The Hindu Business Line : Commodity derivatives

Commodity derivatives will enable banks and mutual funds gain exposure to alternative investments. Exposure to commodity-linked products will increase a portfolio's risk-adjusted returns.

THE Government is likely to allow banks to trade in commodity derivatives. The proposal may well extend to other institutions such as mutual funds and foreign institutional institutions. This is a welcome move. Commodity derivatives will enable banks and mutual funds gain exposure to alternative investments. Specifically, exposure to commodity-linked products will increase a portfolio's risk-adjusted returns because of lower cross-correlations that stocks and bonds have with commodities. Besides, these institutions will provide liquidity to the commodity derivatives market, enabling the hedgers to efficiently control their price risk.

Alternative investments: Bonds and equity fall into the traditional asset class. Exposure to other assets is labelled as alternative investments. Since commodity derivatives move with the underlying, it is equivalent to taking exposure in an alternative asset class.

Anson{+1} shows that commodity futures are a valuable asset class for risk-averse investors. He shows that commodity futures have greater utility, the more risk-averse the investor. Numerous studies in the area of managed futures conclude that commodity derivatives are important to improve portfolio risk-return payoffs. A managed futures account invests in futures and options in the global markets.

Lintner{+2} showed that the risk-return tradeoffs of a portfolio with futures, stocks and bonds clearly dominated the portfolio with stocks alone or that with stocks and bonds.

Of course, it is early days yet for portfolio managers in India to operate managed futures account. Investing in commodity derivatives is, perhaps, the first step in this direction. This is, hence, a compelling reason to allow institutions to trade in commodity derivatives.

Besides diversification, commodity futures help portfolio managers control inflation risk. Gorton and Rouwenhorst{+3} show that commodity futures returns are positively correlated with inflation, unexpected inflation, and changes in expected inflation.

Mutual funds: Professional money managers will no doubt be interested in adding commodity derivatives to their portfolio for the reasons mentioned above. It may not unreasonable to expect all fund-houses to launch a commodity fund after the Securities and Exchange Board of India gives the necessary approval.

Asset allocation would then play an important in portfolio returns because the investor or the fund-of-funds manager will have to allocate assets among bonds, equity and commodities.

Exposure to commodity derivatives provides mutual funds an opportunity to take aggressive bets on a particular sector. Suppose an equity mutual fund has a positive view on the sugar sector and wants to capture the alpha returns from that sector. It would typically have to buy all the stocks in the sugar sector and short the required number of equity index futures to capture the alpha. The strategy could be costly to implement.

Instead, the fund can now buy sugar futures to generate returns specific to that sector. Of course, the fund may be exposed to commodity-market risk. But that risk may be minimal to start with. In any case, the market is yet to develop a commodity index to hedge that market risk.

Banks: These institutions can use commodity derivatives to control inflation risk of their bond portfolio besides deriving benefits from portfolio diversification. Importantly, such an exposure can be used as a hedge against loan-assets.

Credit risk in the agriculture sector is typically a function of the quality/quantity of the harvest and the price that the produce fetches in the wholesale market.

This essentially means that a poor harvest or lower price for the produce can lead to higher credit risk for the banks because farmer-borrower is then more likely to default.

Banks can take a suitable long or short position in commodity derivatives to hedge their credit risk. Note that such a hedge runs a high basis risk. Besides, this hedge will only work to the extent that the farmer-borrowers do not default wilfully.

(Feedback can be sent to bvenky@thehindu.co.in)

References:

1. Anson, Mark, J. P., "Maximizing Utility with Commodity Futures Diversification," Journal of Portfolio Management, Summer, 1999, pp. 86-94.

2. Lintner, John, K., "The Potential Role of Managed Commodity — Financial Futures Accounts in Portfolios of Stocks and Bonds," Annual Conference of the Financial Analysts Federation, Toronto, Canada, 1983.

3. Gorton, Gary, B., and Rouwenhorst, Geert, K., "Facts and Fantasies about Commodity Futures," Yale ICF Working Paper No. 04-20, June 2004.

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