Metals-Snap Shots!!

Silver is a lustrous silvery metal extremely malleable and ductile: symbol Ag (Lat. argentum). Known since prehistoric times, silver occurs native in Peru, but the chief ores are sulpides, from which the metal is extracted by smelting with lead. It is the best metallic conductor of both heat and electricity, and its most important compounds are the chloride and bromide which darken on exposure to light, the basis of photographic emulsions. Silver is used for tableware, Jewellery, coinage, electrical contacts and electro-plating, and as a solder it makes good metallic joints at 720ºC. The world’s greatest producer of silver is Mexico (c. 40,000,000 troy oz. p.a.) followed by the U.S.A., Canada, Peru, the Russia, Australia and Japan.

Aluminium is the most abundant metal, valuable for its light weight, having at. no. 13, at. wt. 26·98, and chemical symbol Al. Nearly one-twelfth of the substance of the earth’s crust is composed of aluminium compounds, but aluminium in its pure state was not readily obtained until the middle of the 19 th century, for it oxidizes rapidly, and much energy is needed to separate the metal from chemical combination. Pure aluminium is a soft white metal. It is one of the lightest of metals, its specific gravity being 2·70, and for this reason is widely used in shipbuilding and aircraft. In the pure state it is a weak metal, but when alloyed with other elements such as cooper, silicon, or magnesium, alloys of great strength are obtained. Commercially, aluminium is obtained from bauxite (q.v) and requires large supplies of electric power, as at Kitimat in Western Canada. Aluminium is much used in steel-cored aluminium overhead cables and for canning uranium slugs for reactors. Aluminium is an essential constituent in the Alcomax series of magnetic materials; and as a good conductor of electricity is used in the form of foil in electrical capacitors. In the U.S.A. the original name suggested by Sir Humphry Davy Aluminum (aloo-) is retained.

Cooper is a chemical element, one of the earliest metals used by man. Chemical symbol Cu; at. no. 29; at. wt. 63·54. It is salmon pink, very malleable and ductile, and used principally on account of its toughness, softness, and pliability, high thermal and electrical conductivity, and resistance to corrosion. When alloyed with tin it forms bronze, a relatively hard metal, the discovery of which opened a new age in human pre-history. Until about a century ago, Spain and Cornwall were the chief producers, but these are now of minor importance compared with the U.S.A. (which produces about a quarter of the world’s output). Chile, Canada, Zambia, and the Katanga area of the Congo. Cooper is usually commercially extracted from cooper pyrites. Large deposits containing cooper sulphide occur in the Lake Superior district in North America, and in Spain. Other ores from which cooper is extracted include malachite, crysocolla, and atacamite.

Gold is a heavy, valuable, yellow metallic element, with symbol Au, atomic number 79, and atomic weight 197·0. Gold has long been valued for its durability, malleability, and ductility, and because it may be easily recognized. It is unaffected by temperature changes and is highly resistant to acids. Its main uses are in coin and jewellery. South Africa produces almost 75 per cent (30,500,000 fine oz. p.a.) of the world’s gold and other major producers are the Russia, Canada, U.S.A., and Australia. For manufacture, gold is alloyed with another strengthening metal, fineness being measured by the parts of pure gold in 24 carat.

Nickel is a lustrous white metal discovered by Cronstedt in 1751, the name being an abbrevation of Swedish kopparnickel (false cooper): symbol Ni, as. wt. 58·71, at. no. 28. It has a high melting point, low electrical and themal conductivity, and can be magnetized. Nickel may be readily forged when hot, and is though, malleable, and ductile when cold. Canada provides the most extensive deposits, which are usually extracted with cooper. Smelting precedes separation, after which the Nickel is purified. It is used in coinage; in chemical and foodstuff industries for its resistance to corrosion; in electronics and for electroplating. The most important use, however, is in alloys with iron, steel, cooper, and chromium, incl. Nickel steel for armourplating and burglar-proof safes, Moneal metal, invar, constantan, nichrome permalloy, perminvar, and other magnetic alloys and stainless steels, cupro-nickel, nickel-silver, and others. Finely divided nickel is used as catalyst in the hydrogenation of vegetable oils.

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Fear not Commodity Investing!!-

For long, the investment universe for Indians consisted of stocks, jewellery, real-estate and bonds. Now, yet another avenue has opened up — commodity futures, thanks to the lifting of the three-decade ban on it.

Though it is four years since the government issued a notification allowing futures trading, commodities attract but lukewarm interest among retail investors.

A large number of brokerage firms are yet to open divisions for the commodities market. Common misgivings among investors are that ``commodities are risky'' and that ``they are difficult to understand'.

Equities versus commodities
Unlike equities, commodities touch every day life. For instance, sugar. Yet, investors keep away from commodities, unable to understand the market. But commodity markets are easier to understand than one imagines.

For one, there are relatively few factors at play, unlike in the case of the equity market where a wide spectrum of factors — earnings, free cash flows, interest rates and risk premiums — drives prices. Also unlike equities, commodities do not carry operational and management risks.

Though to a certain extent, commodity prices are driven by geopolitics and duty structures, they most often reflect the underlying demand-supply situation. A mismatch between them causes price changes.

The risk tag
Investment in any asset class — commodities, stocks, bonds or treasury bills — carries its own risk element. Commodities, in general, are tagged high-risk. This has been validated using statistical tools based on historical data.

Standard deviation is the common tool used to quantify risk, but it reflects volatility more. The risk element is the possibility of the actual varying, on the negative side, from the expected.

Proxies against inflation
Apart from being an asset class, commodities can also be used as instruments to hedge against inflation. In India, a key measure of inflation is the wholesale price index, which comprises both industrial and consumer goods. Though all the goods on the list are not traded in the commodity futures market, investors can use proxies to hedge against inflation. For instance, crude oil can serve as a proxy for diesel and petrol. It may be tempting for investors to invest in commodity stocks rather than in the commodity itself..

For example, the ONGC stock as a hedge against fuel price rise. But investors would need to consider the operational risk that comes with the ONGC stock. A drop in production or drying up of wells would impact the stock adversely limiting its hedging efficacy. But an investment in the commodity itself would not carry this operational risk.

Yet, proponents of the equity market would argue that an investment in a commodity stock is more rewarding than in the commodity itself. The leverage effect that an entity derives would come to the aid of these investors, they say. So how does a firm derive this effect? Take the case of a hypothetical company, Black Tea, which earns an operating profit of Rs 20 crore on a revenue base of Rs 100 crore.

A 10 per cent increase in unit realisation would push its operating profit up to about Rs 30 crore, that is, a 50 per cent growth (assuming the expenditure remains the same). Using the Enterprise Value/earnings befor interest, depreciation, tax and amortisation (EBIDTA) model, a fair value of the Black Tea stock would be 50 per cent higher.

A similar leverage effect is possible in the commodity market as well. For instance, while a barrel of crude oil trades at about Rs 3,900 on the MCX, investors need to pay only the margin, Rs 195 per barrel, to take exposure in a trading lot of 100 barrels.

A 10 per cent rise in crude oil prices would inflate the gains to Rs 390 or about double the investment. Of course, this can work the other way, just as well.

Element of subjectivity
Another argument that stock market proponents might throw is target prices, or the fair value of an asset for an investor. They would argue that arriving at target prices using fundamental analysis is difficult for commodities.

Though the target price — that help establish if an asset is over- or under-valued — approach to investing is thought to be scientific, there is a significant element of subjectivity attached. For, the various valuation models that generate the fair value are based on such subjective elements as growth rates.

Investors need to also understand that target prices do not guarantee returns. Though forecasting the direction of prices does not quantify the possible returns, it is the key to profiting from an investment.

With fewer factors in play in the commodities market, it is easier to forecast the direction of the prices.

