Just as stocks are traded on the stock exchange, commodities like oil, gold, and certain food grains are traded on standardized exchanges. The Chicago Board of Trade (CBOT) is an example of a commodities exchange. The commonly traded commodities come under the categories: energy, metals, and agricultural products.
Index is a ratio that measures change in performance relative to a base. Indexes can be price weighted or value weighted. The Commodity Price Index is a weighted average of selected commodity prices. These commodities are believed to represent the commodity market. We can have an index for each of these commodities or for all of them, taken together.
Types of Commodity Price Indexes
The Reuters-CRB Futures Index is the oldest and most popular commodity price index. The index takes 1947-49 to be the base year. The price of the commodities in the base year is assumed to be 100. The ratio between the weighted average of the futures prices and the weighted average of the base year prices gives us the change in the index.
The futures prices are obtained from the futures contracts that are set to expire on or within six months from the given date of calculation of the index. A futures contract is an obligation to buy or sell a commodity at a predetermined price on the expiry of the contract irrespective of the price of the commodity on that date.
The Reuters-CRB Futures Index is calculated daily and is based on a basket of relevant commodities divided into 4 categories that are allotted weights, based on significance. The maximum weight is given to first category which has sources of energy, viz. crude oil, heating oil, and unleaded gas. Of the three, crude oil is given the maximum weight (23%).
The remaining categories are in the order of increasing liquidity. Category 2 has 7 commodities, each with a weight of 6%. Category 3 has 4 commodities, each commodity has a weight of 5%. The last category has 5 commodities with a total weight of 5%. In other words, the last 3 categories are equally weighted.
The Reuters-CRB Futures Index measures the pulse of the commodity market and can help investors profit from investing in the market.
Standard & Poor's Goldman Sachs Commodity Index (S&P GSCI), Dow Jones AIG Commodity Index (DJ-AIGCI) and Jim Rogers International Commodities Index are a few popular commodity price indexes. The S&P GSCI is a composite index representing an unleveraged, long-only investment in commodity futures.
Both S&P GSCI and DJ-AIGCI have the categories: metals, energy, and agriculture; but the weight allotted to each category is different. DJ-AIGC allocates more to agricultural commodities while S&P GSCI allocates more to the sources of energy.
Relationship between Stock, Bond, and Commodity Market
The relationship between the commodity price indexes and the price of bonds is generally inverse. The main reason for this is inflation. During periods of economic prosperity, there is great demand for raw material, since works of expansion are undertaken on a large scale.
This results in an increase in the commodity price index. The demand for money increases and consequently, interest rates increase. The relationship between bond prices and interest rates is inverse. Hence bond prices and commodity prices are negatively correlated.
Stock prices and currency appreciation are positively related. Inflation results in currency depreciation. However, inflation increases the price of commodities. Hence, a negative relationship exists between stocks and commodities.
Investing in Commodity Indexes
Including commodities in our portfolio along with stocks and bonds would be an excellent way of diversifying the portfolio. Crude oil supply has always been strictly controlled by the oil-producing nations. Controlled oil supply results in an increase in price. Hence, before recession, the price of crude oil was exorbitant.
A smart investor could have benefited from investing in S&P GSCI, since the index allocates a big chunk to the sources of energy. During recession, it is safer to invest in bonds and interest-sensitive stocks. Investing in a commodity index is a passive strategy.
Thus, commodity index funds provide a hedge against inflation and allow the investor to diversify his portfolio. It would be a good idea to invest in commodity indexes once the recession ends, and the price of commodities start appreciating.