Commodity Markets - Emergence, Functioning & As Investment Vehicle

METS INSTITUTE OF MANAGEMENT PART-TIME MASTERS DEGREE IN MANAGEMENT MFM THIRD YEAR SEMESTER FIRST [2012-2013] CERTIFICATE FROM
GUIDE This is to certify that the project entitled Commodities Markets Emergence, Functioning & As An Investment Vehicle has been successfully completed by Mr. Ujval Rajnikant Damania, under my guidance during the third year i.e. 2012-2013 in partial fulfillment of his/her course, Master Degree in Finance management under the University of Mumbai through the METs Institute of Management, General Arun Kumar Vaidya Chowk, Bandra Reclamation, Bandra (W.), Mumbai 400 050. Name of Project Guide: Prof. Nitin Kulkarni Address of the Guide: ______________________________________ ______________________________________ ______________________________________ Telephone Number: Date: Signature of the Project Guide: ______________________________________ ______________________________________ ______________________________________
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Acknowledgements My sincere thanks to Prof. Nitin Kulkarni, for the guidance and support in helping me do this project as a part of Masters in Finance Management (2010 2013). I would like to thank METs Institute of Management, Mumbai for giving us this opportunity of learning and providing us with the environment of learning, self-development and growth for a better future. I would also like to thank the people for sparing their valuable time and contributing their views for this project.
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TABLE OF CONTENTS Emergence of the Commodity Markets 1. Emergence of the Commodity Markets 1.1 History of the Commodity Markets 1.2 History of the Commodity Markets in India 1.3 Present Commodity Market in India 2. International Commodity Exchanges 2.1 Chicago Board of Trade (CBOT) 2.2 Chicago Mercantile Exchange(CME) 2.3 New York Mercantile Exchange(NYMEX) 2.4 London Metal Exchange(LME) 2.5 Tokyo Commodity Exchange(TOCOM) 1 1 2 3 5 5 5 6 6 7
Functioning of Commodity Markets
3. Functioning of Commodity Markets 3.1 Introduction to Commodity Market Futures 3.1.1 Meaning & Objective 3.1.2 Pricing of Commodity Futures 3.1.3 Meaning of Basis and Spreads 3.1.3.1 Basis 3.1.3.2 Spread 4. Participants in the Commodity Derivatives 4.1 Hedgers 4.2 Speculators 4.3 Arbitragers 5. Advanced Concept in Commodity Future 5.1 Hedging 5.1.1 What is Hedging? 5.1.2 Hedge Ratio 5.1.3 Buying Hedge or Long Hedge 5.1.4 Selling Hedge or Short Hedge 5.1.5 Rolling over of Hedge Position
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5.1.6 Benefits & Limitations of Hedging 5.1.6.1 Benefits of Hedging 5.1.6.2 Limitations of Hedging 5.2 Speculation 5.2.1 What is Speculation? 5.2.2 Long Position in Futures 5.2.3 Short Position in Futures 5.2.4 Meaning of Spread Trading 5.2.5 Buying a Spread 5.2.6 Selling a Spread 5.3 Arbitrage 5.3.1 What is Arbitrage? 5.3.2 Cash and Carry Arbitrage 5.3.3 Reverse Cash and Carry Arbitrage 5.4 Introduction to Option 5.4.1 Meaning & Types of Options 5.4.2 Common Terminologies Used in Options on Futures 5.4.3 Factors affecting Option Premium 6. Going Forward : Indian Commodity Markets
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Commodity Market as an Investment Vehicle
7. Gold as a Commodity : An Introduction 7.1 Factors influencing the Gold Market 7.2 Total Investment Demand 7.3 Historical Investment Data For Gold 7.4 Top Gold Holders in the World 7.5 Important World Markets 7.6 Weight Conversion Table 8. Investment in Gold 9. Why Invest in Gold??? 9.1 Portfolio Diversification 9.2 Inflation Hedge 9.3 Dollar Hedge
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9.4 Risk Management 9.5 Demand & Supply 10. Conclusion 11. Reviews 12. Bibliography
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1. EMERGENCE OF THE COMMODITIES MARKETS 1.1 History of Commodities Market Commodities future trading evolved from need of assured continuous supply of seasonal agricultural crops. The concept of organized trading in commodities evolved in Chicago, in 1848. However one can trace its roots to Japan. In Japan, merchants stored the rice in warehouse for the future use. In order to raise cash, warehouse sold receipts against the held rice. These were known as rice tickets. Eventually these rice tickets became accepted as a general commercial currency. In 19th century Chicago in United States had emerged as a major commercial hub, so that wheat producers from Mid-west were attracted here to sell their produce to dealers & distributors. Due to lack of organized storage facilities, absence of uniform weighing & grading mechanisms producers often confined to the mercy of dealers discretion. These situations lead to need of establishing a common meeting place for farmers and dealers to transact in spot grain to deliver wheat and receive cash in return. Gradually sellers & buyers started making commitments to exchange the produce for cash in future and thus contract for futures trading evolved; Whereby the producer would agree to sell his produce to the buyer at a future delivery date at an agreed upon price. Trading of wheat futures became very profitable which encouraged the entry of other commodities in futures market. This created a platform for establishment of a body to regulate and supervise these contracts. Thus Chicago Board of Trade (CBOT) was established in 1848. It was initially formed as a common location known both to buyers and sellers to negotiate forward contracts. However, the popularity of the contracts and the success of the CBOT on Chicago created interest in the other local markets catering to specific commodities to establish trade bodies that would facilitate dealing in futures contracts. In 1870 and 1880s the New York Coffee, Cotton and Produce Exchanges were born. Agricultural commodities were mostly traded but as long as there are buyers and sellers, any commodity can be traded. In 1872, a group of Manhattan dairy merchants got together to bring chaotic condition in New York market to a system in terms of storage, pricing, and transfer of agricultural products.
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The largest commodity exchange in USA is Chicago Board of Trade, The Chicago Mercantile Exchange, the New York Mercantile Exchange, the New York Commodity Exchange and New York Coffee, Sugar and Cocoa Exchange. Worldwide there are major futures trading exchanges in over twenty countries including Canada, England, India, France, Singapore, Japan, Australia and New Zealand. The various exchanges are constantly looking for new products in which futures contract can be traded. In USA, futures trading is regulated by an agency of Department of Agriculture called the Commodity Futures Trading Commission. It regulates the future exchanges, brokerage firms, money managers and commodity advisors. 1.2 History of Commodity Market in India The history of organized commodity derivatives in India goes back to the nineteenth century when Cotton Trade Association started futures trading in 1875, about a decade after they started in Chicago. Over the time derivatives market developed in several commodities in India. Following the start of trading in cotton futures, derivatives trading started in oilseed in Bombay (1900), raw jute and jute goods in Calcutta (1912), Wheat in Hapur (1913) and Bullion in Bombay (1920). However many feared that derivatives fuelled unnecessary speculation and were detrimental to the healthy functioning of the market for the underlying commodities, resulting in to ban of commodity options trading and cash settlement of commodities futures after independence in 1952. The parliament passed the Forward Contracts (Regulation) Act, 1952, which regulated contracts in Commodities all over the India. The act prohibited options trading in goods along with cash settlement of forward trades, rendering a crushing blow to the commodity derivatives market. Under the act only those associations/exchanges, which are granted reorganization from the Government, are allowed to organize forward trading in regulated commodities. The act envisages three tire regulations: (i) Exchange which organizes forward trading in commodities can regulate trading on day-to-day basis; (ii) Forward Markets Commission provides regulatory oversight under the powers delegated to it by the central Government;
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(iii) The Central Government- Department of Consumer Affairs, Ministry of Consumer Affairs, Food and Public Distribution- is the ultimate regulatory authority. After Liberalization and Globalization in 1990, the Government set up a committee (1993) to examine the role of futures trading. The Committee (headed by Prof. K.N. Kabra) recommended allowing futures trading in 17 commodity groups. It also recommended strengthening Forward Markets Commission, and certain amendments to Forward Contracts (Regulation) Act 1952, particularly allowing option trading in goods and registration of brokers with Forward Markets Commission. The Government accepted most of these recommendations and futures trading were permitted in all recommended commodities. It is timely decision since internationally the commodity cycle is on upswing and the next decade being touched as the decade of commodities. Commodity exchange in India plays an important role where the prices of any commodity are not fixed, in an organized way. 1.3 Present Commodity Market in India INDIAN COMMODITY MARKET STRUCTURE
MINISTRY OF CONSUMER AFFAIR, FOOD & PUBLIC DISTRIBUTION
FORWARD MARKET COMISSION
INDIAN COMMODITY EXCHANGE
NATIONAL EXCHANGE
REGIONAL EXCHANGES
NCXDEX
MCX
NMCEIL
ICEX
NBOT
20 OTHER REGIONAL EXCHNAGES
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The Forward Markets Commission (FMC) headquartered at Mumbai, is the regulatory authority for the commodity Derivatives Markets in India. It is the statutory body set up in 1953 under the Forward Contracts (Regulation) Act, 1952. FMC is in turn supervised by Ministry of Consumer Affairs, Food and Public Distribution, Government of India. There are four National level Commodity Exchanges in India The four exchanges are: (i) National Commodity & Derivatives Exchange Limited (NCDEX) Mumbai, (ii) Multi Commodity Exchange of India Limited (MCX) Mumbai, (iii) National Multi-Commodity Exchange of India Limited (NMCEIL) Ahmedabad (iv) Indian Commodity Exchange Limited (ICEX), Gurgaon There are 21 other regional commodity exchanges situated in different parts of India. The functions of the Forward Markets Commission are as follows: (a) To advise the Central Government in respect of the recognition or withdrawal of recognition from any association or in respect of any other matter arising out of the administration of Forward Contracts (Regulation) Act 1952. (b) To keep the forward markets under the observation and to take such action in relation to them, as it may consider necessary, in exercise of the powers assigned to it by or under the Act. (c) To collect and whenever the Commission feels necessary, to publish information regarding the trading conditions in respect of goods to which any of the provisions of the act is applicable, including information regarding supply, demand and prices, and submit to the Central Government, periodical reports of the working of the forward markets relating to such goods. (d) To make recommendations generally with a view to improvising the organization and working of forward markets. (e) To undertake the inspection of the accounts and other documents of any recognized association or registered association or any member of such association whenever it considers it necessary.
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2. INTERNATIONAL COMMODITY EXCHANGES Futures trading is a direct consequence of the problem related to maintenance of a yearround supply of commodities / products that are seasonal as is the case of agricultural produce. Trading on the futures market platform provides the solution to these problems and opens up new opportunities as well. The economic benefits of the exchange traded futures and options include the ability to shift and manage the price risk exposure of the market and tangible positions. With the liberalization in the international trade policies, there is a new need felt in many countries for the price discovery and the existence of a future trading mechanism. This need can be met through commodity exchanges. There are at least a dozen major commodity exchanges that serve as a marketplace for commodities worldwide. Each of these specializes in certain commodities, while others trade in whole different set. 2.1 Chicago Board of Trade (CBOT) The first commodity exchange established in the world was Chicago Board of Trade (CBOT) during the year 1848 by a group of Chicago merchants who were keen to establish a central market place for trade. It trades in financial and agricultural contracts. In recent years, the CBOT has added electronic trading features, which is remarkably different from the earlier open auction market. Commodities traded: Corn, Soyabeans, Soyabean Oil, Soyabean meal, Wheat, Oats, Ethanol, Rough Rice, Gold, Silver, etc. Like any other commodity exchange, the primary role of CBOT is to provide transparency and liquidity in its contracts to its members, clients and market participants like farmers, corporate, small businessmen, financial service providers, international trading firms and speculators for price discovery, risk management and investment. 2.2 Chicago Mercantile Exchange (CME) Popularly known as CME, has been in business for over a hundred years, is the largest futures exchange in US and the largest futures clearing house in the world for futures and options trading. Formed in 1898 primarily to trade in agricultural commodities, the CME introduced
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the worlds first financial futures more than 30 years ago. Today it trades heavily in interest rate futures, stock indices, and foreign exchange futures. The commodity futures profile of CME consists of livestock, dairy and forest products and enables small family farms to large agri-business to manage their price risks. Commodity traded: Butter, Milk, Diammonium, Phosphate, Feeder cattle, Frozen Pork bellies, Lean Hogs, Live Cattle, Non-Fat dry milk, Urea, Urea Ammonium Nitrate, etc. 2.3 New York Mercantile Exchange (NYMEX) The New York Mercantile Exchange is the worlds biggest exchange for trading in physical commodity. It is the primary trading forum for energy products and precious metals. The exchange has been in existence for 132 years and performs trades through two divisions, the NYMEX division, which deals in energy and platinum and the COMEX division, which trades in all the other metals. The exchange also clears the trade for market participants who wish to avoid counter-party credit risk by using standardized contracts for Natural Gas, Crude Oil, Refined Products and Electricity. Commodities Traded: Light Sweet Crude Oil, Natural Gas, Heating Oil, Gasoline, RBOB Gasoline, Electricity, Propane, Gold, Silver, Copper, Aluminum, Platinum, Palladium, etc. 2.4 London Metal Exchange (LME) The London Metal Exchange (LME) is the worlds premier non-ferrous market, with highly liquid contracts. It is the innovative exchange that has maintained its traditional strengths in modern business environment by remaining close to its core users by ensuring that its contracts continue to meet the high expectation of the demanding industry. The exchange was formed in 1877 as a direct consequence of the industrial revolution witnessed in Britain in the 19th century. The primary focus of LME is in providing a market for participants from the non-ferrous base metals related industry to safeguard against risk due to movement in the base metals prices and also arrive at a price that sets benchmark globally. Commodities traded: Aluminum, Copper, Nickel, Lead, Tin, Zinc, Aluminum Alloy, North American Special Aluminum Alloy (NASAAC), Polypropylene, Linear Low Density Polyethylene, etc.
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The LME metal futures contracts run on a daily basis for a period of three months, unlike others commodity markets that are primarily based on monthly prompt dates. The exchange thus combines the convenience of the settlement dates tailored to individual needs with the security of a clearing house for its clearing members. 2.5 Tokyo Commodity Exchange (TOCOM) The Tokyo Commodity Exchange (TOCOM) is the second largest commodity futures exchange in the world with trade in metals and energy contracts. It has made rapid advancement in commodity trading globally since the inception. One of the biggest reasons for this is the initiative TOCOM took towards establishing Asia as the benchmark for price discovery and risk management in commodities like the Middle East Crude Oil. TOCOMs recent tie-up with MCX to explore cooperation and business opportunities is seen as the one of the steps towards providing a platform for the futures price discovery in Asia for Asian players in Crude Oil since the demand-supply situation in U.S. that drives the NYMEX is different from the demand-supply situation in Asia. In January 2003, in a major overhaul of its computerized trading system, TOCOM fortified its clearing system in June by being the first commodity exchange in Japan to introduce an inhouse clearing system. TOCOM launched its option on gold future, the first option contract in Japanese market in May 2004. Commodities Traded: Gasoline, Kerosene, Crude Oil, Gold, Silver, Platinum, Palladium, Aluminum, Rubber, etc. As you can see, commodity exchanges are very readily available all over the world. There are not only commodity exchanges that specialize in certain kinds of trades; there are ones that will trade in a wide variety of products as well. These exchanges can trade in everything from the mundane, to the wacky. Hopefully this summary has piqued your interest regarding the world of commodities trading.