Courtsey:The Hindu

Hedging with Steel Futures!! In LME Perspective

Lets start with the following scenario:

• Seller – HRC Steel Mill, with 100,000 tons per month to sell
• Buyer – Pipemaker, with capacity to produce 10,000 tons per month
• LME steel futures contracts are monthly contracts, expiring, say, on the 15th of the month before the month of delivery. What this means, for example, is
o All February delivery futures contracts will expire on the 15th of January.
o Any futures contract, issued at any time in the preceding 12 months, for August
delivery will expire on the 15th of July.

First week January

• The pipemaker is negotiating an order to supply 5,000 of base grade pipe to a pipeline project in Q4. He will require the tonnage in September, hence demands shipment from his supplier in August.
• The mill wants to produce the steel, and over the next few days negotiates with the pipemaker all the details of the specification – various widths & thicknesses, specific coils weights etc. They sign a forwards contract to this effect, committing the mill to deliver the 5,000 tons in August.

January 10th
Now lets look at the LME steel futures pricing table we looked at in our ‘Interpreting Futures Prices’ section, where we suggested, lets say its January 10th, and the LME steel futures screen for base grade HRC on our computer or in the Financial Times states:

Period Cash 3-month 6-month 12-month
Price $300 $310 $280 $255

For the steel mill, it does not know what the price of August delivery HRC will be. It may think it will be more than US$ 280 ton, or maybe it will be less. It’s a gamble, because at the end of the day the mill does not know what the price will be. No-one does. The mill can not determine its cashflows for Q4. It does not know whether it will make a profit or a loss. And an equity provider does not know whether the mill will be able to repay its loan on time, or even at all.

These are the risks associated with volatile pricing. These are the risks that hedging with futures can eliminate. Using LME steel futures, our mill can lock-in the price of US$ 280 ton.

Step 1

To match his price exposure relating to his contract for delivery of 5,000 tons in August, the mill needs to find the price for 50 futures contracts (1 futures contract = 100 tons of base grade HRC) for August delivery. August delivery contracts expire on the 15th of July, so on January 10th the mill goes to his broker and to secure the 6-month futures price of US$ 280 ton

• Note, for August delivery the mill would be quoted the 6 month price on all days from 16th December to 15th of January. If the mill went to his broker on 17th January for an August delivery contract, he would be quoted the 5-month price.

Step 2

The mill instructs his broker to sell 50 futures contracts (‘lots’) of 6-month futures @US$ 280 ton. The mill is now ‘short’ 5,000 tons in the futures market for August delivery

July 15th
This is the day the mills August delivery contract expires. Futures market now looks like this

Period Cash 3-month 6-month 12-month
Price $260 $240 $250 $295

The price the market is willing to pay for August delivery contracts – remember, that’s what the mill sold in January: 50 futures contracts of 100 tons for August delivery – is the cash price, US$ 260 ton. Remember too, that the cash price is the price that steel buyers in the physical market are willing to pay for August delivery also. So neither the mill nor the pipemaker is faced with the awkward situation where the steel can be bought more cheaply elsewhere. On July 15th US$ 260 ton is both the physical market and futures market price for August delivery.

Step 3

The action the producer takes is to buy back an equal number of identical futures contracts ie 50 lots of 100 tons for August delivery at the cash price of US$260 ton. This has two important consequences.

• First, by selling 50 futures contracts for August delivery in January, the mill was committing itself to deliver 5,000 tons of base grade steel via the exchange in August. However, by buying 50 futures contracts for August delivery on July 15th, the mill has cancelled its obligation to deliver steel via the exchange. 50 contracts sold, less 50 contracts bought, equals zero.
• o This is what is known as ‘closing out’. The ‘open’ position – the commitment to deliver 50 lots ie 5,000 tons of steel underlying 50 futures contracts in August – has be ‘closed’ by taking an equal (50 lots) and offsetting (originally sold, now buying back) position, to take delivery of 50 lots ie 5,000 tons of steel underlying 50 futures contracts in August. The two equal and offsetting positions have cancelled each other out. The mill no longer has any obligation to deliver or take delivery steel across the exchange.
  

• Second, the mill has made a US$ 30 ton profit on his futures contracts – the mill sold 50 lots at US$ 290 ton, and has bought back an identical quantity (50 lots) of identical contracts (August delivery steel futures) at US$ 260 ton. That’s a US$ 30 ton profit

August

But what about the physical steel – the API grade coils wanted by the pipemaker?

Remember, back in January the mill and the pipemaker agreed a forwards contract committing the mill to deliver 5,000 tons of HRC in the specific dimensions etc required. Since January the mill has had 6 months to program his rolling schedule, ensuring the coils are produced at the optimal point for maximum production efficiency.

And Remember last month, in July, August delivery coils were trading at US$ 260 ton. So that’s the base price the pipemaker is going to pay for his August delivery coils, no matter where he gets them from. US$ 260 was both the physical market and futures market price for August delivery.

Step 4
So the mill now makes delivery of the 5,000 tons. The price the pipemaker pays is the August delivery cash price – US$ 260 ton.

The Result

The mill has made a gain of US$30 on his futures transaction.

And the mill has produced and delivered the HRC to the pipemaker under their forwards contract. The pipemaker has paid US$ 260 ton.

The mill’s net income therefore is US$ 260 + $30 = $290, the price at which he hedged this 5,000 ton order back in January.

What if Prices had Risen, rather than Fallen ?

What if, between January 10th and July 15th, the Q1 price rise had continued, and prices on July 15th were actually higher, maybe something like this

Period Cash 3-month 6-month 12-month
Price $340 $340 $350 $315

Well, the mill would take exactly the same set of actions

Step 1 – January 15th
Get a quote from his broker for August delivery futures ie US$ 290 ton.

Step 2 – January 15th
Sell 50 lots of August delivery LME steel futures at US$ 290 ton.

Step 3 – July 15th
Buy 50 lots of August delivery LME steel futures at (the ‘cash’ price of) US$ 340 ton.

• Mill incurs a net loss of US$ 50 ton on the futures transaction.

Step 4 – August
The mill makes delivery of 5000 tons of steel as specified in the forwards contract, and gets paid US$ 340 ton.

The Result

US$ 340 ton from the physical sale, less US$ 50 ton loss on the futures transaction, realizes a net income of US$ 290 ton. Again, the level at which the original hedge was taken out, US$ 290 ton, has been achieved.

Thus, it can be seen, that by using futures, the mill has achieve the August delivery futures prices for his transaction. Even though, back on January 10th the price of US$ 290 was just the culmination of peoples opinions, it turns out that that is the price the mill achieved. It is irrelevent whether the actual August delivery price was higher or lower. The mill eliminated the risk of achieving less than US$ 290 ton, and rather achieved its objective of US$ 290 ton.

But wouldn’t it be good for the mill to have eliminated the downside risk, of achieving less than US$ 290 ton, but was able to participate in (at least some of) the favourable upside of pricing at US 340 ton ?

Yes, it would.

Interpreting Futures Prices!!- Steel

There are many myths and misunderstandings about futures prices

• What do they mean ?
• Where they come from ?
• And aren't they just gambling really ?

In the section below we get behind the myths and explain just what makes up futures prices, and what futures prices mean:

If you asked 3 executives from the steel industry, "what will be the FOB Antwerp price of base grade HRC from first class West European mills in 6 months time ?", you might get answers of US$ 300, US$ 330, and US$ 285. The average of their opinions would be US$ 305.

Now, you might ask them for prices based on 100 tons, and prices based on 1000 tons and 10,000 tons. The 3 executives are likely to adjust their estimates accordingly. For example, 100 ton lots might be priced slightly higher than 10,000 tons lots.

Now, if you asked them for prices for 7 months hence, the pricing of the preceding period - the 6-month prices just discussed - will have an influence on the executive's opinion on the 7-month price. The executives will be stating their 7 month opinion on the basis of

their own opinion of the 6-month and 7-month price

the opinions the 2 other executives expressed for the 6-moonth price

the average 6-moonth price of US$ 305

Essentially, what a Futures Exchange does is provide a forum for the expressions of such opinions about 'future' prices of the product underlying the futures contract, over a number of delivery periods in the future. Because every contract has exactly the same volume of exactly the same underlying, to be delivered to exactly the same place, its easy not to get caught up in technicalities of 'superior vs inferior' qualities, or 'expensive and inexpensive' shipment ports. All those elements are standardized in futures contracts. Everyone can purely focus on price.

