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Why wheat turns to dust when shares crumble

It’s been a bloodbath in stock exchanges round the world in the last few days. But wheat, corn, sugar and soya have little to do with US Fed, the yen or the Nikkei. So why have your commodity chips plummeted as well? ET helps you join the dots.

There are two important facts to remember. First, in 2006, commodity markets attracted ‘hot money’ from some very large non-traditional investors, such hedge funds, pension funds, and indices traders. These cash-rich punters have almost come to dominate the market because their deep pockets allow them to accumulate fairly large positions in any commodity they fancy.

Their favourite trading philosophy is “a little bit in everything and commitment to nothing”.

Hedge funds, which manage about $1.3 trillion worldwide, are loosely regulated private investment funds that seek to profit from new opportunities using alternative investment strategies.

About 8,000 hedge funds trade globally, based on estimates from Hedge Fund Research in Chicago. Commodity-trading hedge funds returned between 13% and 23% last year, according to a survey of 100 commodity funds by NewFinance Capital, an investment adviser based in London.

Global investment in commodity funds doubled to $24 billion in 2006 and may rise 25% in 2007, according to NewFinance. Investment banks, too, have a risk trading culture, deep pockets and both physical and financial traders.
In the US, these non-traditional players on Nymex, CBoT and NyBoT became so numerous that the local regulator, CFTC, decided their trading positions in each commodity should be listed separately in its weekly market round-up.
In India, we saw the same trend of non-traditional players moving in when stock market traders decided to invest in commodity futures as a way of expanding their risk portfolio.

The second fact to remember is that futures are a highly leveraged game. By putting upfront a small amount of cash, called initial margin, you can acquire positions in commodities worth several times over.

However, even this margin money is not without risk. If prices move against you, i.e. the value of the commodity you bought alters, you are expected to put in more cash as variable margin. If you don’t have deep pockets at that juncture, you may have no option but to exit the market with a loss.

When the markets are relatively placid and less volatile, punters face little risk. But a sudden upheaval can kill. That is what happened last week when the Shanghai stock exchange saw its biggest fall in a decade and Wall Street had its worst day since the aftermath of the 9/11 attacks.

Shares began to look risky. Hedge funds and other financial institutions had to suddenly find money to either meet the margin calls on their equity portfolio or sell out. A relatively painless way of doing it was to book profits by selling off their positions in the commodities market. With the big punters heading for the exit simultaneously, the meltdown in equity markets was replicated in the commodity exchanges as well.

When funds liquidated their positions on commodity exchanges, it drove prices of wheat, sugar, coffee and cotton into the ground. The worst hit were the punters’ favourites over the last one year, such as soya and corn. In metals and bullion, there was an additional factor. Traders were suddenly nervous about an impending Chinese economic slowdown. As Chinese demand has been the significant pull factor for global metal prices in 2006, a slowdown would immediately impact the demand-supply equilibrium and the fortunes of players in the entire metals value chain. Funds with long positions turned into sellers.

Gold is usually a natural hedge against inflation. But traders reasoned that if the Chinese economy slows down along with possibly the US economy, then there would be less demand for goods and services and therefore, a lower threat of inflation. Speculators, who were heavily long, headed for the doors.

Should you worry too? For genuine hedgers and traders, there is little reason. After all, there has been no change in the fundamentals in the last few days. Even in precious metals, investment interest remains keen and if global stock markets remain volatile, they may well become the last refuge for punters once again.

Source :ET

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