chapter 1.docx

INTERLINKAGES OF CAPITAL AND COMMODITY MARKET DURING GLOBAL FINANCIAL CRISIS

1. INTRODUCTION

The sudden upsurge in commodity markets from 2002 and their subsequent fall since

September 2008 has invigorated the debate on the role of commodities for strategic and

tactical asset allocations. Further, significant gush in the trade volumes in general and

large volumes of positions held by long only commodity index funds have galvanized the

logomachy over whether a ‘price bubble’ existed in these markets. The debate has even

found its way into the corridors of the United States Congress, where legislators were

contemplating measures to curb excessive speculation (Lieberman, 2008). Certain hedge

fund managers, some policy makers, and commodity end users were of the belief that

there existed a bubble in these markets (Gheit 2008; Masters 2008; Masters and White

2008). However, on the other side, quite a few of academic economists were skeptical of

the bubble theory, stating lack of empirical evidence (Krugman 2008; Pirrong 2008;

Sanders and Irwin 2008).

Instead, this anti-bubble brigade viewed that, markets are driven by fundamental factors

And accordingly commodities are pushed to considerably high levels (Irwin and Good,

2009).Global Financial Crisis has indeed made a historic impact on the financial markets

All across the globe. The markets besides behaving terribly nervous during the crisis period

have experienced sharp falls during the crisis period. Since during the recession times

investors generally look out for more safe investments like gold and crude oil, it is of

academic interest now for us, in this study, to discover how the commodity markets behaved

during the period and thereby draw appropriate inferences and reflections on the episode.

Portfolio management concerns the constructions and maintenance of a collection of

investment. It is investment of funds in different securities in which the total risk of the

portfolio is minimized, while expecting maximum return from it. It primarily involves

reducing risk rather than increasing return. Return is obviously important though, and the

ultimate objective of portfolio manager is to achieve a chosen level of return by incurring

the least possible risk.Determinants of risk attitudes of individual investors are of great

interest in a growing area of finance known as behavioral finance. Behavioral finance

focuses on the individual attributes, Psychological or otherwise, that shape common

financial and investment practices. Unlike traditional assumptions of expected utility

maximization with rational investors in efficient markets, behavioral finance assumes

people are normal.

Despite great interest in this area, not much research looks at the underlying factors that

RAMAIAH INSTITUTE OF MANAGEMENT STUDIES


may lead to individual differences and play a significant role in determining people’s

financing and investment strategies in emerging markets. Study of risk perception and its

impact on investment behavior is one of the core investigation issues of behavioral

finance research.

As such, we attempt to ascertain the answers for the following questions;

(i) Do the commodities too fall when the equities fall? If so, to what extent?

(ii) How is the relationship between commodity markets and equity markets?

This study aims to analyze and throw some more light on the correlation between equity

and commodity markets during the pre, during and Recovery periods. Further, it also

aims to analyze and determine the causes for such behavior. The study also intends to

investigate the preference of investment in capital and commodity market during crisis

period.

1.1 LITERATURE REVIEW



1.1.1 Behavior Finance Perspective of Individual Investor

As a result of traditional finance theory appears to play a limited role in understanding

this issues such as :

(1) Why do individual investors trade

(2) How do they perform the task

(3) How do they choose their portfolios to conform their conditions, and

(4) Why do returns vary so quickly even across stocks for reasons other than risk.

In the new arena of behavior finance or so-called behavior economic, we could to

interpret about individual investors behave in their invest choice more completely. Most

of behavioral finance researchers often claimed that the reality results presents no unified

theory unlike traditional finance Theory appears expected utility maximizations using

rational beliefs. Its means those scholars in this field actually postulate whole investors in

financial market are rationales; they can’t influenced through any factors only maximum

profit for themselves. Most authors show behavior finance perspective on individual

investor, such as Deaux and Emswiller (1974), Lenney (1977), Maital et al. (1986),

Thaler and Johnson (1990) and Beyer and Bowden (1997). Those authors are to exclaim

that individual investor would demonstrate different risk attitude when facing investment

alternatives. Later instruction in our research, we called risk perception and risk tolerance

of individual investor. Comparing with previously research, current study is to focus on

external factors and psychological factors how to affect investor’s investment decision a

nd portfolio choice. For instance, Annaert et al. (2005), Wang et al. (2006) indicate the

impact of information asymmetric problem on investor behave, this is another subject in

behavioral finance field. Most of these researches are pay close attention to behavioral

finance, especially in financial products choices (investment) and behave of individual

investor invest related.