In a futures market, rather than have an average of just three opinions, you've got many hundreds, even hundreds of thousands, of opinions of price expressed every day for every delivery period in the future.

Furthermore, those opinions of given credence because they are expressed through the buying and selling of futures contracts. These futures contracts actually commit the seller or buyer of such contracts to make or take delivery of the underlying. So we're not talking random, uneducated or even educated guesses of what prices may be. We're talking commitments to buy and sell very significant volumes of steel.

Set within the framework of appropriate regulatory and legal environments, futures markets are highly efficient mechanisms to centralize credible opinions about price to transparently discover future prices at which committed and knowledgeable market participants are prepared to buy and sell steel.

Basics of Hedging-Steel!!

Some pointers:

• Your hedge desk should not make a profit. If your hedge desk does make a profit, then it has been speculating.
• Not to hedge, is to speculate.

The first statement might surprise you. And the second might, at first reading, surprise you even more. But they are both truisms.

Hedging is the process of using derivative instruments - futures, options and swaps - to manage the risks imposed by volatile price movements. Familiarity with the basic building blocks of the process provides the novice with the tools to address even the most complex of derivatives. This is because they are all built from relatively simple concepts. That is not to say that hedging is simple. In concept it is, but in practice hedging can get quite complex. Yet all hedging is developed from quite straight forward building blocks. By thoroughly…..But by thoroughly understanding the building blocks with which all the complex derivatives hedging strategies are developed one can rapidly acquire the know-how to hedge away unwanted price risk

At Steel Derivatives we take the raw novice and progressively develop their hedging skill set. Rather than presenting our client with a hedging strategy, we help you develop your own strategy, tailored to your business model.

And further, Steel Derivatives acts in an advisory capacity to help you develop and install the appropriate controls and reporting mechanisms to ensure your hedge desk is appropriately managed. Because hedging should not make a profit. The purpose of a hedge desk is to provide guaranteed stable incomes on the contracts it is instructed to hedge; incomes that will not vary, produce neither a loss nor a profit, not matter what the volatility in product pricing. If your hedge desk does make a profit, or indeed a loss, then de facto it has been speculating. So, to prevent your hedge desk gambling with your company's profitability, all firms necessarily need a set internal controls.

The way many financial institutions view hedging is that, if derivatives instruments are available to hedge away unwanted price risk, then, not to hedge away those risks, is to speculate that those risks will remain favourable to your business model. If, when hedging instruments are available, one retains exposure to price risk, capital lenders will tend to view you as a speculator, one who gambles on pricing remaining favourable. De facto your firm is a higher credit risk. That will tend to dictate less

Steel Derivatives mission is knowledge communication: communicating our knowledge on derivative instruments - steel futures, options, and swaps - to the steel industry.

What are Steel Futures?

In January 2003 Steel Derivatives was retained on a full time basis to drive and co-ordinate the LME's steel futures program.

The majority of the steel industry uses forward contracts. These are contracts where the price is agreed today for steel to be delivered at some later time ie delivery 'forward' of today. All the terms and conditions of the contract - the material specifications, documentation, payments, delivery terms etc - are all tailored to the particular contract. Money changes hands at the time of delivery.

Futures contracts are established on the same principle. A price is agreed today for something to be delivered in the future. But, whilst a forwards contract can be tailored to the specifics of the deal in question, a futures contract is standardized. Same volume, same specification, same documentation, same payments, same delivery terms. The only things in a futures contracts that are non-standardized are:

• The price
• The delivery period

Otherwise Futures contracts are identical to the forwards contracts that the steel industry uses everyday.

There are two important attributes that standardization brings:

• First, if you standardize contracts, they can be exchange traded. This applies to steel, sugar, oil, foreign exchange, government bonds or shares in a company. Provided the contracts are standardized, they can be exchange traded.
• Second, and closely linked to the principle of exchange trading, is the practice of closing out. Essentially if you sell something in an exchange, then buy the same thing back, you cancel out any obligations incurred when selling. Similarly, if you buy something, then sell the exact same thing back to the market, you cancel out any obligations incurred when buying.

The purpose of Steel Futures is to help manage price risks. They are a tool in your risk management tool box.

Futures Vs Forwards (Steel)

What's the difference between forwards and futures ?

• Forward prices are prices agreed today for delivery in the future. The contract which confirms this transaction, and thereby the forward price, is a forwards contract.
• What much of the steel industry deals in now are forwards. You contract today, and commit to prices today, for steel to be delivered in the future ie a period forward of today.
• So what the steel industry has now are monthly forwards contracts. That it prices (and all technical details) agreed today for delivery within a particular month forward of today. Might be 1 month forward, or 3 months forward, or for international shipments 5 or even 6 months forward.

Futures are exactly the same in that capacity. You contract today, and commit to prices today, for steel to be delivered in the future.

The only material difference is that futures contracts are standardised. Every contract is the same. Same underlying, same delivery points, same size, same payment terms etc.

Whereas steel's existing forwards contracts allow individual firms to tailor the contracts to fit with their exact needs, futures contracts do not allow such flexibilities. Futures contracts are merely standardised forwards contracts.

Forwards vs Futures Prices

The forwards price - the price contracted to in your forward contract - is usually unique to that deal. So on any day you'll get a range of forwards prices for the same steel, as determined by differences in payment terms, or delivery terms, or packing, or additional testing. You'll even have different prices for the exact same volume of the exact same steel for the exact same delivery, same payment terms etc.

Not with futures. Because futures contracts are all standardised, and not subject to the tailoring of steel's traditional forwards contracts, at any moment in time there is only one price for each delivery period.

Lets just think about the price at which the steel industry's regular forwards contracts are concluded. The price in a forwards contract is the equilibrium price between what the steel mill thinks its steel is worth - the asking price - and what the buyer thinks its worth - the bid price. You negotiate to arrive at the contract price.

In a futures market, instead of

• One seller and one buyer concluding one contract at one unique price, there are
• Lots of sellers and lots of buyers concluding lots of contracts.

The futures price is the equilibrium price determined by supply and demand of all those contracts.

Price Credibility

So which price is a better reflection of the market ? Which price is more credible ?

• The unique, tailored forwards contract price negotiated between a single seller and single buyer, maybe with unique product, payment terms, and other tailored attributes. And because there are many such contracts, there has to be some interpretation / value judgement to define a 'forward price', otherwise the forward price can only ever be a range.
  

OR

• The futures market price, which is the equilibrium level of many thousands of buy-sell contracts, all standardised, and for which there can only every be one price at any moment in time ?

That's why prices in futures market are trusted. They are reflections of many thousands of transactions - at any one time the futures price is always the equilibrium price of many buyers and sellers. They are credible prices because informed buyers and sellers - you, the steel industry, and other interested parties - will be trading contracts, with firm commitments to make or take delivery of steel.

Steel futures prices are not guesswork or hunches or bets. They are the direct result of informed buyers and sellers quoting, bidding, and trading contracts, with firm commitments to make or take delivery of steel. At any one time the futures price for a particular month is the equilibrium price of that quote / bid / trade activity. That's why they a credible. That's why they are trusted.

Steel Derivatives - History

The Steel Derivatives concept began life as an off-shoot of 'Stemcor Projects & Contracts' (SPC), a division of the Stemcor Group, the world's largest independent steel trading organization. SPC's mission was to supply competitively-priced steels to the world's oil, gas, and power generation companies for their steel-intensive projects such as pipelines, tank storage farms, power stations, petrochemical plants, and off-shore platforms. These projects demanded fixed price steel supply contracts for periods of 6-24 months. With the involvement of financial institutions and its own in house steel procurement expertise, SPC structured novel deals that provided its clients with fixed priced steel, whilst at the same time provided its steel suppliers with prestigious projects at market competitive returns.

