macroeconomic factors such as the U.S dollar and interest rate Comparative returns on stock markets Domestic demand based on monsoon and agricultural

7.2 Total Investment Demands

2010 2011 2012(Q1) 2012(Q2)

Physical Bar Demand 899.5 1171.3 275.4 226.2

Official Coins 213.1 245.5 52.3 53.8

Medals/imitation coins 88.3 87.8 26.5 22.8

Total Bar and Coin Demand (A) 1200.9 1504.6 354.2 302.8

ETF's & Similar Products (B) 382.2 185.1 53.2 -0.8

OTC investments and stock flows (C) 207.7 -76.9 -60.3 59.6

Total Investment Demand (A + B + C) 1790.8 1612.8 347.1 361.6

(figures in tonnes)


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Source: World Gold Council

7.3 Historical Investment Data for Gold

Total Bar&

Coin Investment

ETF's &

Similar ProductsTotal

2002 352 - 352

2003 302 39 341

2004 347 133 480

2005 394 208 602

2006 414 260 674

2007 434 253 687

2008 868 321 1189

2009 779 623 14022010 1201 382 1583

2011 1505 185 1690

(figures in tonnes)

-500

0

500

1000

1500

2000

2010 2011 2012(Q1) 2012(Q2)

T

o

n

n

e

s

Year

Total Investment Demands

Total Bar & Coin Demand ETF's & Similar Products

OTC Investments & Stock Flows


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Source: World Gold Council

7.4 Top Gold Holders in the World

No. Country Tonnes % of Reserve

1 United States 8133.5 75.40%

2 Germany 3395.5 72.30%

3 IMF 2814 *

4 Italy 2451.8 71.20%

5 France 2435.4 71.70%

6 China 1054.1 1.70%

7 Switzerland 1040.1 12.10%

8 Russia 936.6 9.60%9 Japan 765.2 3.10%

10 Netherlands 612.5 60.70%

11 India 557.7 9.90%

12 ECB 502.1 32.20%*IMF balance sheets do not allow this percentage to be calculated

7.5 Important World Markets

London is the biggest and the oldest gold market in the world. Mumbai is under Indias liberalized gold regime. New York is the home of gold futures trading. Zurich is a physical turntable. Istanbul, Dubai, Singapore, and Hong Kong are doorways to important consuming

regions.

Tokyo, where TOCOM sets the mood of Japan.

0

200

400

600

800

1000

1200

1400

1600

1800

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Tonnes

Investment Demand

Total Bar & Coin Investment ETF's & Similar Products Total


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7.6 Weight Conversion Table

To convert form To Multiply by

Troy Ounces Grams 31.1035

Million Ounces Tonnes 31.1035Grams Troy Ounces 0.0321507

Kilograms Troy Ounces 32.1507

Tonnes Troy Ounces 32150.70

Kilograms Tolas 85.755


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8. INVESTMENT IN GOLD

Commodity allocations have become more common among investors as a means by which

portfolio diversification can be enhanced. Globally, commodity assets under management

more than doubled between 2008 and 2012 to nearly US$380bn.

Golds physical attributes and functional characteristics set it apart from the rest of

commodities. Gold is less exposed to swings in business cycles, typically exhibits lower

volatility, and tends to be significantly more robust at times of financial troubles. In turn, this

causes golds correlation to other commodities to be low.

For thousands of years, gold has been valued as a global currency, a commodity, an

investment and simply an object of beauty. As financial markets developed rapidly during the

1980s and 1990s, gold receded into the background and many investors lost touch with this

asset of last resort. Recent years have seen a striking increase in investor interest in gold.

While a sustained price rally, underpinned by the fact that demand consistently outstrips

supply, is clearly a positive factor in this resurgence, there are many reasons why people and

institutions around the world are once again investing in gold.

Gold has attracted investors throughout the centuries, protecting their wealth and providing a

'safe haven' in troubled or uncertain times. This appeal remains compelling for modern

investors, although there are also a number of other reasons that underpin the widespread

renewal of investor interest in gold.


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9. WHY INVEST IN GOLD???

