Commodity derivatives

Why commodity derivatives

India is among the top-5 producers of most of the commodities, A major consumer of bullion and energy products. The possibility of adverse price changes in future creates risk for businesses Reduce or eliminate price risk arising from unforeseen price changes. Helps in hedging the price risk.

Why commodity derivatives

Ensuing discovery of price : can help farmers in deciding which crops to grow. Building a competitive edge ,reduce volatility of their earnings. Opportunity to speculators who are willing to assume risk for a possible return.

Can the commodity derivatives be used for hedging price risk?

Derivatives contracts can be good hedging instruments when they are efficiently priced. We measure efficiency as the outcome of a no-arbitrage condition. In the context of commodity futures, noarbitrage is defined when the futures and the spot price move in tandem.

Types of commodity derivatives

Commodity futures contracts : Agreement for buying or selling a commodity for a predetermined delivery price at a specific future time. The major function of futures markets is to transfer price risk from hedgers to speculators. Commodity Options contracts: Options are also financial instruments used for hedging and speculation. Option holder has the right, but not the obligation, to buy (or sell) a specific quantity of a commodity at a specified price on or before a specified date.

Commodity exchange
 

 

Commodity exchanges are defined as centers where futures trade is organized in a wider sense; It is taken to include any organized market place where trade is routed through one mechanism, allowing effective competition among buyers and among sellers. This would include Auction -type exchanges, but not wholesale markets, where trade is localized, but effectively Takes place through many non-related individual nontransactions between different permutations of buyers and sellers.

Evolution of Commodity Derivative Markets in India

        

The Bombay Cotton Exchange Ltd Gujarati Vyapari Mandali , the Chamber of Commerce at Hapur 1952 Forward Contracts (Regulation) Act, The government banned futures trading in commodities in the 1960s. The Khusro Committee which was constituted in June 1980. Prof. K.N. Kabra . Guru Committee: 2001 on 1.4.2003 the GOI permitting futures trading in the commodities, futures trading is not prohibited in any commodity. Options trading incommodity is, however presently prohibited.

Indian agricultural derivatives markets

  

Local markets for futures on agricultural commodities have been recorded to be around from the 1800. These were banned in the late 60s, and revived in the early 80s. After the successful equity market reforms of 90s, the commodities derivatives regulator tried to replicate similar reforms for the commodity derivatives markets. This effort got significant support in 1999 when the Government of India (GOI) suggested that the Minimum Support Price (MSP) as a price hedging instrument could be replaced with derivatives markets.

Evolution of Commodity Derivative Markets in India

 

2003 - three new national exchanges The Government of India had appointed a committee under the chairmanship of Prof. Abhijit Sen, Member, Planning Commission to study the impact of futures trading, if any, on agricultural commodity prices.


Study did not :

 

Find any visible link between futures trading and price movement and suggested that the Main reason for price changes seemed to be changes in the fundamentals (mainly on the supply side) of these commodities, Price changes were also attributed to changes in government policies.

Indian commodity exchanges



  

There are more than 22 recognised commodity futures exchanges in India divided majorly into two categories: National exchanges Regional exchanges

Hierarchy of Indian commodity futures

Features
             

National Exchanges Compulsory online trading Transparent trading Exchanges de-mutualised deExchange recognised on permanent basis Trade in Multiple commodities Large expanding volumes. Regional Exchanges Online trading not compulsory. De-mutualisation not mandatory. De Recognition given for fixed period after which it could be given for re regulation Generally, these are single commodity exchanges. Exchanges have to apply for trading each commodity. Low volumes in niche markets

Global Commodity Derivatives Exchanges

  

  

The Chicago Board of Trade 1854 -largest today the "to arrive" forward contract, which permitted farmers to lock in the price and deliver the grain much later. The mid 19th century, futures markets had developed into effective mechanisms for managing counterparty and price risks. CBOT merged with Chicago Mercantile exchange july 2007 CME purchased NYMEX august2008 New York Mercantile Exchange (NYMEX), US has the largest traded vol. in the world

 

MCX an independent and de-mutulised multi commodity deexchange Has permanent recognition from Government of India for facilitating online trading, clearing and settlement operations for commodity futures markets across the country. Key shareholders of MCX are Financial Technologies (India) Ltd.,State Bank of India, NABARD, NSE, HDFC Bank, State Bank of Indore, State Bank of Hyderabad,State Bank of Saurashtra, SBI Life Insurance Co. Ltd., Union Bank of India, Bank Of India, Bank Of Baroda, Canara Bank, Corporation Bank

