Professional Documents
Culture Documents
By,
Vinu Baby
07BS4887
IBS Chennai
A STUDY ON THE INTRODUCTION OF
OPTIONS IN INDIAN COMMODITY
EXCHANGES
- A REPORT
By,
Vinu Baby
Distribution List:
Mr. M. Frederics, Anand Rathi Financial Services
Prof. Venkata Subramanian, IBS Chennai
ACKNOWLEDGEMENT
―Success is not a destination, but a journey‖. While I reach towards the end of this
journey, I realize I may not have come this far without the guidance, help and support
of people who acted as guides, friends and torch bearers along the way.
Working at Anand Rathi Financial Services was indeed been a pleasurable experience.
It enabled me to bridge the gap between the practical aspect of the corporate world
and the classroom sessions.
I profusely thank Mr. S Sathyanarayanan, Senior VP, for allowing me to carry out
the summer internship training at Anand Rathi Financial Services Ltd. He also
provided me with a lot of information, which contributed to value addition.
I would like to sincerely thank Mr. S Senthilraja, Human Resource Manager, for
providing me with all the facilities and helping me in getting useful information
regarding the working of stock broking industry.
It‘s been very kind of all the employees of the Company for having helped me with
the project and in the process of learning.
Vinu Baby
Summer trainee
Place : Chennai
Executive summary
Objective
Scope
Methodology
Limitations
Structure, Conduct and Current Status of the Commodity Futures Markets in India
Commodity Derivatives
Futures
Options
Basic terminology
Offset of an Option
Exercising an Option
Global trends in future markets and the road ahead for India
Findings
Suggestions
Reference
EXECUTIVE SUMMARY
Indian commodity exchanges are still in their nascent stages when compared to its
global peers. Even though trading is happening in large volumes in these exchanges,
they are lagging behind in a lot of aspects like infrastructure, delivery and settlement
mechanism etc. The number of products in Indian commodity exchanges are also very
less.
The project aims at studying the scope and possibility of introducing Options as a
derivative trading product in Indian commodity exchanges. Options are already in use
in leading commodity exchanges round the globe. They are not only used as a trading
product, but also as a hedging mechanism. It has proved to be an effective risk
minimizing tool. The fact that Commodity Exchanges are much more volatile than
Stock Exchanges, emphasize the need of introduction of Options in these exchanges.
The working mechanism of Options is explained in the report. It is also explained how
Options can be used as a hedging instrument against rising or falling prices. It helps
the farmers as insurance for their agricultural produce against price fluctuations.
The project also analyzes major research reports published in the area of Indian
Commodity exchanges and the futures trading to study the relationship between
futures trading and Inflation.
Finally, the findings and suggestions of the research are given. It includes suggestions
to revive commodities exchanges, introduce new derivative trading products, develop
the infrastructure and to spread awareness among participants.
So, in a nutshell, the project deals with Options, its trading mechanism and the scope
of its introduction in Indian Commodity Exchanges.
Objective
Commodity Exchanges.
Commodity Exchanges.
Scope
commodity exchanges in the near future. The project explains the working mechanism
of Options as a price hedging instrument. So, this project will help the participants of
the commodity markets to know in detail about Options and to enhance their
introduced in Indian exchanges. It also gives the company a first mover advantage at
the time of introduction of this derivative instrument as the company would be already
The project is done mainly by collecting and analyzing secondary data. The major
sources of these data are websites of foreign commodity exchanges where Options
have already been established. A fair amount of data is collected from magazines and
other academic publications to obtain data regarding the working of Options and
current happenings in this field. Another source of data is the website of Planning
The primary data is the expert opinions and views. These data are collected through
emails and interactions with experts. The experts consist of professionals working in
commodity exchanges and broking houses and those who have done extensive
information from foreign sources need not necessarily reflect how they will be
2. Experts contacted might not have direct experience with Commodity Options
as they are not used in Indian Exchanges. It may be reflected in their opinions.
3. The course of project may be too short to conduct an extensive in-depth study.
4. The product may not work exactly like that in foreign exchanges as it may be
5. The regulatory framework in India may vary from that in use in foreign
exchanges.
Introduction about commodity trading
Ever since the dawn of civilization, commodities trading has become an inte gral part
in the lives of mankind. The very reason for this lies in the fact that commodities
represent the fundamental elements of utility for human beings. The term commodity
refers to any material, which can be bought and sold. Over the years, commodities
markets have been experiencing tremendous progress, which is evident from the fact
that the trade in this segment is standing as the boon for the global economy today.
The promising nature of these markets made them an attractive investment avenue for
investors.