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3. FUNCTIONING OF THE COMMODITY MARKETS 3.1 Introduction to Commodity Markets Futures 3.1.1 Meaning & Objective of Commodity Futures A commodity futures contract is a contractual agreement between two parties to buy or sell a specified quantity and quality of commodity at a certain time in future at a certain price agreed at the time of entering into the contract on the commodity futures exchange. Objectives and benefits: Hedging- Price Risk Management by risk mitigation Speculation- take advantage a favorable price movements Leverage- pay low margin and enjoy large exposure Liquidity- eases of entry and exit of market Price discovery- for taking farm and business decision Price stabilization along with balancing demand and supply position Facilitates integrated price structure Flexibility, certainty and transparency in purchasing commodities facilitate bank financing Facilitates informed lending by the banks
The primary objectives for any futures exchange are effective price discovery and efficient price risk management. In commodity futures, it is necessary to distinguish between investment commodities and consumption commodities. An investment commodity is generally held for investment purposes whereas consumption commodities are held mainly for consumption purposes. Gold and Silver can be classified as investment commodities whereas oil, steel and other commodities can be classified as consumption commodities. Difference between cash and futures market Cash market is the market for buying and selling physical commodity at a negotiated price. Delivery of a commodity takes place immediately. Futures market is the market for buying and selling standardized contract of the commodity at a pre-determined price. Delivery of the commodity takes place during a future delivery period of the contract if the option of delivery is exercised.
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Difference between Future and Forward contract Future contract is an agreement between two parties to buy or sell a specified quantity and quality of asset at a certain time in future at a certain price agreed at the time of entering into the contract on the futures exchange. Forward contract is an agreement entered between two parties to buy or sell an asset at a future date for an agreed price. Forward contract is not traded on an exchange. Size of the contract: Futures contract is standardized in terms of quality and quantity as specified by the exchange. Size of the contract is customized as per the terms of the agreement between the buyer and the seller. Liquidity: Future contract is more liquid as it is traded on the exchange. Forward contract is less liquid due to its customized nature and mutual trade. Counter party Risk: In futures contract the clearing houses becomes a counter party to each transaction, which is called novation, making counter party risk nil. In forward contracts, counter party risk is high due to decentralized nature of the transaction. Regulations: Futures contract is regulated by a government regulatory authority and the Exchange. Forward contract is not regulated by any authority or exchange. Settlement: Futures contract can be settled by cash or physical delivery depending on the commodity futures contract specification. Forward contract is generally settled by physical delivery. 3.1.2 Pricing the commodity futures Meaning & factors affecting cost of carry The relationship between cash price and futures price can be explained in terms of cost of carry. Cost of carry is an important element in determining pricing relationship between spot and futures prices as well as between prices of futures contracts of different expiry months. According to the cost of carry model, futures price depend on the spot prices of a commodity and the cost of storing the commodity from the date of spot prices to the date of delivery of the futures contract. Cost of storage and insurance and cost of financing constitute cost of carry. Estimated cost of futures price is also called Full carry futures price
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Cost of carry model: The cost of carry model can be defined as: F=S+C Where, F = Futures Price S = Spot Price C = Cost of carry For example: If the cost of 100 grams of gold in spot market is Rs. 80,000 & cost of carry is 12% per annum, the fair value of a 4 month futures contract will be: F=S+C F = 80,000 + (80,000 * 12% * 4/12) F = 80,000 + 3,200 F = Rs. 83,200 The fair value of a futures contract is a theoretical value of where a future contract should be positioned, given the current spot price, cost of financing & the time to expiration. Fair value of a futures contract can be calculated using the following: F = S (1 + r) n Where S = Spot Price F = Futures Price r = % cost of financing (annually compounded) n = Time till expiration of the contract If the value of r is compounded m times in a year, the formula to calculate the fair value will be F = S (1 + r/m) mn Where m = number of times compounded in a year
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For example : The cost of 100 grams of gold in spot market is Rs. 80,000 & cost of financing is 12% per annum, compounded monthly, the fair value of a 4 month futures contract will be F = S (1 + r/m) mn F = 80,000 (1 + 0.12 / 12) 12 * 4/12 F = 80,000 (1.01)4 F = 80,000 * 1.0406 F = Rs. 83,248 The fair value of a futures contract with continuous / daily compounding can be expressed as: F = Sern Where F = Futures price S = Spot Price r = % cost of financing n = Time till expiration of the contract e = 2.71828 The above formula is used to calculate the futures price of a commodity when no storage cost are involved. The futures price is equal to the sum of money S invested at a rate of interest r for a period of n years. For example : If the cost of 100 grams of gold in spot market is Rs. 80,000 & cost of financing is 12% per annum, the fair value of a 4 month futures contract will be F = Sern F = 80,000 * e (0.12 * 0.333) F = 80,000 * 2.71828(0.0399) F = 80,000 * 1.04077 F = Rs. 83,261
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3.1.3 Meaning of Basis and Spread 3.1.3.1 Basis Basis is the difference between the cash price of an asset and the future price of the underlying asset. Basis can be negative or positive depending on the prices prevailing in the cash and futures market. If the cash price is less than the futures price, basis is negative and if the cash price is more than the futures price, basis is positive. When the cash price of the an asset increases at a rate faster than the futures price of the underlying asset, it is usually referred to as a strengthening of basis; when the futures price of the underlying asset increases at a rate faster than the cash price of the asset, it is usually referred to as weakening of the basis. If the spot price of the asset is less than the futures price of the underlying asset, the market is said to be in contango. Future price converges close to the spot price of the underlying asset during the delivery month of the futures contract. As the futures contract approaches the expiry, it converges with the spot price. A strong basis is indicative of a short supply in the spot market. As soon as supply needs are met, basis levels will weaken. A crop year when short supply is anticipated or forecast will result in strong basis until supply needs in the spot market are met. A large supply in indicated by a weak basis. A crop year when supplies are forecast to be ample is indicative that basis level will weaken. If the spot price of an asset is less than the futures price of the underlying asset, the market is said to be in contango. When the futures contract approaches the expiry, the spot price and the future price converge with each other If the spot price of an asset is more than the futures price of the underlying asset, the market is said to be in backwardation. When the futures contract approaches expiry, the spot price and future price converge with each other. 3.1.3.2 Spread Spread is the difference in prices of two futures contracts. Futures market can be normal market or the inverted market. If the price of the far month futures contract is higher than the near month futures contract, then it is referred as normal market. If the price of the far month
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futures contract is lower than the near month futures contract, then it is referred to as an inverted market. Spreads can be classified as intra commodity spreads and inter commodity spreads. An intra-commodity spread is the difference in prices between the two futures contracts of the same commodity having different expiry months. Inter commodity spread is the difference in prices of two commodities having the same expiry month.
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4. PARTICIPANTS IN COMMODITY DERIVATIVES 4.1 Hedgers Hedgers are interested in transferring risk associated with transacting or carrying underlying physical asset. Hedging is an insurance used to avoid or reduce price risks associated with any kind of futures transaction. A hedge involves the establishing a position in the futures market that is equal and opposite to a position in the physical market. Hedging works because cash and future prices tend to move in tandem, converging as the futures contract reached expiration. 4.2 Speculators Speculators are interested in making money by taking a view on future price movements. Commodity futures allow speculators to create high leveraged positions to undertake calculative risk, with the objective of correctly predicting the market movement. A speculator is an additional buyer of commodities whenever it seems that market prices are lower than it should be. Conversely, when it appears that prices are too high, a speculator becomes an active seller. 4.3 Arbitragers Arbitragers are interested in locking in a minimum risk profit by simultaneously entering into transactions in two or more markets. Arbitragers lock in profit when they spot cash and carry arbitrage opportunity; or reverse cash and carry arbitrage opportunity.
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5. ADVANCED CONCEPT IN COMMODITY FUTURES 5.1 Hedging 5.1.1 What is Hedging? Hedging means taking a position in futures market that is opposite to a position in the physical market with the objective of reducing or limiting risks associated with the price changes. 5.1.2 Hedge Ratio Hedge Ratio is the ratio of the number of futures contracts to be purchased or sold to the quantity of the cash asset that is required to be hedged. CP FP CP FP
Change in cash price Change in futures price Standard deviation of CP Standard deviation of FP Coefficient of correlation between CP & FP Hedge Ratio
HR
Hedge Ratio (HR) that minimize the variance is HR = * (CP / FP) Hypothetical Example On 3rd March 3012, Mr. Sagar, a Mumbai based gold jeweler buys a 8 kg of gold in cash market as a raw material to make jewellery from it. Mr. Vinod wants to protect himself from a decline in the prices of gold till the jewellery is ready for sale in 15 days. He decides to hedge by selling futures contract of gold. The standard deviations of the change in the cash price of gold and change in futures price of gold over the 15 day period is 1.17 and 0.62 respectively. The coefficient of correlation between the cash price of gold and the futures price of gold for 15 days is 0.60. Standardized futures contract size is 1 kg. The optimal hedge ratio is 0.60 * 1.17 / 0.62 = 1.13
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Mr. Sagar should sell 1.13 * 8 / 1 = 9.04 or sell 9 (rounded off) gold futures contracts to hedge the physical exposure of 8 kg of gold. 5.1.3 Buying Hedge or Long Hedge Buying Hedge is also called the Long Hedge. Buying Hedge means buying the futures contracts to hedge a cash position. Buying Hedge strategy is used by dealers, consumers, fabricators, etc. who have taken or will be taking exposure in the physical market. Uses of Buying hedge strategy To protect increase in the cost of raw material To replace the inventory at lower prevailing cost To protect uncovered forward sale of finished goods
Buying hedge is done with the purpose of protecting against price increase in the spot market of a commodity that has already been sold at a specific price but not purchased yet. It is very common among exporters and importers to sell commodities at an agreed-upon price for forward delivery. If the commodity is not yet in possession, the forward delivery is considered uncovered. 5.1.4 Selling Hedge or Short Hedge Selling hedge is also called Short Hedge. Selling hedge means selling a futures contract to hedge a cash position. Selling hedge strategy is used by the dealers, consumers, fabricators, etc. who have taken or will be taking exposure in the physical market. Uses of Selling hedge strategy To protect the price of finished products To protect inventory not covered by forward sales To protect the prices of estimated production of finished product
Short Hedgers are merchants and producers who acquire inventories of the commodity in the spot market and who simultaneously sell an equivalent amount or less in the futures market. The hedgers in this case are said to be long in the spot transaction and short in the futures transactions.
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5.1.5 Rolling over of Hedge Position If the time period required for a hedge position is later than the expiration date of the current futures contract, the hedger can roll over the hedge position. Rollin over the hedge position means closing out the existing position in one futures contract and simultaneously taking a new position in a futures contract with a later expiration date. If a person wants to reduce or limit the risk due to fall in prices of the finished material to be sold after 6 months and if the futures contracts up to 2 months are liquid, then he can rollover the short hedge position three times till the date when the actual physical sale takes place. Every time the hedge position is rolled over, it limits or reduces the price risk. 5.1.6 Benefits & Limitation of Hedging 5.1.6.1 Benefits of Hedging 1. Hedging reduces or limits the price risk associated with the physical commodity 2. Hedging is used to protect the price risk of a commodity for long periods by rolling over contracts 3. Hedging makes business planning more flexible without interfering with routine business operations 4. Hedging can facilitate low cost financing Hedging is the most common method of price risk management. It is the strategy of offsetting price risk that is inherent in a spot market by taking an equal but opposite position in the futures market. Futures markets are used as a mode by hedgers to protect their businesses from adverse price changes, which could dent the profitability of their business. Hedging benefits all participants who are involved in trading of commodities like farmers, processors, merchandisers, manufacturers, exporters, importers, etc. The following are 2 hypothetical illustrations of the benefits of hedging: Hypothetical Illustration 1: A wheat miller enters into a contract to sell flour to a bread manufacturer four months from now. The price is agreed upon today though the flour would only be delivered after four months. The miller is worried about the rise in the price of wheat during the course of next four months. A rise in the price of wheat would result in losses on the contract to the miller. To safeguard against the risk of increasing prices of wheat, the miller buys wheat futures
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contracts that call for the delivery of wheat in four months time. After the expiry of four months, as feared by the miller, the price of wheat may have risen. The miller then purchases the wheat in the spot market at a higher price. However, since he has hedged in the futures market, he can now sell his contract in the futures market at a gain since there is an increase in the futures price as well. He thus offsets his purchase of wheat at a higher cost by selling the futures contract thereby protecting his profit on the sale of the flour. Thus, the wheat miller hedges against exposure to price risk. Mechanics of Hedging as explained in Illustration 1