  

MCX offers futures trading in the following commodity categories: Agri Commodities, Bullion, Metals- Ferrous & Non-ferrous, Pulses, Oils & MetalsNonOilseeds, Energy, Plantations, Spices and other soft commodities. Amoung worlds top ten commodities MCX ranks 1st in silver , 2nd in gold , and 3rd in copper , zinc,crude oil , natural gas , futures , in terms of no. of contracts traded . MCX continued to be the largest commodity futures exchange during 2007 both in terms of turnover volume and number of contracts.

Contract specifications for wheat

Contract specifications for Guar Seed

Contract specification for Gold

Contract specification for Silver

Top 10 Commodities traded

Most actively traded essential agricultural commodities, namely, chana, wheat, maize and potato . The above does indicate that the commodity derivatives market has a bright future in India.

Basis and basis risk behaviour



We operationalise this as analysing the behaviour of returns on the futures contract vis-a-vis returns on the spot. If the no-arbitrage condition is satisfied, then there should be a very high correlation between the two. We define basis as
 

Basis = rfutures rspot Basis should be very small, and have a low volatility if no-arbitrage conditions hold.

Efficiency on the traditional commodity futures markets



 

 

Thomas and Karande (1999) examined efficiency of the castorcastor-seed futures markets in India. The examination included identifying: 1 The flow of information between futures and spot prices, as well as, 2 The behaviour of the basis and basis risk across two different markets, one export-oriented and exportanother production-oriented. productionThey find that futures dominate spot prices, and that the export-oriented market prices dominate productionexportproductionoriented market except in the harvest season when the relation was reversed.

Facts of agriculture commodities

1 Guar seed: This is the commodity where there has been the longest period with significant liquidity.  2 Wheat: One of the essential commodities where the government maintains a minimum support price (MSP).  3 Pepper: Pepper futures has been traded on an international exchange in Cochin since the eighties.  4 Channa : A commodity that does have an MSP, but it is not a binding constraint in the price discovery process.  5 Jeera : This is one of the newest contracts on the electronic exchange in terms of its liquidity buildup.


Comparitives


Since efficiency and liquidity is best understood as a relative measure, we identify some other Indian markets to provide benchmarks for commodities. The longest running as well as the most liquid derivatives in the Indian market is the futures market on the market index,Nifty. However, the risk of this is that of a diversified portfolio. Another comparitive can be the most liquid single stockfutures contract. e.g.. futures on the Tata Steel stock. Both these financial futures are very different from the commodities contracts because they are cash-settled. cashA last comparitive that we use is the gold futures contract, which is very liquid and is physically settled.

 

Crush Spread
 

 

In agri futures there is a popular type of spread known as Crush Spread. Implies simultaneous of a commodity coupled with the sale of the same commodities bybyproducts futures . If margins becomes negative reverse crush spread is opted for. It is the expected profit margin of commodity processors

Electronic spot exchange NSPOT



Currently all agricultural commodities are traded in the physical markets or mandis. Is a wholly owned subsidiary of the National Commodity & Derivatives Exchange Limited (NCDEX) pave the way for participation by concerned entities irrespective of geographical locations.

Need for an electronic spot exchange



    

Will bring the buyers and sellers (Tradersand Farmers) closer to each other and help in actual price discovery. Wider reach Liquidity Counter Party Guarantee-Risk Mitigation. GuaranteeTimely settlement Also enhance government revenues in the form of higher collection of Mandi Cess as possibility of manipulation is lower .

Constitution of NCDEX Spot Exchange



NSPOT is a public limited company incorporated on 18th Oct 2006 under Companies Act,1956. The Exchange operations are regulated in each State by the rules of respective State Governments . Apart from various other laws of the land such as Companies Act,Stamp Act, Contract Act etc.

Services offered by NSPOT

     

Electronic spot trading facility in multiple commodities with specific delivery centers Grading, quality certification and standardization of commodities Facilitating collateral financing and borrowing against warehouse receipts Customized services relating to storage, transportation, logistics handling and shipment Procurement and disposal of commodities through online trading system Market Intelligence Reports

Trading
  

Various entities can participate on the NSPOT arious platform such as producers i.e. farmers, traders, Bulk consumers, investors, arbitrageurs etc. Farmers can also be member themselves if they comply all the requirements or form Cooperative Marketing Societies who can be members and trade.