The evolution of the organized futures market in India commenced in 1875 with the
setting up of the Bombay Cotton Trade Association Ltd. Following widespread
discontent among leading cotton mill owners and merchants over the functioning of
the Bombay Cotton Trade Association, a separate association, Bombay Cotton
Exchange Ltd., was constituted in 1983. Futures trading in oilseeds originated with the
setting up of the Gujarati Vyapari Mandali in 1900, which carried out futures trading
in ground nuts, castor seeds and cotton. The Calcutta Hessian Exchange Ltd. and the
East India Jute Association Ltd. were set up in 1919 and 1927 respectively for futures
trade in raw jute. In 1921, futures in cotton were organized in Mumbai under the
auspices of East India Cotton Association (EICA). Before the Second World War
broke out in 1939, several futures markets in oilseeds were functioning in the states of
Gujarat and Punjab. Futures markets in Bullion began in Mumbai in 1920, and later,
similar markets were established in Rajkot, Jaipur, Jamnagar, Kanpur, Delhi and
Calcutta. In due course, several other exchanges were established in the country,
facilitating trade in diverse commodities such as pepper, turmeric, potato, sugar and
jaggery.
Post independence, the Indian constitution listed the subject of ―Stock Exchanges and
Future Markets‖ under the union list. As a result, the regulation and development of
the commodities futures markets were defined solely as the responsibility of the
central government. A bill on forward contracts was referred to an expert committee
headed by Prof. A.D. Shroff and selected committees of two successive parliaments
and finally, in December 1952, the Forward Contracts (Regulation) Act was enacted.
The Forward Contracts (Regulation) rules were notified by the central government in
1954. The futures trade in spices was first organised by the India Pepper and Spices
Trade Association (IPSTA) in Cochi n in 1957. However, in order to monitor the price
movements of several agricultural and essential commodities, futures trade was
completely banned by the government in 1966. Subsequent to the ban of futures trade,
many traders resorted to unofficial and informal trade in futures. However, in India‘s
liberalization epoch as per the June 1980 Khusro committee‘s recommendations, the
government reintroduced futures on selected commodities, including cotton, jute,
potatoes, etc.
FMC
Commodity Exchanges
The date, May 19, 2007, is the date on which the trading occurred. The months SEP,
NOV and JAN represent three futures delivery months on which option contracts
could be traded. The futures settlement price for each of these contracts is listed below
the main table. Six different strike prices are shown for each option contract month.
Using the November option month for an example, there are actually many separate
option contracts that are tradeable. Here six different strike prices are shown for both
calls and puts. The example prices show a total of 36 option contracts; 18 call options
and 18 put options.
The prices listed under the columns headed Call-Settle and Put-Settle are premiums
that were determined through trading that day at the exchange. No trading occurred in
contracts indicated by the dashed lines. Price differentials of one-fourth of a cent are
used. The premium on the $7.00 November put option is $0.49 per bushel (named a
"November 7 dollar put"). This would represent a total premium of
This option is "in-the-money" since the strike price is greater than the November
futures contract settlement price. The intrinsic value is
The remainder of the premium, $0.49 - $.1475 = $0.3425 is the time value remaining
in the option.
The November $6.75 put is "out-of-the-money." That is, it has no intrinsic value and
the prudent person would not exercise R at the given futures market price. Even
though it has no intrinsic value; there is still a time value associated with it as
indicated by its $.34 premium. There are about five months before expiration in which
market prices could fall below the $6.75 strike price and thus make it an "in-the-
money option. The premium quoted reflects that time value.
Evaluating Option P rices.
For selecting the best suitable Option, the Option prices are to be evaluated. While
evaluating Option contracts and prices, there would arise two critical questions.
First, let's consider a method for evaluating the price insurance levels being offered.
There are three steps to consider in evaluating options prices. The first factor is the
selection of the appropriate option contract month. To do this, select the option
which will expire closest to but not before the time the physical commodity will be
sold or purchased. For example, if soya beans will be harvested and sold in
November, the January option would be appropriate. The November option would
generally not be chosen since trading on it will have ceased prior to the actual harvest
and sale.
The second step is to select the appropriate type of option. If the producer wishes to
insure products against price declines, then he or she would be interested in buying a
put (the right to sell). If the producer‘s motive is to insure future commodity
purchases against price increases, then the purchase of a call (the right to buy) will be
needed. To continue the above example, if a soya bean producer wishes to insure the
beans he will be selling in November, then he will be interested in purchasing the right
to sell a January (put) option.
The third step to consider in evaluating option prices is to calculate the minimum
cash selling price (MSP) being offered by the put option selected. Or, for a call
option, the maximum purchase price (MPP) would need to be calculated. These
calculations can be accomplished in fi ve steps and will be illustrated using the
preceding sample quotes.
2. Subtract the premium from the strike price for a put, or add the premium for a call.
In the example, a $7.00 January put cost $0.48 per bushel. So, $7.00 - $0.48 = $6.52
per bushel.