Agrees to sell flour to manufacturer Buy Wheat Futures Contract bread
APRIL
WHEAT MILLER
JULY
Sell Wheat Futures Contracts Buy Wheat in the Physical Market for delivery of flour to Bread Manufacturer
Hypothetical Illustration 2: An automobile manufacturer purchases huge quantities of steel as raw material for automobile production. The automobile manufacturer enters into a contractual agreement to export automobiles 3 months hence to dealers in East European market. This presupposes that the contractual obligation has been fixed at the time of signing the contractual agreement for exports. The automobile manufacturer is now exposed to risk in the form of increasing steel prices. In order to hedge against price risk, the automobile manufacturer can buy Steel futures contracts, which would mature 3 months hence. In case of increasing or decreasing steel prices, the automobile manufacturer is protected. Let us analyze the different scenarios:
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Scenario 1: Increasing Steel Prices If steel prices increase, this would result in increase in the value of the Futures contracts, which the automobile manufacturer has bought. Hence, he makes profit in the futures transaction. But the automobile manufacturer needs to buy Steel in the physical market to meet his export obligation. This means that he faces a corresponding loss in the physical market. But this loss is offset by his gains in the futures market. Finally, at the time of purchasing steel in the physical market, the automobile manufacturer can square off his position in the futures market by selling the Steel Futures contract, for which he has an open position. Scenario 2: Decreasing Steel Prices If steel prices decrease, this would result in decrease in the value of the Futures contracts, which the automobile manufacturer has bought. Hence, he makes losses in the futures transaction. But the automobile manufacturer needs to buy Steel in the physical market to meet his export obligation. This means that he faces a corresponding gain in the physical market. The loss in the futures market is offset by his gains in the physical market. Finally, at the time of purchasing steel in the physical market, the automobile manufacturer can square off his position in the futures market by selling the Steel Futures contract, for which he has an open position. This results in a perfect hedge to lock the profits and protect from increase or decrease in raw material prices. This also provides the added advantage of Just in Time Inventory management for the automobile manufacturer.
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Mechanics of Hedging as explained in Illustration 2
JUNE
Export Contract to sell Automobiles in October Buy Steel Futures Contracts
(export)
AUTOMOBILE MANUFACTIURER
SEPTEMBER
Sell Steel Futures Contracts Buy Steel from Physical Market to meet export requirement
Hypothetical Illustration 3: A farmer plans to harvest Guar seed crop in the month of November. But in the harvesting season (November), the Guar seed prices usually decline due to excess supply in the market. This usually forces the farmer, who requires income for the next subsequent harvesting season, to sell his harvest at a discount. The farmer has two options to counter this risk he is exposed due to price fluctuations: Option A: Store the Guar seed, which has been harvested for few months and subsequently sell the Guar seed when the prices increases (in the non-harvest) season). But, this would not be possible if the farmer requires the proceeds from the sale of this harvest to finance the next crop season. Also, the farmer would require adequate storage space and would require following preservation techniques to ensure that the stored harvest would not be destroyed due to infestation. Option B: Alternatively, the farmer can hedge himself by selling November Guar seed Futures contract in the month of September. Any decline on the spot prices in the month of November would result in decline in the futures prices, which he has already sold at higher
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price. Upon harvest, the farmer would offset his futures transaction by buying Guar seed November futures contract and simultaneously sell his Guar seed crop harvest in the physical market. This ensures that the farmer is protected against any decline in the prices in the physical market. Mechanics of Hedging As explained in Illustration 3
SEPTEMBER
Sell Guar seed November Futures
FARMER
NOVEMBER
Buy Guar seed November Futures to square-off transaction Sell Guar seed Harvest
5.1.6.2 Limitations of Hedging 1. Hedging cannot eliminate the price risk associated with the physical commodity in totality due to the standardized nature of futures contracts 2. Because of the basis risk, hedging may not provide full protection against the adverse price changes 3. Hedging involves transaction costs 4. Hedging may require closing out a futures position before it enters into the delivery period 5.2 Speculation 5.2.1 What is Speculation? Speculation means anticipating future price movements to make profits from it. The main objective of speculation in a commodity futures market is to take risks & profit from anticipated price changes in the futures price of an asset.
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5.2.2 Long position in futures Long position in commodity futures contract without any exposure in the cash market is called speculative transaction. Long position in futures for speculative purpose means buying a futures contract in anticipation of increase in the prices before the expiry of the contract. If the prices of the futures contracts increase before the expiry of the contract then the trader makes the profit by squaring off the position and if the prices of the futures contract decrease then the trader makes losses. 5.2.3 Short position in futures Short position in a commodity futures contract without any exposure in the cash market of the commodity means a speculative transaction. Short position in futures for speculative purpose means selling a future contract in anticipation of decrease before expiry of the contract then the trader makes profit on squaring off the position and if prices of the futures contract increase then the trader makes losses. 5.2.4 Meaning of Spread Trading Spread refers to difference in prices of two futures contracts. An understanding of spread in relationship in terms of fair spread is essential to earn a speculative profit. Considerable knowledge of a particular commodity is also necessary to enable the trader to use the spread trading strategy. When actual spread between two futures contracts of the same commodity widens, buy the near month contract because it is under-priced and sell the far month contract because it is over-priced. When actual spread between two futures contract of the same commodity narrows, sell the near month contract because it is over-priced and buy a far month contract because it is under-priced. A calendar spread is a spread between the same variable at two points in time. An intra-commodity spread consists of one long future and one short. Both have the same underlying, but different maturities. An inter-commodity spread consists of a long-short position in futures on different underlying commodities. Both typically have the same maturities.
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Spreads can also be constructed with the futures traded on different exchanges. Typically this is done using the futures on the same underlying, either to earn arbitrage profits or, in case of the underlying commodity, to create an exposure to price spreads between two geographically separate delivery points. 5.2.5 Buying a Spread Buying a spread is an intra-commodity spread strategy. It means buying a near month contracts and simultaneously selling a far month contract. This strategy is adopted when the near month contract is underpriced or the far month contract is overpriced. A trader of the above strategy buys the near month contract and sells the far month contract when the spread is not fair and squares off the positions when the spread corrects and the contract are traded at a fair price. 5.2.6 Selling a spread Selling a spread is also an intra-commodity spread strategy. It means selling a near month contract and simultaneously buying a far month contract. This strategy is adopted when the near month is overpriced or far month contract is underpriced. A trader of the above strategy sells near month contract and buys the far month contract when the spread is not fair and squares off the positions when the spread corrects and contracts are traded at fair spread. 5.3 Arbitrage 5.3.1 What is Arbitrage? Arbitrage means locking in profit by simultaneously entering into transactions in two or more markets. If the relationship between spot prices and the future prices in terms of basis or between prices of the two futures contracts in terms of spread changes, it gives rise to arbitrage opportunities. Difference in the equilibrium price determined by the demand and supply at two different markets also gives opportunities to arbitrage. The futures price must be equal to the spot prices plus cost of carrying the commodity to the futures delivery date else arbitrage opportunity arises. Mathematically, it can be expressed as F (o, n) = S0 (1+ c) F (o, n) = Futures price of the commodity at t = 0 for the expiry at t = n S0 = Spot price of the commodity at t = 0
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c = Cost of carry from t = 0 (present) to t = n (expiry date of futures) expressed as a percentage of the spot price Cost of carry relationship also applies to price relationship that should exist between futures contracts of the same commodity with different expiry dates. The far month futures price must be equal to the near month future price plus cost of carrying the commodity from the near month to the far month expiry date else arbitrage opportunities arise. Arbitrage provides market efficiency in commodity futures and hence prices are quoted at their fair value most of the times. 5.3.2 Cash and Carry Arbitrage Cash and Carry arbitrage between spot and futures prices means buying the physical commodity borrowed funds and simultaneously selling in the futures contract in the first transaction and closing the futures contract by delivering the physical commodity on maturity in the second transaction. Cash and carry arbitrage opportunity arises when the futures price of the asset is more than the spot price of the asset plus cost of carrying the asset to the futures expiry date. 5.3.3 Reverse Cash and Carry Arbitrage Reverse cash and carry arbitrage between spot and futures prices means lending funds realised from selling the physical commodity and simultaneously buying the futures contract in the first transaction and closing out the futures contract by taking the delivery of the physical commodity on maturity in second transaction. Reverse cash and carry arbitrage opportunity arises when the futures price of the asset is less than the spot price of the asset plus cost of carrying the asset to the futures expiry date.
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5.4 Introduction to Options 5.4.1 Meaning & Types of Options An Option on futures gives the right but not the obligation on the part of the holder to buy or sell the underlying futures contract by a certain date at a certain price. Two types of options A Call Option is contract that gives the owner of the call option the right, but not obligation to buy the underlying asset by a specified date and at a specified price. A Put Option is a contract that gives the owner of the put option, the right, but not the obligation to sell the underlying asset by a specified date and at a specified price. A Commodity Option gives the owner the right to buy or sell a commodity at a specified price and before a specified time. Base on the exercise mode, there are two types of options that are currently being traded. American Style Options In an American option, the buyer of the option can choose to exercise his option at any given period of time between the purchase date & the expiry date of the underlying futures contract. European Style Option In a European option, the buyer of the option can choose to exercise his option only on the date of expiration of the underlying futures contract. Since the American option provides greater degree of flexibility to the investor, the premium paid to buy an American style option is equal to or greater than the European style option. 5.4.2 Common Terminologies used in options on futures In the money A call option is said to be in the money if the price of the underlying futures contract is above the strike price. A put option is said to be in the money if the price of the underlying futures contract is below the strike price.
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At the money A call option is said to be at the money if the underlying futures contract is equal to the strike price. A put option is said to be at the money if the underlying futures contract is equal to the strike price. Out of the money A call option is said to be out of the money if the underlying futures contract is below the strike price. A put option is said to be out of the money if the underlying futures contract is above the strike price. Deep in the money An option contract that is so far in the money that it is unlikely to go out of money prior to expiration. Close to the money An option contract whose strike price is close to the futures price of the underlying. Deep out of money An option contract that is so far out of the money that it is unlikely to go in the money prior to expiration. Underlying Futures contract It is the corresponding futures contract that can be either bought or sold by exercising the option. Exercise Action taken by the buyer of the option whose intention is to deliver / take delivery of the underlying futures contract.
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Only the buyer of an option contract has the right to exercise the option. The seller of the option (option writer) is obligated to deliver / take delivery of the underlying futures contract as & when the buyer wishes to exercise his option. Exercise price It is also called the strike price & is the price at which the buyer / seller of the option may buy or sell the underlying futures contract respectively. Expiration Date Is the last day on which an option can be either exercised or offset. In the case of a call option, exercising would generate a long futures position. In the case of a put option, exercising would generate a short futures position. Premium It is the cost paid to buy an option at a specific strike price / exercise price. The premium to be paid depends upon the strike price relative to the futures price, time till expiration & market volatility. Delta Delta is the first derivative in the option-pricing model. It is also called the hedge ratio. Delta is defined as the change in price of the option premium corresponding to the change in price of the underlying futures contract. Since options premiums do not always move as much as the underlying futures price, the delta factor is used. Generally, a change in the futures price of the underlying will result in a smaller change in the price of the option premium. Delta is expressed in percentage terms & ranges from 0% for deep out of money options to 100% for deep in the money options. Delta or at the money options is usually 50% or 0.5. The value of delta decreases when the futures price moves from in the money to at the money to out of money. Similarly, the value of delta increases when the futures price moves from out of money to at the money to in the money.
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Gamma The change in value of delta corresponding to ta change in the underlying futures price is called Gamma. It is also called the curvature of the option. The changes in Gamma are dynamic i.e. the value of Gamma moves up or down as the futures price of the underlying changes. Theta Theta is the measure of the change in option premium corresponding to a one day change in its time to expiration. It is also called the time decay. Vega Vega is the change in the option premium corresponding to a 1% change in volatility in the futures price of the underlying. Vega is a measure of the sensitivity of options to market volatility. Rho The rho of a portfolio is a measure of the portfolios linear exposure to changes in the riskfree interest rate. It measures the sensitivity of the portfolio to interest rates. Intrinsic Value The amount by which an option is in the money is called intrinsic value of the option. Intrinsic value is calculated by taking the difference between the strike price and the current price of the underlying. Intrinsic value for a CALL OPTION is calculated as
INTRINSIC VALUE CURRENT PRICE OF UNDERLYING FUTURES CONTRACTS STRIKE PRICE
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Intrinsic value for a PUT OPTION is calculated as

