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Economics Essays - Equity Commodity Investment

Equity Commodity Investment

“A COMPARATIVE STUDY BETWEEN EQUITY & COMMODITY INVESTMENT OPTION”

ABSTRACT

India, a commodity based economy where two-third of the one billion population depends on agricultural commodities, surprisingly has an under developed commodity market. Unlike the physical market, futures markets trades in commodity are largely used as risk management (hedging) mechanism on either physical commodity itself or open positions in commodity stock. For instance, a jeweller can hedge his inventory against perceived short-term downturn in gold prices by going short in the future markets.

The study aims to know how of the commodities market and how the commodities traded on the exchange. The idea is to understand the importance of commodity derivatives and learn about the market from Indian point of view. In fact it was one of the most vibrant markets till early 70s. Its development and growth was shunted due to numerous restrictions earlier. Now, with most of these restrictions being removed, there is tremendous potential for growth of this market in the country.

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ACKNOWLEDGEMENT

SYNOPSIS FOR THESIS

DESIRED AREA

Investments - Commodity Market in India

TITLE OF THE THESIS

Comparative Study between Equity & Commodity Investment Options”

PROBLEM DEFINITION / HYPOTHESIS / RESEARCH OBJECTIVE

  • To have a comparative study between two major Investments options - Equity & Commodity on the basis of their returns.
  • To study simple properties of commodity futures as an asset class and analyze the hedging properties
  • To understand the possible returns by investing in Commodity Futures when the Commodity Spot Prices are falling and comparing them with those in Stocks and Bonds.

INTRODUCTION / LITERATURE TO THE AREA OF RESEARCH

In the Capital Markets of the world, preferably in India, Stock is considered as the first option of investment. But, as we all know that there are many other options available with the people to invest / park their hard earned in & some of these options are Derivative Market, Mutual Funds, NSC, KVPS, Insurance, FD, Savings A/c’s & obviously less considered is the Commodity Market. In the above mentioned options there are some options that do not have the risk factor in it & thus they give less return, while others having risk gives more return to the investor.

One does not know that the Investments in Commodities will also yield almost the same returns as compared with the Stock, having the same amount of risk involved.

SCOPE

This research would throw light on the mentioned objectives & make people aware of Commodity Futures as an Investment option – which is at its growing stage.

RESEARCH METHODOLOGY

Primary Data Collection

  • Guidance from the External Guide.
  • Guidance from the Internal Guide.
  • Help from Faculties.
  • Commodities Dealers.
  • Commodities Players (Investors).

Secondary Data Collection

  • Web sites
  • Journals
  • Magazines (Financial)
  • Newspapers
  • Research Papers on the same topic
  • Reports of Experts

“Investment is a term with different closely-related meanings in business, finance and economics, related to saving or deferring consumption. An asset is usually purchased, or in a similar way a deposit is made in a bank, in hopes of getting a future return or interest from the same. Literally, investment means the "action of putting something somewhere else"

In finance, investment can be referred to as buying securities or other monetary assets in the money markets or capital markets, or in fairly liquid real assets, such as gold, real estate etc. Valuation is the method for finding the true value of an asset.

Different financial investments include shares, bonds and other equity investments. These financial assets are then expected to provide income/ positive future cash streams, and may increase or decrease in its value giving the investor capital gains or losses.

Trading in contingent claims or derivative securities do not necessarily have future positive cash flows, and so are not considered assets, or securities or investments. Nevertheless, since their cash flows are closely related to or it is derived from cash flow of specific securities, they are often treated as investments.

Banks, mutual funds, pension funds, insurance companies, collective investment schemes, and investment clubs can be used to make investments indirectly. An intermediary generally makes an investment using money from many individuals, each of whom receives a claim on the intermediary, though their legal and procedural details differ.

LITERATURE REVIEW

The capital market (securities markets) is the market for securities, where the companies and the government can raise funds for long term. Stock market and the bond market form part of capital market. Financial regulators, such as the RBI and SEBI, keep a watch on the capital markets in their respective countries to ensure that investors are protected against any fraud. The capital markets consist of the primary market, where the company floats new securities to investors, and the secondary market, where existing securities are traded.

STRUCTURE OF CAPITAL MARKET

Primary Market

Secondary Market

Derivative Market

Commodity Market

International Market

IPO Public Issue)

Right Issue

Private Placement

Sale purchase of existing share & debenture & Mutual fund

Option

Future

Call

Option

Put Option

Gold

Silver

Material

Etc.

NYSE Composite

NASDAQ Composite

Dow Jones I.A.

S4P 500

NIKKEI – 225

NSE

BSE

Dealing in

MCX dealing in

STRUCTURE OF SECURITY MARKET

Primary Market

Secondary Market

Derivative Market

Commodity Market

International Market

IPO Public Issue)

Right Issue

Private Placement

Sale purchase of existing share & debenture & Mutual fund

Option

Future

Call

Option

Put Option

Gold

Silver

Material

Etc.

NYSE Composite

NASDAQ Composite

Dow Jones I.A.