As steel price volatilities increased in the latter 1990s, the value at risk of SPCs traditional structured solutions was threatening the sustainability of its activities. Yet in depth exposure to the oil, gas, and energy business models gave SPCs founder and Managing Director, John Short, a critical insight into oil, gas, and energy derivatives - exchange traded futures, and 'over the counter' (OTC) options and swaps instruments. If steel could develop such instruments - lock-in its cash flows, hedge away the negative impacts of price uncertainty whilst retaining the opportunity to participate in favourable movements in price - then price steel's volatility could be managed.

In 2000 Short left the Stemcor Group to pursue the vision of exchange traded steel futures. An informal consulting company was born with a focus on structured finance and risk management techniques in, and steel procurement for, steel-intensive projects in the oil, gas, and general construction industries. Having refined his structured trade and commodity finance skills at a City investment bank, Short went to Oxford University where he led team of finance MBAs on two distinction-graded theses on Steel Futures. The collective knowledge from the MBA team and Oxford faculty was then forged with that of the original consultancy. In 2002 the consultancy was awarded projects examining various aspects of steel futures, options and swaps in Europe, Middle East, SE Asia and Far East.

The culmination of this work led to Short's paper submitted to the Steel Futures I seminar in London (December 2002) declaring that technical design of steel futures contracts was essentially complete. To a large extent, all that remained was 'buy-in' - the desire of direct and indirect participants of the global steel industry to understand and grasp the opportunity to use steel futures in their day to day business.

In January 2003, after further work in Asia, the consultancy was retained exclusively by the LME for their Steel Futures Project. Along with Laplace Conseil, who provided the LME with an initial study, Steel Derivatives is proud to be associated with the LME, whose expertise in running a futures exchange and hosting metals contracts has provided the platform to bring these steel contracts to market. Steel Derivatives remains closely involved with the LME, driving the process forward and heading various 'steel working parties' charged with refining various contract elements in consultation with industry. Meantime our work on OTC products embraces a much wider community of financial instruments and instrument providers, from basic swaps through to complex option products. Furthermore we continue to offer the advisory services on which the company was founded - structured finance, steel procurement, and risk management in relation to steel intensive projects.

Increase Investor Confidence-FMC

The commodity futures market is preparing itself for the next phase of growth, which will see greater participation of hedgers, corporate entities, exporters, processors and producers, said BC Khatua, chairman, Forward Markets Commission (FMC). In order to ensure this, he said there was need for more stringent and responsive regulation that would increase the confidence of market participants, maintain financial and market integrity, and discourage malpractices.

Mr Khatua was addressing a meeting of the members of the various exchanges belonging to the west zone-MCX, NCDEX and Ahmedabad-based NMCE-in Mumbai on August 31. The FMC has been holding meetings with the members of commodity exchanges on a regular basis to discuss various market related issues and to understand the impact of regulatory measures. In the last financial year, four such meetings were held, one in each of the four zones.

In his address, Mr Khatua underlined the recent regulatory and developmental measures taken by the FMC While outlining the future plans of the FMC, he said that the proposed amendments to the Forward Contracts and Regulation Act, 1952, would strengthen the hands of the FMC. He emphasised that because of the exponential growth and advent of sophisticated technology, the task of regulation had become very
challenging. He also pointed out the need for strengthening the corporate governance structure of the intermediaries to generate market confidence. The exchanges and their members should not only strengthen their capital base but also put in place a comprehensive and transparent governance structure.

During the technical sessions held on the occasion, several issues, such as changes in contract specifications, issues in delivery and penalty for failure in delivery, position limits and linking of the same to capital adequacy, capital adequacy of members, differential margining, discussion forum for developments in trade, etc., were taken up. The FMC and the National Exchanges responded to general issues raised by the participants and agreed to look into specific suggestions.

Friday's meeting was the first meet in a series of four meetings proposed to be convened by the FMC in the current financial year for discussing various trade and market related issues.

Derivatives Hedging::Corporate Uses!!

If you are considering a stock investment and you read that the company uses derivatives to hedge some risk, should you be concerned or reassured? Warren Buffett's stand is famous: he has attacked all derivatives, saying he and his company "view them as time bombs, both for the parties that deal in them and the economic system" (2003 Berkshire Hathaway Annual Report).
On the other hand, the trading volume of derivatives has escalated rapidly, and non-financial companies continue to purchase and trade them in ever-greater numbers. Consider the Chicago Mercantile Exchange, which is the largest exchange for futures contracts in the United States. As of November 2004, the average daily volume of futures contracts reached 3.2 million, up a stunning 40% from the previous year. In the same month, foreign-exchange futures set a new record for single-day volume, reaching more than half-a-million contracts, with a notional value of over $72 billion.

To help you evaluate a company's use of derivatives for hedging risk, we'll look at the three most common ways to use derivatives for hedging.

Foreign-Exchange Risks
One of the more common corporate uses of derivatives is for hedging foreign-currency risk, or foreign-exchange risk, which is the risk that a change in currency exchange rates adversely impacts business results.

Let's consider an example of foreign-currency risk with ACME Corporation, a hypothetical U.S.-based company that sells widgets in Germany. During the year, ACME Corp sells 100 widgets, each priced at 10 euros. Therefore, our constant assumption is that ACME sells 1,000 euros worth of widgets:

When the dollar-per-euro exchange rate increases from $1.33 to $1.50 to $1.75, it takes more dollars to buy one euro, or one euro translates into more dollars, meaning the dollar is depreciating or weakening. As the dollar depreciates, the same number of widgets sold translates into greater sales in dollar terms. This demonstrates how a weakening dollar is not all bad: it can boost export sales of U.S. companies. (Alternatively, ACME could reduce its prices abroad, which, because of the depreciating dollar, would not hurt dollar sales; this is another approach available to a U.S. exporter when the dollar is depreciating.

The above example illustrates the "good news" event that can occur when the dollar depreciates, but a "bad news" event happens if the dollar appreciates and export sales end up being less. In the above example, we made a couple of very important simplifying assumptions that affect whether the dollar depreciation is a good or bad event:

(1) We assumed that ACME Corp manufactures its product in the U.S. and therefore incurs its inventory or production costs in dollars. If instead ACME manufactured its German widgets in Germany, production costs would be incurred in euros. So even if dollar sales increase due to depreciation in the dollar, production costs would go up too! This effect on both sales and costs is called a natural hedge: the economics of the business provide their own hedge mechanism. In such a case, the higher export sales (resulting when the euro is translated into dollars) are likely to be mitigated by higher production costs.

(2) We also assumed that all other things are equal, and often they are not. For example, we ignored any secondary effects of inflation and whether ACME can adjust its prices.

Even after natural hedges and secondary effects, most multinational corporations are exposed to some form of foreign-currency risk.

Now let's illustrate a simple hedge that a company like ACME might use. To minimize the effects of any USD/EUR exchange rates, ACME purchases 800 foreign-exchange futures contracts against the USD/EUR exchange rate. The value of the futures contracts will not, in practice, correspond exactly on a 1:1 basis with a change in the current exchange rate (that is, the futures rate won't change exactly with the spot rate), but we will assume it does anyway. Each futures contract has a value equal to the "gain" above the $1.33 USD/EUR rate. (Only because ACME took this side of the futures position, somebody - the counter-party - will take the opposite position.

In this example, the futures contract is a separate transaction; but it is designed to have an inverse relationship with the currency exchange impact, so it is a decent hedge. Of course, it's not a free lunch: if the dollar were to weaken instead, then the increased export sales are mitigated (partially offset) by losses on the futures contracts.

Hedging Interest-Rate Risk
Companies can hedge interest-rate risk in various ways. Consider a company that expects to sell a division in one year and at that time to receive a cash windfall that it wants to "park" in a good risk-free investment. If the company strongly believes that interest rates will drop between now and then, it could purchase (or 'take a long position on') a Treasury futures contract. The company is effectively locking in the future interest rate.

