Introduction
Commodities are goods generally of the same quality and usefulness no matter where they are produced. Most grocery store customers don’t consider the country of origin when they purchase an ear of corn or a bag of wheat flour. Since commodities may be substituted for one another, the term can be used for a wide variety of items for which consumers don’t place a high value on the manufacturer’s name (Bhugaloo, 2008). Typically, when discussing investments, financiers will narrow their focus to a small number of commodities in high demand everywhere. Many of the commodities that traders concentrate on are the raw ingredients for produced items. Commodities are often categorized as either “hard” or “soft” by investors. examples of Metals such as aluminum, Gold and copper as well as energy resources such as crude oil, unleaded gasoline, and natural gas, are examples of “hard commodities” that must be extracted from the ground by mining or drilling. Grown or raised in a ranching operation, “soft commodities” include foodstuffs like maize, wheat, and beef. Many people’s mental image of a futures market trading floor includes heated screaming battles, frenetic turn signals, and tense traders vying for position in order to have their orders filled.
In these marketplaces, buyers and sellers interact to do business in an ever-expanding range of goods. Products that are traded on a commodities market include not just agricultural products, petroleum and metals, but also currencies, stocks and derivatives (Suaste, 2021). Goods that provide a safe haven or hedge against inflation seem to be at the core of this purported chaos. Commodities are a hedge against inflation since their prices tend to grow in tandem with rising consumer prices. Commodities are one of the few investments that tend to perform well during periods of increasing inflation, especially periods of unanticipated inflation. Whenever there is a surge in demand for anything, the price at which that thing may be purchased or produced increases, as well as the price of the raw materials that go into making that thing (Swarup, 2017). Therefore, the futures prices serve as brokerage firms for the most up-to-date supply and demand data and as continuous auction marketplaces.
Commodities Overview
Commodities provide an opportunity for investors to diversify their holdings beyond just stocks and bonds. During times of market volatility, some investors turn to commodities since their prices often move in the opposite direction of equities. Historically, only professional traders could afford to devote the time, money, and knowledge necessary for commodities trading. Options for entering the commodities markets have expanded in recent years. Commodity trade predates both stock and bond trading by a long shot. Many successful empires owe their growth to the development of sophisticated commerce networks that allowed for the easy flow of goods (Bhugaloo, 2008). Commodities are still traded internationally in the present day. The term “commodities exchange” may refer to either a specified area where commodities are traded or may a legal entity designed to regulate the dealing of regular commodity contracts and associated financial products. in the past years, a number of commodity exchanges have either merged or ceased operations. Most markets provide a limited selection of commodities, however a select few focus on a narrower range. The United States is home to various stock exchanges including The New York Mercantile Exchange, and the Chicago Mercantile Exchange (Swarup, 2017).
Characteristics of the Commodities market
The fundamental laws of supply and demand are the engine that propel the commodities markets. Whenever there is a shift in supply, there is corresponding movement in demand. Consequently, the normally steady and predictable demand for livestock might increase in the event of any substantial interruptions in the supply of a product, such as a widespread health condition that hits cattle. Costs may also be affected by changes in demand and supply as well as by technical and economic developments on a global scale. In particular, the growing importance of China and India in global manufacturing has reduced the supply of commodities like steel available to the rest of the globe. Commodities are widely traded natural resources that may be classified as either agricultural, metals and energy (Miller, & Shorter, 2016). Commodities have two defining features: they are indispensable to contemporary society and their prices vary wildly. By facilitating important futures contracts, the commodities markets contribute to stable prices since it enables investors to determine the exact cost of their product before delivery to the customer.
For the most part, commodities are only available in certain areas. While these resources are essential to the economies of almost all areas, only a select few may legally use them. As a result, a sizable worldwide market has emerged to facilitate the movement of goods from their most cost-effective origins to the places where they are most desperately required. Platinum and Gold for example, are both identical in every way to one another and may be used interchangeably with no loss of value (Swarup, 2017). Since there is no way to tell one commodity from another, they are completely fungible (interchangeable). Oil and many agricultural goods are two examples of commodities whose quality varies, but which are still graded and categorized as a distinct kind with consistent and, consequently, fungible qualities since it is difficult, if not impossible, to evaluate the whole product. The existence of enormous commodities markets, full of traders and speculators who cannot verify the goods before buying, is made possible solely by the fact that inspection is not required.
