Tag: University of Mumbai BMS Notes

Joseph Schumpeter propounded the well-known innovative theory of entrepreneurship. Schumpeter takes the case of a capitalist closed economy which is in stationary equilibrium. He believed that entrepreneurs disturb the stationary circular flow of the economy by introducing an innovation and takes the economy to a new level of development. The activities of the entrepreneurs represent a situation of disequilibrium as their activities break the routine circular flow.

Innovations of entrepreneurs are responsible for the rapid economic development of any country.

Talking about innovation, he referred to new combinations of the factors of production, Schumpeter had assigned the role of innovator to the entrepreneur, who is not a man of ordinary managerial ability, but one who introduces something entirely new.

The Innovation Theory of Profit was proposed by Joseph. A. Schumpeter, who believed that an entrepreneur can earn economic profits by introducing successful innovations.

In other words, innovation theory of profit posits that the main function of an entrepreneur is to introduce innovations and the profit in the form of reward is given for his performance. According to Schumpeter, innovation refers to any new policy that an entrepreneur undertakes to reduce the overall cost of production or increase the demand for his products.

Thus, innovation can be classified into two categories; The first category includes all those activities which reduce the overall cost of production such as the introduction of a new method or technique of production, the introduction of new machinery, innovative methods of organizing the industry, etc.

The second category of innovation includes all such activities which increase the demand for a product. Such as the introduction of a new commodity or new quality goods, the emergence or opening of a new market, finding new sources of raw material, a new variety or a design of the product, etc.

The innovation theory of profit posits that the entrepreneur gains profit if his innovation is successful either in reducing the overall cost of production or increasing the demand for his product. Often, the profits earned are for a shorter duration as the competitors imitate the innovation, thereby ceasing the innovation to be new or novice. Earlier, the entrepreneur was enjoying a monopoly position in the market as innovation was confined to himself and was earning larger profits. But after some time, with the others imitating the innovation, the profits started disappearing.

An entrepreneur can earn larger profits for a longer duration if the law allows him to patent his innovation. Such as a design of a product is patented to discourage others to imitate it. Over the time, the supply of factors remaining the same, the factor prices tend to rise as a result of which the cost of production also increases. On the other hand, with the firms adopting innovations the supply of good sand services increases and their prices fall. Thus, on one hand the output per unit cost increases while on the other hand the per unit revenue decreases.

There is a point of time when the difference between the costs and receipts gets disappear. Thus, the profit in excess of the normal profit disappears. This innovation process continues and also the profits continue to appear or disappear.

Innovation could involve any of the following:

1. Innovation of new products.
2. Innovation in novel methods or processes of production.
3. The opening up of a new market.
4. Entrepreneurs might find new source of supply of raw materials
5. Innovation in management. This means reorganization of an industry.

Let us try to understand the meaning of different facets of the term innovation.

The introduction of new product means the product which the consumers have not seen and is of a new and better quality and utility. A new method of production refers to a novel process not yet been used in manufacturing and commercial production. This may increase the productivity and lower cost of production.

The discovery of a new market means a new market which may have existed before but was not entered by the enterprise for commercial purposes. A new source of raw material similarly refers to a source or a place which has not been commercially exploited by the enterprises before. Innovation in management refers to reorganization and reconciliation of the position of the enterprise in the industry by building a monopoly like control or dismantling existing monopoly of others in the industry.

Schumpeter was very explicit about the economic function of the entrepreneur, whom he considered as the prime mover in economic development and the entrepreneur’s task is to innovate or carry out new combinations.

Schumpeter had differentiated between invention and innovation. We should understand that invention refers to creation of new materials and innovation refers to application of new materials into practical use in industry. Similarly, there is a distinction between an innovator and an inventor. The inventor is the one who invents new materials and new methods. On the other hand, the innovator is the one who utilizes these inventions and discoveries in order to make new combinations.

Bringing about innovations is the main task of the entrepreneur and not the maintenance of the enterprise. Entrepreneurs dream and have a willingness to establish a private kingdom. They enjoy creating and getting things done. These “innovating entrepreneur” has played an important role in the rise of modem capitalism.