S4P 500

NIKKEI – 225

NSE

BSE

Dealing in

MCX dealing in

A) Primary Market: It is that part of the capital markets that deals with the issuance of new securities. Companies, governments or public sector institutions can obtain funds through the issue of a new stock or bond which is called initial public offering (IPO). This is typically done through a syndication of securities dealers which in return earn a commission that is built into the price of the security offering.

B) Secondary Market: The secondary market is the market for trading of securities that have already been issued in the market. Aftermarket is known as the market that exists in a new security just after the new issue. Investors and speculators can easily trade on the exchange once a newly issued stock is listed on a stock exchange, as market makers make bids and offers in the new stock.

C) Derivative Market: -

Derivative Market

Future Market

Option Market

Future Contract

Say – One month

– Two month

– Three month

Call Option

Put Option

  • Premium will change at the time of buying
  • No Risk
  • Premium will change at the time of sells
  • No Risk

Future Contracts: - The future contracts are the future contracts or bids for some specific period like one month, two months and three months, accepted from investor in capital market which is put.

Option Market :- The option market is the place where trading is for call and put or buy and sell and only the premium is charged for all call and put trading.

D) Commodity Market:

Commodity trading might sound like a strange term, but simply put, commodities are items like, wheat, corn, gold and silver, and Cattle and Pork Bellies, and Crude Oil and it has emerged as an important player in the way that people invest in and speculate.

INVESTMENT ALTERNATIVES

INVESTMENT

Financial Assets

Real Estate

Marketable Financial Assets.

Non-marketable Financial Assets

Treasury Bills

C.D.

C.P.

Repo

Govt. Fixed Insurance bond

Govt. Securities

Debenture

Shares

Mutual Fund

Equity

Pref

NSS

Bank Deposit

Post Office

KVP

NSC

Company Deposit

EPF/PPF

LIC

Gold

Silver

Previous objects

Painting /Art

Land / Building

Machinery/Equipment etc

MARKETABLE FINANCIAL ASSETS

  • Equity or Preference shares
  • Govt/PSU/Pvt/other bonds
  • Mutual Funds

Shares (Equity and Preference Share): If you have equity shares of a company, you have an ownership stake in that company. This essentially means that you have a residual interest in income and wealth of the company. Equity shares are classified into the following broad categories -

  • Blue chip shares
  • Growth shares
  • Income shares
  • Cyclical shares
  • Speculative shares

Bonds: Bonds or debentures represent long-term debt instruments where issuer of a bond promises to pay a stipulated stream of cash flow. Bonds may be classified into the following categories -

  • Government securities.
  • Savings bonds
  • Government agency securities.
  • PSU bonds
  • Debentures of private sector companies
  • Preference shares

Money Market Instruments:- Money market instruments are debt instruments which have a maturity of less than one year at the time of issue. The important money market instruments are:

  • Treasury bills
  • Commercial paper
  • Certificates of deposit

Mutual Funds:

A Mutual Fund is a trust that collects the savings of a number of investors, and invest in capital market instruments such as shares, debentures and other securities who share a common financial goal. Unit holders share the income earned through these investments and the capital appreciation in proportion to the number of units owned by them. Mutual Fund offers an opportunity to invest in a diversified, professionally managed basket of securities at a relatively low cost and thus is the most suitable investment for the common man.

NON-MARKETABLE FINANCIAL ASSETS:

A good portion of financial assets is represented by non-marketable financial assets. These can be classified into the following broad categories.

  • Bank deposits
  • Post office deposits
  • Company deposits
  • Provident fund deposits/EPF
  • LIC
  • NSC
  • NSS
  • KVP

Life Insurance: Life insurance can also be considered as an investment as insurance premiums represent the sacrifice, and the assured sum represents the benefit. The important types of insurance policies in India are :

  • Endowment assurance policy
  • Money back policy
  • Whole life policy
  • Term assurance policy

REAL ESTATES AND OTHERS

Real Estate: Residential house is the most important asset in the portfolio for the bulk of the investors. More affluent investors are likely to be interested in the following types of real estate, in addition to a residential house -

  • Agricultural land
  • Semi – urban land
  • Commercial property

Precious Object: Precious objects are items that are highly valuable in monetary terms. Some important precious objects are ;

  • Gold and silver
  • Precious stones
  • Art objects

Financial Derivatives: A financial derivative is an instrument whose value is derived, from the value of an underlying asset be it a real asset, such as gold wheat or oil, or a financial asset, such as a stock, stock index, bond or foreign currency.

Forwards Contracts

A forward contract, as it occurs in both forward and futures markets, always involves a contract initiated at one time;

  • Performance in accordance with the terms of the contract occurs at one time;
  • Performance in accordance with the terms of the contract occurs at a subsequent time.

Further, the type of forward contracting to be considered here always involves an exchange of one asset for another and the price at which the exchange occurs is set at the time of the preliminary contracting. Actual payment and delivery of the good occur afterwards.

Futures Contracts

A futures contract is highly standardized forward contract with closely specified contract terms and it calls for the exchange of some good at a future date for cash, with the payment for the good to occur at that future date like all forward contracts. The buyer of a futures contract undertakes to receive delivery of the good and pay for it while the seller of a futures promises to deliver the good and take delivery of payment. The price of the good is determined at the initial time of contracting.