3. Subtract (for a put) or add (for a call) the "opportunity cost" of paying the
premium for the period it will be outstanding. For example, if the option premium of
$.48 per bushel is paid in May and the option is liquidated by offsetting in November,
an interest cost for the 6 month period needs to be added. If borrowed funds are used
and the interest rate is twelve percent, (for example), then the cost would be one
percent per month or six percent for six months. The interest cost associated with a
$0.48 per bushel put option premium wo uld be $0.03 (0.48 x 0.06) per bushel. This
leaves a net price of $6.52 - $0.03 = $6.49.
4. Subtract (for a put) or add (for a call) the commission fee for both buying and
offsetting the option. Assume the brokerage firm charges $100.00 per round turn for
handling each option contract. The per bushel commission fee would be $0.02 ($100
for 5000 bushels). The net price is now $6.49 - $0.02 = $6.47.
5. One final adjustment must be made to these prices. The option strike price must be
localized to reflect the difference between prices at the major commodity markets and
the local cash market. To localize the price, we must subtract the expected harvest
time basis. Basis is the difference between the local price and futures market delivery
point price at delivery time. This basis reflects the price differences between the large
national and local markets. By adjusting the option price for basis, a minimum selling
price can now be obtained for a put or a maximum purchase price obtained for a call.
For example, if the normal harvest basis is $0.30 under, then the likely minimum local
cash price becomes $6.47 - $0.30 = $6.17 +. The plus sign refers to the fact that this is
the minimum price expected from a cash sale protected by a purchased put option.
Minimum Selling Prices for Put Options with Different Strike Prices
Consider a put purchase for price insurance in soya beans. Assume that a farmer
plants soya beans in May expecting to harvest 10,000 bushels of soya beans in
November. He must recognize that other than weather, his biggest risk during the
production season is not knowing the price he will get for his beans at harvest. Farmer
wishes to reduce this risk by "insuring" a future price that will cover production costs.
He can do this by purchasing 2 January soya bean put options (options to sell
10,000 bushels of January soya bean futures) at a strike price of $7.00 per bushel. As a
result, Farmer has established a minimum cash price for his soya beans of $7.00 per
bushel minus the premium, less the normal local basis while retaining upside price
potential.
Example 1 shows the result if prices increase during the production period. Example 2
shows the result of prices decrease. In each case, the cost of price insurance - the
premium and other costs - was $0.53 cents per bushel and the actual difference
between his local cash price and the national market prices (basis) was -$.30 as he
anticipated.
In Example 1, as futures and cash prices rise, the options end up out-of-the-money and
are allowed to expire. But despite the premium and other cost of $0.53 per bushel, the
rise in cash prices resulted in a realized price of $7.28 per bushel. The net price would
have been $7.80 per bushel had the put not been bought, emphasizing that the use of
options may not maximize price at any point in time. Options may be highly effective
over time in assuring a more stable income and avoiding disastrous losses resulting
from dramatic price level changes.
Example 2 - Put Option When Prices Fall
*** January soya bean futures assumed to be trading at $5.60 per bushel, giving the
put option an intrinsic value of $1.40 per bushel. It is further assumed that the put had
a time value of $0.04 per bushel. The total premium would, therefore, be $1.44.
In Example 2, futures prices fell along with cash prices. The put option at a strike
price of $7.00 per bushel was iii-the-money in November. The put was offset by
selling two January soya bean put options for a premium of $1.44 per bushel. The
offset resulted in a $.91 per bushel gain ($1.44 premium resale -$O.53 original
premium and costs paid) which, when added to the cash price of $5.30, gave Farmer a
realized price of $6.21 per bushel. The net price received is $.04/bu. greater than the
expected minimum sale price established in May due to the additional $.04/bu. time
value received from the offset. Had the put not been bought, the realized cash price
would have been $5.30 per bushel.
Using options to insure against rising prices
Users of agricultural commodities, such as grain for feed use, may desire insurance
against price increases on anticipated future purchases.
For example, consider a shopkeeper who thinks that he can make profit if he could
purchase 5,000 bushels of corn for not more than the current price of $3.40 per bushel.
The existing stock will be sufficient till the end of February, and the corn will need to
be purchased at that time. The shopkeeper would be satisfied with the expected return
and desires to insure against an increase in the price of corn. Since the call option
provides the right to purchase corn at a specified price in the future, he will be
interested in purchasing a call option. Also, the March option contract month would
be the appropriate month to select as it matures closer to, but not before, the time
when corn will be purchased.
The operator now needs to determine the one strike price that will meet his objective
of buying corn for no more than $3.40 per bushel. Each strike price can be evaluated
by the following formula:
The producer can normally purchase corn for $0.20 over the March futures in late
February, can buy and sell an option contract for $100 ($0.02 per bushel for 5,000
bushels), and has an opportunity cost of 1 % per month. An example of a March corn
call option might result in the following maximum purchase prices.
