A study of commodity mutual funds and commodity indices

Abstract

The dynamics of commodity prices, production, and inventories is the driver for commodity markets. Commodity markets tend to experience price fluctuations as well as volatility due to changing supply, demand and inventory conditions. This necessitates hedging, which could be done through physical storage (costly method) or through financial instruments such as futures or options contracts (less costly). Commodity futures are derivatives (standardized in terms of quality, quantity and settlement dates) which carry with them legally binding obligations and are traded on regulated exchanges and are marked to market. Each futures exchange has a clearing house to eliminate counterparty risk and margin trading occurs in futures markets. Thus commodity futures trading takes place in a well-regulated environment and even though margin trading allows leveraging, margin requirements can regulate excessive speculations. A vast majority of futures contracts are closed out or rolled over before the delivery date; so the commodity usually does not change hands at all. Several participants operate in the futures market. Hedgers operate to offset the price risk inherent in any spot market position by taking an equal but opposite position in the futures market. Speculators, including banks and other financial institutions, look to profit from the view they take on the future direction of commodity prices. They assume the risk and provide liquidity to the market. Contrary to popular belief, successful speculators actually promote price stability in markets. By buying low and selling high, speculators drive up low prices and drive down the high prices and hence reduce volatility . Bose has observe that in India, even though large institutional operators are not yet allowed in the market the price rise in commodities has been attributed to the role of the futures market. It has been alleged that accumulated net long positions, in effect constituting a bet that prices would rise, actually affected prices. However, the author sees that there is no economic justification in clubbing all speculative activities and no reason why they should all work in one direction; even if the large funds are operating in the market different fund managers take positions according to their own portfolio management needs and have various different trading strategies, which, in the author’s opinion in fact adds to market liquidity .