Prices for commodities, like those for all others, are determined by the market’s response to fluctuations in supply and demand (Dorfleitner, Gerl, & Gerer, 2018). Whenever there is a rise in demand and a decrease in supply, prices go up. The price of a good or service fluctuates constantly as the supply and demand for that product changes. Agricultural items are not the only ones whose prices fluctuate with the seasons (Chevallier, 2011). The price of maize, for instance, often reaches its highest point in March and April, just before the growing season begins, and its lowest point in September and October, after the crop has been harvested. Not only does the weather have a role in the cyclical nature of the economy, but so do the shifts in demand that occur throughout the year. Natural gas peaks in the winter since it is mostly used for home heating, whereas crude oil prices tend to climb in the summer because of increased driving for holidays. Commodity investment may provide diversification benefits since commodity prices fluctuate less predictably than other asset classes like equities and bonds. Commodity investments have always been a reliable hedge against economic instability. Given the need of most commodities, especially food and energy, the demand for and price of these goods remains mostly unaffected by economic downturns.
Types of Commodities
The main commodities which are involved in trading are divided in four categories which include energy, metal, agricultural and meat.
Metals
Commodities in the metals sector include silver, Copper Gold and platinum. in many cases some metals such as Gold are seen as a safe haven during instances of market turbulence because of its actual, transportable worth. To protect their wealth from rising inflation or currency depreciation, some investors choose to purchase precious metals. Oil, gasoline, and gas are all examples of energy commodities. Historically, increasing oil prices have resulted from a combination of global economic advancements and decreased oil outputs from existing oil wells throughout the globe. This is because demand for energy-related goods has increased in case there is shortage in oil supply.
Energy
Energy commodity investors need to keep in mind the effects of economic downturns, and the growth of renewable energy sources like solar power, wind power and biofuel. created to take the role of crude oil as a key energy source. pork bellies, feeder cattle Lean pigs and live cattle are all forms of meat and livestock products.
Agriculture
Crops such as maize, soy, cacao, wheat, cotton, coffee, rice and sugar are all considered agricultural commodities. In the agriculture industry, the price of grains is especially unpredictable during the summer and other times of weather change. Rising demand for food and agricultural products in the face of shrinking supplies presents an opportunity for investors in the agriculture industry (Nijs, 2014).
Using Future as a method of Investing in Commodities
Futures contracts are an option for commodity investing. Futures contracts are binding legal agreements to acquire or sell a certain commodity at a future date and price. When one purchases a futures contract, he or she agrees to purchase and take delivery of the hedged item at the contract’s expiration date (Miller, & Shorter, 2016). Investors who get involved in futures contract agree to outsource the fundamental commodity on the expiry date. You may get futures contracts for just about every commodity you can think of. Speculative investors and commercial/institutional consumers of the commodities make up the bulk of those who trade in the commodities future’s markets (King, 2009). Futures contracts are included into the budgets of manufacturers and service providers to help standardize costs and lessen cash flow issues. Producers and suppliers who are vulnerable to price fluctuations in the commodities they use may choose to hedge their exposure by investing in the commodities markets.
One major industry that needs reliable fuel pricing in order to plan ahead is the aviation business. Airlines hedge their risks using futures contracts because of this need. Using forward contracts, airlines may lock in gasoline prices for a certain time period. Consequently, companies will be protected against swings in the price of gasoline and crude oil. Futures contracts are used by several farmer’s cooperatives as well. Businesses that rely on some degree of stability in the pricing of products for the management of operational expenditures may go bankrupt if they are unable to protect themselves from the effects of commodity market volatility by purchasing futures contracts. In addition to hedge funds and institutional traders, speculative speculators play a role in futures markets of such commodities. Speculators are high-level investors or traders that buy and sell assets quickly using specific tactics in order to benefit on small shifts in the asset’s value. In this way, speculators are banking on the price fluctuating in their favor (Dorfleitner, Gerl, & Gerer, 2018). Unlike airlines, which need fuel to keep their planes flying, speculators don’t have to worry about running short of the items they are betting on. The buyer may never really get the product.
