Commodity as An Asset Class

FINANCIAL MARKETS

CAPITAL MARKET

MUTUAL FUNDS

FOREX MARKET

COMMODITY MARKET

DEBT MARKET

MONEY MARKET

Overview of Presentation

• Supply/Demand and the ‘New consumers’Supply/Demand and the ‘New consumers’

• Other Factors too:Other Factors too:- The US Dollar – outlook - The US Dollar – outlook - Real Interest Rates – not rising …- Real Interest Rates – not rising …- The Commodity Cycle - lasts years …- The Commodity Cycle - lasts years …- Massive Reserves - Developmental demand - Massive Reserves - Developmental demand - The Economic Cycle - The Economic Cycle

• Portfolio Diversification With CommoditiesPortfolio Diversification With Commodities- Better Returns- Better Returns- Diversification benefits- Diversification benefits- Hedge Against Inflation- Hedge Against Inflation- Scenario Analysis- Scenario Analysis

• India StoryIndia Story

Supply & Demand /New Customers

World Demand – New ConsumersAluminum: pounds per capita consumption

Source – World Meta Bureau

World Demand – New ConsumersSteels: pounds per capita consumption

Source – World Meta Bureau

• If supply cannot expand at the rate of intended demand, the price of commodities MUST rise in order to squeeze demand back to the available supply.

• In the true sense; a rising price is the market’s way of rationing demand.

• Accordingly, central banks run serious risks by tightening monetary policy in hopes of suppressing the rise in commodity prices.

We could say…

Other Factors

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Q Dollar broke down in 2002

Dollar Index: Euro, Yen,Pound, CDN Dollar

US DOLLAR INDEX CONTINUOUS [FINEX] (72.9500, 74.3200, 72.1700, 74.1700, +1.22000)

Other Factors: the US DollarThe Dollar broke down in 2002 …

Created Using Metastock

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Gold(US$/oz)

GOLD USD/Oz

USD Index

Gold, USD INDEX

Other Factors: the US DollarIn fact, the gold price often turns with US$ …

Created Using Metastock

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S&P Commodity Index, USD INDEX

Commodity Prices and US$So does S&P commodity price index …

USD Index

S&P Commodity Index

Created Using Metastock

The Outlook for the US DollarThe RMB and Asian currencies must rise!

Source - IMF

• When the dollar declines against the Asian currencies:

Local demand picks up

Local prices eventually start rising …

• But since Asian consumers are driving commodity prices, the dollar’s decline against

Asian currencies is far more important for commodities than other factors such as the

dollar’s relationship with say the Euro!

• 2010 Phenomenon: Gold & Euro:

Sudden payment crisis in some EC countries (Greece/Portugal/Spain/Ireland) caused a

loss of confidence in the Euro

We could say…

Commodity Prices and Interest Rates… with the S&P Commodity Index …

News: 15th November 2010

• Gold gained half a % on Monday, after falling three % in the previous session on talk of an imminent interest rate hike by China that triggered a broad commodities decline.

• Copper fell on Friday, receding from the previous session's record high to hit a one-week low on talk of an interest rate hike in top consumer China, but analysts said good fundamentals supported the metal longer-term.

• Oil prices slumped more than 3 % on Friday, retreating from a 25-month high, amid a broad commodities rout on fears that China may raise interest rates to brake its economy and concerns about euro zone debt.

• When real interest rates (inflation-adjusted) decline, demand for goods and services generally responds positively

• This demand is reflected in the demand for raw material in general and key commodity prices specifically

• In fact, the data shows that both the Dollar and real interest rates are negatively correlated with commodity prices

We could say…

The Commodity CycleThe shortest copper cycle lasted 16 years

50 day Moving Average

COMEX Copper Prices from Jan 1988- Oct 2010

TubeSheetsWires

The Gold CycleThe shortest gold cycle lasted for 10 years…

The Commodity CycleThe shortest gold cycle lasted for 10 years…

50 day Moving Average

COMEX Gold Prices from Jan 1979- July2010

The Wheat CycleThe shortest wheat cycle lasted 16 years

The Commodity Cycle

Subprime crisis

Iraq War

Gulf war

NYMEX Crude Oil Prices from Jan 1980- July2010

50 day Moving Average

Reserves

Foreign Exchange Reserve (Sept 2010)

Country Mn $ Country Mn $

China 2648300 Singapore 214,662

Japan 1050235 Switzerland 255,522

Euro system 726850 Germany 197107

Russia 501100 Algeria 150000

Saudi Arabia 410300 Thailand 182691

Republic of China 380505 France 142834

India 295792  Italy 144287

South Korea 289780 United States 128,601

Hong Kong 266100    

Brazil 282921    

   Total Sum of all Countries 10008392

Source - IMF

Investment Demand in CommoditiesCommodity “asset class” room to grow!

• The value of managed assets in the world is about $55 trillion …

• Estimates suggest that only $175-200 billion of this is invested in commodities

• Assuming that the “commodity asset class” will grow to about 3% of all assets …

• There could be an 8-fold increase in commodity investments!

Opportunities in CommoditiesCommodity “asset class” room to grow!