CURRENT PRICE OF UNDERLYING FUTURES CONTRACTS
INTRINSIC VALUE
STRIKE PRICE
Time value is the amount an investor is willing to pay for an option above its intrinsic value in the hope that some time before the expiration of the contract, the value of the underlying will generate positive cash flows.
TIME VALUE
PREMIUM
INTRINSIC VALUE
The time value of an option contract decreases as the underlying futures contract approaches the expiry. 5.4.3 Factors affecting Option premium There are six major factors that influence option premiums. They are a) Changes in the price of the underlying futures contract b) Strike price c) Time until expiration d) Volatility of the underlying futures contract e) Dividends f) Risk free interest rates Changes in the price of the underlying futures contract can increase or decrease the value of an option. The price changes have opposite effect on call and puts. For instance, as the value of the underlying futures contract rises, the value of the call option will increase and the value of the put option will decrease. A decrease in the price of the underlying futures contract will have the opposite effect.
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The strike price determines whether or not an option had an intrinsic value. An options premium generally increases as the option becomes further in the money, and decreases as the option becomes more deeply out of money. Time until expiration affects the time value component of an options premium. Generally, as expiration approaches, the level of an options time value for both puts and calls decreases. The effect is mostly noticed with the at-the-money options. The effect of volatility can have a significant impact on the time value portion of an options premium. Volatility is simply a measure of risk (uncertainty), or variability in the price of the underlying futures contract. Higher volatility estimates reflect greater expected fluctuation (in either direction) in the price levels of the underlying. This expectation generally results in higher option premium for the puts and calls alike, and is most noticeable with at-the-money options. The effect of an option premium on the underlying securitys dividend and the current riskfree interest rate has a small but measurable effect. This effect the cost of carry of the shares in an underlying security the interest that might be paid for margin or received from an alternative investments (such as a Treasury bill), and the dividends that would be received by owning shares outright.
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6. GOING FORWARD: INDIAN COMMODITY MARKETS Ever since the first national level commodity exchange was introduced in 2003, commodity exchanges have seen an exponential growth. In the last fiscal turnover in Indias commodity exchanges rose 52% to Rs. 181, 26,103 crores in 2011-12 as against 119, 48,942.35 crores in 2010-11 amidst high volatility, according to data released by Forward Markets Commission. The turnover on the Indian commodity bourses has increased 120 times after electronic trading was introduced in 2003, according to the Forward Markets Commission (FMC), the commodities market regulator. The MCX is the world's largest exchange in silver, the second largest in gold, copper and natural gas and the third largest in crude oil futures. However, as a whole, exchange-traded commodities account for only a fifth of the total volume of commodities traded in India. Globally, the futures market in commodities is 30-40 times the size of the underlying physical commodity trade. The commodity markets are at a juncture where investment in education and research is important to sustain their growth. The MCX has been taking various initiatives to systematically develop markets through continuous innovation, education and research focused on spreading awareness of the modern trading mechanisms facilitated by commodity exchanges. To widen and deepen our commodities market for the future, policymakers need to strengthen the institutional infrastructure through market-friendly policies on taxation, enabling of institutions, such as banks and mutual funds, to participate in the commodity futures market, and the provision to initiate trading in options and intangible commodities. Following are the bold and the revolutionary steps taken by Forward Markets Commission & NCDEX the largest Agriculture Exchange to strengthen the futures market. 1. Staggered Delivery: Most of the agricultural commodities traded on the domestic exchanges are under the Compulsory Delivery system wherein it is mandatory for sellers to deliver goods upon the expiry of the contract. In a move which gives the seller an option to tender delivery much before the expiry of the contract, the Regulator has introduced a system of staggered delivery in Compulsory Delivery contracts which could go a long way towards easing pressures towards the expiry of the contract and facilitate convergence in the futures and underlying physical markets..
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2. Reduction in Delivery Default Penalty: In scenarios of shortage of goods in the Exchange accredited warehouses, when sellers were not in a position to effect delivery this led default penalty being priced into the futures prices. The penalty has been reduced from 3% to 1.5 % plus the difference in the Settlement Price and the average of three of the highest spot prices during five days after expiry of the contract in select commodities. Relaxing the penalty percentage would reduce the probability of nonconvergence between spot and future prices and ensure more orderly expiries of the contracts. 3. Change in Validity Structure: Agricultural commodities have a fixed validity period during which they are eligible to be delivered on the exchange platform. This validity period is in general governed by the shelf life of the commodity. Taking into consideration the low availability and high demand for select commodities in the current season, the Exchange proactively has reduced the validity period of in respect of agricultural commodities like Mustard Seed, Pepper, Soya Bean and Chana. This would result in stocks being moved out of the warehouse at regular intervals during the year which is beneficial in years of shortages. Given the above, a greater adoption of hedging instruments available on commodity exchanges can help commodity value chain participants and also end users mitigate price risk which will be in the larger interest participant in the exchange. The above steps are designed to further strengthen the commodities futures market in India.
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7. Gold as a Commodity: An Introduction Gold is primarily a monetary asset and partly a commodity. More than two thirds of Golds total accumulated holdings, relating to the value of investment is with the central banks reserves, private players and high karat jewelry. Gold is highly liquid. Gold held in central banks, other than major institutions, and retail jewelry is reinvested in the market. Due to a large stock of gold, against its demand, it is argued that the core driver of the real price of gold is stock equilibrium rather than flow equilibrium. 7.1 Factors Influencing the Gold Market: Above ground supply from sales by central banks, reclaimed scrap, and official gold loans Producer/ mining hedging interest World macroeconomic factors such as the U.S dollar and interest rate Comparative returns on stock markets Domestic demand based on monsoon and agricultural
7.2 Total Investment Demands 2010 899.5 213.1 88.3 1200.9 382.2 207.7 1790.8 2011 1171.3 245.5 87.8 1504.6 185.1 -76.9 1612.8 2012(Q1) 2012(Q2) 275.4 226.2 52.3 53.8 26.5 22.8 354.2 302.8 53.2 -0.8 -60.3 59.6 347.1 361.6 (figures in tonnes)
Physical Bar Demand Official Coins Medals/imitation coins Total Bar and Coin Demand (A) ETF's & Similar Products (B) OTC investments and stock flows (C) Total Investment Demand (A + B + C)
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Total Investment Demands

