Commodities

Who invest in Commodities and why?

There are two kinds of investors who invest in commodities. One who use it as a hedging tool to lock future prices and the second who use it to make profits by speculating on the future price movements. The first set of investors are usually investors who want to buy these commodities at a future price but are unsure of the future prices. e.g. Farmers would want to sell their grains at a particular future date. However, they are not sure what the future prices would be. Hence they would go Short in a particular futures contract in order to lock future prices. The same is applicable to any dealer who would be buying Gold on a future date and would want to lock the buying price today.The later set of investors trade on commodity futures and gain/lose depending on the future prices. They trade on these futures not with an intent of getting the actual commodity.

Why do Portfolio Managers like Commodities? 

Commodity futures are the only investment tools providing a negative correlation to all other investment asset classes (stock, bonds, etc). This is because commodities tend to gain (during depressions) when all other asset classes loose value. Due to this -ve correlation commodities help reduce the overall risk of the portfolio hence making it much more attractive to investors.

When to invest in Commodities?

People usually tend to invest in commodities when there are economic downturns. In times of economic depressions, the stock market usually tends to go down. Due to the -ve correlation that commodities have with the stock markets people invest in commodities as a hedging tool.

Technorati Tags: Commodities

OPEC

I was reading on OPEC the other day and found it interesting. For all thee knowledge lovers, here I go...

OPEC stands for 'Organization of Petroleum Exporting Countries'. It's member countries are namely Algeria, Angola, Ecuador, Indonesia, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates and Venezuela. Venezuela was the first OPEC member. The OPEC, formed in 1949, was mainly formed to help maintain steady economic  growth of producing countries via control of oil prices and production, avoid unnecessary fluctuations in oil prices, to provide sufficient supply of petroleum to consuming countries and to provide capital returns to those investing in the petroleum industries.

OPEC controls about two-thirds of the worlds oil reserves and roughly 36% of the world's oil production (as of March,2008). With this high percentage of world's oil supply coming from OPEC it is believed that the price of petroleum is highly controlled by OPEC. However, off late, it is believed that OPEC's control on petroleum prices has reduced than before thanks to Russia which has emerged as a major oil producer. A recent article I read here says Russia to be the highest producer of oil in the world. Also, new findings of oil reserves in the Gulf of Mexico and the North Sea have led to less price control in the hands of OPEC.

OPEC usually receives its income in US-dollars. Hence changes in the value of the dollar affects OPEC's decision on how much oil to produce. e.g. if the value of the US-Dollar reduces, OPEC countries received less in terms of other currencies in terms of purchasing power.

OPEC Quotas and Production in thousands of barrels per day

(Reproduced from http://en.wikipedia.org/wiki/OPEC )

If you would like to know more on OPEC then click here.

 

The above article has been reproduced from http://www.wikipedia.org and has been modified for conciseness.

How is an 'Asset Bubble' created?

Once there was a little island country. The land of this country was the tiny island itself. The total money in circulation was $2 as there were only two pieces of $1 coins circulating round. There were 3 citizens living on this island country. A owned the land. B and C each owned $1. Now the following series of events happen: -

1. B decided to purchase the land from A for $1 . A and C now each own $1 while B owned a piece of land that is worth $1. The net asset of the country = $3 
2. C thought that since there is only one piece of land in the country and land is produce-able asset, its value must definitely go up. So, he borrowed $1 from A and together with his own $1, he bought the land from B for $2.  
       A has a loan to C of $1, so his net asset is $1.
       B sold his land and got $2, so his net asset is $2.
       C owned the piece of land worth $2 but with his $1 debt to A, his net asset is $1.
       The net asset of the country = $4.
3. A saw that the land he once owned has risen in value. He regretted selling it. Luckily, he has a $1 loan to C. He then borrowed $2 from B and acquired the land back from C for $3. The payment is by $2 cash (which he borrowed) and cancellation of the $1 loan to C.
   As a result,
       A now owned a piece of land that is worth $3. But since he owed B $2, his net asset is $1.
       B loaned $2 to A. So his net asset is $2.
       C now has the 2 coins. His net asset is also $2.
       The net asset of the country = $5. A bubble is building up.
4. B saw that the value of land kept rising. He also wanted to own the land. So he bought the land from A for $4. The payment is by borrowing $2 from C and cancellation of his $2 loan to A.
   As a result,
       A has got his debt cleared and he got the 2 coins. His net asset is $2.
       B owned a piece of land that is worth $4 but since he has a debt of $2 with C, his net Asset is $2. 
       C loaned $2 to B, so his net asset is $2.
       The net asset of the country = $6; even though the country has only one piece of land and $2 in circulation.
5. Everybody has made money and everybody felt happy and prosperous.
6. One day an a thought came to C's mind. "Hey, what if the land price stop going up, how could B repay my loan? There is only $2 in circulation, I think after all the land that B owns is worth at most $1 only." A also thought the same.
7. Suddenly, nobody wanted to buy land anymore.
   In the end,
     - A owns the $2 coins, his net asset is $2. 
     - B owed C $2 and the land he owned which he thought worth $4 is now $1. His net asset became -ve $1. 
     - C has a loan of $2 to B. But it is a bad debt. Although his net asset is still $2. 
     - The net asset of the country = $3 again.
8. Who has stolen the $3 from the country? Of course, before the bubble burst B thought his land worth $4 and the net asset of the country was $6 in paper. However, now his net asset is $2.  
   The net asset of the country = $3 again.
9. B had no choice but to declare bankruptcy. C has to relinquish his $2 bad debt to B but in return he acquired the land which is worth $1 now. 