Option

Option contracts grant the right but not the compulsion to buy in the case of a call or sell, in the case of a put a specified quantity of an asset at a predetermined price on or before a specified future date option contract would expire if it is not in the best interest of the option owner to exercise.

Swaps

Swaps normally trade in the OTC market but there is monitoring of this market segment. Swaps are agreement between two parties to exchange cash flows in the future according to a approved formula and In case of popular interest rate swap, one party agrees to pay a series of set cash flows in exchange for a sequence of variable cost.

When compared to global derivatives markets Indian derivative markets are still in the emerging stage. Indian derivatives markets share in the world derivatives market’s value and volumes are very small. But with the starting of trading in different financial and commodities segment, Indian markets are growing very fast. Indian markets are operating with high efficiency and on parity with international standards.

The major exchanges and the derivative products traded in India:

1. Bombay Stock Exchange (BSE)

2. National Stock Exchange OF India Ltd (NSE)

3. National Commodity & Derivatives Exchange Limited (NCDEX)

4. Multi Commodity Exchange of India Ltd (MCX)

5. National Multi Commodity Exchange of India Ltd (NMCE)

INVESTMENT ATTRIBUTES

For evaluating an investment values, the following attributes are relevant.

  • Rate of return
  • Risk
  • Safety
  • Profitability
  • Purchasing power risk
  • Maturity
  • Marketability
  • Tax shelter
  • Convenience

Rate of Return:

The rate of return on an investment for a period (which is usually a period of one year) is defined as follows:

Rate of return = Annual income + (Ending price – Beginning price)

Beginning price

To illustrate, consider the following information about a certain equity share.

  • Price at the beginning of the year: Rs. 80.00
  • Dividend paid in the year: Rs. 4.00
  • Price at the end of the year: Rs. 87.00

The rate of return of this share is calculated as follows:

4.00 + (87.0-80.00)

= 13.75 percent

80.00

Yield

  • In general, yield is the yearly rate of return for any investment and is expressed as a percentage,
  • With stocks, yield can refer to the rate of income generated from a stock in the form of regular dividends and is often represented in percentage form, calculated as the annual dividend payments divided by the stock's current share price.

Investors can use yield to measure the performance of their investments and compare it to the yield on other investments or securities. Generally, higher risk securities offer higher expected yields as compensation for the additional risk incurred through ownership of the security. Investors looking to make income or cash flow streams from equity investments commonly look for stocks that shell out high dividend yields, in other words, stocks that give a relatively large amount of annual cash dividends for a relatively low share price.

Annual income (interest or dividends) divided by the current price of the security. This measure looks at the current price of a bond instead of its face value and represents the return an investor would expect if he/ she purchased the bond and held it for a year. This measure is not an accurate reflection of the actual return that an investor will receive in all cases because bond and stock prices are continuously changing due to market factors.

Capital Appreciation: It’s the rise in the market price of an asset. Capital appreciation is one of two major ways for investors to profit from an investment in a company. The other is through dividend income.

Risk

The risk of investment may be classified in following ways

Type of Risk

  • Internal Rate of Return Risk
  • Market risk
  • Inflation Risk
  • Default Risk
  • Business Risk
  • Financial Risk
  • Management Risk
  • Liquidity Risk

The rate of return from investments like equity shares, real estate, and gold can vary rather widely. The risk of investment refers to the variability of its rate of return: How much do individual outcomes deviate form the expected value? A simple measure of dispersion is the range of values, which is simply the difference between the highest and the lowest values. Other measures commonly used in finance are as follows:

Variance :This is the mean of the squares of deviations of individual returns around their average values

Standard deviation:This is the square root of variance

Beta :This reflects how volatile the return from an investment is, in response to market swings.

Risk = Actual Return – Expected Returns

Condition:

  • If, Actual Return = Expected Return = Risk Free Investment
  • If, Actual Return > or < Expected Return is risky investment

Low Variance (Low Risk)

High Variance (High Risk)

Expected

Return

Marketability:

An investment is highly marketable or liquid if: (a) it can be transacted quickly: (b) the transaction cost is low; and (c) the price change between two successive transactions is negligible. The liquidity of a market may be judged in terms of its depth, breadth, and resilience. Depth refers to the existence of buy as well as sell orders around the current market price. Breadth implies the presence of such orders in substantial volume. Resilience means that new orders emerge in response to price changes. Generally, equity shares of large, well – established companies enjoy high marketability and equity shares of small companies in their formative years have low marketability. High marketability is a desirable characteristic and low marketability is an undesirable one.

How does one evaluate the marketability of an investment like a provident fund deposit which is non-marketable by its very nature? In such a case, the relevant questions of ask is: can withdrawals be made or loans be taken against the deposit? Such as investment may be regarded as highly marketable if any of the following conditions are satisfied:

  • A substantial portion of the accumulated balance can be withdrawn without significant penalty;
  • A loan (representing a significant portion of the accumulated balance) can be raised at a rate of interest that is only slightly higher than the rate of interest earned on the investment itself.

