Harvard Case - An Investment Linked to Commodity Futures
"An Investment Linked to Commodity Futures" Harvard business case study is written by Jay O. Light, Kenneth A. Froot, Nancy Donohue. It deals with the challenges in the field of Finance. The case study is 13 page(s) long and it was first published on : Jul 8, 1992
At Fern Fort University, we recommend that the university proceed with the investment in commodity futures, but with a cautious and strategic approach that prioritizes risk management and diversification. This strategy involves a phased investment approach, starting with a smaller allocation and gradually increasing exposure based on market performance and the university's risk tolerance.
2. Background
Fern Fort University, a prestigious institution with a strong endowment, seeks to diversify its portfolio by investing in commodity futures. This decision is driven by the desire to generate higher returns and hedge against inflation. The university is considering investing in agricultural commodities, specifically corn and soybeans, due to their historical price volatility and potential for growth. However, the investment carries significant risks, including price fluctuations, market volatility, and potential for losses.
The main protagonists in this case are the university's investment committee, responsible for making investment decisions, and the university's endowment manager, tasked with implementing the investment strategy.
3. Analysis of the Case Study
This case study can be analyzed using a financial analysis framework that focuses on:
- Financial Analysis: We need to analyze the historical performance of corn and soybean futures, considering factors like price volatility, seasonality, and correlation with other asset classes. This analysis will help us understand the potential returns and risks associated with this investment.
- Risk Assessment: A thorough risk assessment is crucial. This includes identifying potential risks like price fluctuations, market volatility, counterparty risk, and regulatory changes. We need to develop a comprehensive risk management plan to mitigate these risks.
- Capital Budgeting: The university needs to determine the optimal allocation of funds to commodity futures, considering the overall portfolio diversification strategy and risk tolerance.
- Return on Investment (ROI): The investment committee needs to evaluate the expected ROI of the commodity futures investment, comparing it to other investment opportunities.
- Cash Flow Management: The university needs to assess the impact of the investment on its cash flow, considering potential margin calls and the need for liquidity.
4. Recommendations
- Phased Investment Approach: The university should start with a smaller allocation to commodity futures, gradually increasing exposure based on market performance and risk tolerance. This approach allows for a controlled entry into the market and minimizes potential losses.
- Diversification: The university should diversify its commodity futures investment across different agricultural commodities and potentially other asset classes. This reduces the overall risk by spreading investments across various markets.
- Risk Management: The university should implement a comprehensive risk management plan that includes:
- Setting clear investment objectives and risk tolerance levels.
- Establishing stop-loss orders to limit potential losses.
- Monitoring market conditions closely and adjusting the investment strategy as needed.
- Utilizing hedging strategies to mitigate price fluctuations.
- Professional Expertise: The university should engage with experienced commodity futures traders and investment professionals to gain insights and guidance on market dynamics and risk management.
5. Basis of Recommendations
These recommendations are based on the following considerations:
- Core Competencies and Consistency with Mission: The university's core competency lies in education and research. Investing in commodity futures is a strategic move to enhance the endowment's returns and ensure long-term financial stability, aligning with the university's mission.
- External Customers and Internal Clients: The investment strategy should be aligned with the interests of both external stakeholders, such as donors, and internal stakeholders, including faculty and students.
- Competitors: The university should benchmark its investment strategy against other institutions with similar endowments and consider best practices in the industry.
- Attractiveness ' Quantitative Measures: The investment committee should evaluate the potential ROI of the commodity futures investment using quantitative measures like NPV, IRR, and payback period.
- Assumptions: These recommendations are based on the assumption that the university has a long-term investment horizon and a moderate to high risk tolerance.
6. Conclusion
Investing in commodity futures can be a viable strategy for diversifying the university's endowment portfolio and potentially enhancing returns. However, it is essential to approach this investment with a cautious and strategic approach that prioritizes risk management and diversification. By implementing a phased investment strategy, diversifying across different commodities, and engaging with experienced professionals, the university can mitigate potential risks and maximize the potential benefits of this investment.
7. Discussion
Alternative options to investing in commodity futures include:
- Investing in real estate: Real estate can offer diversification and potential for appreciation.
- Investing in private equity: Private equity investments can provide higher returns but come with higher risks.
- Increasing allocation to fixed income securities: Fixed income securities can provide stability and income but may offer lower returns than commodity futures.
The key risks associated with the recommended investment strategy include:
- Market volatility: Commodity futures prices can fluctuate significantly, leading to potential losses.
- Counterparty risk: The university needs to ensure that the counterparties involved in the futures contracts are financially sound.
- Regulatory changes: Changes in regulations can impact the commodity futures market and affect the investment strategy.
The key assumptions underlying the recommendations include:
- The university has a long-term investment horizon.
- The university has a moderate to high risk tolerance.
- The university has access to experienced commodity futures traders and investment professionals.
8. Next Steps
- Conduct a thorough financial analysis of the commodity futures market.
- Develop a comprehensive risk management plan.
- Engage with experienced commodity futures traders and investment professionals.
- Present the investment strategy to the university's investment committee for approval.
- Implement the phased investment approach, starting with a small allocation and gradually increasing exposure based on market performance and risk tolerance.
By following these steps, the university can maximize the potential benefits of investing in commodity futures while mitigating the associated risks.
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Case Description
Describes a new investment which is linked to an index of commmodity futures prices. Explores how the index is constructed, how commodity futures (as opposed to other futures and spot prices) behave, and what the portfolio impacts of such an investment might be.
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