You may need to register a new trading account if you want to trade futures contracts but your current broker doesn’t provide that service. The investor must sign a paper stating that he or she has read about and accepts the risks connected with futures trading. The minimum deposit for buying a futures contract varies from broker to broker, and the value of your account will rise or fall as the contract’s price changes. With a drop in the contract’s worth comes the risk of a margin call, which would need more funds being deposited into the account in order to maintain the position (Jessop, 2019). High leverage means that even a relatively modest change in commodity prices may have a disproportionately big effect on a trader’s net worth. Investing directly in commodities futures transactions is high-risk for novice investors due to the high volatility of the markets. If a business goes wrong then, you might lose your whole original investment before one can change the plan or get the chance to exit the position, which is the other side of the great potential for profit. Options are a common addition to futures contracts. Options on futures contracts may reduce the danger of trading in the futures market. In some ways, acquiring options might be compared to making a down payment on a larger purchase. In the case of an option, the holder has the right but not the duty to actually complete the transaction before the contract’s expiration date (Baker, 2021). If the futures contract price doesn’t change as you predicted, you will only lose the amount you spent on the option.
How stock is used in commodities investment
When looking to join the marketplace for a certain commodity, many traders choose to do so via the purchase of shares in a company with ties to that commodity. Investors with a penchant for petroleum may put their money to work in a number of different ways inside the sector. If you want to invest in the gold industry, you may buy shares in mining corporations, smelters, refiners, or any company that handles bullion. It is often held that stock prices are more stable than those of futures contracts. Buying, holding, trading, and keeping tabs on stocks may be simplified. Additionally, investments might be targeted to a certain industry. To make sure a firm is a smart investment and commodities play, investors need do their homework (Bhugaloo, 2008). Alternatives on equities are another investment option for traders. Alternatives on stocks are comparable to futures contracts in that they demand a lesser initial commitment than purchasing equities outright. So, although the loss you may sustain from buying a financial asset is limited to the amount of the option itself, the price action of a commodity may not always correspond with the price fluctuations of the shares of a firm with a connected investment (Jessop, 2019).
in the market’s stocks are considered are popular entry point when dealing with commodities since most traders already have a trading account and can make trades quickly and easily. Stocks are usually rather liquid, and traders have simple access to information concerning a certain organization mainly its financial status. Investing in equities as a means of participating in the commodities market comes with certain significant drawbacks. Never assume that a stock is a simple “play” on commodities costs. Additionally, the value of a stock may be affected by company-specific variables unrelated to the value of the associated commodity that the investor is seeking to monitor.
The success of the company that produces the commodity you’ve invested in will have a greater impact on the worth of your investment as compared to the commodity itself. This success can be affected by a number of factors, including the quality of the company’s management, the effectiveness with which it runs its operations, and its ability to maintain costs as low as possible. Many commodity companies have global operations, often in underdeveloped nations that provide greater geopolitical and financial risks (King, 2009). Commodity futures are the greatest financial tool for commodities trading since they facilitate trade and allow investors to time the market. the contracts are forward contracts that are regulated in terms of the quantity, delivery date, delivery price and are traded on a number of structured exchanges. On the delivery date, the futures contract will be null and void.
Construction and valuation of an exchange trade product – ETC or ETN – based on commodities
Exchange Traded Product (ETC) is described as a security or financial product that may be bought and sold on the stock exchange much as a bond would. Exchange-traded products (ETPs) provide investors with a low-risk and low-cost alternative to get exposure to a particular index or asset class. ETPs allow investors to have exposure to a broad range of assets in a simple manner, since they are passive investments that often have lower costs than index funds and active mutual funds (Fassas, 2012). When exchange-traded products first appeared, they combined the low-cost, benchmark strategy of stock index funds with the instruments’ instantaneous marketability. To keep up with the ever-changing financial markets, exchange-traded products (ETPs) have expanded their coverage to include a wider variety of asset classes. ETPs not only replicate a stock index, but also provide investors access to previously inaccessible asset types, therefore enhancing portfolio diversification.
Types of Exchange-Traded Products
Exchange-traded funds (ETFs)
Exchange-traded funds are described mutual funds that trade like stocks on the stock market. Since their inception in 1993, exchange-traded funds have seen tremendous growth in terms of product offerings. The most common kind of index fund that exchange-traded funds follow is the Standard & Poor’s 500; but, ETFs may also be designed to track specific markets, commodities, industries, or even currencies. As is the case with most investments, the price of an exchange-traded fund will go up and down. Like stocks, ETFs trade continuously throughout the day (Kosev, & Williams, 2011).