Criticisms:

Schumpeter’s theory has been subjected to the following criticisms:

1. Critics feel that the theory over emphasized on innovative functions of the entrepreneur. It ignored the organizing aspects of entrepreneurship.
2. Schumpeter had completely ignored the risk-taking function of the entrepreneur, which cannot be ignored. Whenever an entrepreneur develops a new combination of factors of production, there is enough risk involved.
3. The theory is more applicable in developed countries only. In developing countries there is a paucity of innovative entrepreneurs.
4. The theory does not provide the explanation as to why few countries have more entrepreneurship talent than others.

Despite of all the above criticisms Schumpeter’s theory is considered as a landmark in the expansion of entrepreneurship theories.

An Entrepreneurial Culture Assessment

Openness: A willingness to share information and lessons learned widely

• Do you share lessons learned from success as well as failure?
• Is it a norm for individuals to share constructive criticism to push thinking and minimize risk?
• Do employees at every level understand “the big picture”?

Adaptability: A commitment to monitoring your organization’s internal environment through measurement and your external environment through research and using the results to identify possibilities for change and improvement

• Are you monitoring customer (e.g., client, donors, volunteers) feedback — quantitative and qualitative — to detect shifts in needs and/or behaviors?
• Do you regularly seek feedback from external stakeholders about your performance and what more you could be doing to serve your mission?
• Do you question the status quo (a.k.a., “We have always done it this way.”) to ensure that it is still the best way?

Results and Rewards: A dedication to tracking outcomes and impact, but also rewarding the right behaviors, including organizational citizenship

• Do you push decisions downward to those on the front line and with the most information?
• Do you reward the right behavior more than you reprimand negative behavior?
• How does your organization handle failure? Do you learn from it and share lessons learned?

Learning Organization: A promise to employees to support a learning organization that will encourage them to grow and learn without fear

• Do all employees have goals for personal improvement that are regularly discussed and nurtured?
• When something goes wrong, does everyone pitch in without playing the blame game?
• Do you share best practices and newsworthy trends with everyone for feedback and possible implementation within the organization?

Role

1. Create a culture of experimentation

Articles, books, and other resources give the same account: Failure is a precursor to success. When you accept failure as a part of the learning process that helps you achieve your goals, you get more comfortable with this concept.

The key to making failure work for you is conducting experiments that are small enough you won’t be left shirtless if things go south. Creating a company culture that experiments on a regular basis thrives only when you’ve also developed a consistent feedback loop. This crucial communication tool ensures you’ll have the clues needed to iterate and produce something remarkable. 

2. Make idea generation a habit

Innovation begins with an idea. And to exponentially increase the odds of producing a winning idea for your business, quantity trumps quality. Of course, not every idea will be a great one. But a large arsenal of thoughts from which to choose makes it easier to refine your understanding of what your customers want from you. 

Work to make idea generation a habit in your business. Encourage team members to bring forth their own suggestions, and create a system to catalog what is presented.

3. Diversify your experiences

When it comes to innovation, realize that homogeneity is a liability. Steve Jobs knew this to be true. It’s why he encouraged others to branch out to take the road less traveled. “If you’re gonna make connections which are innovative … you have to not have the same bag of experiences as everyone else does,” Jobs said in 1982, as he accepted the “Golden Plate” award from the Academy of Achievement in Washington, D.C. He was 26.

Make it a point to step outside your comfort zone. Accumulate new experiences for yourself both professionally and personally. As you look to build a rockstar team, be intentional about seeking talent that brings to the table diverse backgrounds, experiences and ways of thinking.

The observations, skills and expanded frame of reference you obtain as a result will prevent you from being satisfied with the status quo.

4. Encourage dissent

Want to improve the quality of your ideas? Encourage others to tear them down. A capable team of people whose opinions you value will generate constructive criticism to help make your idea better. You’ll produce a much better product or offering than you ever could have done alone. 

Research backs up this principle. Data from UC Berkeley demonstrates that conflict improves the ideation process. A team whose members cosign everything you say can’t help you or your company become more innovative.

5. Obsess over your customers.

Your business exists to serve your customers. The more value you provide, the more they will reward you with their loyalty. When you focus your efforts on knowing your customers intimately, you’ll gain a tremendous amount of insight into how to solve their problems like none other.

