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What Investment Bankers Should Know about Commodities

The commodities asset class in investment banking includes a wide variety of goods, ranging from agricultural commodities (such as corn, soybeans, and cattle) to precious metals. While assets such as stocks, bonds, and real estate are purchased for the expected stream of revenues that will come from owning the assets, commodities don't provide such cash flows and are purchased and sold on the basis of their consumption and speculative values.

Many firms buy and sell commodities in order to hedge their natural positions in commodities — airlines buy oil in the futures markets and farmers sell wheat in the futures markets. However, many investors buy and sell commodities as investments — in effect, speculating on future prices.

One of the attractions to commodities as an asset class is that commodity prices and stock and bond prices generally don't move together. This quality helps to reduce risk of a portfolio that includes commodities along with stocks and bonds.

Investors can take positions in commodities either by purchasing the physical commodity — taking delivery of 5,000 bushels of corn or 1,000 barrels of crude oil — or by agreeing to buy or sell claims to these assets in the futures markets. Investors can buy or sell futures contracts based on many commodities, and these markets are global in nature.

As you may suspect, transacting in the futures markets is the preferred method because these contracts are liquid (they can be readily bought and sold), and the investor doesn't have to find a place to store all that corn or crude oil.

Investors generally invest in commodities either passively or actively. Passive investment is often done by taking a position in a commodities index. A commodities index is much like a stock index, and the value of the index rises and falls as the value of the individual commodities rises and falls.

One of the most popular ways to gain broad exposure to commodities is to purchase a futures contract on the Goldman Sachs Commodities Index.

If investors want to attempt to beat the market and earn rates of return that exceed that of a simple index of commodities, they may look to the services of a commodity trading advisor (CTA; a professional money manager who specializes in commodities) or may invest in managed futures (funds of futures contracts where the typical fees are similar to those in the hedge fund and venture capital industries).

The greater fool theory says that the prices of some assets aren't determined because an investor thinks it's worth the price but because the investor thinks he can sell it to someone in the future at an even higher price — that is, sell it to a greater fool.

The greater fool theory explains speculative bubbles through time from tulip mania in the Netherlands in the 1600s to the Internet bubble in 2000 and the residential real estate bubble of the last few years. Many people believe that the price of some commodities like gold are largely determined by the greater fool theory.

Warren Buffett has made the point that if you put all the world's gold together, it would form a cube about 68 feet per side. For the value of that cube of gold, Buffett notes you could buy all the farmland in the United States and about 16 Exxon Mobils, and you'd have $1 trillion left over for walking-around money. What would you rather have?

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