Tax Shelter:

Some investments provide tax benefits; others do not. Tax benefits are of the following three kinds.

Initial Tax Benefit; An initial tax benefit refers to the tax relief enjoyed at the time of making the investment. For example, when you make a deposit in a Public Provident Fund Account, you get a tax benefit under Section 80 C of the Income Tax Act.

Continuing Tax Benefit: A continuing tax benefits represent the tax shield associated with the periodic returns form the investment. For example, dividend income and income from certain other sources are tax – exempts, upto a certain limit, in the hands of the recipient.

Terminal Tax Benefits; A terminal tax benefit refers to relief from taxation when an investment is realized or liquidated. For example, a withdrawal from a Public Provident Fund Account is not subject to tax.

Convenience:

Convenience broadly refers to the ease with which the investment can be made and looked after. Put differently, the questions that we ask to judge convenience are:

  • Can the investment be made readily?
  • Can the investment be looked after easily?

The degree of convenience associated with investments varies widely. At one end of the spectrum is the deposit in a savings bank account that can be made readily and that does not require any maintenance effort. At the other end of the spectrum is the purchase of a property that may involved a lot of procedural and legal hassles at the time of acquisitions and a great deal of maintenance effort subsequently.

A COMPARATIVE STATEMENT OF VARIOUS INVESTMENTS ALTERNATIVES

A summary evaluation of these investment avenues in terms of key investment attributes is given in Exhibit below. It must be emphasized that within each investment category individual assets display some variations.

Exhibit: Summary Evaluation of Various Investment Avenues

Return

Current yield

Capital appreciation

Risk

Marketability / Liquidity

Tax shelter

Convenience

Equity Shares

Low

High

High

Fairly high

High

High

Non – convertible Debentures

High

Negligible

Low

Average

Nil

High

Equity Schemes

Low

High

High

High

High

Very high

Debt Schemes

Moderate

Low

Low

High

No tax on dividends

Very high

Bank deposits

Moderate

Nil

Negligible

High

Nil

Very high

Public provident fund

Nil

Moderate

Nil

Average

Section 80 C benefit

Very high

Residential

Moderate

Moderate

Negligible

Low

High

Fair

Gold and Silver

Nil

Moderate

Average

Average

Nil

Average

INVESTMENT VERSUS SPECULATION

While it is difficult to draw the line of distinction between investment and speculation, it is possible to broadly distinguish the characteristics of an investor from those of a speculator as follows.

Investor

Speculator

Planning horizon

An investor has a relatively longer planning horizon. His holding period is usually at least one year.

A speculator has a very short planning horizon. His holding may be a few days to a few months.

Risk disposition

An investor is normally not willing to assume more than moderate risk. Rarely does he knowingly assume high risk.

A speculator is ordinarily willing to assume high risk.

Return expectation

An investor usually seeks a modest rate of return which is commensurate with the limited risk assumed by him

A speculator looks for a high rate of return in exchange for the high risk borne by him.

Basis for decisions

An investor attaches greater significance to fundamental factors and attempts a careful evaluation of the prospects of the firm

A speculator relies more on hearsay, technical charts, and market psychology.

Leverage

Typically an investor uses his own funds and eschews borrowed funds.

A speculator normally resorts to borrowings, which can be very substantial, to supplement his personal resources.

APPROACHES FOR INVESTMENT DECISION MAKING

The stock market is thronged by investors pursuing diverse investment strategies which may be subsumed under four broad approaches.

  • Fundamental approach
  • Psychological approach
  • Academic approach
  • Eclectic approach

Common errors in investment management

Investors appear to be prone to the following errors in managing their investments.

  • Inadequate comprehension of return and risk.
  • Vaguely formulated investment policy
  • Naïve extrapolation of the past
  • Cursory decision making
  • Simultaneous switching
  • Misplaced love for cheap stocks
  • Over-diversification and under-diversification
  • Buying shares of familiar companies
  • Wrong attitude toward losses and profits
  • Tendency to speculate

HOW TO INVEST IN EQUITY SHARES OR (I.P.O.)

Equity capital represents ownership capital. Equity shareholders collectively own the company. They bear the risk and enjoy the rewards of ownership. Of all the form of securities, equity shares appear to be most romantic. While fixed income investment avenues may be more important to most of the investor, equity shares seem to capture their interest the most. The potential rewards and penalties associated with equity shares make them an interesting, even exciting, proposition. No wonder, equity investment is a favourite topic of conversation in parties and get – together.

Terminology

The amount of capital that a company can issue as per its memorandum represents the authorized capital. The amount offered by the company to the investors is called the issued capital. That part of the issued capital that has been subscribed to by the investors is called the paid-up capital. Typically, the issued, subscribed, and paid-up capital are the same.

The par value is stated in the memorandum and written on the share scrip. The par value of equity shares is generally Rs 10 (the most popular denomination) or Rs 100. Infrequently, one comes across par values like Re1, Rs 5, Rs 40, and Rs 1,000. The issue price is the price at which the equity share is issued. When the issue price exceeds the par value, the difference is referred to as the share premium. Not that the issue price cannot be, ordinarily, lower than the par value.

