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Emerging Commodity Markets: Current Status and Utilization

Emerging Commodity Markets: Current Status and Utilization

PARK Hwan-Il

June 9, 2011

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Originally released on May 12, 2011

The continued uptrend in the prices of crude oil, gold, corn, raw cotton, etc. has rekindled interest in commodities as an investment asset. Spot and future prices of commodities have been on the rise since the first half of 2010, either breaking new records or coming close. The Commodity Research Bureau(CRB) spot price index posted 580.32 on April 11, the highest since the index began in 1940 (average CRB was 577.25 in April). As rising commodity prices and inflation hedging investment in commodities gain more attention, demand for commodities is growing accordingly. A total of 646 Korean funds are dedicated to commodities, 23% of the total funds. The total value of the commodity funds amounts to 5.2 trillion won (12% of the entire funds) and these funds have seen a net inflow of investment for four consecutive months since January of this year.

Growth in commodity prices leads to rising inflation and increased production costs which dent profits. Companies who failed to manage the risks stemming from growth in the prices of raw materials are susceptible to pullbacks in operating profit. Futures prices of West Texas Intermediate (WTI) crude oil, corns and raw cotton rose 27%, 86%, 147% from a year ago respectively. Rising producer and consumer prices are highly likely to lift inflation, shrinking the economy and stunting economic growth. Continued growth in commodity prices and the resulting uptick in inflation are expected to increase the importance of the functions and value of the commodity market.

As the commodity market is anticipated to have a bigger impact on the Korean economy and asset portfolios, it is urgent to form a consensus and lay the foundation for the development of Korea's commodity market. As of now, the Korean commodity market mainly trades in gold and pork futures, thus it has great potential for further growth. Although gold and pork futures were first listed in 1999 and 2008 respectively, trade volume is too low for the market to perform as a full-blown futures market.

As the importance of the commodity market in the real economy and financial market grows, the characteristics of the commodity market such as high risks and high returns should be well understood and utilized. Investors and companies who try to manage risks from growth in spot prices have to clearly set the level of bearable risks. The entire process of investment and risk management should be transparent, and whether the level of tolerable risks is maintained should be closely monitored.

The inclusion of investment in commodities in asset portfolios can help make higher expected profit. Since the commodity market is rarely correlated to the financial market, investment in commodities can lower the risk of portfolios. Hedging strategies should be drawn up under a specific goal and a good understanding of hedging mechanisms would prevent hedgers from turning into speculators. The objective of hedging is to hedge against the risk of a spot market position a company is currently taking, so taking a bigger futures market position than the current spot market position can translate into a risky speculative trade

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