1.1.2 Risk Perception, Risk Tolerance and Portfolio Choice

Financial risk tolerance is defined as the maximum amount of uncertainty that someone is

willing to accept when making a financial decision. Although the importance of assessing

financial risk tolerance is well documented, in practice the assessment process tends to be



very difficult due to the subjective nature of risk taking (the risk of investor willing to

reveal their risk tolerance) and objective factors such as Grable and Joo (1997), Grable

and Lytton (1999), and Grable (2000).

Risk tolerance represents one person’s attitude towards taking risk. This indicated is an

important concept that has implications for both financial service providers (asset

management institution or other financial planner) and consumers (investors). For the

latter, risk tolerance is one factor which may determine the appropriate composition of

many assets in a portfolio which is optimal and satisfied investors invest preference in

terms of risk and return relative to the needs of the individual investors Droms, (1987),

Hallahan et al., (2004).

There are some empirical evidence showing the impact of risk perception; risk tolerance

and socio-economic on portfolio choice, for instance, Carducci and Wong (1998), Grable

and Joo (1997), Grable and Lytton (1999), Grable (2000), Hallahan et al., (2003),

Hallahan et al., (2004), Frijns et al., (2008), and Veld and Veld-Merkoulova (2008). In

terms of different risk perception or risk tolerance level, individual investor may show

different reaction base upon their psychology factor and economic situation, which would

lead to heterogeneous portfolio choice for individual investors. For this reason, it is

crucial to recognize and attitudinal how individual investors with different risk

perceptions and risk tolerance make their invest products choice on investment plan, in

particular socio-economic status differentials may make their choice vary and difference.

1.1.3 Investor’s Socio-Economic Status and Risk Tolerance Some researchers have indicated that the validity of widely used demographics as

determinants of risk tolerance is noteworthy as the relationship between socio-economic

status differences including gender, age, income level, net assets, marital status,

educational level and investment decision or portfolio choice. With regard to the financial

risk tolerance literatures, there is much interest in the demographic determinants and risk



attention (involving three risk types: risk aversion, risk moderate and risk seeking) is

particularly focused on age, gender, education level, income level, marital status, the

number of dependents and net assets. Specifically, although debate remains on some

issues, a range of common findings are generally observed. There are five phenomenons

in socio-economic status variables differential and portfolio choice as the following: First,

risk tolerance decreases with age (e.g., Morin and Suarez 1983; Roszkowski, Snelbecker,

and Leimberg 1993). Second, females have a lower preference for risk than males (e.g.,

Roszkowski, Snelbecker, and Leimberg 1993; Grable 2000). Third, risk tolerance

increases with education level (e.g., Roszkowski, Snelbecker, and Leimberg 1993;

Haliassos and Bertaut 1995). Fourth, risk tolerance increases with income level and net

assets (e.g., Cohn et al. 1975; Roszkowski, Snelbecker, and Leimberg 1993; Bernheim,

Skinner, and Weinberg 2001). Fifth, single (i.e., unmarried) investors are more risk

tolerant than married (e.g., Roszkowski, Snelbecker, and Leimberg 1993).

Orthodox models regard commodity prices as steered by both systematic and

idiosyncratic factors. Proponents of commodity investment usually establish their

rationale on diversification benefits rather than expected returns since the theoretical and

empirical evidence for excess returns to commodities has been inconclusive. Further,

volatility and the effect of financialisation continue to be open questions. Broad

macroeconomic factors like; the short interest rate, dividend yield and corporate bond

spread, inter-link commodity futures to stock and bond markets but idiosyncratic factors

create segmentation between commodities and financial assets, as well as between groups

of commodities (Frankel and Rose 2009, Hong and Yogo 2009).

Commodity prices are observed to be volatile and volatility by nature varies with time.