2000
1500 T o 1000 n n e 500 s 0 2010 -500 2011 2012(Q1) 2012(Q2)
Year Total Bar & Coin Demand OTC Investments & Stock Flows
Source: World Gold Council
ETF's & Similar Products
7.3 Historical Investment Data for Gold
Total Bar ETF's & & Similar Products Coin Investment 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 352 302 347 394 414 434 868 779 1201 1505 -
Total
39 133 208 260 253 321 623 382 185 (figures in tonnes)
352 341 480 602 674 687 1189 1402 1583 1690
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Investment Demand
1800 1600 1400 1200
Tonnes
1000 800 600 400 200 0 2002 2003 2004 2005 2006 2007 2008 2009 2010 Total
Source: World Gold Council
2011
Total Bar & Coin Investment
ETF's & Similar Products
7.4 Top Gold Holders in the World

No. 1 2 3 4 5 6 7 8 9 10 11 12 Country United States Germany IMF Italy France China Switzerland Russia Japan Netherlands India ECB Tonnes 8133.5 3395.5 2814 2451.8 2435.4 1054.1 1040.1 936.6 765.2 612.5 557.7 502.1 % of Reserve 75.40% 72.30% * 71.20% 71.70% 1.70% 12.10% 9.60% 3.10% 60.70% 9.90% 32.20%
*IMF balance sheets do not allow this percentage to be calculated
7.5 Important World Markets London is the biggest and the oldest gold market in the world. Mumbai is under Indias liberalized gold regime. New York is the home of gold futures trading. Zurich is a physical turntable. Istanbul, Dubai, Singapore, and Hong Kong are doorways to important consuming regions. Tokyo, where TOCOM sets the mood of Japan.
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7.6 Weight Conversion Table
To convert form Troy Ounces Million Ounces Grams Kilograms Tonnes Kilograms
To Grams Tonnes Troy Ounces Troy Ounces Troy Ounces Tolas
Multiply by 31.1035 31.1035 0.0321507 32.1507 32150.70 85.755
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8. INVESTMENT IN GOLD Commodity allocations have become more common among investors as a means by which portfolio diversification can be enhanced. Globally, commodity assets under management more than doubled between 2008 and 2012 to nearly US$380bn. Golds physical attributes and functional characteristics set it apart from the rest of commodities. Gold is less exposed to swings in business cycles, typically exhibits lower volatility, and tends to be significantly more robust at times of financial troubles. In turn, this causes golds correlation to other commodities to be low. For thousands of years, gold has been valued as a global currency, a commodity, an investment and simply an object of beauty. As financial markets developed rapidly during the 1980s and 1990s, gold receded into the background and many investors lost touch with this asset of last resort. Recent years have seen a striking increase in investor interest in gold. While a sustained price rally, underpinned by the fact that demand consistently outstrips supply, is clearly a positive factor in this resurgence, there are many reasons why people and institutions around the world are once again investing in gold. Gold has attracted investors throughout the centuries, protecting their wealth and providing a 'safe haven' in troubled or uncertain times. This appeal remains compelling for modern investors, although there are also a number of other reasons that underpin the widespread renewal of investor interest in gold.
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9. WHY INVEST IN GOLD??? 9.1 Portfolio Diversification The key to diversification is finding investments that are not closely correlated to one another; gold has historically had a negative correlation to stocks and other financial instruments. Recent history bears this out: The 1970s was great for gold, but terrible for stocks The 1980s and 1990s were wonderful for stocks, but horrible for gold As of 2008, this decade has been a good one for gold, and an unfavorable one for stocks Properly diversified investors combine gold with stocks and bonds in a portfolio to reduce the overall volatility and risk. Effective portfolio diversifier: This phrase summarizes the usefulness of gold in terms of Modern Portfolio Theory a strategy which is used by many investment managers today. An investor can reduce portfolio risk simply by holding combinations of instruments which are not perfectly positively correlated. In other words, investors can reduce their exposure to individual asset risk by holding a diversified portfolio of assets. Diversification may allow for the same portfolio expected return with reduced risk. Using this approach, gold can be used as a portfolio diversifier to improve investment performance. Effective diversification during stress periods: Traditional methods of portfolio diversification often fail when they are most needed, that is during financial stress (instability). On these occasions, the correlations and volatilities of return for most asset class (including traditional diversifiers, such as bonds and alternative assets) increase, thus reducing the intended cushioning of a diversified portfolio. Gold is a foundation asset within any long term savings or investment portfolio. For centuries, particularly during times of financial stress and the resulting 'flight to quality', investors have sought to protect their capital in assets that offer safer stores of value. A potent wealth preserver, golds stability remains as compelling as ever for todays investor.
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As one of the few financial assets that do not rely on an issuer's promise to pay, gold offers refuge from widespread default risk. It offers investors insurance against extreme movements in the value of other asset classes. A number of compelling reasons underpin the widespread renewal of interest in gold as an asset class: Asset allocation is a vital aspect of any investment strategy. Balancing asset classes of different correlations can significantly enhance returns whilst reducing risk. Many investors believe their portfolios are sufficiently diversified. However, the majority of investment strategies focus primarily on only a few asset classes stocks, bonds and cash. Such portfolios may be vulnerable when these asset classes react to market conditions in a similar fashion. To counter this effect, many investors now seek more effective diversification by incorporating alternative investments, such as commodities, into their portfolio. Gold has shown very strong returns over recent years. Still, its most valuable contribution to a portfolio lies in the fact that it is not correlated with most other assets (as shown in the chart below). This independence comes from the fact that golds price is not driven by the same factors that drive the performance of other asset classes.
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3-year correlations of weekly returns in INR