The Economic Cycle… and generally decline during/after recessions

The Economic Cycle

Goldman Sachs Index

Recessionary phase

Agri commodity prices

Commodity Prices

Source: IMF

• The dollar has a major impact on commodity prices

…

• So do real interest rates …

• The commodity cycle generally lasts for years

• The Commodity complex has become an “investment

class”

• Recessions damage commodity prices

• Recovery pushes up prices

Conclusion…

Portfolio Diversification

Commodity Delivers Better Returns…absolute and risk adjusted returns…

Stocks Bonds Commodity Futures

Mean Return 11.02% 7.71% 11.02%

Std. Dev 14.90% 8.47% 12.12%

The average historical risk premium of Commodity Futures has been about 5% per annum during the period from 1959 to 2010.

Commodity Futures Stocks Bonds

Average 5.23 5.65 2.22

Standard Deviation 12.1 14.85 8.47

Sharpe Ratio 0.43 0.38 0.26

Quarter Commodities Equities Comments

Q2 1970 3.6% -16.9%

Q4 1973 10.1% -12.6% 1973 Oil Crisis

Q2 1974 6.0% -8.3% US Recession

Q3 1974 32.0% -22.6% UK Recession

Q3 1975 19.5% -10.6%

Q3 1981 1.0% -10.6% US Recession

Q1 1982 9.5% -9.7% US Recession

Q2 1984 -0.6% -6.9%

Q4 1987 -1.8% -15.4% Black Monday

Q1 1990 0.0% -14.2%

Q3 1990 55.2% -18.1% Gulf War

Q1 1992 2.8% -8.0% Gulf War

Q3 1998 -4.4% -11.9% Asian/ Russian Crises

Q4 2000 7.2% -6.1% Dot Com Crash

Q1 2001 -10.3% -12.8% Dot Com Crash

Q3 2001 -9.9% -14.3% 9/ 11 Crash

Q2 2002 0.0% -9.0% Dot Com Collapse

Q3 2002 11.5% -18.3% Dot Com Collapse

Q1 2008 11.2% -8.1% Credit Crisis

Commodity prices and prices for stock and bonds respond differently to changes in market and economic conditions. The difference in how they respond to global events and the timing to these responses can provides commodities with valuable benefits when combined with other financial assets.

Diversification Benefits …when other disappoint, commodities stands!!!

Source – DataStream

Diversification Benefits …the importance of negative correlation…

Portfolio I

Consider a position consisting of a USD 1,000,000 investment in S&P 500. The daily volatility for S&P 500 is 1.37% (2nd Jan, 2009 to 30th May, 2009).

VaR for S&P 500

Since size of the position is USD 1 million, the standard deviation of daily changes in the value of the position is 1.37% of USD 1 million or USD 13700. The 1-day 99% VaR of a USD 1 million position in S&P is

2.33*13700 = USD 31921

Portfolio II

Position consisting of a USD 1,000,000 investment in Gold. The daily volatility for Gold is 1.44% (2nd Jan, 2009 to 30th May, 2009)

VaR for Gold

Since size of the position is USD 1 million, the standard deviation of daily changes in the value of the position is 1.44% of USD 1 million or USD 14400. The 1-day 99% VaR of a USD 1 million position in S&P is

2.33*14400 = USD 33552

Diversification Benefits …the importance of negative correlation…

So if we combine these two Single-Asset Case portfolio and form a new Two-Asset Case portfolio the VaR for the portfolio should be???

Simple – Sum of the VaR for the two portfolio’s, Right??? Therefore VaR for this portfolio is

USD 31921 + USD 33552 = USD 65473

No !! Correlation gets involved here. If S&P 500 and gold were perfectly correlated (+1), the VaR for the portfolio would equal the VaR for the S&P 500 plus the VaR for the gold (31921+33552 = 65473).

Less than perfect correlation leads to some of the risk being “diversified”.

IF Correlation between both the asset classes during the given time period is -0.71

Diversification Benefits …the importance of negative correlation…

VaR for the portfolio

The standard deviation of the change in the value of the portfolio consisting of both stocks over a one-day period is therefore

SQRT (13700^2 + 14400^2 + (2*-0.71*13700*14400)) = USD 10719

The 1-day 99% VaR for the portfolio is therefore

2.33*10719 = USD 24977

The amount (31921 + 33552) – 24977 = USD 40496 represents the benefits of diversification.

IMPORTANTLY COMMODITY HAS HISTORICALLY PROVIDED IMPORTANTLY COMMODITY HAS HISTORICALLY PROVIDED DIVERSIFICATION DUE TO LOW OR NEGATIVE CORRELATION WITH DIVERSIFICATION DUE TO LOW OR NEGATIVE CORRELATION WITH

OTHER ASSET CLASSES!!!OTHER ASSET CLASSES!!!

Diversification Benefits …the importance of negative correlation…

In Summary, Commodities Offer:

•Positive Expected Risk Premium

•Strong Diversification Effects

•Unique Risk Hedging

•Benchmark Choices

•Variety of Investment Vehicles

DISCLAIMER: The Information in the presentation is solely for informational purpose and should not be regarded as a recommendation by FTKMC. All information in the presentation is obtained from the sources believed to be reliable and FTKMC or any of the associate entities make no representation as to its completeness or accuracy. FTKMC accepts no obligation to correct or update the information or opinion. No member of FTKMC or its associate entities accept any liability whatsoever, or other loses arising from the use of the material in the presentation and or further communication in relation to this presentation.

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