The book value of an equity share is equal to :

Paid-up equity capital + Reserves and Surplus

Number of outstanding equity shares

Quite naturally, the book value of an equity share tends to increase as the ratio of reserves and surplus to the paid – up equity capital increases. The market value of an equity share is the price at which it is traded in the market. The price can be easily established for a company that it listed on the stock market and actively traded. For a company that is listed on the stock market but traded very infrequently, it is difficult to obtain a reliable market quotation. For a company that is not listed on the stock market, one can merely conjecture as to what its market price would be if it were traded.

Stock Market Classification of Equity Shares

In stock market parlance, it is customary to classify equity shares as follows:

Blue – chip shares

Shares of large, well-established, and financially strong companies with an impressive record of earnings and dividends.

Growth Shares

Shares of companies that have a fairly entrenched position in a growing market and which enjoy an above average rate of growth as well as profitability.

Income shares

Shares of companies that have fairly stable operations, relatively limited growth opportunities, and high dividend payout ratios.

Cyclical Shares

Shares of companies that have a pronounced cyclicality in their operations.

Defensive Shares

Shares of companies that are relatively unaffected by the ups and downs in general business conditions.

Speculative Shares

Shares that tend of fluctuate widely because there is a lot of speculative trading in them.

Note that the above classification is only indicative. It should not be regarded as rigid and straitjacketed. Often you can’t pigeonhole a share exclusively in a single category. In fact, many shares may fall into two (or even more) categories.

SPECIFICATION OF INVESTMENT OBJECTIVES AND CONSTRAINTS

The first step in the portfolio management process is to specify the investment policy, which summarizes the objectives, constraints, and preferences of the investor. The investment policy may be expressed as follows:

  • Objectives
  • Return requirements
  • Risk tolerance
  • Constraints and Preferences
  • Liquidity
  • Investment horizon
  • Taxes
  • Regulations
  • Unique circumstances

Objectives

The commonly stated investment goals are:

  • Income to provide a steady stream of income through regular interest/dividend payment.
  • Growth To increase the value of the principle amount through capital appreciation.
  • Stability. To protect the principle amount invested from the risk of loss.

Since income and growth represent two ways by which return is generated and stability implies containment or even elimination of risk, investment objectives may be expressed more succinctly in term of return and risk. As an investor, you would primarily be interested in a higher return in the form of income and / or capital appreciation) and a lower level of risk. However, return and risk typically go hand in hand. So you have to ordinarily bear a higher level of risk in order to earn a higher return. How much risk you would be willing to bear to seek a higher return, depends on your risk disposition. Your investment objective should state your preference for return relative to your distaste for risk.

Risk Assessment

Financial advisers, mutual funds, and brokerage firms have developed risk questionnaires to help investors determine whether they are conservative, moderate, or aggressive. Typically, such risk questionnaire have 7 to 10 questions to gauge a person’s tendency to make risky or conservative choices in certain hypothetical situations. While these risk questionnaires are not precise, they are helpful in getting a rough idea of an investor’s risk tolerance.

Constraints

In pursuing your investment objective, which is specified in terms of return requirement and risk tolerance, you should bear in mind the constraints arising out of or relating to the following factors:

Liquidity: Liquidity refers to the speed with which an asset can be sold, without suffering any discount to its fair market price. For example, money market instruments are the most liquid assets, whereas antiques are among the least liquid.

Taking into account your cash requirements in the foreseeable future, you must establish the minimum level of ‘cash’ you want in your investment portfolio.

Investment Horizon: The investment horizon is the time when the investment or part thereof is planned to be liquidated to meet a specific need. For example, the investment horizon may be ten years to fund a child’s college education or thirty years to meet retirement needs. The investment horizon has an important bearing on the choice of assets.

Tax: What matters finally is the post-tax return from an investment. Tax considerations therefore have an important bearing on investment decisions. So, carefully review the tax shelters available to you and incorporate the same in your investment decisions.

Regulations: While individual investors are generally not constrained much by law, institutional investors have to conform to various regulations. For example, mutual funds in India are not allowed to hold more than 10 percent of the equity shares of a public company.

Unique Circumstances: Almost every investor faces unique circumstances. For example, an individual may have the responsibility of looking after ageing parents. Or, an endowment fund may be precluded form investing in the securities of companies making alcoholic products and tobacco products.

Selection of Asset Mix

Based on your objectives and constraints, you have to specify your asset allocation, that is, your have to decide how much of your portfolio has to be invested in each of the following asset categories:

  • Cash
  • Bonds
  • Stocks
  • Real estate
  • Precious metals
  • Other

Gambling: Gambling is fundamentally different from speculation and investment in the following respects:

  • Compared to investment and speculation, the result of gambling is known more quickly. The outcome of a roll of dice or the turn of a card is known almost immediately.
  • Rational people gamble for fun, not for income.
  • Gambling does not involve a bet on an economic activity. It is based on risk that is created artificially.
  • Gambling creates risk without providing any commensurate economic return.