At the end of all  this: -

• A owns the 2 coins, his net asset is $2.
• B is bankrupt; his net asset is 0 dollar. (B lost everything )
• C got no choice but end up with a land worth only $1 (C lost one dollar)
• The net asset of the country = $3.

*****************End of Story***************** 
The net outcome of the above bubble is a redistribution of wealth. A is the winner, B is the loser, C is lucky that he was spared.

Few points worth noting: - 

1. When a bubble is building up, the debt of individual in a country to one another is also building up.  
2. This story of the island is a close system whereby there is no other country and hence no foreign debt. The worth of the asset can only be calculated using the island's own currency. Hence, there is no net loss.
3. An over-damped system is assumed when the bubble burst, meaning the land's value did not go down to below $1.
4. When the bubble burst, the fellow with cash is the winner. The fellows having the land or extending loan to others are the loser. The asset could shrink or in worst case, they go bankrupt.
5. If there is another citizen D either holding a dollar or another piece of land but refrain to take part in the game, at the end of the day, he will neither win nor lose. But he will see the value of his money or land go up and down like a see saw.
6. When the bubble was in the growing phase, everybody made money.
7. If you are smart and know that you are living in a growing bubble, it is worthwhile to borrow money (like A) and take part in the game. But you must know when you should change everything back to cash.
8. Instead of land, the above applies to stocks as well.
9. The actual worth of land or stocks depends on psychology to a great extent. 

The above narration is an excerpt from a public web site. I don't recollect the web site name and hence cannot cite the source for reference. The excerpt has been reproduced here with slight modifications for better clarity.

Prisoner's Dilemma

Consider this scenario: -

Two Prisoners, A and B, are suspects for a crime and are put behind bars. The cops have no evidences against either of them. So the cops offer the following to each of the prisoners. "If you deny your crime and the other accepts, you get a term of 10 years and the other goes free. If you both accept, each one gets 5 years and if you both deny you both get 6 months each." The offer is summarized below

	Prisoner B Rejects his crime	Prisoner B Accepts his crime
Prisoner A Rejects his crime	A gets 6 months B gets 6 months	A gets 10 years B goes free
Prisoner A Accepts his crime	A goes free B gets 10 years	A gets 5 years B gets 5 years

Given the above scenario, how do you expect each of the Prisoner's to react considering the fact that neither of the prisoners knows what the other is going to do.

Consider Prisoner A. What would be the best course of action for Prisoner A given the actions of Prisoner B.

1. If B rejects his crime, the best course of action for A would be to accept his crime.
2. If B accepts his crime, the best course of action for A would be to accept his crime.

Consider Prisoner B. What would be the best course of action for Prisoner B given the actions of Prisoner A.

1. If A rejects his crime, the best course of action for B would be to accept his crime.
2. If A accepts his crime, the best course of action for B would be to accept his crime.

Since neither A nor B are aware of the actions of the other, they both end up accepting their Crimes thereby getting terms of 5 years each.

The above scenario is what is referred to as the Prisoner's Dilemma and is a classic example of Game Theory. It explains why, even though by co-operating each player can benefit more, each player tries to maximize his/her payoff at the cost of the other player's payoff.

One application of the above theory is to explain how firms in an Oligopoly work together. Oligopoly refers to a market where there are a few firms competing with each other. If all firms in an oligopoly collude together, they can artificially jack up the prices and earn extra ordinary profits. However, each firm has an incentive to reduce prices in order to increase sales so that they can increase their profits even more as compared to their competitors. Because of this suspicion that the other firms might reduce prices, every firm reduces it prices and the collusion fails. Because of this none of the firms in an Oligopoly earn extraordinary profits.

However, there are Oligopolies that collude and work successfully by raising prices artificially. One example which I can cite is 'OPEC'.

LiveJournal Tags: Prisoner's Dilemma,Game Theory,Oligopoly

Ever heard the terminology top line and bottom line?

Ever heard of the term top line and bottom line being used by financial analysts? So what do these terms refer to and why are they called so.

Starting with top line; it refers to the total sales or revenue generated by a firm.

For e.g. if a firm sells 100 cars/fiscal @ Rs.1,00,000 (oh yes, its the nano!!) then the top line would be Rs.1,00,00,000. (The Math here has been simplified to drive home the point!! ).

Now, say the Net Income (profit) earned on every car is Rs.20,000, then the bottom line would be Rs.20,00,000. (Again, we exclude the effects of Depreciation, Taxes, SG&A and other accounting stuff to keep the math simple).

So why are these terms referred to as they are?

Try reading an income statement of any firm. If you see at the top you would find the Sales/Revenues being shown. Hence, in general usage, Sales/Revenues are referred to as top line because of their close proximity to the top part of an income sheet. If you keep coming down the income statement you will see that there are deductions( depreciation, taxes, interest expenses, etc ) and additions (gain from sale of securities, etc) being made to the top line. After all adjustments are made to the top line, the firm would report its Net Income ( or Profit ) at the bottom of the income statement and hence the term bottom line because of it's close proximity to the bottom of the income statement.

Also commonly referred as

Top line : - Revenue, Sales

Bottom line: - after tax profit, bottom line, net, net profit, profit

LiveJournal Tags: Income Statements,Top Line,Bottom Line