Here is a different example of a perfect interest-rate hedge used by Johnson Controls, as noted in its 2004 annual report:

Fair Value Hedges - The Company [JCI] had two interest rate swaps outstanding at September 30, 2004 designated as a hedge of the fair value of a portion of fixed-rate bonds…The change in fair value of the swaps exactly offsets the change in fair value of the hedged debt, with no net impact on earnings. (JCI 10K, 11/30/04 Notes to Financial Statements)

Johnson Controls is using an interest rate swap. Before it entered into the swap, it was paying a variable interest rate on some of its bonds. (For example, a common arrangement would be to pay LIBOR plus something and to reset the rate every six months).

Now let's look at the impact of the swap, illustrated below. The swap requires JCI to pay a fixed rate of interest while receiving floating-rate payments. The received floating-rate payments (shown in the upper half of the chart below) are used to pay the pre-existing floating-rate debt.

JCI is then left only with the floating-rate debt, and has therefore managed to convert a variable-rate obligation into a fixed-rate obligation with the addition of a derivative. And again, note the annual report implies JCI has a "perfect hedge": The variable-rate coupons that JCI received exactly compensates for the company's variable-rate obligations.

Commodity or Product Input Hedge
Companies that depend heavily on raw-material inputs or commodities are sensitive, sometimes significantly, to the price change of the inputs. Airlines, for example, consume lots of jet fuel. Historically, most airlines have given a great deal of consideration to hedging against crude-oil price increases - although at the start of 2004 one major airline mistakenly settled (eliminating) all of its crude-oil hedges: a costly decision ahead of the surge in oil prices.

Monsanto (ticker: MON) produces agricultural products, herbicides and biotech-related products. It uses futures contracts to hedge against the price increase of soybean and corn inventory:

Changes in Commodity Prices: Monsanto uses futures contracts to protect itself against commodity price increases… these contracts hedge the committed or future purchases of, and the carrying value of payables to growers for soybean and corn inventories. A 10 percent decrease in the prices would have a negative effect on the fair value of those futures of $10 million for soybeans and $5 million for corn. We also use natural-gas swaps to manage energy input costs. A 10 percent decrease in price of gas would have a negative effect on the fair value of the swaps of $1 million. (Monsanto 10K, 11/04/04 Notes to Financial Statements)

Conclusion
We have reviewed three of the most popular types of corporate hedging with derivatives. There are many other derivative uses, and new types are being invented. For example, companies can hedge their weather risk to compensate them for extra cost of an unexpectedly hot or cold season. The derivatives we have reviewed are not generally speculative for the company. They help to protect the company from unanticipated events: adverse foreign-exchange or interest-rate movements and unexpected increases in input costs. The investor on the other side of the derivative transaction is the speculator. However, in no case are these derivatives free. Even if, for example, the company is surprised with a good-news event like a favorable interest-rate move, the company (because it had to pay for the derivatives) receives less on a net basis than it would have without the hedge.

Commodities Hedging::Corporates

The Hedging Decision
The issue of whether or not to hedge risk continues to baffle many corporations. At the heart of the confusion are misconceptions about risk, concerns about the cost of hedging, and fears about reporting a loss on derivative transactions. A lack of familiarity with hedging tools and strategies compounds this confusion. Corporate risk managers also face the difficult challenge of getting hedging tools (i.e., derivatives) approved by the company's board of directors. The purpose of this article is to clarify both some of the basic misconceptions surrounding the issue of risk as well as the tools and strategies used to manage it.

The Challenge
An effective hedging program does not attempt to eliminate all risk. Rather, it attempts to transform unacceptable risks into an acceptable form. The key challenge for the corporate risk manager is to determine the risks the company is willing to bear and the ones it wishes to transform by hedging. The goal of any hedging program should be to help the corporation achieve the optimal risk profile that balances the benefits of protection against the costs of hedging.

This article will outline seven steps designed to help risk managers determine whether or not their companies stand to benefit from a hedging program.

STEP 1: Identify The Risks
Before management can begin to make any decisions about hedging, it must first identify all of the risks to which the corporation is exposed. These risks will generally fall into two categories: operating risk and financial risk. For most non-financial organizations, operating risk is the risk associated with manufacturing and marketing activities. A computer manufacturer, for example, is exposed to the operating risk that a competitor will introduce a technologically superior product which takes market share away from its leading model. In general, operating risks cannot be hedged because they are not traded.

The second type of risk, financial risk, is the risk a corporation faces due to its exposure to market factors such as interest rates, foreign exchange rates and commodity and stock prices. Financial risks, for the most part, can be hedged due to the existence of large, efficient markets through which these risks can be transferred.

In determining which risks to hedge, the risk manager needs to distinguish between the risks the company is paid to take and the ones it is not. Most companies will find they are rewarded for taking risks associated with their primary business activities such as product development, manufacturing and marketing. For example, a computer manufacturer will be rewarded (i.e., its stock price will appreciate) if it develops a technologically superior product or for implementing a successful marketing strategy.

Most corporations, however, will find they are not rewarded for taking risks which are not central to their basic business (i.e., interest rate, exchange rate, and commodity price risk). The computer manufacturer in the previous example is unlikely to see its stock price appreciate just because it made a successful bet on the dollar/yen exchange rate.

Another critical factor to consider when determining which risks to hedge is the materiality of the potential loss that might occur if the exposure is not hedged. As noted previously, a corporation's optimal risk profile balances the benefits of protection against the costs of hedging. Unless the potential loss is material (i.e., large enough to severely impact the corporation's earnings) the benefits of hedging may not outweigh the costs, and the corporation may be better off not hedging.

STEP 2: Distinguish Between Hedging and Speculating
One reason corporate risk managers are sometimes reluctant to hedge is because they associate the use of hedging tools with speculation. They believe hedging with derivatives introduces additional risk. In reality, the opposite is true. A properly constructed hedge always lowers risk. It is by choosing not to hedge that managers regularly expose their companies to additional risks.

Financial risks - regardless of whether or not they are managed - exist in every business. The manager who opts not to hedge is betting that the markets will either remain static or move in his favor. For example, a U.S. computer manufacturer with French franc receivables that decides to not hedge its exposure to the French franc is speculating that the value of the French franc relative to the U.S. dollar will either remain stable or appreciate. In the process, the manufacturer is leaving itself exposed to the risk that the French franc will depreciate relative to the U.S. dollar and hurt the company's revenues.

A reason some managers choose not to hedge, thereby exposing their companies to additional risk, is that not hedging often goes unnoticed by the company's board of directors. Conversely, hedging strategies designed to reduce risk often receive a great deal of scrutiny. Corporate risk managers who wish to use hedging techniques to improve their company's risk profile must educate their board of directors about the risks the company is naturally exposed to when it does not hedge.

STEP 3: Evaluate the Costs of Hedging in Light of the Costs of not Hedging
The cost of hedging can sometimes make risk managers reluctant to hedge. Admittedly, some hedging strategies do cost money. But consider the alternative. To accurately evaluate the cost of hedging, the risk manager must consider it in light of the implicit cost of not hedging. In most cases, this implicit cost is the potential loss the company stands to suffer if market factors, such as interest rates or exchange rates, move in an adverse direction. In such cases the cost of hedging must be evaluated in the same manner as the cost of an insurance policy, that is, relative to the potential loss.

In other cases, derivative transactions are substitutes for implementing a financing strategy using a traditional method. For example, a corporation may combine a floating-rate bank borrowing with a floating-to-fixed-rate swap as an alternative to issuing fixed-rate debt. Similarly, a manufacturer may combine the spot purchase of a commodity with a floating-to-fixed swap instead of buying the commodity and storing it. In most cases where derivative strategies are used as substitutes for traditional transactions, it is because they are cheaper. Derivatives tend to be cheaper because of the lower transaction costs that exist in highly liquid forward and options markets.

STEP 4: Use the Right Measuring Stick to Evaluate Hedge Performance
Another reason for not hedging often cited by corporate risk managers is the fear of reporting a loss on a derivative transaction. This fear reflects widespread confusion over the proper benchmark to use in evaluating the performance of a hedge. The key to properly evaluating the performance of all derivative transactions, including hedges, lies in establishing appropriate goals at the onset.