-0.03 0.10 0.07 0.08 0.06 0.02 -0.02 0.15 0.09 0.01 0.31 0.25 -0.05 0.00 0.05 0.10 0.15 0.20 0.25 0.30 0.35 MSCI US MSCI EM BSE SENSEX 30 spot Bombay SE 200 spot MSCI India BarCap Global Agg JPM EMBI Global JPM GBI EM JPM GBI India INR 3-month deposit DJ UBS Comdty Index Brent crude oil (INR/bbl)
(Source: Barclays Capital, Bloomberg, World Gold Council; calculations based on total return indices in INR unless not applicable.)
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-0.13 0.06 -0.05 -0.07 -0.05 0.21 -0.01 0.11 0.08 -0.14 0.38 0.35 -0.20 -0.10 0.00 0.10 0.20 0.30 0.40 0.50 MSCI US MSCI EM BSE SENSEX 30 spot Bombay SE 200 spot MSCI India BarCap Global Agg JPM EMBI Global JPM GBI EM JPM GBI India INR 3-month deposit DJ UBS Comdty Index Brent crude oil (INR/bbl)
(Source: Barclays Capital, Bloomberg, World Gold Council; calculations based on total return indices in INR unless not applicable.)
Achieving True Diversification Even when compared to other commodities, gold tends to offer further diversification to an investors portfolio. This is primarily due to the particular composition and dynamics of gold demand and supply. The composition of gold demand is in itself varied: it is a luxury consumption-good; a prevalent yet hidden element in modern technology; a financial asset that offers capital preservation and risk protection; and it is used as a monetary asset throughout the world. Therefore, it is less exposed to swings in business cycles and, significantly, it tends to preserve capital at times of financial duress. In turn, this causes golds correlation to be low within the larger commodity complex Negative Correlation when needed the most In a recent study titled Gold: hedging against tail risk conducted by the World Gold Council found that gold not only tends to have a low correlation to many other assets, including commodities, but that this correlation changes during periods of economic turmoil in a way that benefits investors. Gold tends to protect against so-called tail risks, or events that are not very likely and may not be frequent, but when they do occur they have a significant negative
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impact on an investors capital or wealth. This is a by-product of golds performance during times of systemic risk when market participants seek high quality, real assets to preserve capital and minimize losses. As shown in the chart below, when equity prices fall by more than two standard deviations, the correlation between gold and equities tends to turn negative, while the correlation of most other commodities to equities rises significantly. However, when the economy recovers and equity prices rise sharply, their correlation to gold tends to be slightly positive. The rationale behind this behaviour is that, in a strong economy, equity prices tend to rise, but consumers also opt to increase their spending, which may include jewellery or technological devices and this, in turn, supports golds performance. Weekly-return correlation between equities, gold and commoditieswhen equities move by more than 2
S & P 500 return up by more than 2
S & P 500 return down by more than 2
-0.5
-0.3
-0.1
0.1
0.3
0.5 Correlation
Coorelation between S&P 500 and Gold (US$/oz) Coorelation between S&P 500 and S&P GSCI
(Source: Bloomberg, World Gold Council)
9.2 Inflation Hedge Market cycles may come and go, but - over the long term - gold keeps its purchasing power. Its value, in terms of the real goods and services that it can buy, has remained remarkably stable. In contrast, the purchasing power of many currencies has generally declined due to the impact of rising prices for goods and services. As a result, gold is often bought to counter the effects of inflation and currency fluctuations. Much has been said over the past few years with the respect to inflation and gold as the thought is that gold is a good hedge against inflation.
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This is partially due to the thought that the price of gold stays relatively constant and the valuation of currencies merely fluctuate around it. As a result, many people, funds, and countries, are looking towards gold as a hedge against inflation. Inflation & Gold: The Gold Standard Prior to 1971, the United States was on the gold standard, the value of the US Dollar was pegged to the value of gold. Valuations of currency are a direct result of the supply of currency which was adjusted based on the price of gold so were the interest rates During the time of the gold standard, periods of economic contraction and rising unemployment were not met with a reduction of rates and an increase in money supply in effort to spur investment. Instead, as the price of gold fell, the value of the dollar also decreased because of the peg. However, the money supply stayed inflated on the way down. This caused an increase in interest rates to reduce money supply during periods of deflation which raised the cost of capital and the cost of investment due to the physical quantity of dollars in circulation needing to contract in order to keep the value of the dollar pegged to gold. Such increases in rates lead the supply of money in the economy to contract when we needed it to expand the most. Gold was considered to be a hedge against inflation due to the appreciation in price relative to actual inflation during the 1970s, where the prices of the gold actually rose. This is mainly because the relationship between the inflation and gold is mathematically inverse. Gold is priced in US Dollars. This means that as the demand for gold increases, the demand for dollars also increases. Not only domestically but also abroad.
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110 100 90 80 70 60 50 40 30 20 10 0
2010-2013
1-Jan-03
1-Jan-04
1-Jan-05
1-Jan-06
1-Jan-07
1-Jan-08
1-Jan-09
1-Jan-10
1-Jan-11
Gold Futures
Core CPI
US Dollar Index
(Source: Bloomberg)
The value of gold, in terms of the real goods and services that it can buy, has remained largely stable for many years. In 1900, the gold price was $20.67/Oz, which equates to about $1700/Oz in today's prices. In the five years to end-June 2012, the price of gold averaged around $1126/Oz.
Nominal Gold v/s Real Gold(Inflation Adjusted)

$ / o z
2000 1800 1600 1400 1200 1000 800 600 400 200 0 370 360 350
$ 340 / 330 o 320 z

310 300
11/1/2004
10/1/2007
12/1/2008
11/1/2011
7/1/2002
2/1/2003
9/1/2003
4/1/2004
6/1/2005
1/1/2006
8/1/2006
3/1/2007
5/1/2008
7/1/2009
2/1/2010
9/1/2010
4/1/2011
Nominal Gold
Real Gold(Inflation Adjusted)

(Source: Bloomberg)
6/1/2012
1-Jan-12
1-Jul-02
1-Jul-03
1-Jul-04
1-Jul-05
1-Jul-06
1-Jul-07
1-Jul-08
1-Jul-09
1-Jul-10
1-Jul-11
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Currencies in terms of Gold

160 140 120 100 80 60 40 20 0
1-Jan-03
1-Jan-04
1-Jan-05
1-Jan-06
1-Jan-07
1-Jan-08
1-Jan-09
1-Jan-10
1-Jan-11
Gold
Euro
Pound
CHF
US $ Index
(Source: Bloomberg)
So the real price of gold has endured a century characterized by sweeping change and repeated geopolitical shocks and more than retained its purchasing power. In contrast, the real value of most currencies has generally declined. 9.3 Dollar Hedge At first, investors looked for currencies which they could regard as safe havens. But even the most apparently safe of currencies is subject to economic and political risk and to unpredictable political manipulation. Accordingly, therefore, there was revived and increased interest in ways to hedge these risks. Among these ways was investment in gold. It has long been thought that gold was a good protection against depreciation in a currencys value, both internally (i.e. against inflation) and externally (against other currencies). In the latter case it is normally considered, in particular, to be a hedge against fluctuations in the US dollar, the worlds main trading currency. The price of gold is inversely related to the US dollar. It can be explained with the help of setting up an example: Lets assume that in the world there are only three currencies. We will assume the first currency is the US dollar and the second currency is gold. Gold is treated as currency because a lot of people who demanded gold in global markets are people who are looking for a store of value for their money and because people who are investing in gold or buying gold are
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often comparing it to other currencies. For the third currency we will group together all the other currencies in the world and treat it as one currency. For example we will group together the Euro, the Japanese Yen, the Thai Baht, the Indian Rupee and so on and just treat it as one currency which we are going to call the Rest Of the World.
GOLD
1 g = 1000 USD 1 USD = 2 ROW 1 g = 2000 ROW
1g = 1000 USD
1g = 2000 ROW
USD 1 USD = 2 ROW
ROW
We are going to assume that the exchange rate between US dollars and gold is such that you can exchange 1 unit of gold for 1,000 US dollars. Typically in the gold market one unit of gold is equal to one ounce so what we are saying is that 1 unit of gold or 1 ounce of gold is equal to 1000 US dollars. That is the exchange rate between US dollars and gold. We are also going to assume that the exchange rate between US dollars and Rest of the World (ROW) currencies is such that 1 US dollar is equal to 2 ROW currency. This is really just the same as saying that 1 US dollar is worth twice as much as the average rest of the world currency. Exchange rates are interlinked If the exchange rate between Gold/US dollars and US dollars/ROW currency is defined, effectively the exchange rate is between Gold and ROW currencies are defined. 1 unit of Gold is equal to 2000 ROW currency.
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Gold Prices are usually denominated in US Dollars When we go out into the market and buy gold the price of gold is typically denominated in US dollars. What that means is that when we buy gold we are buying exposure to this number [1G = 1000 USD] meaning the profitability of our investment of buying gold or trade of selling gold will be dependent upon this exchange rate between Gold and US dollars. To be more explicit when we buy gold if the exchange rate between Gold and US dollars is 1 unit of gold is equal 1,000 US dollars and if after we buy gold this exchange rate changes to 1 unit of gold is equal to 500 US dollars we will have incurred a lost on our investment. On the other hand if the exchange rate changes such that 1 unit of gold is equal to 2,000 US dollars we will see a profit. So its really keen to know that when we go out into the gold market and buy gold we are buying exposure to this exchange rate [between Gold and US Dollars].
1 g = 500 USD (LOSS) 1 g = 1000 USD 1 g = 2000 USD (PROFIT)
1 g = 1000 USD 1 USD = 2 ROW 1 g = 2000 ROW GOLD
(constant) 1g = 1000 USD 1g = 2000 USD 1 g = 500 USD 1g = 2000 ROW
USD 1 USD = 2 ROW 1 USD = 1 ROW 1 USD = 4 ROW
ROW
Gold prices are linked to the value of US Dollars The exchange rate between US dollars and gold is dependent upon the other two exchange rates so if we assume for a second that the exchange rate between Gold and ROW currency is constant that implies that a change in the exchange rate between US dollars and ROW currency will cause a change between US dollars and gold. So lets assume that the exchange rate between US dollars and ROW now changes such that 1 US dollar = 1 ROW currency. In
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other words, the value of the US dollar has gone down relative to the rest of the world. We can see that the new exchange rate between US Dollars and Gold is such that that 1 unit of goal is equal to 2,000 US dollars. In other words because the US dollar has become weaker or is worth less relative to rest of the world currencies that means that the price of gold in US dollars has gone up. The opposite is also true. Let us assume that instead 1 US Dollar = 2 ROW currency that 1 US Dollar = 4 ROW currency. This means the value of the US dollar has gone up by a factor of 2 and would imply that the price of gold would be equal to 500 US dollars. So the big picture here is that because gold is denominated in US dollars you are getting exposure to the exchange rate between US Dollars and ROW currency. Historical relationships Now based upon this you might expect historically to see a relationship between Gold prices in US dollars and the exchange rate between US dollars and ROW currency. This is what that chart looks like:
Gold in $ & US $ Index