GUIDELINES FOR AGGRESSIVE EOUITY INVESTORS

Aggressive equity investors play the equity game actively and vigorously. They spend more time and effort in managing their portfolio than their conservative counterparts. They are inclined to take greater risks, albeit in a calculated manner, to earn superior rates of return. They seem to relish the thrill and adventure of playing the equity game.

In addition to the general guidelines for investment, aggressive equity investors should also bear in mind the following guidelines especially relevant for them.

  • Focus on investments you understand and play your own game.
  • Monitor the environment with keenness.
  • Scout for 'special' situations in the secondary market.
  • Pay heed to growth shares.
  • Beware of the games operators play.
  • Anticipate earnings ahead of the market.
  • Leverage your portfolio when you are
  • Take swift corrective action.

GUIDELINES FOR CONSERVATIVE EOUITY INVESTORS

Conservative equity investors seek to minimize investment risk as well as the time and effort devoted to portfolio management. What they want is peace of mind, not the adventure of aggressive investment. Satisfied with a reasonable return, they do not deliberately strive for spectacular gains.

In addition to the general guidelines for investment, conservative equity investors should also bear in mind the following guidelines especially applicable to them.

  • Avoid certain kinds of shares
  • Apply stiff screening criteria
  • Look for relatively safe opportunities in the primary market.
  • Participate in the schemes of mutual funds
  • Join a suitable portfolio management scheme
  • Consult an investment advisor
  • Refrain from short-term switch hitting

Avoid Certain Kinds of Shares

Experience suggests that the following kinds of shares are not suitable for conservative investors.

Shares of Unlisted companies There are more than 10,000 public limited companies in India. Only about 7000 of these are listed on the stock exchanges, the rest are not. Don't buy shares of unlisted companies. There 'is no organized market for them and there is no reliable way of assessing their market price. How does one find out whether a share is listed or not? It is very simple: a listed share is included in the quotation list of the stock exchanges where it is listed; an unlisted share is not included in the quotation list.

Inactively Traded Shares Listing does not ensure liquidity. A major bane of the Indian equity investors is that many listed shares are not actively traded. You should avoid such shares. To find out whether a share is actively traded or not, look at the frequency with which it has been traded in the last three months or so. If it is traded less than once in a week, it may be regarded as an inactively traded share.

Manipulated Shares Some business groups resort to manipulation of the shares of their companies. This mostly is in the form of market support to boost share prices, particularly before a public issue or rights issue. It can take other forms as well. Besides manipulating share prices, such groups also resort to 'creative accounting' meant to enhance reported profit artificially. As a general guideline, avoid such manipulated shares.

Cornered Shares Stock market operators engage in cornering operations from time to time. While such shares may excite aggressive investors, conservative investors, as a rule, should scrupulously avoid such shares.

Apply Stiff Screening Criteria

The conservative investor should consider only those shares in the secondary market, which satisfy stiff requirements. The screening criteria recommend are as follows:

Size The Company should not be very small. Its turnover should preferably be greater than Rs 10 crore and its equity base larger than Rs 2 crore.

Competitive Position The Company must have a reasonably strong competitive position. It should enjoy a respectable share of the market. Better still, it should have a market share that is growing.

Industry Prospects The prospects of the industry to which the company belongs must be above average. It should certainly not be an industry that is stagnating or declining.

Price-earnings Ratio The price-earnings ratio of the company must not be very high. As a general guideline, one has to be very cautious if the price-earnings ratio is more than 15 and or significantly higher than the industry average.

Dividend and Bonus Record The Company should have a reasonably good track record of dividend payment and bonus shares.

IMPLICATIONS OF VOLATILITY

Diversify: Keeping all your eggs in one basket may be risky. Spread the risk with a diversified portfolio of investments in different assets.

Don’t Overreach: Take only as much risk as you can afford. Do not invest in stocks using borrowed money.

Control Emotions: Don’t get overly worried by a sudden drop or too optimistic by a rally. Be objective and ignore market noise.

Reallocate: Your asset mix may have changed due to change in stock prices. Rebalance your portfolio to suit your investment profile.

COMMODITY TRADING

Lots of people have made huge profits in the commodity markets as it is one of the few investment areas where an individual with limited capital can make astonishing profits in a relatively short period of time. However, commodity trading has a bad reputation as being too risky for the average individual because most people lose money. The truth is that commodity trading is only as risky as you want to make it.

Those who want to earn quickly by trading are likely to lose because they have to take big risks. If you act cautiously, treat your trading like a business instead of a giant gambling casino and are prepared to settle for a reasonable return, the risks are acceptable. The possibility of success is excellent.

The method of trading commodities is also known as futures trading. Unlike other kinds of investments, such as stocks and bonds, you do not actually buy anything or own anything when you trade futures. You are just speculating on the future movement of the price in the commodity you are trading. This is like a bet on future price movement. The terms "buy" and "sell" only indicate the direction you expect future prices will take.

If, for instance, you were speculating in steel, you would buy a futures contract if you have a notion that the price would be going up in the future. You would sell a futures contract if you think that the price would go down. For every trade, there is always a buyer and a seller. Neither person has to own any steel to participate. He must only deposit sufficient capital with a brokerage firm to make sure that he will be able to pay the losses if his trades lose money.