Talk to your customers every chance you get. Take the opportunity to walk a mile in their shoes so you can develop a deeper empathy for their issues. Seek out pain points at every step of their customer journey and brainstorm ways to improve the experience for them.

McClelland’s theory of needs is one such theory that explains this process of motivation by breaking down what and how needs are and how they have to be approached. David McClelland was an American Psychologist who developed his theory of needs or Achievement Theory of Motivation which revolves around three important aspects, namely, Achievement, Power and Affiliation.

This theory was developed in the 1960s and McClelland points out that regardless of our age, sex, race or culture, all of us possess one of these needs and are driven by it. This theory is also known as the Acquired Needs as McClelland put forth that the specific needs of an individual are acquired and shaped over time through the experiences he has had in life.

Psychologist David McClelland advocated Need theory, also popular as Three Needs Theory. This motivational theory states that the needs for achievement, power, and affiliation significantly influence the behavior of an individual, which is useful to understand from a managerial context.

This theory can be considered an extension of Maslow’s hierarchy of needs. Per McClelland, every individual has these three types of motivational needs irrespective of their demography, culture or wealth. These motivation types are driven from real-life experiences and the views of their ethos.

Need for Achievement

The need for achievement as the name itself suggests is the urge to achieve something in what you do. If you are a lawyer it is the need to win cases and be recognized, if you are a painter it is the need to paint a famous painting. It is the need that drives a person to work and even struggle for the objective that he wants to achieve. People who possess high achievement needs are people who always work to excel by particularly avoiding low reward low-risk situations and difficult to achieve high-risk situations.

Such people avoid low-risk situations because of the lack of a real challenge and their understanding that such achievement is not genuine. They also avoid high-risk situations because they perceive and understand it to be more about luck and chance and not about one’s own effort. The more the achievements they make the higher their performance because of higher levels of motivation.

These people find innovative clever ways to achieve goals and consider their achievement a better reward than financial ones. They take calculated decision and always appreciate feedback and usually works alone.

The individuals motivated by needs for achievement usually have a strong desire of setting up difficult objectives and accomplishing them. Their preference is to work in a results-oriented work environment and always appreciate any feedback on their work. Achievement based individuals take calculated risks to reach their goals and may circumvent both high-risk and low-risk situations.

They often prefer working alone. This personality type believes in a hierarchical structure derived primarily by work-based achievements.

Need for Power

The need for power is the desire within a person to hold control and authority over another person and influence and change their decision in accordance with his own needs or desires. The need to enhance their self-esteem and reputation drives these people and they desire their views and ideas to be accepted and implemented over the views and ideas over others.

These people are strong leaders and can be best suited to leading positions. They either belong to Personal or Institutional power motivator groups. If they are a personal power motivator, they would have the need to control others and an institutional power motivator seeks to lead and coordinate a team towards an end.

The individuals motivated by the need for power have a desire to control and influence others. Competition motivates them and they enjoy winning arguments. Status and recognition are something they aspire for and do not like being on the losing side.

They are self-disciplined and expect the same from their peers and teams. They do not mind playing a zero-sum game, where, for one person to win, another must lose and collaboration is not an option. This motivational type is accompanied by needs for personal prestige, and better personal status.

Need for Affiliation

The need for affiliation is the urge of a person to have interpersonal and social relationships with others or a particular set of people. They seek to work in groups by creating friendly and lasting relationships and has the urge to be liked by others. They tend to like collaborating with others to competing with them and usually avoids high-risk situations and uncertainty

The individuals motivated by the need for affiliation prefer being part of a group. They like spending their time socializing and maintaining relationships and possess a strong desire to be loved and accepted. These individuals stick to basics and play by the books without feeling a need to change things, primarily due to a fear of being rejected.

People in this group tend to adhere to the norms of the culture in that workplace and typically do not change the norms of the workplace for fear of rejection. Collaboration is the way to work for the competition remains secondary. They are not risk seekers and are more cautious in their approach. These individuals work effectively in roles based on social interactions, for instance, client service and other customer interaction positions.

Using the Theory

McClelland’s theory can be applied to manage the corporate teams by being identifying and categorizing every team member amongst the three needs. Knowing their attributes may certainly help to manage their expectations and running the team smoothly.

