Portfolio Diversification with Commodity Derivatives
Don’t put all your eggs in one basket—this age-old proverb aptly describes portfolio diversification, a crucial investment concept. Investors are warned against investing in any one asset class because unavoidable circumstances can negatively impact their entire investment. So, they are encouraged to invest in various asset classes to diversify their portfolio.
Here, we will look at how commodity derivatives help in portfolio diversification and other important aspects.
An Overview of Commodity Trading
First, let us briefly look at commodity trading, which has held a place of significance in the Indian economy for a very long time. Commodities are raw materials or agricultural products that people can exchange on the markets. These are tangible goods, which include any movable properties other than money, securities and actionable claims as per the Securities Contracts (Regulation) Act, 1956 (SCRA).
Two main types of commodities are traded in the commodity markets in India, and they can be categorised as agricultural goods and non-agricultural goods. Commodity trading primarily occurs when traders buy and sell their products through derivatives on commodity exchanges.
What Are Commodity Derivatives Contracts?
Commodity derivatives are financial contracts whose value is determined by the value of the underlying commodity. These instruments allow a trader to profit from price movements of commodities without actually owning them.
Section 2 of SCRA has described a commodity derivative as a contract:
- Used for the delivery of goods notified by the Government of India in the Official Gazette, or,
- Which derives its value from prices or price indices of underlying commodities as notified by the Central Government in consultation with the regulatory authority but doesn’t include securities as referred to in the definition of derivatives
Types of Commodity Derivatives Contracts
Detailed below are the different types of commodity derivatives:
- Commodity Futures
Commodity futures are financial agreements to purchase or sell a particular quantity of a commodity for a fixed price on a specific date in the future. Holders of a futures contract have an obligation to execute it.
A trader is not required to pay the commodity’s whole price when they purchase a futures contract. Instead, they can simply pay a margin of the cost, which is usually a pre-fixed percentage of the initial market price.
- Commodity Options
Commodity options provide the holders with the right (but not an obligation) to purchase or sell the underlying commodity futures at a specific price by the expiration date. To own this right, the options-holder must pay a premium to the seller. The option seller must honour the contract if the buyer exercises it.
How Do Commodities Add Value to Investment Portfolios?
Apart from portfolio diversification, commodities derivatives carry various other crucial benefits which have been discussed below:
- Used for Hedging against Inflation and Geopolitical Risks
The rise in the prices of goods and services over time is known as inflation. When your investment delivers a rate of returns higher than the inflation rate, it is a fruitful investment.
If you invest in commodities, it will help you maintain parity with increasing prices and provide a good hedge against inflation. Furthermore, commodities act as a hedge against disruptions in the supply chain caused by geopolitical events which result in scarcity.
- Helps in Portfolio Diversification
Commodities usually share an inversely proportional relationship with traditional asset classes such as stocks and bonds, i.e. a fall in the price of stocks and bonds is often accompanied by a price rise of commodities.
Although commodities hold the potential to generate superior returns, they are quite volatile and carry high risks. But, if you add them to a portfolio of traditional assets, the overall risk exposure of the investment portfolio will decrease because of negative correlation.
- Improves Potential Returns
Price fluctuations of individual commodities depend on many factors, such as demand and supply in domestic/international markets, exchange rates and various macroeconomic conditions. The commodity derivatives market holds massive potential to generate higher returns, and proper research and strategies implementation will help traders improve their returns.
- Ensures Liquidity
Commodity investments are very liquid, and investors can sell them off at their convenience. It is a significant benefit compared to static investments such as real estate or bank FDs (Fixed Deposits).
Limitations of Commodity Trading
We have discussed the benefits of commodity derivatives trading in the previous section. But you need to be aware of its limitations as well:
- Leverage may Go out of Hand
Leverage is beneficial for commodity traders, but you have to use it judiciously. The initial margin requirement is low, which is a significant benefit. But, it might tempt you to take a large position with less upfront capital which can result in major losses. You need to be aware that even a small price change can have large consequences in the commodity markets.
- Excessive Volatility May Result in Confusion
Many experienced investors suggest that commodities have double the volatility as stocks and four times the volatility of bonds. Moreover, there are certain commodities that are more volatile than others, such as crude oil. These massive price movements make it difficult for traders to calculate their returns.
How Can People Invest In Commodities?
Apart from commodity futures and options, you can invest in commodities in the following ways:
- Direct Investment
Directly purchasing commodities in physical form and selling them later is the most straightforward way of investing in commodities. High transaction costs, storage and delivery logistics are essential factors that you need to consider, and it takes up a lot of effort on the part of individual investors.
- Investment in Commodity Stocks
Purchasing shares of companies producing commodities is another investment option. For example, if you wish to take exposure to the energy sector, you can purchase stocks from an energy company. Prices of the stocks generally follow the price of energy resources.
Moreover, you can earn profits even if the commodity itself is not performing very well because commodity stocks usually do not fall or rise along with the commodity.
- Investment in Commodity ETFs and Mutual Funds
This is a good investment option for investors who don’t wish to own physical commodities. Many mutual funds and ETFs (Exchange Traded Funds) facilitate commodity exposure. Investors hold the units electronically in their demat account and don’t have to face problems related to storage or purity.
You need to diversify your investment portfolio to mitigate overall risks. Investing in commodities can contribute to portfolio diversification. While you can purchase physical commodities and sell them off later, commodity derivatives contracts are a better alternative because you don’t have to worry about storage and delivery. Moreover, you can hedge your investments against inflation and geopolitical risks by investing in commodities.
Frequently Asked Questions
What are contract specifications in commodity derivatives?
A contract specification in commodity derivatives specifies all the essential information related to a contract, such as a contract type, name of the commodity, quality, delivery centre etc., to ensure proper delivery.
What is a cash settlement?
Cash settlement is the process of settling a futures contract by paying money difference at the time of contract maturity instead of delivering the physical commodity.
What is price volatility?
Price volatility is the measurement of fluctuation of price changes over a particular time frame. Generally, it is expressed in the form of a percentage and calculated as the standard deviation of change in percentage in daily prices. It is used to measure the average daily volatility in a particular period.
Who are the participants of the commodity derivatives market?
Participants in a commodity derivatives market include farmers, wholesalers, importers, brokers, exporters, financial investors, arbitrageurs, government agencies, financial institutions etc.