As noted previously, many derivative transactions are substitutes for traditional transactions. A fixed-rate swap, for example, is a substitute for the issuance of a fixed-rate bond. Regardless of market conditions, the swap's cash flows will mirror the bond's. Thus, any money lost on the swap would have been lost if the corporation had issued a bond instead. Only if the swap's performance is evaluated in light of management's original objective (i.e., to duplicate the cash flows of the bond) will it become clear whether or not the swap was successful.

STEP 5: Don't Base Your Hedge Program On Your Market View
Many corporate risk managers attempt to construct hedges on the basis of their outlook for interest rates, exchange rates or some other market factor. However, the best hedging decisions are made when risk managers acknowledge that market movements are unpredictable. A hedge should always seek to minimize risk. It should not represent a gamble on the direction of market prices.

STEP 6: Understand Your Hedging Tools
A final factor that deters many corporate risk managers from hedging is a lack of familiarity with derivative products. Some managers view derivatives as instruments that are too complex to understand. The fact is that most derivative solutions are constructed from two basic instruments: forwards and options, which comprise the following basic building blocks:

Forwards Options
- Swaps - Caps
- Futures - Floors
- FRAs - Puts
- Locks - Calls
- Swaptions

The manager who understands these will be able to understand more complex structures which are simply combinations of the two basic instruments.

STEP 7: Establish A System of Controls
As is true of all other financial activities, a hedging program requires a system of internal policies, procedures and controls to ensure that it is used properly. The system, often documented in a hedging policy, establishes, among other things, the names of the managers who are authorized to enter into hedges; the managers who must approve trades; and the managers who must receive trade confirmations. The hedging policy may also define the purposes for which hedges can and cannot be used. For example, it might state that the corporation uses hedges to reduce risk, but it does not enter into hedges for trading purposes. It may also set limits on the notional value of hedges that may be outstanding at any one time. A clearly defined hedging policy helps to ensure that top management and the company's board of directors are aware of the hedging activities used by the corporation's risk managers and that all risks are properly accounted for and managed.

Conclusion
A well-designed hedging program reduces both risks and costs. Hedging frees up resources and allows management to focus on the aspects of the business in which it has a competitive advantage by minimizing the risks that are not central to the basic business. Ultimately, hedging increases shareholder value by reducing the cost of capital and stabilizing earnings.

Quotes and Nuggets from a Trading Seminar!!

Psychology is the most important component of successful trading. Regardless of whether a trader uses discretionary methods or a mechanical trading system, the proper mindset differentiates successful traders from others.

Six Keys to Success in Trading Futures
1 Correct Mindset
2 Commitment
3 Proper Capitalization
4 Position Sizing
5 Money Management
6 Be Responsible for Your Own Trading

Gordon Gecko was wrong. Greed is not good. (Gecko was the character in the movie "Wall Street.") Greed, fear, anger and all emotions can be a trader's downfall.

Success in trading is its own reward. The money is merely a by-product of that success--not the goal.

Discipline is the one quality that all traders must possess. This is the ability to master your mind, your body and your emotions. Know yourself. Your risk tolerance, your experience and your capitalization will play the biggest parts in determining what you will trade, and how. Lose your ego. Letting your ego influence your decision-making is the easiest way to end your career as a trader.

Five Common Trading Mistakes
1 Trading without a plan or with a poor plan
2 Losing your discipline. Not enough patience.
3 Trading without stops. Canceling stops.
4 Hanging onto a losing position. Turning a winner into a loser.
5 Too much risk. Not enough capital.

A great trader who has made tens of millions of dollars from the stock and commodities markets said the one individual universal reason for failure in trading is the inability to take a loss. The true path to riches lies not with the wins but managing the losses in a prudent and confrontational manner.

The true path to success always must journey through failure. The true winner in futures trading is the one who perseveres. The race is a marathon, not a sprint.

Why to traders and investors fail?
1 Limited trading capital.
2 No experience
3 No psychological preparation.

You are responsible. Win or lose, you are responsible for the outcome. Don't blame the market or your broker. Losses are an opportunity to focus on the problem. Don't get caught up in personal denial.

There is no Holy Grail. There is no get-rich-quick scheme. There is no free lunch. No one else can do this for you. If something sounds too good to be true, it probably is. When it comes to trading, there is no "hoping," no "wishing," and no "praying." There is just the cold, hard reality of the market.

Looking at timeframes when trading a market, start out with the longest first. This would be the monthly charts, then the weekly charts, then the daily charts, and then even the hourly or minute charts. You begin with the bigger picture and work your way down to smaller timeframes.

W.D. Gann's Four Essential Trading Qualities:
1 Patience
2 Knowledge
3 Guts
4 Health and Rest

There you have them. Of all the seminars I have attended, and all the books I have read, and all the successful traders I have personally interviewed, there is a common and very important theme that comes to the surface: Trading success comes less from the specific types of trading methods you employ or the types of markets you trade, or what trading timeframes you use. Trading success comes more from knowing yourself, knowing how to control your emotions, and forgetting about your ego.

Commodities and Portfolio Returns

Do Commodities Enhance Portfolio Returns?

Commodities as a group, measured by the long-only indices, have a low correlation to traditional asset classes such as fixed income and equities, we would expect a diversification benefit by adding an allocation to commodities to a traditional portfolio. This diversification benefit is often cited as a key reason for making an allocation to commodities. The degree to which commodities provide a hedge against inflation depends largely on the index used to represent commodities.

While we recognize that a tactical allocation to commodities may be beneficial during inflationary periods, over the long-term most commodity prices do not keep pace with the CPI (again, energy being the key exception). For this reason, we believe commodities are better viewed on an individual basis with a focus on those commodities or areas of the commodity market that provide the greatest potential for long term gains.

The Case For Commodities

Recent gains in the commodity markets have been substantial and many are asking if now is a good time to allocate assets to this area of the market. As seen by the returns in the graph below, the major long-only commodity indices posted annualized gains approaching 20% over the past five years. Indeed, rising commodity prices seem to dominate the headlines as of late. Proponents of investing in commodities point to increased demand from emerging markets as a key factor that could drive higher long-term prices. Proponents also point to the time lag in bringing new supply of certain commodities to the market. There can be significant time required to build new oil refineries, steel production facilities and mining operations, all of which are capital-intensive investments and could contribute to supply shortages.

Other points made for investing in commodities include strong performance by financial assets over the past 20 years, driven largely by falling interest rates. While a number of factors could contribute to inflationary pressures going forward, including excessive monetary liquidity and supply/demand imbalances, most commodities, as we have seen, do not constitute a good long-term inflation hedge.

Given the recent gains in commodities, most notably energy-related commodities, it is difficult to make a case that now is a good time to take a long position in an index with a significant weighting in energy. Crude oil has increased five fold since 1998, rising from $10 a barrel to over $50 today, and continues to press toward new highs almost daily. Likewise, natural gas has more than doubled since the end of 2001.

While we recognize that there are a number of factors that could increase demand for natural resources and commodities, we also recognize that current record high prices of many commodities may not be sustainable and may present significant risk. We are also mindful that a slowdown in emerging markets could result in a slowing demand for commodities and put downward pressure on commodity prices, as emerging markets are a primary source of demand for many commodities.

Conclusions and Recommendations

We believe that individual commodities should be evaluated based on their relative attractiveness in order to fully capture the benefit of investing in this area. Based on historical data, energy-related commodities have outpaced inflation and have provided the most attractive returns while agricultural related commodities have failed to keep pace with inflation.

Our conclusion is that accessing commodities through long-only indices is not the most effective means to benefit from this area of the market. While long-only commodity indices provide a simple way to gain exposure to a cross section of the commodity market, we believe that commodities are better viewed on a sector-specific basis to determine which commodities may make compelling investments. Other vehicles, such as managed futures strategies, may be more appropriate when seeking to gain exposure to commodities.