The following two steps process can be used to apply McClelland’s theory:

Step 1: Identify the Motivational Needs of the Team

Examining the team to determine which of the three needs is a motivator for each person. Personality traits and past actions can help in this process.

For example, someone who always takes charge of the team when a project is assigned. The one who speaks up in meetings to encourage people, and delegates responsibilities in order to facilitate achieving the goals of the group. Someone who likes to control the final deliverables. This team member is likely being driven by power.

Another team member who does not speak during meetings, and is happy agreeing with the team thoughts, is good at managing conflicts and may seem uncomfortable while someone talks about undertaking high-risk, high-reward tasks. This team member is likely being driven by affiliation.

Step 2: Approaching Team According to To Their Need type

Based on the motivating needs of the team members, alter your leadership style to assign projects according to the type of the need of each individual team member. Challenging projects would definitely be a part of a work portfolio of someone who enjoys power while relatively simpler projects go to the kitty of someone derived from affiliation.

This information is crucial to influence while setting up relevant goals for the individual, monitoring, providing feedback, recommending the learning plan, etc. If a particular need type does not fit the position of the individual, he/she can be made aware of the same, so that they can either work in the right direction or accept their fate.

The Knight’s Theory of Profit was proposed by Frank. H. Knight, who believed profit as a reward for uncertainty-bearing, not to risk bearing. Simply, profit is the residual return to the entrepreneur for bearing the uncertainty in business.

Knight had made a clear distinction between the risk and uncertainty. The risk can be classified as a calculable and non-calculable risk. The calculable risks are those whose probability of occurrence can be anticipated through a statistical data. Such as risks due to the fire, theft, or accident are calculable and hence can be insured in exchange for a premium. Such amount of premium can be added to the total cost of production.

While the non-calculable risks are those whose probability of occurrence cannot be determined. Such as the strategies of a competitor cannot be accurately assessed as well as the cost of eliminating the completion cannot be precisely calculated. Thus, the risk element of such events is not insurable. This incalculable area of risk is the uncertainty.

Due to the uncertainty of events, the decision-making becomes a crucial function of an entrepreneur or manager. If the decisions prove to be correct by the subsequent events, an entrepreneur makes a profit and vice-versa. Thus, the Knight’s theory of profit is based on the premise that profit arises out of the decisions made under the conditions of uncertainty.

Knight believes that profit might arise out of the decisions made concerning the state of the market, such as decisions with respect to increasing the degree of monopoly in the market, decisions regarding holding stocks that might result in the windfall gains, decisions taken to introduce new product and technique, etc.

The major criticism of the knight’s theory of profit is, the total profit of an entrepreneur cannot be completely attributed to uncertainty alone. There are several functions that also contribute to the total profit such as innovation, bargaining, coordination of business activities, etc.

There are certain risks that are measurable and the probability of such risk can be statistically estimated and hence such risks can be insured. Example of insurable risks include theft of commodities, fire in the enterprise, accidental death etc. On the other hand, there are certain risks which cannot be calculated.

The probability of their occurrence cannot be statistically ascertained. Such risks include risks associated to changes in prices, demand and supply. These risks are non-insurable. Prof. Knight opined that the profit is the reward for bearing the non-insurable risks and uncertainties.

Uncertainty-bearing is one of the most vital functions in a dynamic economy. The entrepreneur bears the uncertainty involved in the enterprise. The expectation of profit is the supply price of the entrepreneurial uncertainty bearing exercise. In a state of economy (competitive) where there is no risk, every entrepreneur will have a minimum supply price.

If the reward allocated to the entrepreneur is below it, the entrepreneurs will abstain from providing their entrepreneurial services. The existence of uncertainty tends to raise the minimum supply price. The entrepreneurs expect a level of profit for bearing the uncertainty.

The salient points of Knight’s theory include:

1. According to the theory, the entrepreneur earns pure profits for bearing the uncertainty.
2. The probability of uncertainty or non-insurable risks cannot be statistically estimated.
3. Entrepreneurs undertake risks of varying degrees according to their ability ad inclination. The theory suggests that the more risky the nature of enterprise, the higher level of profit earned by the entrepreneurs.
4. Profit is the reward of the entrepreneur for bearing uncertainties and risks. Hence, it should be a part of the normal cost.
5. The reward of the entrepreneur is uncertain. Entrepreneur guarantees interest to lender of capital, wages to workers and rent to the landlord.
6. The level of uncertainty in business can be reduced by applying the technique of consolidation. The total level of uncertainty can be reduced by pooling individual instances.

