Commodities: An Alternative Investment Class
*This is sponsored content from National Stock Exchange*
When an investor is considering available investment choices, he often ends up choosing between debt and equity alone. Alternative investment class, which includes commodities, real estate, investment trusts etc., are often left untouched.
We are looking at the commodity segment here and how it works as an effective hedge against inflation. Historically, inflation and commodities are known to walk hand-in-hand. Well, this is because, inflation is calculated by determining the increase in price of a basket of goods and services, which also includes commodities. So, if commodities are on the rise, we can expect inflation to increase, and vice-a-versa.
The below graph is a depiction of the long-term correlation between commodities and inflation.
Inflation Versus Debt And Equity
Debt assets often have a predetermined interest payment and under-perform during inflation as rising prices make fixed payments redundant. Equity assets also under-perform during inflation, as the companies are weighed down by increasing input cost. Commodities outshine these two major assets classes during inflationary periods.
Equity can be categorized into two broader classes when we discuss commodity. One, if commodity is the output, like for mining companies. Here, the correlation between commodity and equity would be positive, as higher metal prices (output) would cause mining company shares to rise. Other, where commodity is an input, like automobile sector, the correlation between equity and commodity is negative. Higher input cost, like steel, could hamper profit margins and share price. Broadly, commodities and equities are inversely correlated.
Derivatives are instruments that are often used to deal in commodities. Derivatives are contractual agreements that obtain their value from the underlying asset (commodity here). Exchange-traded derivatives, like futures and options, are backed by execution guarantee of the exchange. The exchange stands as the counter party for each participant. The participants in a derivative market comprise of hedgers, speculators, and arbitrageurs.
Understanding Futures And Options
Suppose a cotton producer owns cotton in plenty. To do away with the downside in price, he could sell cotton futures on the exchange and lock in the rate. He could sell at Rs 19,000, and after that, if prices decline to Rs 16,000, he stands at a gain of Rs 3,000.
Similarly, if a company has to buy crude oil and anticipates that prices could surge in the coming year, it can purchase one-year crude oil futures today. This would deal with the risk of rising price. Though the company would have to buy crude oil at a higher price from the market, future contract gain would compensate for the loss.
NSE Starts Commodity Futures Trading
India has a few dominant exchanges that trade in bullion, base metals, agricultural commodities, and energy. Recently, NSE (National Stock Exchange) started with Gold (1 kg), GoldMini (100 gms), and Silver (30 kg) future contracts. The exchange also plans to offer agricultural and metal derivatives in the near future.
The buyer of the option has almost unlimited opportunity of profits while the seller has a considerable risk of loss. Options are used for hedging or taking additional risk.
The Black-Scholes Model is widely used for pricing option contracts, the formulae for which is quite invigorating. It is crucial to understand that option prices depend on many variables like the underlying price, time to expiration, implied volatility, risk-free rate and strike price.