Financialisation and macroeconomic commodity price drivers do affect and alter

volatility and correlation gradually. Accordingly, it is established that there are inter -

linkages between the commodity and equity markets. Commodity futures transactions are

often considered a high-risk

transaction, as the scheme allows investors to hold large positions with little own capital.

Accordingly, an investor who carries too much risk without enough funds may suffer the

unpleasant fate. However, the attraction for institutional investor is not the type of wager

but the quality of diversification of investment. As such, investors have become aware

that the prices on



commodity markets are not linked with prices on equity markets. Modern Investment

Theory upholds the view that real risk is not the fluctuation in individual assets but only

that part which cannot be annulled by the possession of other assets. Consider an asset, X,

whose price fluctuations are very large. If another asset, Y, provides an offsetting effect,

the actual risk of the asset X is reduced by holding the asset Y. Essentially, previous

studies (Gorton et al., 2007) notice that there is a low correlation between price

fluctuations in equities and commodity futures. One can apparently wonder whether the

sharp upsurge in investor appetite for commodities has had a significant impact on the

pricing of commodity -related financial instruments. Obviously, one may expect

commodities and equities not to move in sync because of the risk factors that account for

the cross sectional variations in equity returns have historically had no forecasting power

in commodity markets. The reason concerning why the large-scale influx of financial

institutions in commodity markets could be of importance for pricing is if it has led to a

reduced scope for cross-market arbitrage opportunities (Basak and Croitoru, 2006) and, in

the process, has more closely associated the commodity and equity markets.Another

conduit for links between commodity and equity markets is if financial institutions

respond differently from traditional commercial traders to extreme stock market

movements in particular, if sharp downward movements in one market force financial

investors to liquidate positions in commodity markets so as to raise cash for margin calls.

The role of commodity futures is widely accepted as risk diversifiers and inflation

hedgers, and because of their low transaction costs and high potential for alpha

generation through long-short dynamic

trading (Gorton and Rouwenhorst (2006) and Fuertes et al., 2009). These stylized facts

have been very well acknowledged by commodity marketers as these are at the root of

most commodity sales pitches. During the past decade, investors across the globe, have

sought a huge

exposure to commodity prices by directly purchasing commodities, by taking absolute

positions in commodity futures, or by investing in exchange-traded commodity funds

(ETFs) and in commodity index funds. There has been a remarkable expansion in global

commodity futures transactions in recent years, particularly, the speed of expansion

accelerated from the period

2005 onwards (Heaney,2006 and Zulauf et al., 2006). Commodity investment has often

been thought of as a standalone investment as well as an important diversifier to

traditional stock and bond portfolios. Erb and Harvey (2006) note that the annualized



return of Commodity Market Index (Goldman Sachs Commodity Index (GSCI))

outperformed the Equity Market Index (S&P

500) total return with returns of 12.2%forthe period December 1969 to May 2004. They

also observe that diversification into commodities would have historically improved the

performance of equity markets (Erb and Harvey, 2005). Gorton and Rouwenhorst (2006)

also made further, comparable conclusions.

Commodity markets have indeed attracted significant financial investments and thereby

behaving more like financial markets in terms of the incentives and approaches for

participants. In the recent past, a large amount of trading in commodity markets is carried

out through futures contracts, which are usually cash-settled rather than physically

delivered. This tendency has gone

indeed alongside the proposition by market commentators that speculative activity is the

key driver behind the steady surge. As a result, commodity markets have by far lost their

original function of trade and physical delivery of goods, and have become suitable for

speculative and hedging purposes.

This financialisation of commodity markets has been largely due to the increased

participation of financial investors in derivatives markets. It can be observed that the

rapid growth of commodity derivatives markets since the early 2000 is associated with a

host of factors like; dot-com bubble-burst, low interest environments, sustained

depreciation in the US dollar ,in conjunction with the entry of new players like;

investment funds, mutual funds, pension and hedge funds and sovereign wealth funds

apart from the macroeconomic drivers like the demand and supply fundamentals that have

contributed to the volatility. Further, industrialization in China, India, and emerging Asia

that accelerated the consumption of fuels, metals, and food has also played its

role in the escalation of commodity markets(Helbling et al., 2008). Further, it is also

argued that the flight of funds from equity and bonds markets was caused mainly due to

the monetary easing in the advent of financial crisis in the summer 2007 in US.