Criticisms:

F.H. Knight’s theory is one of the most sophisticated theories to explain supply of entrepreneurship based on profit. But, the theory suffers from certain drawbacks as pointed by the critics.

1. The role of an entrepreneur has not been elaborately provided by the theory. The entrepreneur’s activity has been restricted to uncertainty bearing. Modern business activities are different. Often, there is a dichotomy between ownership and management. These factors have not been taken into consideration.
2. The uncertainty-bearing theory discussed the concept of profit in a vague way. The exact estimation of profit for the entrepreneur has not been provided in the theory.
3. Profit as a residual income of the entrepreneur has been criticized.
4. Critics feel that uncertainty-bearing should not be treated like other factors of production like land, labour and capital. It is a psychological concept and should be treated in a different manner.

Hagen in his theory had accredited the withdrawal of status respect of a group as the starting point for entrepreneurship development process. Before we discuss the concept of withdrawal of status respect let us try to consider the various crucial facets of the theory.

The theory is based on a general model of the society. His theory viewed the entrepreneur as a trouble shooter who contributes to economic development. The creativity of the entrepreneur brings about social transformation and economic development. Economic growth is associated with the social and political changes. He didn’t encourage the entrepreneurs to imitate other’s technology.

Hagen had ascribed the genesis of entrepreneurship to withdrawal of status respect of a group. The social group that experiences the withdrawal of status respect engulfs itself into aggressive entrepreneurism. In such a situation the status loosing group and the members of status loosing group endeavour to regain their status by undertaking rigorous entrepreneurial drive.

Hagen had suggested the events that could create as well as indicate withdrawal of status respect of a social group. First, dislodgment of a traditional elite group from its prior status, Second, defamation of valued symbols through some change in the attitude of the superior group. Third, Unpredictability of status symbols in the changed allocation of economic power. Fourth, when social group doesn’t enjoy the expected status when it migrates to a new society.

There four possible reactions to the withdrawal of status respect which relates to four different personality types:

(i) The retreatist: An individual who works in the society but is indifferent to the work and position.

(ii) The ritualist: An individual who works in the manner accepted and approved by the society but has no hopes of improving his/her position.

(iii) The reformist: An individual who fights against the injustice and tries to rebels against the established society in order to form a new society.

(iv) The innovator: An individual who endeavours to bring about new changes and utilizes all opportunities. This personality reflects the personality of an entrepreneur.

Criticisms:

1. The theory lacks general application. It is not always true that all the social groups have behaved in the manner as advocated in the theory.
2. The theory ignores the various other factors accountable for development of entrepreneurship.

X-inefficiency is the difference between efficient behaviour of firms assumed or implied by economic theory and their observed behaviour in practice. It occurs when technical-efficiency is not being achieved due to a lack of competitive pressure. The concepts of x-inefficiency were introduced by Harvey Leibenstein

The degree of efficiency maintained by individuals and firms under conditions of imperfect competition. According to the neoclassical theory of economics, under perfect competition individuals and firms must maximize efficiency in order to succeed and make a profit; those who do not will fail and be forced to exit the market. However, x-efficiency theory asserts that under conditions of less-than-perfect competition, inefficiency may persist.

Economic theory assumes that the management of firms act to maximize economic profits which is accomplished by adjusting the inputs used or the output produced. In perfect competition, the free entry and exit of firms tends toward firms producing at the point where price equals long run average costs and long run average costs are minimized. Thus firms earn zero economic profits and consumers pay a price equal to the marginal cost of producing the good. This result defines economic efficiency or, more precisely, allocative economic efficiency.

X-inefficiency is not the only type of inefficiency in economics. X-inefficiency only looks at the outputs that are produced with given inputs. It doesn’t take account of whether the inputs are the best ones to be using, or whether the outputs are the best ones to be producing, which is referred to as allocative efficiency. For example, a firm that employs brain surgeons to dig ditches might still be x-efficient, even though reallocating the brain surgeons to curing the sick would be more efficient for society overall.