We also recognize that macro economic trends will likely favor real assets going forward and that some commodities will benefit from increased global demand. We recommend that clients consider the available long-only alternatives to protect portfolios from rising inflation.

While commodities represent an opportunity to add exposure to an asset class with a low correlation to equity and fixed income, their ability to act as a long-term hedge against inflation remains unclear because most commodities have not kept pace with inflation over the long-term. Additionally, the diversification benefit to an already diversified portfolio that results from their low correlation to other asset classes does not appear compelling enough to warrant a strategic allocation to the long-only indices. The same diversification benefit could be achieved by adding other asset classes to a portfolio with lower volatility. Additionally, much of the returns offered by these investments come from sources other than the underlying commodities themselves. By approaching physical commodities and natural resources from a sector basis we believe investors can benefit from those areas that have the most potential for producing the greatest returns and benefits to the portfolio.

Commodities:A Distinct Asset Class

As we have seen, commodities encompass a wide range of products including basic and precious metals, agricultural and food products, and energy related products such as crude oil and natural gas. We view an asset class as a group of securities with similar characteristics and properties that tend to react in similar way to economic factors.

For example, equities, fixed income and real estate are examples of pure asset classes because their returns are driven by similar factors. Additionally, securities in these different assets classes are mutually exclusive of one another indicating that an equity security is distinct from a fixed income security and vice versa. Given this framework, do commodities represent a distinct asset class?

We believe that commodities are most accurately viewed individually or on a sector basis, rather than collectively as one asset class. The reason for this is that the returns of one type of commodity may have little correlation with the returns of another type of commodity. An example would be an agricultural commodity such as wheat or corn and crude oil. Weather patterns in certain areas of the world will
impact corn or wheat prices, whereas these same weather patterns will have little or no impact on the change in oil prices, which may be driven by geopolitical events or other factors. Our analysis of the correlation between the prices of several commodities confirms this.

For example, the long-term correlation between the price of crude oil and gold is -0.03. Similarly, the long-term correlation between the price of sugar and crude oil is -0.37%. Therefore, when analyzing investments in commodities, we believe it is important to evaluate commodities individually or on a sector basis and determine which commodities make sense as tactical or strategic investments.

Sources of returns--Commodity Indices

Long-only commodity indices derive their returns from several sources

Collateral Yield: In a long-only commodity index, futures positions are unleveraged, meaning they must be fully collateralized, usually with Treasury Bills. Therefore, a portion of the return will come from the underlying cash position that supports the futures contract. Some managers seek to actively manage this underlying cash position in order to enhance the overall return of products tracking the index. Others simply invest the cash in short-term Treasuries, which are then rolled over at maturity. Depending on the type of fixed income security used to collateralize positions in the long-only commodity index, the return on the underlying cash position could range from 2-4%.

There is some debate as to whether or not the yield on the underlying cash position should be included as a source of commodity index returns, because an investor could theoretically achieve this return by simply allocating cash to Treasuries and because this portion of return has no direct relation to the actual commodities. If this portion of the return were not included in the long-only indices, it would alter their long-term performance.

Rebalancing Yield: A second source of return from long-only commodity indices comes from what is known as the rebalancing yield. This portion of the return is attributable to the fact that commodity prices are not correlated with each another due to the varying factors that affect the price of each commodity. Because commodities do not rise and fall together, an index consisting of many commodities that is rebalanced regularly on a price basis is able to extract a return based on the tendency of commodities to revert to their mean prices. Historical data confirm that a price-rebalanced index will tend to extract a return from “buying low” and “selling high” the uncorrelated commodities.

Robert Greer, senior vice president and portfolio manager for the PIMCO Real Return Fund, estimates that according to historical data, a commodities index can earn a rebalancing yield of approximately 2.5% on a long-term basis. The frequency of rebalancing is of particular importance, as data has shown that indices that rebalance more frequently are able to extract a greater return than those that rebalance less frequently.

Roll Yield: In addition to these two sources of return, a long-only commodity index will have gains associated with the change in price of the underlying commodities and the futures contracts on those commodities. For example, as a contract nears expiration, it will be “rolled over” to purchase new contracts on the commodity. At the time the position rolled over, there will be a gain or a loss depending on whether the underlying commodity has risen or declined in value. This portion of return is known as the “roll yield,” and will depend in large part on whether the underlying commodities are increasing or decreasing in value as well as the allocations of various commodities in the index.

Risk Premium: Finally, participants in the futures market can earn an insurance (or risk) premium since the long position is absorbing price risk that commodity producers, who are natural sellers, do not want. There may often be an imbalance between those wanting to sell futures contracts (like a farmer) and those willing to purchase futures contracts (such as a cereal manufacturer). The consumer (buyer of commodities) has less price risk than the producer because the end user can raise prices on the final product.

Investors in the futures markets serve to balance the market demand and in return, they are compensated for providing liquidity and assuming price risk.18 As a result, the investor is able to extract a return and profit from participation in the market and achieve an inherent positive return, or a compensation for the risk assumed by the investor. This component of return is closely related to the gain or loss on the underlying futures contract discussed previously.

An investor purchasing a futures contract and holding it to expiration will capture some risk premium in the marketplace and will also have a gain or loss depending on where the price settles at maturity. While these components of return are shown separately, they are closely linked and in some cases indistinguishable.

In evaluating the sources of long-only commodity index returns, we believe it is important to focus on those sources that relate specifically to an investment in commodities. As figure 1 shows, the key sources of return for a long-only commodity index are the gain or loss on the underlying futures contracts, the rebalancing yield, and a risk premium for providing liquidity to the market. The yield on the underlying cash position may or may not be considered as a source of returns to the index, although returns of the major indices include these in their total return calculations.

In the final analysis, the two main sources of return that relate directly to commodities are the gains and losses on the underlying futures contracts and the return that will come from providing liquidity to the markets due to the nature of futures contracts and the commodities markets. When analyzing long-only commodity index returns, it is important to focus on those sources that are related to commodities rather than those that are exogenous to the actual changes in prices of the futures contracts.

Investors who consider an allocation to commodities should also recognize the potential volatility of returns for long-only indices. In 1998, for example, the GSCI declined by 35%, a substantial one-year loss that was driven in large part by difficulties in the emerging markets. While this is comparable to the 30% decline in the Russell 2000 Growth Index during 2002, commodities do not provide the same long-term upside as small cap equities, with the key exception being energy related commodities, which have provided higher real returns. The longer-term standard deviation of the GSCI is close to 20% and, while this index has shown strong gains, the impact of the oil crisis of the 1970s heavily influenced the returns of this index. For example, from January 1970 through January 1980, the GSCI increased at an annualized rate of 21.8%, in large part due to the steep rise in oil prices during this time period.

Analysis of Commodity Indices!!

In calculating returns, the GSCI, RICI and the DJ-AIG indices use an arithmetic weighted average of the underlying commodities to represent the index. The CRB Index utilizes both geometric and arithmetic averages of the prices of the underlying commodities to construct returns. Geometric averaging creates lower overall volatility of returns than arithmetic averaging and, according to the CRB, geometric averaging “has the statistically attractive property that successive percentage changes in a component’s price do not alter that component’s relative weight in the index.”

Arithmetic averaging, on the other hand, causes the relative weight of a component to increase (or decrease) as that component appreciates (or depreciates) in value. The method used by the CRB allows the index to maintain equal weight in the 17 individual components so that no single commodity has undue impact on the index. The index is also less subject to the fluctuations associated with temporary supply and demand imbalances in any one commodity.

Compared to other long-only commodity indices, the DJ-AIG offers a more balanced mix of commodities and is not as impacted by the performance of the energy sector as the GSCI. In terms of liquidity, the GSCI and the DJ-AIG have several products that seek to replicate the returns of the indices, which makes them more accessible to institutional investors. These indices are also the most widely followed and considered proxies for the commodity market. In analyzing performance, the CRB Index has trailed the other indices over time by a significant margin. This is due in part to its larger weighting in “softs” and lower weighting in energy related commodities compared to the other indices.

