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The Importance of Commodity Derivatives

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Published: Tue, 12 Dec 2017

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.

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


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