Strike Price Premium Brokerage Fee Opportunity Cost Basis Maximum Purchase Price
----------------------------Dollars Per Bushel----------------------------
$2.80 +0.43 +0.02 +0.01 +0.20 $3.46
2.90 +0.26 +0.02 +0.005 +0.20 3.385
3.00 +0.18 +0.02 +0.004 +0.20 3.404
3.10 +0.13 +0.02 +0.003 +0.20 3.453
3.20 +0.07 +0.02 +0.001 +0.20 3.491
Only the $2.90 strike price will allow the shopkeeper to lock in a maximum buying
price for his corn needs that meets his objective. He buys one $2.90 March corn call
option and forwards a check for $1,400. ($1,400. = 5,000 bushels x $0.26 + $100.00
brokerage fee). By utilizing the $2.90 call option, the shopkeeper can now be sure he
will not pay more than $3.385 for his corn needs should corn prices rise, but may still
buy corn for less if corn prices fall. The following illustrations show the results
obtained if prices rise and if they fall.
On the other hand, if the market moves in favor of a position, the virtually unlimited
profit potential to the buyer of an options contract is parallel to a futures position, net
of the premium paid for the options contract. Therefore, protection from unfavorable
market moves is achieved at a known cost, without giving up the ability to participate
in favorable market moves.
Futures Vs Options
Futures Options
While the loss that can be incurred on an Options contract is limited to the premium,
the loss that can be incurred on a Futures contract is the opportunity cost resulting
from locking in a price and forfeiting the benefits of favorable market moves.
So, as far as farmers and manufacturers are considered, Options are more beneficial
than futures.
Introduction of Options in India
Trading in commodity options contracts has been banned since 1952. The market for
commodity derivatives cannot be called complete without the presence of this
important derivative. Both futures and options are necessary for the healthy growth of
the market. While futures contracts help a participant (say, a farmer) to hedge against
downside movements, it does not allow him to reap the benefits of an increase in
prices.
So, using a future contract, a farmer can only hedge against price falls. If the prices
are going up in contrast to his predictions, the farmer cannot really take advantage of
the situation. Similarly, using futures, a buyer can only lock the rise of price of a
commodity which he intends to buy in near future. It is an obligation to buy the
underlying commodity. If the prices are going down as against his predictions, he will
not be able to reap gains by taking advantage of the situation as it is necessary to
perform the contract. Options help the participant in such conditions. It does not create
an obligation.
But the introduction of Options is still in papers only. Recently, Government delisted
four commodities from being traded in exchanges. As there are still controversies that
futures trading fuels inflation in the country, it will not be very easy for the
Government to introduce Commodity Options. For commodity derivatives to work
efficiently, it is necessary to have a sophisticated, cost-effective, reliable and
convenient warehousing system in the country. So, the Government has to ensure that
before introducing more complex derivative instruments.
No doubt, there is an immediate need to bring about the necessary legal and regulatory
changes to introduce commodity options in the country. The matter is said to be under
the active consideration of the Government and the options trading may be intr oduced
in the near future.
Impact of various studies and researches
There are a lot of studies and research works carried out in the area of Commodity
Futures Markets in India. These findings and suggestions obviously have an impact on
the likeliness towards Introduction of Options in Indian Exchanges.
So, a detailed analysis is made on some of these studies and the research reports
published by various scholars. The major committee which studied the Commodity
Futures market in India recently is Abhijit Sen Committee. The Committee submitted
a report on 29th April 2008. This report is supposed to be an important one which may
influence the decision of the Government as to introduce Options in India.
Analysis of some other studies which were conducted in this arena is also made to
know more about the findings of these researches. These studies include one which
was done by IIM Bangalore, to find out the impact of futures trading on Commodities.
Their objective was to compare post-futures and pre-futures price fluctuations of
various commodities.
A very recent study on Commodity Derivative Market and its Impact on spot market
was conducted by GC Nath and Thulasamma Lingareddy, which was published early
this year. This study compares the prices of underlying commodities in pre-futures
period with that of post-futures period.
As these studies are considered to be important with regard to this research, these
reports are studied analyzed and the major findings are included here.
Report on Commodity Futures – Abhijit Sen Committee
In the wake of consistent rise of rate of inflation during the first quarter of calendar
year 2007 and responding to the concerns expressed at various forums, Parliamentary
Standing Committee of the Ministry of Consumer Affairs Food and Public
Distribution, appointed an Expert Committee under the Chairmanship of Prof. Abhijit
Sen, Member of Planning Commission, to examine whether and to what extent futures
trading has contributed to price rise in agricultural commodities. The objectives of the
committee were:
1. To study the extent of impact, if any, of futures trading on wholesale and retail
prices of agricultural commodities
2. Depending on this impact, to suggest ways to minimize such an impact
3. Make such other recommendations as the Committee may consider appropriate
regarding increased association of farmers in the futures market/trading so that
farmers are able to get the benefit of price discovery through Commodity
Exchanges.