Eminent International Indices-Commodities

The following is a brief summary of several long-only commodity index products that are available to investors seeking broad exposure to the commodity markets.

Commodities Research Bureau (CRB) Index: The CRB Index began trading on New York Futures exchange in 1986 and is the oldest of the indices. While futures on the index began trading in 1986, it was first calculated by the CRB in 1957 and has data going back to 1958. The index includes 17 individual components, which are equally weighted. This is one of the key drawbacks to the index because a product like corn or wheat will have the same weighting in the index as crude oil, when oil has significantly more economic impact than corn.

Goldman Sachs Commodity Index (GSCI): The GSCI index was created in 1992 and is available in the form of a single futures contract on the Chicago Mercantile Exchange. While it was launched in 1992, the GSCI has back-tested data going back to 1970. The index consists of 24 individual components and weights are assigned based on a five-year moving average of world production values. The result is that the index has a heavier weighting in commodities with more economic importance and higher liquidity. Consequently, the GSCI has a weighting of nearly 70% in energy related commodities making its performance highly sensitive to the energy markets and fluctuations in energy prices. The GSCI is rebalanced annually, and utilizes an arithmetic average in constructing returns for the index. Given its liquidity and longer performance data, the GSCI is often used as a proxy to analyze commodity returns.

Rogers International Commodity Index (RICI): Jim Rogers, a private investor and former hedge fund manager, created the RICI in 1998. Its weightings are based on world consumption patterns of raw materials and their relative importance in international commerce according to the research of Jim Rogers. The RICI is the broadest and most comprehensive index, consisting of 35 different commodities. Some of these components are less liquid and include obscure commodities such as flaxseed, azuki beans, canola oil, and raw silk. Weights for the individual components are fixed and the index is rebalanced monthly. The RICI is only available through a limited partnership and while it offers the broadest exposure of the major commodity indices, there could be some risk related to the liquidity of some of the index components.

Dow Jones AIG (DJ-AIG) Index: The DJ-AIG was established in 1999 and relies primarily on liquidity data and, to a lesser extent, dollar-adjusted production data in determining the relative weights of commodities in the index. All data used in both the liquidity and production calculations are averaged over a five-year period to determine component weights.11 The index holds 20 components and limits any related group of commodities to 33% in order to ensure diversified exposure to commodities. Like the GSCI, the DJ-AIG index is rebalanced annually. The reason for using liquidity data rather than production data is that liquidity is an important indicator of the value placed on a commodity by financial and physical market participants. Production data alone can underestimate the investment value that financial market participants place on certain commodities.

Commodities Investing-III::Participants & Exposure

There are essentially two ways for investors to gain broad exposure to changes in commodity prices. First, there are several long-only commodity indices that give investors exposure to passive long positions in a number of commodity futures contracts. This allows them to participate in gains that would otherwise only be earned from holding individual positions in these contracts. An investment in a commodity index does not give the investor ownership of the cash commodity, but rather, an exposure to changes in the future expected price,7 thus allowing an investor exposure to a broad section of the commodities market.

The second way for investors to gain broad exposure to commodities is through managed futures products that take both long and short positions in various commodities using different trading strategies. There are advantages and disadvantages to each type of product. We will first look at long-only commodity indices, how they are constructed, and how an investor might utilize these products to invest in this asset class.

LONG-ONLY COMMODITY INDICES
Just as stock index funds seek to replicate a portion of the equities market, long-only commodity indices give an investor exposure, typically through futures contracts, to a crosssection of the commodities market. As with equity indices, that have specific weights in individual securities, commodity indices have weights to certain areas of the commodity market, such as energy, grains, metals, or livestock.

Commodity Incdices and their Construction
Commodity indices can be constructed using several different methodologies, all of which will impact the returns and the underlying volatility of the index. The three primary methodologies include production weighting, optimized weighting, or equal weighting.

Production weighting involves assigning weights based on a moving average of world production.A production-weighted index will also have a heavier weighting in sectors that may be more important in the economy such as oil and natural gas. As a result, these allocations will have a disproportionate impact on the performance of the index.

An optimized-weighted index includes specific constraints and objectives such as correlation with inflation, negative correlation to equities and fixed income, a focus on liquidity, and the sectors that are most relevant.

Finally, an equal-weighted index keeps price fluctuations in any one sector from disproportionately impacting the index, but does not over/underweight sectors that may be more important in the economy, such as oil and natural gas, which are key elements in most industrial economies.

Commodities Investing-II::Participants

There are two groups of participants in the futures markets.

The first group of participants comprises buyers and sellers of goods, known as commercial participants, or hedgers. This group includes farmers and other producers of goods who wish to sell their products at a specified price as well as buyers of commodities who wish to hedge against price increases.Commercial participants are not in the futures markets to make a profit, but rather to protect themselves against price changes. For example, if the price of corn drops before the time the farmer sells his futures contract, he is still guaranteed the price at which he sold the contract.

The second group of participants in the futures market is investors (also known as speculators). Investors serve an important function in the futures market because there is often an imbalance between those wanting to sell contracts and those wanting to buy. Investors provide much needed liquidity to the futures markets and are compensated for taking on this role.

One of the distinguishing factors regarding the futures markets is that they exist primarily to protect against price uncertainty for buyers and sellers of goods. As a result, most of the participants are not in the market to make a profit, but
rather to hedge against price risk. This can sometimes create opportunities for investors (or speculators) to make a profit.

Commodities different and Paper Assets!!
Commodities differ from paper assets (equity and fixed income) in that they require storage costs. While paper assets can be held in brokerage accounts at little or no cost, commodities such as crude oil, wheat, or livestock obviously cannot be stored in a vault or electronically in a database and storage costs for commodities can sometimes be significant. Storage costs must be a consideration for an investor, as they will impact the pricing structure of futures contracts of individual commodities. For this reason, the change in the price of futures contract for a commodity may vary from the change in the price of the underlying commodity because futures contracts take into account these storage costs. As a result of storage costs, longer dated futures contracts (for example, delivery in six months), will generally be priced higher than shorter dated futures contracts for delivery in one month.

Commodities Investing!!-I

Commodities are broadly defined as “generic, largely unprocessed, goods that can be processed and resold.” Investing in commodities represents an investment in the basic production inputs in the economy. By investing in commodities, an investor gains exposure to changes in commodity prices, which are ultimately driven by global supply and demand. A growing economy will see increased demand for commodities due to increased consumption, which puts upward pressure on prices. Higher prices typically result in increased supply coming online, which consequently drives prices lower. The key factors helping to drive demand over the long-term are a growing population, industrialization, and consumption while supply can be impacted by geopolitical events, weather patterns, or available capacity for processing commodities.

INVESTING IN COMMODITIES: AN OVERVIEW OF THE FUTURES MARKET
Investing in commodities is usually accomplished through the use of futures contracts and, therefore, understanding how the futures market functions is important.

Futures markets have been in existence for centuries and provide an efficient vehicle for buyers and sellers of goods to reduce price uncertainty and risk. A simple example would be a farmer who harvests a corn crop in the fall, but wants to guarantee a selling price several months prior to the harvest. The farmer can go to the futures market and sell a contract, whereby the purchaser of the contract agrees to buy his corn at a set price several months in the future. This transaction essentially eliminates the uncertainty that corn prices could drop prior to the time the farmer brings his crop to the market.

Alternatively, a company that buys large quantities of corn, may want to hedge its risk of rising corn prices by locking in a set price for some point in the future by buying a futures contract on corn. Although the purchaser of a futures contract agrees to take physical delivery of the goods upon expiration of the contract, most futures contracts are settled on a cash basis. In purchasing a futures contract, the investor posts a margin, that represents a percentage of the actual price of the futures contract and can be as little as 5% of the cost of the contract. As the price of the underlying commodity fluctuates and the value of the contract changes, the account is “marked to market” on a daily basis and the investor may be required to post additional funds to the account if the account value falls below a specified level.