2000 1800 1600 1400 100 $ 80 60 40 20 0 I n d e x 140 120
$ 1200 / 1000 o 800 z

600 400 200 0
4-Jan-2000
4-Jan-2001
4-Jan-2002
4-Jan-2003
4-Jan-2004
4-Jan-2005
4-Jan-2006
4-Jan-2007
4-Jan-2008
4-Jan-2009
4-Jan-2010
4-Jan-2011
Gold Prices
Dollar Index
(Source: Bloomberg)
4-Jan-2012
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The graph covers the period from 2000 to 2012. The blue line shows the price of gold in US dollars which weve been referring to as the exchange rate between US dollars and gold. The red line shows the value of the US dollar relative to a basket of currencies from the ROW and so when the red line is going up it means that the value of the dollar is strengthening relative to other currencies and if the pink line is going down it means that the dollar is weakening relative to other currencies. From the above chart we can infer these two lines tend to the inverses of one another. (U.S. Dollar Index is calculated by factoring in the exchange rates of six major world currencies: the euro, Japanese yen, Canadian dollar, British pound, Swedish krona and Swiss franc.)
Conclusion The profitability of the investment in gold is simply determined by changes in exchange rate between the US dollar and ROW currencies. In other words when we buy gold we are getting inverse US Dollar exposure. 9.4 Risk management Financial asset classes and instruments usually carry three main types of risk. Credit risk: the risk that a debtor will not pay Liquidity risk: the risk that the asset cannot be sold as a buyer cannot be found Market risk: the risk that the price will fall due to a change in market conditions Credit risk Gold is unique in that it does not carry a credit risk. Gold is no one's liability. When you invest in gold, theres no risk that a coupon or a redemption payment will not be made, as for a bond. Theres no chance that a company will go out of business, as with equity. Unlike a currency, the economic policies of the issuing country cannot affect the value of gold, nor can inflation in that country undermine it.
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Liquidity risk Gold benefits from demand among a wide range of buyers - from the jewellery sector to financial institutions, to the technology sector and manufacturers of industrial products and medicines. A wide range of investment channels is available, including coins and bars, jewellery, futures and options, exchange-traded funds, certificates and structured products. Worldwide markets trade gold 24 hours a day. The gold market is deep and liquid, as demonstrated by the fact that gold can trade at narrower spreads and more rapidly than most diversifiers or even mainstream investments. Market risk Gold, like all financial assets, is subject to market risk. However, it tends to have low correlations to most assets usually held by institutional and individual investors, which significantly enhances gold's attractiveness as a portfolio diversifier. Volatility is a good indicator of market risk, measuring the dispersion of returns for a given security or market index. The more volatile an asset, usually the riskier it is. The gold price is typically less volatile than other commodity prices. This is because of the depth and liquidity of the gold market, which is supported by the availability of large above-ground stocks of gold. Gold is virtually indestructible, which means nearly all the gold ever mined still exists today. Much of it is in near market form, meaning sudden excess demand for gold can usually be satisfied with relative ease. Adding to price stability, gold is mined all over the world. Unlike many other commodities, this geographical diversity reduces the chance of supply shocks from any specific country or region impacting heavily on golds price. Consequently, gold is generally less volatile than heavily traded blue-chip stock market indices such as the FTSE 100 or the S&P 500.
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Gold and S&P 500 Annualized Volatility
9.5 Demand & Supply The demand and supply dynamics of the gold market underpin the precious metals extensive appeal and functionality, including its characteristics as an investment vehicle.
Demand Flows, 5-year average 2007(Q1) to 2011(Q4)