In order to examine whether futures trade could have led to price rise in agricultural
commodities, the committee has relied on WPI data as these are a closer proxy of
producer prices of agricultural produce than retail prices. Of the 43 agricultural
commodities that have futures trading, 24 commodities accounted for 98.7% of total
value of futures trading of agricultural commodities in 2006 -07. Among the 24
commodities with major share in futures trade, 3 do not feature in the WPI basket at
all.
So, these 3 commodities were excluded and mapping was done of 21 commodities
with regard to the events of futures trade in these. Annualized Trend Growth Rate and
Volatility of WPI of Selected Agricultural Commodities in which Futures are traded
were calculated. Both WPI trend growth rate as well as WPI vol atility was obtained
for pre-futures period as well as post-futures period.
The data showed that the annual trend growth rate in prices was higher in the post -
futures period in 14 commodities, viz. Chana, Pepper, Jeera, Urad, Chillies, Wheat,
Sugar, Tur, Raw Cotton, Rubber, Cardamom, Maize, Raw Jute and Rice; and lower in
7 commodities, viz. Soya oil, Soya bean, Rape seed / Mustard seed, Potato, Turmeric,
Castor seed, and Gur. The first set of commodities account for 48.2% of futures
trading volume in agriculture and have a weight of 10.1% in the WPI. Corresponding
figures for the second set are 21.3% and 1.7%. Since the number of commodities in
which inflation accelerated is double the number in which this decelerated, and their
weights are also much higher in both futures trading and in the WPI, there is some
support for the claim that opening up of futures markets spurred inflation. Also,
significantly, all sensitive commodities (i.e. food grains and sugar) recorded some
acceleration in inflation after the start of futures trading.
An analysis was also carried out at macro rather than specific commodity level taki ng
August 2004 as the cut-off point to divide pre-futures and post-futures periods. This is
the middle month of the second quarter (July-Sept) of 2004-05 when, taking
acceleration in total futures trading volume as the barometer, such trading picked up
reasonably. After taking equal observations for both pre and post futures period, trend
growth rates for both periods were calculated. This was done for
(i) The weighted average WPI of the 21 selected commodities that have
significant futures trading
(ii) All primary agricultural goods (i.e. Food and Non-Food Articles in the
WPI Primary Articles Group) and
(iii) The weighted composite index of the 87 processed and unprocessed
agricultural commodities. It was observed that not only did inflation
accelerate post-futures in every case; price volatility was also generally
higher in the post-futures period.
The futures on urad, tur wheat, rice etc were delisted from the Indian exchanges. The
committee has studied each of these commodities to analyze the factors behind the
inflation and to check whether futures trading has actually resulted in price rise.
The report states that the price of tur was not influenced by the futures trading, but the
domestic demand and supply. In the next year after the introduction of futures, the
supply of tur was huge, which lead to a steep fall in price. And in 2007, its price again
went up as the production was dull. This evidence contradicts the claim that futures
trading caused excessive increase in tur prices.
By considering exports and government stock change into account, total rice
availability in the domestic market declined by over 5 million tonnes in 2005 but
recovered well beyond the 2004 level in 2006 and increased further by more than 1.5
million tonnes in 2007. The price of rise does not increase marginally in any of these
years and was increased only after the delisting of rice from futures trading. So, the
report states that speculation in futures markets cannot be said to have exerted any
strong upward pressure on spot prices of rice.
Production of urad declined and was below the average production in the years 2004-
05 and 2005-06. But it was recovered in 2006-07. The price of urad was behaving
unusually. Thus, Urad inflation did flare up very unusually in the period when
futures‘ trading was active (August 2004 to January 2007). But this was a period of
below normal production and, although higher imports cushioned supply.
Wheat production was a little bit fluctuating over these years. It went down in 2004 -
05 and then increased sharply. Exports were declined and as a result of these factors,
market availability of wheat increased. But despite that, the inflation persisted. Wheat
prices behaved unusually and annualized wheat WPI inflation at 9.8% during the 30
months when futures trading was liquid (August 2004 to February 2007) stands in
sharp contrast to inflation in either the previous 30 months (1.5%) or in the year
subsequent to de-listing (0.3%, y-on-y February 2008).
The report states that Critics of futures trading have focused most on outcomes in
wheat, and linked this not only with speculative gains at cost of both producers and
consumers but also with failures in public grain management in the face of
uncertainties in both domestic production and world trade.
The possible reasons for the rise in wheat prices are:
1. Price rise in the initial period was as a result of output decline in 2004-05.
2. The world wheat prices have played a significant role in igniting wheat prices
in India.
3. The increased demand for wheat during the period.
4. Even though wheat was available in private market, the government stock of
wheat was too low to meet the increased demand.
5. In 2006-07, even though the production was increased, the ratio of market
arrivals to production was low as a result of private trade.