Both the commodity's commercial producers and commercial consumers also participate in addition to speculators. The most important economic purpose of the futures markets for the commercial participants is that they can hedge their risk from changing prices.

On one side of a transaction may be a producer like a farmer. He has a field full of corn growing on his farm. It will be ready for harvest in another three months. If he is concerned about the price going down during that time, he can sell futures contracts equivalent to the size of his crop and deliver his corn to complete his obligation under the contract. Despite how the price of corn changes in the three months until his crop will be ready for delivery, he is definite to be paid the current price.

On the other side of the transaction might be a producer such as a cereal manufacturer who needs to buy lots of corn. The manufacturer may be concerned that in the next three months the price of corn will go up, and it will have to pay more than the current price. To protect against this, manufacturer can buy futures contracts at the current price. In three months manufacturer can fulfill its obligation under the contracts by taking delivery of the corn. This guarantees that regardless of how the price moves in the next three months, manufacturer will pay no more than the current price for its corn.

Also, there are futures for financial instruments and intangibles such as currencies, bonds and stock market indexes. Every futures market has producers and consumers who need to evade their risk from future price movements. The speculators deal in the physical commodities to provide liquidity. This maintains an orderly market where price changes from one trade to the next are small.

The speculator merely offsets his position at some time before the date set for future delivery rather than taking delivery or making delivery. If price has moved in the right direction, he will gain or vice versa.

Futures markets provide continuous, accurate, well-publicized price information and continuous liquid markets in addition to reducing the costs of production, marketing and processing. Futures trading is therefore valuable to the public which eventually consumes the goods traded in the futures markets. Without the speculator futures markets could not function.

Speculators earn substantial returns by performing the valuable functions of providing liquidity and assuming the risk of price fluctuation. The potentially large profits are available just because there is also a risk of huge loss.

Genesis of Commodity Trading

Commodity trading is nothing but trading in commodity derivatives (futures or options). In other words, if you are keen at taking a buy/sell position based on the future performance of commodities like gold, silver, agricultural commodities, metals, crude etc; then you could do so by trading in commodity derivatives.

Commodity derivatives are traded at the commodity exchanges. There are currently 2 major commodity exchanges NCDEX (National Commodity and Derivative Exchange) and MCX (Multi-Commodity Exchange). Gold, Silver, Agri-commodities including grains, pulses, spices, oils and oilseeds, mentha oil, metals and crude are some of the commodities that the exchanges deal in.

Earlier, all the sellers and buyers of a commodity used to come to a common market place for the trade. Buyer could judge the amount of produce that year while the seller could judge the amount of demand of the commodity. Thus they could dictate their terms and hence the counter party was left with no choice. Thus, in order to hedge from this unfavorable price movement, need of the commodity exchange was felt.

Commodity

A commodity may be defined as an article, a product or material that is bought and sold. It can be classified as every kind of movable property, except Actionable Claims, Money & Securities.

Commodities actually offer immense potential to become a separate asset class for market-savvy investors, arbitrageurs and speculators. Retail investors, who claim to understand the equity markets, may find commodities an unfathomable market. But commodities are easy to understand as far as fundamentals of demand and supply are concerned. Retail investors should understand the risks and advantages of trading in commodities futures before taking a leap. Historically, pricing in commodities futures has been less volatile compared with equity and bonds, thus providing an efficient portfolio diversification option.

In fact, the size of the commodities markets in India is also quite significant. Of the country's GDP of Rs 13,20,730 crore (Rs 13,207.3 billion), commodities related (and dependent) industries constitute about 58 per cent.

Currently, the various commodities across the country clock an annual turnover of Rs 1, 40,000 crore (Rs 1,400 billion). With the introduction of futures trading, the size of the commodities market grows many folds here on.

Commodity Market

Commodity market is an important constituent of the financial markets of any country. It is the market where a wide range of products, viz., precious metals, base metals, crude oil, energy and soft commodities like palm oil, coffee etc. are traded. It is important to develop a vibrant, active and liquid commodity market. This would help investors hedge their commodity risk, take speculative positions in commodities and exploit arbitrage opportunities in the market.

Historical background

From the beginning of civilization, commodities trading have turn out to be an important part in the lives of mankind. The reason for this is the fact that commodities symbolize the fundamental elements of utility for human beings. The term ‘commodity’ refers to any material, which can be bought and sold. Commodities in a market's context means any movable property other than actionable claims, money and securities. Over the years commodities markets have been experiencing tremendous progress, because the trade in this segment is standing as the bonus for the global economy today. The promising nature of these markets has made them an eye-catching investment avenue for investors.

In the early days people followed a mechanism for trading called Barter System, which involves exchange of goods for goods. This was the first form of trade between individuals. The absence of commonly accepted medium of exchange has initiated the need for Barter System. People used to buy those commodities which they lack and sell those commodities which are in excess with them. The commodities trade is believed to have its genesis in Sumeria. The early commodity contracts were carried out using clay tokens as medium of exchange. Animals are believed to be the first commodities, which were traded, between individuals. The internationalization of commodities trade can be better understood by observing the commodity market integration occurred after the European Voyages of Discovery. The development of international commodities trade is characterized by the increase in volumes of trade across the nations and the convergence and price related to the identical commodities at different markets. The major thrust for the commodities trade was provided by the changes in demand patterns, scarcity and the supply potential both within and across the nations.