Leibenstein regards entrepreneurship as a creative response to X-efficiency. Other people’s lack of effort and the consequent inefficiency of the organizations that employ them, create opportunities for entrepreneurs. Entrepreneurial activities pose a competitive threat to inefficient organizations.

Leibenstein identifies two main roles for entrepreneurs. The first role is the ‘input completion’ involves making available inputs which improve efficiency of existing production methods or facilitates the introduction of new ones. It is normally effected by intermediation in factor markets, in particular the markets for venture capital and management skills. The role of entrepreneur is to improve the flow of information in these markets.

The second role ‘gap filling’ is closely related to arbitrage function emphasized by Kirzner. Leibenstein provides a very vivid description of gap filling, visualizing the economy as a net made up of nodes and pathways.

The nodes represent industries or households that receive inputs (or consumer goods) along the pathway and send outputs (final goods and inputs for the other commodities) to the other nodes. The perfect competition model would be represented by a net that is complete: one that has pathways that are well marked and well defined, one that has well-marked and well-defined nodes, and one in which each element (that is firm or household) of each node deals with every other node along the pathways on equal terms for the same commodity.

The concept of X-efficiency was introduced by Harvey Leibenstein a noted economist in1966 in his article titled “Allocative efficiency vs. X-efficiency”. This is also referred to as X-inefficiency. In general X-inefficiency refers to the difference between the optimal efficient behaviour of business in theory and the observed behaviour is practice which occurs owing to different factors.

X-efficiency refers to the effectiveness with which a given set of inputs are used to produce outputs. If a particular firm is producing the maximum output it can, given the resources it employs with the best available technology, it is said to be technical-efficient. X-inefficiency occurs when technical-efficiency is not achieved. Whenever an input is not used effectively the difference between the actual output and the maximum output attributable to that input is a measure of the degree of X-efficiency.

Harvey Leibenstein had mentioned that for allocative efficiency the whole economy was considered whereas in case of X-efficiency just specific companies and industries are to be considered.

X-efficiency arises either because the firm’s resources are used in the wrong way or because they are wasted, that is, not used at all.

The entrepreneur has been entrusted two roles; first the role of a gap filler and second an input completer. The production function usually has certain deficiencies. These deficiencies and gap arise because all the factors of production function cannot be marketed. The entrepreneur has been entrusted the job to fill the gaps in the market. The second role of the entrepreneur is input completion. The entrepreneur has to mobilize all the available inputs in order to improve the efficiency of existing production methods.

Leibenstein advocated two types of entrepreneurship. First type is the ‘Routine entrepreneurship’ which involves the important functions of management of business. Second type is that of the ‘New entrepreneurship’ which involves innovative entrepreneurship.

Criticisms:

The Leibenstein’s theory has been often compared with the neoclassical views.

The theory has many novel contributions but has been criticized on following counts:

1. The exact influence which the X-efficiency has on output of an organisation cannot be determined.
2. The theory is less predictable as compared to normal theories.

Basis risk in finance is the risk associated with imperfect hedging due to the variables or characteristics that affect the difference between the futures contract and the underlying “cash” position.

Basis risk is the financial risk that offsetting investments in a hedging strategy will not experience price changes in entirely opposite directions from each other. This imperfect correlation between the two investments creates the potential for excess gains or losses in a hedging strategy, thus adding risk to the position.

It arises because of the difference between the price of the asset to be hedged and the price of the asset serving as the hedge namely b = S – F, before expiration, any difference at expiration will be offset by arbitrage. Other examples of aspects that may cause basis risk to arise:

a) Quality: the hedge in place may have a different grade (which may not be perfectly correlated with the basis)

b) Timing: A mismatch between the expiration date of the hedge asset and the actual selling date of the asset

c) Location/Transportation Costs: Due to the difference in the location of the asset to be hedged and the asset serving as the hedge, an unforeseen rise in transportation costs may cost the producer who hedges more money.

• Basis risk is the potential risk that arises from mismatches in a hedged position.
• Basis risk occurs when a hedge is imperfect, so that losses in an investment are not exactly offset by the hedge.
• Certain investments do not have good hedging instruments, making basis risk more of a concern than with others assets.

Under these conditions, the spot price of the asset, and the futures price, do not converge on the expiration date of the future. The amount by which the two quantities differ measures the value of the basis risk. That is,

Basis = Futures price of contract − Spot price of hedged asset.