Exchange-traded commodities (ETCs)
This are viewed as kind of debt security that does not need interest charges. They’re intended to provide you easy access to a certain product or set of products. When it comes to giving investors broad exposure to foreign exchange markets, the ETC structure is often used.
Exchange-Traded Notes (ETNs)
These are a kind of interest-free debt security that is similar to exchange-traded certificates. The sole purpose of these is to replicate the performance of the corresponding underlying asset or index. Both are issued currency, but their issuing bodies are distinct. While Exchange Traded Notes (ETNs) are issued by banks, Exchange Traded Certificates are offered by SPVs with separated holdings. ETNs are similar to unsecured and classed bonds in terms of yield, but they pay out in the same way as the market instrument or property.
ETF Construction
There are many who have no problem relying on a variety of electronic gadgets, such as watches and laptops, to get them through life. Some people are curious as to the construction and inner workings of the technologies they utilize. If you’re the latter and you’re an investor who values the advantages that ETFs provide, you should read up on how they came to be. Mutual funds and ETFs have certain similarities. But exchange-traded funds (ETFs) have some advantages that mutual funds lack (Chevallier, 2011). Benefits of this novel and appealing investment product may be enjoyed by ETF investors without their having to understand the intricate mechanisms at work behind them. You’ll be a smarter investor overall if you understand the process by which ETFs are created.
Many investors choose ETFs over mutual funds because of the tax and expense benefits they provide. The processes of issuing and redeeming ETF shares are almost mirror images of those of mutual funds. When people put money into a mutual fund, that money is used to buy assets and then more shares of the fund are issued to those people. Shares in a mutual fund are redeemed when an investor sells or “redemptions” them back to the fund administrator in exchange for cash. However, no money is exchanged during the creation of an exchange-traded fund.
A possible ETF manager, also known as a sponsor, must first file an application with the U.S. Securities and Exchange Commission before an ETF may begin trading. Once the plan is approved, the sponsor will engage into an arrangement with an authorized participant, who will then be able to issue and redeem ETF shares. This participant may be a market maker, specialist, or large institutional investor. Sponsors often qualify as authorized participants themselves. As part of the ETF development process, the approved participant will buy stock, deposit that stock into a trust, and then utilize the units resulting from that trust to create ETFs. These are packages of stocks ranging from 10,000 to 600,000 shares, with one creation unit of a certain ETF often denoting 50,000 shares. The trust subsequently transfers legal ownership of the underlying shares to the authorized participant via the issuance of ETF shares. Because the exchange of one set of securities for another is treated as an in-kind transfer, no taxes need to be paid as a result of the deal (Fassas, 2012). Once the authorized participant has the ETF shares, he or she may sell them on the stock market to the broader public. Shares of an exchange-traded fund (ETF) are traded like any other security on the open market, with the exception that the financial fundamentals used to create the units are held in a trust account (Kosev, & Williams, 2011). The trust’s main functions are to distribute dividends to ETF shareholders from stocks owned in the trust and to oversee the ETF’s administration. Because the buying and selling of ETF shares doesn’t affect the underlying creation units, this is the case.
How to Redeem an ETF
There are two main ways in which investor can sell their ETF investment or holdings and they include; The first option is to put the stock up for sale on the regular market. The vast majority of private investors chooses this option. The second is to acquire the stocks or bonds by buying enough ETF shares to establish a “creation unit.” As a result of the high number of shares needed to constitute a creation unit, this choice is often limited to institutional investors. As soon as an investor cashes in on their holdings, the creation unit is cancelled and the securities are transferred to the buyer. The tax benefits to the investment portfolio are a major selling point of this choice. To create an exchange-traded fund, a financial firm commonly referred as the sponsor purchases a group of equities to serve as the ETF’s assets (Fassas, 2012). The company then issues exchange-traded fund shares that are valued according to the trust’s holdings. It’s possible for the market price of an ETF share to be different from the portfolio’s NAV due to the fact that the shares trade on the open market.