Investments* (1236 t) 32.7% Technology (455 t) 12% Jewellery (2104 t) 55.3%
(Source: Bloomberg GFMS, World Gold Council) *Investment excludes OTC investment and other stock flows, and central banks
Demand for gold is widely dispersed around the world. East Asia, the Indian sub-continent and the Middle East accounted for approximately 65% of consumer demand in 2011. India, Greater China (China, Hong Kong and Taiwan), US and Turkey represented well over half of consumer demand. A different set of socio-economic and cultural incentives drives each market, creating a diverse range of factors influencing demand. Rapid demographic and other
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socio-economic changes in many of the key consuming nations are also likely to produce new patterns of demand in the foreseeable future. Jewellery demand Jewellery consistently accounts for the majority of gold demand. In the 12 months to December 2011, appetite for jewellery amounted to around US$99.2 billion. India is the largest consumer in volume terms, accounting for 29% of demand in 2011. Indian gold demand is supported by cultural and religious traditions which are not directly linked to global economic trends. A steadily rising price reinforces the inherent value of gold jewellery, an intrinsic part of its desirability. Several countries, including China and India, offer clear and considerable potential for future growth. Investment demand Since 2003, investment has represented the strongest source of growth in demand. The last five years to the end of 2011 saw an increase in value terms of around 534%. In 2011 alone, investment attracted net inflows of approximately US$82.9bn. Numerous factors motivate both institutional and private investors to seek gold investments. Of the key drivers behind investor demand, one common thread emerges: all are rooted in gold's abilities to insure against instability and protect against risk. The positive price outlook is underpinned by expectations that growth in demand will continue to outstrip that of supply. In turn, positive price expectations themselves have become a driver of further investment demand in gold. Gold investment can take many forms and investors often choose to invest through a number of different channels for greater flexibility. The growth in investment demand has sparked numerous innovations in gold investment, ranging from online bullion sales to gold ETFs. There are now a wide variety of investment products to suit both the private and institutional investor.
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Technological demand The use of gold in various electronic, industrial, medical and dental applications (together classed as Technology) accounts for around 12% of gold demand, an annual average of over 450 tonnes from 2007-2011.
Supply Flows, 5-year average 2007(Q1) to 2011(Q4)
Mine Production* (2,377 t) 61.4% Net Official Sector Sales (47 t) 1.5% Recycled Gold 37.1%
(Source: Bloomberg GFMS, World Gold Council) *Net of producer hedging
Mine production Gold is produced from mines on every continent except Antarctica, where mining is prohibited. There are several hundred gold mines operating worldwide ranging in scale from minor to enormous. This figure does not include mining at the very small-scale, artisanal and often unofficial level. Today, the overall level of global mine production is relatively stable. Supply from mine production has averaged approximately 2,602.2 tonnes per year over the last five years. The stability of production comes from the fact that when new mines are developed, theyre mostly serving to replace current production, rather than expanding global production levels. Even a sustained price rally, as experienced by gold over the last 11 years, doesnt translate easily into increased production.
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Recycled gold While gold mine production is relatively inelastic, the recycling of gold ensures there is a potential source of readily available supply when needed. This helps to cater for an increase in demand and keep the gold price stable. The high value of gold makes recovery economically viable, as long as the precious metal is in a form that is capable of being extracted, melted down, re-refined and reused. Between 2007-2011, recycled gold contributed an average 37% to annual supply flows. Central Banks Central banks and multinational organisations (such as the International Monetary Fund) currently hold just under one-fifth of global above-ground stocks of gold as reserve assets (amounting to around 29,000 tonnes, dispersed across circa 110 organisations). On average, governments hold around 15% of their official reserves as gold, although the proportion varies country-by-country. The advanced economies of Western Europe and North America typically hold over 40% of their total external reserves in gold, largely as a legacy of the gold standard. Developing countries, by contrast, have no such historical legacy and therefore have much smaller gold reserves, typically holding around 5% or less of their total external reserves in gold. First, the economies of a number of emerging markets have been growing very rapidly and increasingly these countries are being identified as buyers of significant quantities of gold for their reserves. The primary reason for this has been a desire to move towards restoring a prior balance between foreign currencies and gold that has been eroded by the rapid increase in their holdings of foreign currencies. For this group, gold has also become an increasingly attractive means of diversifying their external reserves. Additionally, central banks across Europe have reduced their appetite for sales in the wake of the global financial crisis and ongoing difficulties in the euro zone.
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10. CONCLUSION While gold does fit within the definition of a commodity an economic good, which is valued and useful and has little or no difference in composition or quality regardless of the place of production its market dynamics and the sheer diversity of its application make it distinct from other commodities. Gold has a unique performance profile in terms of returns, volatility and correlation, and these characteristics combine to produce in gold a very different reaction to economic and financial variables relative to other commodities in periods of expansion and recession alike. Gold is used as inflation hedges or to protect against currency devaluation, and in general provide some degree of diversification to an investors portfolio. However, gold can be regarded as different precisely because it performs all such functions. An outright position in gold reduces risk without diminishing long-term expected returns. These characteristics significantly improve and protect the performance of an investment portfolio. This research supports the premise that gold should not be viewed only as part of a broader commodity allocation, but as a separate and integral part of a well-diversified investment portfolio.
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11. REVIEWS ON COMMODITY BY RESEARCH ANALYSTS & COMMODITY TRADERS 11.1 Gold and silver prices have surged in the last 3-4 weeks due to monetary easing measures from EU, USA and Japan policy makers. However, in the last week gold and silver prices slightly declined as the recent developments in Greece, Spain and Italy that included riots against austerity measures may have pulled down not only bullion rates but also the Euro. On the other hand the uncertainty around Europe could curb the bullion rates rally: If the ECB will lower its rate again this could pull down the Euro. The progress in Europe including the budget issues in Spain and Greece are likely to keep the volatility high of the Euro. The correlation between the Euro/USD and precious metals remains mid-strong and positive: during September the correlation between Euro/USD and gold reached 0.60. This means if the Euro and other risk will continue their downward trend, this could further impede gold and silver from rising during the following week. Additionally, strength in Indian rupee v/s the US Dollar also exerted down side pressure on the precious metals. Nowadays, Central banks have gotten out of the central banking business and into the central planning business, meaning that they are devoted to raising up if they can- economic growth and employment through the dubious means of suppressing interest rates and printing money. Gold is money that governments dont print. Its a way to hold value when there is nothing to invest in because it stores value the way money is supposed to. The obsession with gold, actually and politically occurs among those who regard economics as a branch of morality. Gold is solid, gold is durable, gold is rare, gold is even (in certain very peculiar circumstances) convertible. To believe in thrift, solidity and soundness is to believe in some way in the properties of gold. Gold support is at $1761 and $1741. Resistance is $1792 and $1826. Breakout above $1800 would confirm, indicating rising inflation expectations in response to QE3. Silver support is at $33.57 and $33. Resistance is at $34.60 and $35.20. On domestic front, silver is looking listless, as absence of any trigger from the overseas markets has led to a sideways trading range. By Sunit Rathod, Research Analyst, HDIL Securities
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11.2 Since the beginning of mankind gold has been one of the most valuable and standardized precious commodity in the world, kings used it as their currency in form of gold coins, gold has been precious to mankind. In modern times also all the countries used to value their currency against gold which made gold a very important commodity, until recently in the last 50 years with the USA, all the countries stopped valuing their currencies against gold. But gold has not lost its importance. Till today almost all countries buy gold to top up their gold reserves. Thus from olden times kings and to modern day governments all have been known to make investments in gold. Even the ordinary individual since olden times have been making investments in gold especially in countries like India gold is the most favorite mode of investment. Over the period of time in the long run gold has never given negative returns. Gold is the most standardized precious commodity and the most liquid commodity. Investments in gold can be liquidated instantly and anywhere in the world Gold is one of the best hedge commodity, and there is a very strong correlation between the performance of gold vis-a-vis other asset classes like the equity markets and the real estate markets Up till 2008 before the stock markets crash gold had under-performed almost for a decade, this was due to the other asset classes giving better returns but with the crash of 2008 and the crash of the equity and real estate markets and practically the USA and European economies in disastrous state, gold emerged as the best hedge commodities against the failures of other asset classes. The returns in gold have far exceed the returns in equity and real estate markets. Until the world economies dont revive and the other asset classes dont start giving positive returns gold will continue to remain bullish. But once the other asset classes start giving good returns investments will flow into these asset classes from gold. Then we may see gold stagnating or declining. But in the cyclical nature of economy and business gold has and will always remain as a good investment and a good hedge against inflation in the long run. By Sameer Hathiwala, Proprietor, Zen Securities
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11.3 Investing directly in commodities, such as gold or silver, tends to be more difficult for investors than investing in stocks and bonds. A major reason for this is that stocks and bonds are readily transferable and easily accessible to the average investor. Traditionally, commodities have been more difficult to invest in due to the complex way in which they trade through the futures and options markets. In other words, an investor can't just buy a gold bar. Gold is more accessible to the average person because an investor can easily purchase gold bullion, from a dealer or, in some cases, from a bank. However, with the advent of more advanced financial instruments, gold, along with other commodities, has become much easier to invest in without having to buy the physical metal. There are now exchange traded funds (ETF), which replicate the movements of the underlying commodity, giving investors direct exposure. Given the Indian mentality about buying the yellow metal directly in the form of ornaments for various occasions, the demand for the same never really has a downside. Indians are known to spend whole-heartedly on marriages. Thus, there would be 2 kinds of people investing in gold and silver, the ones who want returns out of their investment, typically the ones investing in ETFs and the other category who buy the metal itself for various occasions, thus keeping the demand balanced at all times. As regards the views about the future of gold and silver is concerned, the surge in gold prices in rupee term is an outcome of the rupee's depreciation than any increase in demand for the yellow metal. Also looking at the reforms the government is bringing, the rupee is bound to appreciate against the dollar, thus making the metal prices fall, which will be later balanced again by the surge in demand. By Gaurav Banga, Chartered Accountant, HDFC Bank
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11.4 Commodity allocation has become a common phenomenon among investors and fund managers. Studies conducted by World Gold Council shows that if an investor adds 2% to 10% of gold to his portfolio, he tends to increase the risk adjusted return. Gold has been a hedge against inflation and has been a safest form of investment especially in a crisis situation. Having a low correlation with various other asset classes including commodities and tends to benefit investors during periods of economic turmoil. With growing uncertainties in the European countries and risk of sovereign default, gold makes an excellent investment opportunity to add to ones portfolio. An optimum portfolio would be 50% in equities, 40% in fixed income and 10% in gold. By Rohan DSouza, Senior Commodity Trader, Ariston Securities
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12. BIBLIOGRAPHY http://www.google.co.in http://economictimes.indiatimes.com http://en.wikipedia.org www.gold.org www.mcxindia.com http://www.cmegroup.com/ Bloomberg Professional Service Data Terminal Reuters Data Terminal www.nseindia.com www.ftkmc.com
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METS INSTITUTE OF MANAGEMENT PART-TIME MASTERS DEGREE IN MANAGEMENT MFM THIRD YEAR SEMESTER FIRST [2012-2013] CERTIFICATE FROM

Functioning of Commodity Markets

Commodity Market as an Investment Vehicle

Commodity Markets Emergence, Functioning & As An Investment Vehicle

Commodity Markets Emergence, Functioning & As An Investment Vehicle

Commodity Markets Emergence, Functioning & As An Investment Vehicle

MINISTRY OF CONSUMER AFFAIR, FOOD & PUBLIC DISTRIBUTION

FORWARD MARKET COMISSION

INDIAN COMMODITY EXCHANGE

20 OTHER REGIONAL EXCHNAGES

Commodity Markets Emergence, Functioning & As An Investment Vehicle

Commodity Markets Emergence, Functioning & As An Investment Vehicle

Commodity Markets Emergence, Functioning & As An Investment Vehicle

Commodity Markets Emergence, Functioning & As An Investment Vehicle

Commodity Markets Emergence, Functioning & As An Investment Vehicle

Commodity Markets Emergence, Functioning & As An Investment Vehicle

Commodity Markets Emergence, Functioning & As An Investment Vehicle

Commodity Markets Emergence, Functioning & As An Investment Vehicle

Commodity Markets Emergence, Functioning & As An Investment Vehicle

Commodity Markets Emergence, Functioning & As An Investment Vehicle

Commodity Markets Emergence, Functioning & As An Investment Vehicle

Commodity Markets Emergence, Functioning & As An Investment Vehicle

Commodity Markets Emergence, Functioning & As An Investment Vehicle

Commodity Markets Emergence, Functioning & As An Investment Vehicle

Commodity Markets Emergence, Functioning & As An Investment Vehicle

Commodity Markets Emergence, Functioning & As An Investment Vehicle

Commodity Markets Emergence, Functioning & As An Investment Vehicle

Mechanics of Hedging as explained in Illustration 2

Export Contract to sell Automobiles in October Buy Steel Futures Contracts

Commodity Markets Emergence, Functioning & As An Investment Vehicle

Sell Guar seed November Futures

Commodity Markets Emergence, Functioning & As An Investment Vehicle

Commodity Markets Emergence, Functioning & As An Investment Vehicle

Commodity Markets Emergence, Functioning & As An Investment Vehicle

Commodity Markets Emergence, Functioning & As An Investment Vehicle

Commodity Markets Emergence, Functioning & As An Investment Vehicle

Commodity Markets Emergence, Functioning & As An Investment Vehicle

Commodity Markets Emergence, Functioning & As An Investment Vehicle

Commodity Markets Emergence, Functioning & As An Investment Vehicle

Intrinsic value for a PUT OPTION is calculated as

Commodity Markets Emergence, Functioning & As An Investment Vehicle

Commodity Markets Emergence, Functioning & As An Investment Vehicle

Commodity Markets Emergence, Functioning & As An Investment Vehicle

Commodity Markets Emergence, Functioning & As An Investment Vehicle

Commodity Markets Emergence, Functioning & As An Investment Vehicle

Total Investment Demands

1500 T o 1000 n n e 500 s 0 2010 -500 2011 2012(Q1) 2012(Q2)

ETF's & Similar Products

7.3 Historical Investment Data for Gold

Commodity Markets Emergence, Functioning & As An Investment Vehicle

Total Bar & Coin Investment

ETF's & Similar Products

7.4 Top Gold Holders in the World

*IMF balance sheets do not allow this percentage to be calculated

Commodity Markets Emergence, Functioning & As An Investment Vehicle

7.6 Weight Conversion Table

To Grams Tonnes Troy Ounces Troy Ounces Troy Ounces Tolas

Multiply by 31.1035 31.1035 0.0321507 32.1507 32150.70 85.755

Commodity Markets Emergence, Functioning & As An Investment Vehicle

Commodity Markets Emergence, Functioning & As An Investment Vehicle

Commodity Markets Emergence, Functioning & As An Investment Vehicle

Commodity Markets Emergence, Functioning & As An Investment Vehicle

3-year correlations of weekly returns in INR