9.1 Portfolio Diversification

The key to diversification is finding investments that are not closely correlated to one

another; gold has historically had a negative correlation to stocks and other financial

instruments. Recent history bears this out:

The 1970s was great for gold, but terrible for stocks The 1980s and 1990s were wonderful for stocks, but horrible for gold As of 2008, this decade has been a good one for gold, and an unfavorable one for

stocks

Properly diversified investors combine gold with stocks and bonds in a portfolio to reduce the

overall volatility and risk.

Effective portfolio diversifier: This phrase summarizes the usefulness of gold in terms of

Modern Portfolio Theory a strategy which is used by many investment managers today.

An investor can reduce portfolio risk simply by holding combinations of instruments which

are not perfectly positively correlated. In other words, investors can reduce their exposure to

individual asset risk by holding a diversified portfolio of assets. Diversification may allow for

the same portfolio expected return with reduced risk.

Using this approach, gold can be used as a portfolio diversifier to improve investment

performance.

Effective diversification during stress periods: Traditional methods of portfolio

diversification often fail when they are most needed, that is during financial stress

(instability). On these occasions, the correlations and volatilities of return for most asset class

(including traditional diversifiers, such as bonds and alternative assets) increase, thus

reducing the intended cushioning of a diversified portfolio.

Gold is a foundation asset within any long term savings or investment portfolio. For

centuries, particularly during times of financial stress and the resulting 'flight to quality',

investors have sought to protect their capital in assets that offer safer stores of value. A potent

wealth preserver, golds stability remains as compelling as ever for todays investor.


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As one of the few financial assets that do not rely on an issuer's promise to pay, gold offers

refuge from widespread default risk. It offers investors insurance against extreme movements

in the value of other asset classes.

A number of compelling reasons underpin the widespread renewal of interest in gold as an

asset class:

Asset allocation is a vital aspect of any investment strategy. Balancing asset classes of

different correlations can significantly enhance returns whilst reducing risk.

Many investors believe their portfolios are sufficiently diversified. However, the majority of

investment strategies focus primarily on only a few asset classes stocks, bonds and cash.

Such portfolios may be vulnerable when these asset classes react to market conditions in a

similar fashion.

To counter this effect, many investors now seek more effective diversification by

incorporating alternative investments, such as commodities, into their portfolio.

Gold has shown very strong returns over recent years. Still, its most valuable contribution to

a portfolio lies in the fact that it is not correlated with most other assets (as shown in the chart

below). This independence comes from the fact that golds price is not driven by the same

factors that drive the performance of other asset classes.


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(Source: Barclays Capital, Bloomberg, World Gold Council; calculations based on total return indices in INR unless not

applicable.)

0.25

0.31

0.01

0.09

0.15

-0.02

0.02

0.06

0.08

0.07

0.10

-0.03

-0.05 0.00 0.05 0.10 0.15 0.20 0.25 0.30 0.35

Brent crude oil (INR/bbl)

DJ UBS Comdty Index

INR 3-month deposit

JPM GBI India

JPM GBI EM

JPM EMBI Global

BarCap Global Agg

MSCI India

Bombay SE 200 spot

BSE SENSEX 30 spot

MSCI EM

MSCI US

3-year correlations of weekly returns in

INR

3-year correlations of weekly returns in INR


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(Source: Barclays Capital, Bloomberg, World Gold Council; calculations based on total return indices in INR unless not

applicable.)

Achieving True Diversification

Even when compared to other commodities, gold tends to offer further diversification to an

investors portfolio. This is primarily due to the particular composition and dynamics of golddemand and supply. The composition of gold demand is in itself varied: it is a luxury

consumption-good; a prevalent yet hidden element in modern technology; a financial asset

that offers capital preservation and risk protection; and it is used as a monetary asset

throughout the world. Therefore, it is less exposed to swings in business cycles and,

significantly, it tends to preserve capital at times of financial duress. In turn, this causes

golds correlation to be low within the larger commodity complex

Negative Correlation when needed the most

In a recent study titled Gold: hedging against tail risk conducted by the World Gold Council

found that gold not only tends to have a low correlation to many other assets, including

commodities, but that this correlation changes during periods of economic turmoil in a way

that benefits investors. Gold tends to protect against so-called tail risks, or events that are not

very likely and may not be frequent, but when they do occur they have a significant negative

0.35

0.38

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Brent crude oil (INR/bbl)

DJ UBS Comdty Index

INR 3-month deposit

JPM GBI India

JPM GBI EM

JPM EMBI Global

BarCap Global Agg

MSCI India

Bombay SE 200 spot

BSE SENSEX 30 spotMSCI EM

MSCI US

5-year correlations of weekly returns in

INR

5-year correlations of weekly returns in INR


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impact on an investors capital or wealth. This is a by-product of golds performance during

times of systemic risk when market participants seek high quality, real assets to preserve

capital and minimize losses.