Basis risk is not to be confused with another type of risk known as price risk.

Some examples of basis risks are:

• Treasury bill future being hedged by two year Bond, there lies the risk of not fluctuating as desired.
• Foreign currency exchange rate (FX) hedge using a non-deliverable forward contract (NDF): the NDF fixing might vary substantially from the actual available spot rate on the market on fixing date.
• Over-the-counter (OTC) derivatives can help minimize basis risk by creating a perfect hedge. This is because OTC derivatives can be tailored to fit the exact risk needs of a hedger.

Components of Basis Risk

Risk can never be altogether eliminated in investments. However, risk can be at least somewhat mitigated. Thus, when a trader enters into a futures contract to hedge against possible price fluctuations, they are at least partly changing the inherent “price risk” into another form of risk, known as “basis risk”. Basis risk is considered a systematic, or market, risk. Systematic risk is the risk arising from the inherent uncertainty of the markets. Unsystematic, or non-systematic, risk, which is the risk associated with a specific investment. The risk of a general economic turndown, or depression, is an example of systematic risk. The risk that Apple may lose market share to a competitor is unsystematic risk.

Between the time a futures position is initiated and closed out, the spread between the futures price and the spot price may widen or narrow. As the visual representation below shows, the normal tendency is for the basis spread to narrow. As the futures contract nears expiration, the futures price usually converges toward the spot price. This logically happens as the futures contract becomes less and less “future” in nature. However, this common narrowing of the basis spread is not guaranteed to occur.

Different Types of Basis Risk

• Price basis risk: The risk that occurs when the prices of the asset and its futures contract do not move in tandem with each other.
• Location basis risk: The risk that arises when the underlying asset is in a different location from the where the futures contract is traded. For example, the basis between actual crude oil sold in Mumbai and crude oil futures traded on a Dubai futures exchange may differ from the basis between Mumbai crude oil and Mumbai-traded crude oil futures.
• Calendar basis risk: The selling date of the spot market position may be different from the expiry date of a futures market contract.
• Product quality basis risk: When the properties or qualities of the asset are different from that of the asset as represented by the futures contract.

A perfect hedge is a position undertaken by an investor that would eliminate the risk of an existing position, or a position that eliminates all market risk from a portfolio. In order to be a perfect hedge, a position would need to have a 100% inverse correlation to the initial position. As such, the perfect hedge is rarely found.

A common example of a near-perfect hedge would be an investor using a combination of held stock and opposing options positions to self-insure against any loss in the stock position. The downside of this strategy is that it also limits the upside potential of the stock position. Moreover, there is a cost to maintaining a hedge that grows over time. So even when a perfect hedge can be constructed using options, futures and other derivatives, investors use them for defined periods of time rather than as ongoing protection.

When the term perfect hedge is thrown about in the world of finance, it usually means an ideal hedge as judged by the speaker’s own risk tolerance. There is really no reason to completely remove all the risk out of an investment, as neutering risk has a similar impact on rewards. Instead, investors and traders look to establish a range of probability where the worst and best outcomes are both acceptable.

Traders do this by establishing a trading band for the underlying they are trading. The band can be fixed or can move up and down with the underlying. However, the more complex the hedging strategy, the more likely it is that hedging costs themselves can impact overall profit.

The same is true of investors in traditional securities. There are many strategies to hedge owned stocks involving futures, call and put options, convertible bonds and so on, but they all incur some cost to implement. Investors also try to create “perfect” hedges through diversification. By finding assets with low correlation or inverse correlation, investors can ensure smoother overall portfolio returns. Here again, the cost of hedging comes into play in that an investor ties up capital and pays transaction fees throughout the process of diversification.

Perfect hedges do exist in theory, but they are rarely worth the costs for any period of time except in the most volatile markets. There are several types of assets, however, that are often referred to as the perfect hedge. In this context, the perfect hedge is referring to a safe haven for capital in volatile markets. This list includes liquid assets like cash and short-term notes and less liquid investments like gold and real estate. It takes very little research to find issues with all of these perfect hedges, but the idea is that they are less correlated with financial markets than other places you can park your money.