Undoubtedly, financial activity in the commodity markets has gained widespread

momentum since 2000 putting the volumes of traded derivatives at 20 to 30 times the

physical production of many of the commodities (Redrado et al., 2008; Domanski and

Heath, 2007). In view of this, we argue that increased financialization of commodity

markets of late has increased their exposure to macroeconomic and financial shocks

compared to the earlier cycles.



1.1.4Integration of Capital, Commodity and Currency Markets: A Study on

Volatility Spillover: Suhail Palakkod

In this study an effort has been made to analyse the integration and interrelationship

among the capital market, currency market and commodity market in India through the

volatility spillover frame work. The study found out that the volatility spillover from

currency markets and commodity markets to capital markets. Likewise the volatility

spillover from capital market to currency markets and there is no spillover from

commodity market to currency markets. In case of commodity market there is no

evidence of volatility spillover.

1.1.5 Interlinkages between Equity, Currency, Precious Metals and Oil Markets: An

Emphasis on Emerging Markets: Lucia Morales

This thesis examines the interlinkages between equity, currency, precious metals and oil

markets. The author of this thesis considered it appropriate to implement such an analysis

due to the fact that the relationships between financial markets, currency markets and the

above-mentioned commodities markets have not been analyzed to the extent that it is

proposed in the present thesis. Using daily data, the study focuses on the investigation of

the relationships that exist between these financial and commodity markets for a time

period that spans from 1995 to 2008; different time periods and sub-samples are also

analysed, in order to obtain an in-depth understanding of the interlinkages between these

markets. The main findings show that exchange rates and stock prices seem to be



independent. Overall, there is no evidence of these two variables moving together either

in the long-run or short-run. The results show evidence of a unidirectional causality

relationship running from stock returns to exchange rates in some of the countries under

analysis, with weak evidence of a causal relationship running from exchange rates to

stock returns. In relation to the volatility analysis, there is some commonality regarding

the behaviour of the variables, with a unidirectional spillover effect between the markets,

which is found from the stock returns equation to the exchange rates equation. The lack of

significant spillovers from exchange rate changes to stock returns found here for some

countries across a number of exchange rates is consistent with existing research in this

area. The analysis of precious metals markets shows that they do not seem to be strongly

affected by movements in equity markets; on the other hand, oil prices tend to be

positively correlated with precious metals markets, the latter having an important

influence on them.

1.1.6Frankel, J.A., and Rose, A.K. (2009), “Determinants of Agricultural and

Mineral Commodity Prices”, unpublished manuscript, Harvard University.

This paper presents a theory that allows a role for macroeconomic determinants of real

commodity prices. Broad macroeconomic factors like; the short interest rate, dividend

yield and corporate bond spread, inter-link commodity futures to stock and bond markets

but idiosyncratic factors create segmentation between commodities and financial assets,

as well as between groups of commodities.

1.1.7Hong, H., and Yogo, M. (2009), “Digging into Commodities”, Working Paper,

Department of Economics, Princeton University, Princeton, NJ

This paper investigates the determinants of aggregate commodity returns and establishes

the following findings.



(1) Common predictors of bond and stock returns, such as the short rate and the yield

spread, also predict commodity returns. A high yield spread predicts low commodity

returns, consistent with commodities being a hedge for market fluctuations.

(2) Even controlling for these common predictors, a low aggregate basis (the ratio of

futures to spot price averaged across commodities) predicts high returns on being long

commodity futures, consistent with the theory of backwardation. A low aggregate basis

also predicts low spot-price growth, consistent with the theory of storage. The component

of aggregate basis that is orthogonal to these common predictors does not predict bond or

stock returns, suggesting that aggregate basis is a predictor that is local to the commodity

market.

(3) Aggregate basis explains as much of the variation in expected commodity returns as

the common predictors.

(4) Recent evidence suggests that aggregate basis has become a more important

determinant of commodity returns relative to the common predictors.