In the long run, the current value of an ETF’s shares may vary significantly from the fund’s net asset value due to the ETF’s structure. Market participants may try to acquire the comparatively underpriced shares by redeeming their own shares if the market price diverges significantly to the upside. However, if the price goes far below the Net Asset Value, traders may be tempted to unload the basket and use the proceeds to launch new exchange-traded funds. With increased liquidity, ETFs benefit from this sort of arbitrage activity, which also has the effect of keeping the Net Asset Value and current price relatively stable (Kosev, & Williams, 2011).
Tax Implications
When seen alongside a different investment redemption, the tax consequences of an ETF redemption become clearer. All shareholders in a mutual fund are subject to additional taxation when one shareholder redeems shares. This is due to the fact that the financial asset may be required to sell assets in order to satisfy the redemption demand, so earning a capital gain that will be subject to taxation. Additionally, all capital and dividends must be distributed annually by mutual funds. What this implies is that even if the portfolio has experienced an appreciable loss in value, a tax liability will still exist for the capital gains that were required to be paid out. By redeeming a large portion of their holdings in the form of stock, ETFs lessen the risk of this occurring. In such a scenario, the redeemer would get the trust interests with the least expensive basis (Cugia, 2015). as the ETF’s cost basis has increased, its capital gains have decreased. Because a redeemer’s taxable liability is based on the amount it paid for ETF shares rather than the fund’s cost basis, it makes no difference which shares it receives.
Exchange Traded Notes
In order to facilitate investment in illiquid products like commodities and currencies by ordinary investors, ETNs were created. Barclays Bank created exchange-traded notes in 2006 to facilitate retail investment and optimize profits in illiquid instruments, such as those involved in the commodities and currency markets. Barclays improved the tax situation for investors by eliminating the charges associated with owning commodities, currencies, and derivatives by switching to a debt structure. An Exchange Traded Note is a guaranteed wager on the movement of a certain index issued by a financial institution. The ETN will move in the same direction as the underlying index. ETNs are based on comparable financial engineering that investment banks have used for years to design structured products for their institutional customers. When compared to ETFs, ETNs stand out due to their lack of asset ownership. The ETNs are a kind of unsecured debt.
Due to the lack of underlying assets, investors in ETNs will not receive any dividends or interest payments for as long as they keep the ETN. Total index return is reflected in ETN shares since dividend value is included in the index return rather than distributed to investors on a regular basis. Traders in ETNs do not have to pay taxes on their brief investment income, unlike shareholders of many dividend-paying mutual funds and exchange-traded funds. The tax rate on relatively brief capital gains is the same as the rate on an individual’s regular paycheck. A lengthy capital gains tax is due from the investor upon the sale of the ETN. It is only upon sale of the ETN that the investor is subject to taxation. Regular ETFs would expose a long-term investor to annual capital gains taxation. ETNs have a substantial advantage over other investment vehicles because of their capacity to increase returns by avoiding yearly taxes on payouts. However, currency exchange traded notes are not eligible for this tax treatment.
In theory, an ETF will provide the same return as the index it follows, less the management fee. However, there will be instances when the spread between the ETF and its index is more than the cost of the ETF itself. The tracking error refers to the amount by which the portfolio’s return deviates from the value of the index. When an exchange-traded fund does not own all the components of a benchmark index due to the number of components or the illiquidity of the components, tracking inaccuracy may become a serious problem. Consequently, there is a possibility that the ETF’s value will deviate from that of the reference index. Tracking error is entirely removed from ETNs since the issuer guarantees payment equal to the index’s value less the ETN’s cost ratio. It’s important to remember that ETNs are built on something solid (Ramaswamy, 2011). They are often made up of stock swaps, futures, options and other financial instruments to mimic the performance of a certain index. The investor is unconcerned with the underlying basis; rather, they care only if the bank’s strategy matches the index, in which case the bank is responsible for returning the difference. ETNs provide ordinary people access to markets and complicated techniques that would otherwise be out of reach, thanks to the investment banking industry’s expertise in financial engineering. For instance, in 2011, Barclays Bank developed exchange-traded notes that enabled investors to benefit from spikes in stock market volatility.
There is just market risk associated with ETFs, but with ETNs, investors also take on the credit risk of the issuing financial institution. The credit risk problem is not to be taken lightly in light of the speed with which the banking system collapsed during the 2008 recession. The failure of a bank is a real possibility. When compared to ETFs, ETNs lack the liquidity to trade frequently and may also have holding-period risk. Over extended time periods, an ETN’s performance may diverge from that of its underlying benchmark or index.