Imperfect Hedge

The hedger’s gain and loss in the spot and futures market are not fully offset and the hedger will end up with some gain or loss. This is called imperfect hedge. Note that the gain or loss of hedging will be much less than not utilizing hedge.

Seller’s hedge or short hedge

Following the example from the previous page, assume the price has gone down between the time of selling the futures contract and November 1st and the basis has changed a bit (imperfect hedge). Let’s explore two cases:

• On November 1st, the spot market prices are $59.5/bbl and the December futures contract would be $60.60/bbl.
• On November 1st, the spot market prices are $59.60/bbl and the December futures contract would be $60.40/bbl.

Buyer’s hedge or long hedge

Following the example from the previous page, assume prices have gone down from the time the refinery buys the future contracts until November 1st. Let’s consider the above cases:

• On November 1st, the spot market prices are $59.50/bbl and the December futures contract would be $60.60/bbl.
• On November 1st, the spot market prices are $59.60/bbl and the December futures contract would be $60.40/bbl.

Inflation hedging

Commodity returns have tended to pick up when inflation has been rising and decline when inflation has been falling, in contrast to both equities and bonds.

Other asset classes which are typically considered inflation hedges, such as real estate and inflation-linked bonds, currently trade on historically very expensive valuations, unlike commodities.

While deflationary pressures exist, there are signs that inflation is building.

Labour markets are tight and the 12-month core inflation rate, which excludes commodity prices, has been running above 2% since last November. It would be complacent to ignore the dangers of inflation.

All the more so given the sums that have been pumped into the financial system and the policy bias towards generating inflation.

Commodities diversify equity risk

Commodities diversify equity risk but, given their intrinsic link with economic growth, it would be unrealistic to expect them to hedge so-called tail risks such as the economic downturn resulting from the financial crisis of 2008-09.

In reality, the relationship between commodities and equities varies considerably. At times there is a negative correlation, but on average they show a low but positive correlation.

Nonetheless, so long as commodities are not perfectly correlated with equities, even a small allocation to an equity-heavy portfolio can result in a reduction in overall volatility.

Assuming a 0.2 correlation between equities and commodities, reasonable given historic experience, we estimate that commodities only have to generate returns of around 2% a year to improve portfolio risk-adjusted returns.

Potential for more attractive risk-adjusted returns

So far we have argued that there is a case for a strategic allocation to commodities even if returns are relatively muted. In fact, however, current conditions suggest that they could actually be much better than that.

Certainly, commodities look cheap compared with their history, particularly against equities.

Furthermore, many commodities are trading below their costs of production, a key valuation anchor. They are one of the few global asset classes that can lay a claim to being cheap.

So, we would argue, there has rarely been a better time to buy commodities. However, effective implementation is key.

Passive investors tracking well known benchmarks are exposed to a host of undesirable costs and consequences which active managers can avoid or even profit from.

With prices low and many commodities poorly-researched, this should be an excellent environment in which active managers could add value.

A tradable commodity can be bought and sold, just like you trade in equity/shares. You buy a commodity, expecting future Price appreciation. When the future price hits the target, you sell it. This is the modus operandi. On the other side, sellers of a commodity sell it when they think there is no room for appreciation for future price. Open a demat account today.

Even today in villages, farmers exchange commodities among themselves. In the organized commodity trading world, things are a little different. Commodity trading is regaining its importance among investors. This trading happens on a commodities exchange, where various commodities and their derivatives products are bought/sold. The most commonly traded items are agricultural products and contracts based on them. But, increasing non-agro commodities are also being traded like diamonds, steel, energy items etc.

There are two sides to the same coin. Commodity trading has its own advantages and disadvantages.

The advantages include commodity futures are highly leveraged investments, which means with a relatively small amount of money you can take a bigger bet. Commodity future markets generally are very liquid, which means entry and exit are easy. Commodity futures can potentially give huge profits, if traded carefully and smartly

The disadvantages of commodity futures trading are that markets are volatile, which means risk is higher. Direct investment in the commodity markets is of high-risk, especially for new investors. So, be careful. Gains and losses are magnified by leverage, which means you win big or lose big.

Cash commodities or “actuals” refer to the physical goods, e.g., wheat, corn, soybeans, crude oil, gold, silver that someone is buying/selling/trading as distinguished from derivatives.