As shown in the chart below, when equity prices fall by more than two standard deviations,

the correlation between gold and equities tends to turn negative, while the correlation of most

other commodities to equities rises significantly. However, when the economy recovers and

equity prices rise sharply, their correlation to gold tends to be slightly positive. The rationale

behind this behaviour is that, in a strong economy, equity prices tend to rise, but consumers

also opt to increase their spending, which may include jewellery or technological devices and

this, in turn, supports golds performance.

(Source: Bloomberg, World Gold Council)

9.2 Inflation Hedge

Market cycles may come and go, but - over the long term - gold keeps its purchasing power.

Its value, in terms of the real goods and services that it can buy, has remained remarkably

stable. In contrast, the purchasing power of many currencies has generally declined due to the

impact of rising prices for goods and services. As a result, gold is often bought to counter the

effects of inflation and currency fluctuations.

Much has been said over the past few years with the respect to inflation and gold as the

thought is that gold is a good hedge against inflation.

-0.5 -0.3 -0.1 0.1 0.3 0.5

S & P 500 return down by more than 2

S & P 500 return up by more than 2

Correlation

Weekly-return correlation between equities, gold and

commoditieswhen equities move by more than 2

Coorelation between S&P 500 and Gold (US$/oz)

Coorelation between S&P 500 and S&P GSCI


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This is partially due to the thought that the price of gold stays relatively constant and the

valuation of currencies merely fluctuate around it.

As a result, many people, funds, and countries, are looking towards gold as a hedge against

inflation.

Inflation & Gold: The Gold Standard

Prior to 1971, the United States was on the gold standard, the value of the US Dollar was

pegged to the value of gold. Valuations of currency are a direct result of the supply of

currency which was adjusted based on the price of gold so were the interest rates

During the time of the gold standard, periods of economic contraction and rising

unemployment were not met with a reduction of rates and an increase in money supply in

effort to spur investment. Instead, as the price of gold fell, the value of the dollar also

decreased because of the peg. However, the money supply stayed inflated on the way down.

This caused an increase in interest rates to reduce money supply during periods of deflation

which raised the cost of capital and the cost of investment due to the physical quantity of

dollars in circulation needing to contract in order to keep the value of the dollar pegged to

gold.

Such increases in rates lead the supply of money in the economy to contract when we needed

it to expand the most.

Gold was considered to be a hedge against inflation due to the appreciation in price relative to

actual inflation during the 1970s, where the prices of the gold actually rose.

This is mainly because the relationship between the inflation and gold is mathematically

inverse.

Gold is priced in US Dollars. This means that as the demand for gold increases, the demand

for dollars also increases. Not only domestically but also abroad.


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(Source: Bloomberg)

The value of gold, in terms of the real goods and services that it can buy, has remained

largely stable for many years. In 1900, the gold price was $20.67/Oz, which equates to about

$1700/Oz in today's prices. In the five years to end-June 2012, the price of gold averaged

around $1126/Oz.

(Source: Bloomberg)

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Nominal Gold v/s Real Gold(Inflation

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Nominal Gold Real Gold(Inflation Adjusted)


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(Source: Bloomberg)

So the real price of gold has endured a century characterized by sweeping change and

repeated geopolitical shocks and more than retained its purchasing power. In contrast, the real

value of most currencies has generally declined.

9.3 Dollar Hedge

At first, investors looked for currencies which they could regard as safe havens. But even

the most apparently safe of currencies is subject to economic and political risk and to

unpredictable political manipulation. Accordingly, therefore, there was revived and increased

interest in ways to hedge these risks. Among these ways was investment in gold. It has long

been thought that gold was a good protection against depreciation in a currencys value, both

internally (i.e. against inflation) and externally (against other currencies). In the latter case it

is normally considered, in particular, to be a hedge against fluctuations in the US dollar, the

worlds main trading currency.

The price of gold is

Documents

Commodity Markets - Emergence, Functioning & as Investment Vehicle