Market Development

In the context of the development of commodities markets, integration plays a pivotal role in surmounting the barriers of trade. The development of trading mechanisms in the commodities market segment largely helped the integration of commodities markets. The major thrust for the integration of commodities trading was given by the European discoveries and the march of the world trade towards globalization. The commodities trade among different countries was originated much before the voyages of Columbus and Da Gama. During the first half of the second millennium India and China had trading arrangements with Southeast Asia, Eastern Europe, the Islamic countries and the Mediterranean. The advancements in shipping and other transport technologies had facilitated the growth of the trade in this segment. The unification of the Eurasian continent by the Mongols led to a wide transmission of people, ideas and goods. Later, the Black Death of 1340s, the killer plague that reduced the population of Europe and Middle East by one-third, has resulted in more per capita income for individuals and thus increased the demand for Eastern luxuries like precious stones, spices, ceramics and silks. This has augmented the supply of precious metals to the East. This entire scenario resulted in the increased reliance on Indian Ocean trade routes and stimulated the discovery of sea route to Asia.

The second half of the second millennium is characterized by the connectivity of the markets related to the Old and the New worlds. In the year 1571, the city of Manila was found, which linked the trade between America, Asia, Africa ad Europe. During the initial stages, because of the high transportation costs, preference of trade was given to those commodities, which had high value to weight ratio. In the aftermath of the discoveries huge volumes of silver was pumped into world trade. With the discovery of the Cape route, the Venetian and Egyptian dominance of spice exports was diluted. The introduction of New world crops into China has lead to the increased demand for silver and a growth in exports of tea and silk. Subsequently, Asia has become the prime trader of spices and silk and Americas became the prominent exporter of silver.

Earlier investors invested in those companies, which specialized in the production of commodities. This accounted for the indirect investments in commodity assets. But with the establishment of commodity exchanges, a shift in the investment patterns of individuals has occurred as investors started recognizing commodity investments as an alternative investment avenue. The establishment of these exchanges has benefited both the producers and traders in terms of reaping high profits and rationalizing transaction costs. Commodity exchanges play a vital role in ensuring transparency in transactions and disseminating prices. The commodity exchanges ensured the standard of trading by maintaining settlement guarantee funds and implementing stringent capital adequacy norms for brokers. In the light of these developments, various commodity based investment products were created to facilitate trading and risk management. The commodity based products offer a huge collection of benefits that include presenting risk-return trade-offs to investors and providing information on market trends and supporting in framing asset allocatment strategies. Commodity investments are always thought to be as defensive because during the inflation, which adversely affects the performance of stocks and bonds, commodities offer a defense to investors thus, maintaining the performance of their portfolios.

Derivatives

Another major leap in the development of commodities markets is the growth in commodities derivative segment. Derivatives are instruments whose value is determined based on the value of an underlying asset. Forwards, futures and options are some of the well-known derivatives instruments widely used by the traders in commodities markets. Derivatives trading have a long history. The first recorded incident of commodities trade was traced back to the times of ancient Greece. In the year 1688 De la Vega reported the trading in 'time bargains' which were the then commonly used terms for options and futures. Though the first recorded futures trade was found to have happened in Japan during the 17th century, evidences reveal that the trading in rice futures was existent in China, 6000 years ago. Derivatives are useful for both the producers and the traders for the mitigation of risk in their business. Trading in futures is an outcome of the mankind's efforts towards maintaining the supply balance of seasonal commodities throughout the year. Farmers derived the real benefits of derivatives contracts by assuring the prices they want to procure on their products. The volatility of prices has made the commodity derivatives not only significant risk hedging instruments but also strategic exchange traded assets. Slowly, traders and speculators, who never intended to take the delivery of goods, entered this segment. They traded in these instruments and made their margins by taking the advantage of price volatility in commodity markets.

The dawn of the 21st century brought back the good times for commodity markets. With the end of a 20 year bear market for commodities, following the global economic recovery and increased demand from China and other developing nations, has revitalized the charisma of commodities markets. According to the forecasts given by experts commodities markets are likely to experience a bright future with the depreciation in the value of financial assets. Furthermore, increasing global consumption, declining U.S. Dollar value, rising factor-input costs and the recent recovery of the market from the clutches of bear trend are considered to be the positive symptoms, which contribute to the acceleration of growth in commodity markets segment.

India Connection

Coming to the Indian scenario, despite a long history of commodity markets, commodity markets in India are still in their initial stages of development. The essential contributors of this scenario include stringent regulatory restrictions, intermediate ban on commodity trading and policy interventions by the government. Commodity markets have a enormous potential in the Indian market particularly because of the agri-based economy here. Because of the government's scheme for agricultural liberalization, commodities trading in India have gained increased force in activities. Forward Markets Co


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