Steps to minimize the potential risks of Derivatives trading
1. Pace and sequence of market opening.
New and modern technology-driven Exchanges with best international practices
have come up. All these developments have taken place in the backdrop of a long
history of ban in forward trading when the perception about these markets was not
good. That perception has not gone away totally. Even today people express their
doubts about the need and efficacy of these markets. Therefore, it becomes all the
more important that these markets are set up on a strong foundation. There should
not occur any mishap or mischief which may discredit the market as a whole. The
Government/Regulator/Exchanges should be able to explain that the markets are
beneficial to all groups and if there are any transitional costs, these are the
minimum and will be more than compensated with the overall benefit to the
economy and the stakeholders.
Before taking any steps to lift the ban on the four delisted commodities, the
government should take necessary steps. A cautious approach is to be adopted for
revival of futures trade in these commodities rather than have to confront a stop go
situation again in the future.
2. Regulatory framework
In order to defend the market against criticism, it is essential to minimize the
potential adverse impact of futures trading on prices of agricultural products. This
requires properly functioning and regulated markets. There is a need for a clear
and unambiguous regulatory framework. The broad parameters of the functioning
of the markets have to be clearly laid down. The regulatory authority sho uld have
the capacity and the power to discipline the market. Once these pre-requisite are in
place they will not only help in controlling aberrations in the market but also help
the government and the regulator to explain to various stakeholders at large any
abnormal behavior in the market that might occur as a result of some basic
fundamental demand and supply factors.
The regulatory framework for the market is provided in the Forward Contract
(Regulation) Act, 1952. The FMC (Forward Markets Commission) was set up
under this act.
3. Derivatives Markets to be Anchored to Physical Spot-Markets
The derivative market has to be anchored to physical cash market. The physical
spot markets have large number of infirmities. Till these infirmities are reformed,
it will be difficult for the futures market to progress far ahead of them. Futures
markets can act as a catalyst of change for spot markets and nothing more.
Whenever futures markets try to grow faster than the under-developed physical
markets of underlying commodities, the mismatch between the two gets widened,
thereby opening up futures market to the criticism of being driven by speculators,
even if benign and closely regulated.
Futures markets efficiency is contingent on the efficiency of spot markets.
Efficient spot markets reduce the cost of future- spot arbitrage. Efficient spot
markets in commodities would require integration of markets across geographical
regions and quality. This reduces the basis risk in the use of futures contracts.
Integration of the spot markets requires development of rural communication,
transport and storage infrastructure. The committee is of the view that in order to
expedite this, a substantial part of the transaction tax which is now being imposed
on futures markets should be earmarked for development of the required physical
market infrastructure.
4. Speculation an Integral part of Efficient Futures Market
The commodities with a history of high price volatility are prone to excessive
speculative interests which open up futures market to the charge of distorting
prices having no linkage to the fundamentals of the demand and supply factors.
The presence of the speculators on the futures market is often looked upon with
suspicion. It must be remembered that if only the farmers and consumers were to
operate on the agricultural commodity markets, there is likely to be mismatch in
their respective marketing strategies and therefore, they would not be able to
transact business at any given point of time since the total volume of business
would be very thin. The market would, therefore, become illiquid. Hence,
speculators step into to provide the transaction matching through risk transfer and
consequential liquidity. In a free market with availability of technology for
instantaneous flow of information speculative funds cannot bring secular price rise
as supply responses (through inventory unloading, imports and production) are
fast. It is opacity or non-availability of efficient markets, like futures markets that
gives power to the manipulator-speculator. On the other hand, an efficient and
transparent market with sufficient depth of participation will encourage
responsible and informed speculation.
5. Consultative Mechanism for Development of the market
The exchanges as well as FMC should have a strong back up of domain knowledge
of commodities which are traded on the exchange platforms. The knowledge of
fundamental economic characteristics of production, marketing and use of the
commodity so as to understand the factors influencing their prices is of utmost
importance. Once a proper contract design of a product is in place, the surveillance
of the market becomes easy. There should be a consultative group comprising of
persons with proven domain knowledge of the commodity sector, both in the FMC
as well as in the Exchanges.
Other Major Studies
A number of studies and researches were made on the Commodity Futures market and
its impact on underlying commodity prices. There was a much wider scope for such
kind of studies as there was always a debate going on whether Futures trading has
influenced Commodity prices or not. It further went up when the government planned
to ban futures trading on a few commodities. Since the introduction of Futures, the
prices of underlying commodities were shooting up. The findings of a few important
studies are analyzed to know the influence of Futures trading on Commodity Prices.
The first conclusion of this study is that all these crops, except sugar, witnessed higher
price increase in the post-exchange period compared to the pre-exchange period.
However, as the study notes, sugarcane prices are to a large extent controlled by
government and sugar prices play little role in determining the sugarcane prices,
though they affect the payment capacity of the sugar mills and the prices to be offered
for the next year. In case of guar grown mainly in the arid regions of Rajasthan, a
normal monsoon gives a production that would meet the demand of guar seed for two
to three years. The price increase in the year 2005-06 followed low carry-over stocks
and increased export demand. In case of wheat, the high increase in prices after 2005
followed low production and low stock availability with the government. Tur showed
a sharp increase in prices during 2006 following low stocks and production. Urad also
showed continuous production decline 2004 onwards and a rise in the prices. Changes
in fundamentals (mainly from the supply side) were thus found important in causing
the higher post-futures price rise, with government policies also contributing, and the
role of futures trading remains unclear.