One of the most appealing features of ETNs is their potential to avoid the short-term capital gains tax, as stated above. The existing advantage may be diminished if the Internal Revenue Service (IRS) decides to alter the regulations.
How to invest in Commodities using ETFs
If you’re an investor looking to get into the commodities market, you may do so via a variety of exchange-traded vehicles, including exchange-traded funds. Exchange-traded funds and exchange-traded notes trade on stock exchanges like stocks and provide investors exposure to commodities price movements without the risk of direct investment in future. Typically, commodity ETFs use futures contracts to follow the price of the underlying commodity(s) or basket of commodities that make up an index. In such cases, investors would even back the ETF with physical storage of the underlying commodity. Exchange-Traded Notes are a kind of unsecured debt security that are created to track the price movement of a certain commodity or commodities index. The issuer guarantees the value of ETNs.
Unlike commodity futures contracts, which need a dedicated brokerage account, exchange-traded funds and exchange-traded notes enable investors to track the price movements of a commodity or basket of commodities with little overhead. Due to the similarity between ETFs and stock trading, there are no maintenance or liquidation fees associated with ETNs. Not all commodities, however, have corresponding exchange-traded funds (ETFs) or exchange-traded notes (Marszk, 2018). It’s also possible that the underlying ETF or ETN won’t mirror the price change of the commodity exactly if it experiences a large swing. Moreover, since the issuer is guaranteeing the ETN, the ETN itself is subject to credit risk.
The differences between ETC and ETNs
ETCs
Unlike traditional stocks, ETCs are based on the value of a commodity or a commodities index and are traded on a stock market. Without having to commit to futures contracts or actually purchase the commodity, investors may still benefit from exposure to the commodities market. In this respect, ETCs are similar to stocks in that the value of their shares rises and falls in tandem with the market price of the commodities underpinning them. Through ETCs, regular people may more easily participate in commodities that would otherwise be out of reach, without having to deal with the complexity of futures contracts or option contracts. An ETC provides exposure to a specific commodity, whereas an ETF often holds a diversified portfolio of equities or other assets.
ETNs
Commodity Exchange-Traded Notes are investments that mirror the performance of an exchange-traded fund by purchasing and selling the fundamental commodity or trading contracts on that commodity. This is not something that an ETC performs directly. In the case of an ETC, a bank underwrites the note or debt instrument on behalf of the ETC’s issuer. This “note” structure is identical to that of an ETN. So, there’s a chance the underwriter won’t pay its bills and the ETN won’t be backed by money. Despite the continued value of the fundamental commodity, the ETN would become worthless in this scenario. A combination of an exchange-traded fund and an exchange-traded note and ETC. An underwritten note serves as security, while the commodities themselves are bought using the funds from investors’ investments in the ETC (Marszk, 2018). There will be less potential for default by the underwriters. Because the note follows an index rather than the underlying derivative contracts ETCs, like ETNs, have low tracking errors. Since an ETF’s price fluctuation is based on the value of its holdings, it might experience tracking error if the underlying commodity’s price fluctuation is not precisely represented in the ETF’s price fluctuation.
Conclusion
Commodities are good which are typically of the same quality and utility no matter where they are produced. When buying an ear of corn or a bag of wheat flour, the vast majority of consumers don’t pay any consideration to where the product was produced. Commodities include a broad category of products for which brand names aren’t very important to buyers since they may be easily replaced with generic versions. Down most cases, while considering possible investments, bankers will zero in on a select few items that are in universal demand. Commodities that traders focus on often serve as base materials for other products. In the same way that bonds may be purchased and sold on the stock market, so too can Exchange Traded Products. Investors now have a low-cost, low-risk option to get exposure to a certain index or asset class via exchange-traded funds. Since ETPs are passive investments with often lower expenses than index funds and active mutual funds, investors may easily get exposure to a diverse collection of assets without having to make complicated trades. As soon as they hit the market, exchange-traded products were able to merge the low-cost, benchmark approach of stock index funds with the instruments’ rapid marketability. Exchange-traded products have broadened their scope in recent years to reflect the diversifying nature of the world’s financial markets. ETPs not only allow investors to mirror a stock index, but also get exposure to assets they may not have had before.
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