Trading process


Participant would need to apporach NSPot either as a client or as a member sell

Deposit the goods at NSPOT specified warehouse

3.Assess the goods for quality specification

4 .Seller specifiy quantity and quality of goods he wants to sell

5. The exchange would take charge of goods by demating

6.Electronically, exhibit through the internet the quality, deliverable lots and place of delivery to all the members before commencement of trade

7. All orders shall be matched online by process put in place price time priority basis by NSPOT

8.All the outstanding trade position at the end of the day will result in delivery obligation on the settlement date which is usually same day, next day, third day and maximum up to 11 day

9. On the settlement date NSPOT will conduct the settlement of contract. i.e. pay in and payout of funds

Trading Model of NSPOT

  

Continuous market Electronic Auctions: Discrete E-Markets : offers unique facility of Ediscrete markets as per the needs of the organizations. e.g. . NSPOT developed a discrete market for FCI suiting OMSS scheme.

Membership


  

spread all over the country are present in more than 15 states. Trading and Clearing Members (TCM) Associate Members Commodity Participants (CP)

Advantages


Benefits to Farmers
Direct access to a national level transparent market, where direct selling to end users would be feasible.  Realizing the best possible price at the time of sale.  Counterparty guarantee.  Cost reduction  availability of warehouse receipt financing  bargaining power due to availability of an alternative market


Advantage


Benefits to trader.
Common national level platform for buying and selling of commodities  Facilitates bulk procurement operations  Customized services relating to storage and logistics  Availability of professional services for grading and standardization  Avoidance of hassles relating to physical market operations


Advantages


Benefits to Arbitrageurs
  

Advantage of cash-future arbitrage electronically cashDisposal of deliveries received on futures market Jobbing and spread trading between cash and futures Transparent spot price available for Due Date Rate calculation Ease of moving towards compulsory delivery contracts through structured spot market Healthy growth of futures market ensured through development of the structured spot market

Benefits to Futures Exchanges

  

NSEL
     

NSEL commenced its operations on15th October 2008 Promoted by Financial Technologies (India) Ltd (FTIL) and National Agricultural Cooperative Marketing Federation of India Limited (NAFED). It provides an electronic, transparent, well organized and centralized trading platform with the facility to access and participate the market remotely It facilitates risk free and hassle free purchase and sell of quality and quantity specified commodities Launched a unique investment product (e-Series) on its platform. (eFor the growth and development of bullion trade and industry, NSEL launched, Indian Bullion Market Association (IBMA) which is consortium of leading bullion dealers and jewellery merchants, bullion importers-exporters, importersBullion Banks, refineries. .

Unresolved Issues and Future Prospects



Ban on Commodity Options -;

Commodity

options contracts has been banned since

1952. While futures contracts help a participant to hedge against downside price movements, it does not allow him to reap the benefits of an increase in prices.

Unresolved Issues and Future Prospects

The


Warehousing and Standardization:

necessary to have a sophisticated, cost-effective, costreliable and convenient warehousing(The Habibullah (2003) task force)

Appropriate


standardization through

independent labs or quality testing centers should be set up in each region to certify the quality,

So

that the final buyer gets standard goods

Unresolved Issues and Future Prospects



Cash Versus Physical Settlement:

 

cash settlement of outstanding contracts at maturity is not allowed. Due to promblems of warehousing only 1%-5% are 1%physically settled As market grows need for a stronger regulator will arise . The SEBI and FMC also need to work closely with each other due to the inter-relationship between the two markets. inter-

The Regulator:
 

Unresolved Issues and Future Prospects



Lack of Economy of Scale:

There are too many (3 national level and 21 regional) commodity exchanges.  Over 80 commodities are allowed for derivatives trading, in practice derivatives are popular for only a few commodities.


 

Convergence of securities and commodities derivatives markets Consolidation

Unresolved Issues and Future Prospects



Tax and Legal bottlenecks:

There are at present restrictions on the movement of certain goods from one state to another.  Also, regulatory changes are required to bring about uniformity in octroi and sales taxes etc.  VAT has been introduced in the country in 2005, buthas not yet been uniformly implemented by all states.