The IIMB study also finds that spot price volatility increased after introduction of
futures in case of wheat and urad. However, it does not find any major change in
volatility for gram, excepting an abnormal rise in FY 2006-07, or for tur and sugar. In
case of guar seed, volatility was in fact found lower after introduction of futures trade.
In an interesting extension to this, the study found evidence that (i) increased spot
price volatility (especially for wheat but also of gram) was associated with an increase
in seasonality of prices so that farmers gained less than traders; and (ii) a tendency for
retail margins to increase so that volatility increase was even more for retail prices
than wholesale prices. In case of sugar also, although volatility of spot wholesale
prices did not increase with introduction of futures, retail price volatility did increase.
An important finding of the IIMB study is that many contracts traded on Indian
Commodity Exchanges do not satisfy a fairly minimal condition for these to be
attractive for hedging by those holding physical commodities. A generally accepted
measure of whether a futures contract is attractive for hedging is its basis risk. Here
basis is defined as the observed difference between spot and futures prices, and
basis risk is measured by variance of this basis. Hedging can reduce price risks of
commodity holding if basis risk is less than price risk (i.e. variance of spot prices), and
becomes more attractive the lower the basis risk. The IIMB study found that not only
was basis risk high for commodities studied, this was higher than price risk for many
contracts.
Despite these rather negative results on functioning of futures markets, the IIMB study
does highlight one very significant positive development following the recent growth
of modern Exchanges. It notes that the growth of these Exchanges appears to have
helped in integrating geographically separated markets.
Another interesting finding of the study was that there is a lead-lag relationship
between futures trading and spot price volatility. It suggests that speculative activity in
futures market can destabilize spot prices and therefore warns against aggressive
attempts to expand futures trading, especially if driven not by those who manage price
risks in physical trade by hedging in futures markets but by speculators or others
based on exaggerated claims regarding futures markets efficacy.
Challenges facing the market
Commodity exchanges in Indian are still at a nascent stage, and there are numerous
bottlenecks in the growth of the commodity futures market. The challenges facing the
Indian Commodity markets are very serious in nature and cannot be ignored as they
can paralyze the agricultural futures markets, much against the objective of
agricultural liberalization. The main problem is that the commodity markets are under
the control of Government.
Towards the growth of any market, the trading conditions or the terms and conditions
of contracts play a crucial role. The contracts should be market friendly in terms of
attracting both the big and small traders alike. In majority of the contract
specifications, it was found that the size is too big for small traders and producers to
trade. Unless such finer aspects are dealt with proper attention at the regulatory level
and the exchange level, attracting small traders and farmers into commodity futures
trading becomes impossible. Especially in a country like India, where corporate
farming is absent and predominant section of the farmers own small agricultural lands,
meeting the specifications of the contract becomes difficult. Such farmers prefer spot
markets rather than commodity markets for trading. Even the small traders refrain
from trading owing to the capital constraints.
Another key component required for the development of commodities market in India
is the infrastructure. Though there are number of exchanges in India, they lack in
infrastructure exception to a few large exchanges like National Commodity
Derivatives Exchange (NCDEX) and Multi Commodity Exchange (MCX).
Infrastructure requirements like warehousing facilities, clearing house and modern
trading ring are absent in majority of the exchanges. As a result, majority of the
exchanges have to depend on a few commodities and consequently, the turnover is
low.
Warehousing facilities is one major impediment to the growth of commodity markets
in India. Though Government organization, Food Corporation of India, plays a vital
role in storage of commodities, the infrastructure does not support future trading
adequately. For the commodity futures to work effectively, the seller must deposit the
deposit the commodity traded in a warehouse and the buyer should take physical
delivery of the commodity in a warehouse at a location of his choice. However, at
present, only a few warehouses can handle such kind of delivery requests and that too
for specific commodities. Because of lack of adequate warehousing facilities that can
ensure the quality standards of the commodities traded, traders and farmers still prefer
local rural markets for trading the commodities. This factor is hindering the
emergence of nation-wide commodity market in India.
Another major challenge to the growth of the commodity markets is the number of
exchanges itself. Among the 27 commodity exchanges operating in India, majority of
the exchanges are specialized in trading a few commodities. While geographical
spreading of the exchanges is important for the development of nation-wide
commodity market, there is no real integration among the existing exchanges. And
most of these exchanges except NCDEX and MCX still practice outcry system of
trading, it is cumbersome to trade in these specialized exchanges.