1.1.8 Gorton, G., and K. Rouwenhorst (2006), “Facts and Fantasies about

Commodity Futures,”

This paper constructs an equally-weighted index of commodity futures monthly returns

over the period between July of 1959 and March of 2004 in order to study simple

properties of commodity futures as an asset class. Fully-collateralized commodity futures

have historically offered the same return and Sharpe ratio as equities. While the risk

premium on commodity futures is essentially the same as equities, commodity futures

returns are negatively correlated with equity returns and bond returns. The negative

correlation between commodity futures and the other asset classes is due, in significant

part, to different behavior over the business cycle. In addition, commodity futures are

positively correlated with inflation, unexpected inflation, and changes in expected

inflation.



.

1.2 RESEARCH STRATEGY

1.2.1 OBJECTIVES OF THE STUDY

1. To study the correlation between the commodity markets and equity markets

during crisis period.

2. To analyze and determine the customer awareness and preferences of investment

in capital and commodity market during financial crisis.

3. To analyze the impact of financial crisis on investment in financial securities and

commodity market

1.2.2 HYPOTHESIS

H0 = There is no correlation between the commodity markets and equity markets.

H1= There is a correlation between the commodity markets and equity.

1.2.3 STUDY PERIOD

Daily data sourced from the aforesaid exchanges has been employed for the respective

analyses. In order to study the movements of the markets during the pre-recession,

recession and Recovery periods, we adopt the comparable time horizon i.e., for pre-



recession period we consider the period from September 2007 to August 2008, for

recession period we consider September 2008 to August 2009 and for Recovery period

September 2009 to August 2010 is considered.

1.2.4 Research Methodology

Our hypothesis is that there exists a correlation between the commodity markets and

equity markets in view of the inter-linkages owing to various factors. Therefore, we study

the relationship between commodity markets and equity markets between varying periods

and compare the trend in the developed countries. To understand the developed markets

we have considered the popular global markets . The study is structured into three phases:

(i) Pre-Recession period

(ii) Recession period and

(iii) Recovery period.

In all these phases, the correlation between commodity markets and capital market has

been studied.

1.2.5 TYPE OF STUDY

Type of study done to complete the project is descriptive cum correlational study.

1. Descriptive research is used to describe characteristics of a population or

phenomenon being studied. It does not answer questions about how/when/why the

characteristics occurred.

2. A correlational study determines whether or not two variables are correlated. This

means to study whether an increase or decrease in one variable corresponds to an

increase or decrease in the other variable.



1.2.6 RESEARCH DESIGN:

Research Design is based on correlational research, on the other hand, the Researcher has

to use facts or information already available, and analyze these to make a critical

evaluation of the topic.

1.2.7 SOURCES OF THE DATA:

Primary Data:

1.The primary data is collected using questionnaire where the objective was to know the

awareness and preferences of investment in capital and commodity market.

2.The primary data is also collected through discussions with various investors in

financial securities and commodity market

Secondary Data:

The main sources of data are collected through website, various Publication books,

magazines, newspaper and reports prepared by research Scholars .



1.2.8 DATA COLLECTION AND ANALYSIS

The data collected is analyzed by using MS-EXCEL. In the process of analysis chi-square

test is used and even correlation between the global commodity index Amex Gold Bugs

and global capital market Nasdaq is done using excel to understand the correlation

between the two global markets. For Commodity markets, to consider the global scenario

we use total (unlevered) returns on the second most widely used investable benchmark,

Amex Gold BUGS (Basket of Unhedged Gold Stocks) Index. On the same lines, for

Capital markets, to study the global scenario we use, Nasdaq Composite model captures

the analysis of AMEX Gold BUGS and NASDAQ to understand the movement as a

commodity in association with equity markets to understand the global market

1.2.9 LIMITATIONS OF THE STUDY

1. Understanding the nature of the risk is not adequate unless the investor or analyst

is capable of expressing it in some quantitative terms. Expressing the risk of a

stock in quantitative terms makes it comparable with other stocks.

2. Measurement cannot be assured of cent percent accuracy because risk is caused by

numerous factors such as social, political, economic and managerial efficiency.

3. Time was a limiting factor.

4. Only those investors who deal in capital markets are considered.


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