As a result of these small exchanges spreading across the nation and specializing in
select few commodities, the turnover, volume of trade and the revenues of exchanges
are all low. It is very difficult for the exchanges to sustain the momentum and provide
value added services to the market functionaries with such low revenues. In order to
overcome the problem of multiple commodity exchanges, many economists have
suggested the integration of the exchanges and consolidation and then in the later
stage opt for demutualization of exchanges similar to the Chicago Mercantile
Exchange and International Petroleum Exchange. The integration of exchanges and
clearing house can also solve the problem of warehouses to a significant extent.
Currently, a few large exchanges like NCDEX and MCX are attracting bulk of the
trading and traders because of their technology and national-wide trading terminals.
As a result, those exchanges have succeeded to gain the required financial strength.
Global trends in derivatives markets and the road ahead for India
As the derivatives market emerge and bloom in India, financial markets all over the
world are being rapidly transformed by the Internet revolution. Participation level of
individuals, organization of trading, speed of price discovery are all undergoing major
changes and Indian markets have to rapidly adjust themselves to these changes.
Till the integration happens, we should expect to see important changes in the existing
regional exchanges. Faced with competition from nation-wide exchanges, they would
have to improve their technology, transparency and methods of operation in the short
run if they are serious about staying in business. Also with the co ntinued acceptance
and popularity of institutionalized commodity futures trading, probably the bulk of
informal futures trading will slowly be absorbed in the regulated, through-exchange
trading as the price and liquidity benefits outweigh the added transaction costs. That
would, indeed, be a positive development for all concerned.
Perhaps the biggest event in financial markets around the world – not just
commodities or futures markets but securities markets as well – in recent years has
been the emergence of Electronic Communication Networks (ECNs). In Indian
exchanges, the outcry system has already been replaced by the ECN system.
Over time, new products are likely to be introduced in the Indian futures markets. A
category of futures that have are extremely popular in developed countries will
perhaps make their appearance in India too. These are the weather derivatives, which
are now being offered in India as bank products but not actively traded in the bourses.
If properly designed such futures can help farmers hedge the climate and rainfall
related risks that are concomitant with Indian agriculture.
In about a decade‘s time, commodity futures in India have come a long way from the
domain of barely legal bets to trading on multi-commodity national level exchanges
with sophisticated products, technology and contract specifications. Its rise offers
participants in Indian agriculture a much needed way to hedge their risks. While as of
now, small and medium farmers and farmer cooperatives are still hard to find amidst
the users of futures markets, hopefully that will change soon as the futures rise in
popularity and stature. Then they would truly make a difference where it matters most.
Findings
Futures‘ trading in commodities has a long tradition in India going back to
1875 when the Bombay Cotton Trade Association was set up. This was
followed by a mushrooming of Exchanges throughout the country.
Futures markets faced a lot of challenges since 1960s when they were accused
of fuelling inflation and were perceived not to have any role as the State
intervened directly in prices and distribution of large number of essential
commodities which were short in supply. The market survived in the situation
as very few commodities were permitted for futures trading.
Adoption of liberal economic policies since 1991 gave fillip to efforts to open
up futures trading, which culminated into total withdrawal of prohibition in
2003. Since then, Futures trading is undergoing fast changes.
There has been a fall in agri-commodity volumes during 2007-08 over the
previous year. This place was taken over by bullion and other metals. Negative
sentiments have been created by the decision to de-list futures trade in some
important agricultural commodities.
Analysis of 21 agricultural commodities (accounting for about 98% of share in
total futures trade in agricultural commodities) shows that the annual trend
growth rate of prices accelerated after introduction of futures trading in the case
of many more of these commodities than there were cases of deceleration. In
particular, prices of all food grains accelerated in the post-futures period.
The fact that agricultural price inflation accelerated during the post futures
period does not, however, necessarily mean that this was caused by futures
trading.
A study of supply fundamentals (production, changes in inventory and
international trade) show that changes in these also contributed to higher
inflation during the period under consideration
In contrast to the view that futures markets cause increases in prices, the most
of the existing literature on the subject emphasizes that such markets help in
price discovery, provide price risk management and also bring about
integration of markets.
Although the volume of futures trading in India has increased phenomenally in
recent years, its ability to provide instruments of risk management has not
grown correspondingly.
Suggestions
Reforming spot markets should be given top priority. Till the infirmities of spot
markets are removed, it will be difficult for the futures market to progress far
ahead of them.
Another enabler of the market will be to upgrade the quality of regulation both
by the FMC and by the Exchanges. An important element of this is to require
exchanges to act as self regulatory organizations, capable of demonstrating fair
play, objectivity and customer orientation.
FMC should frame regulations on various aspects of market operations for
transparent and efficient functioning of the market. The care should be taken to
enable farmers and small operators to take benefit of these markets. Exchanges
should be directed to design their market procedures and contracts such as to
enable farmers an easy access to these market and protection against any
market malpractices.
There should be a consultative group comprising persons with proven domain
knowledge of commodity sector both in the FMC as well as in the exchanges.
The structure of markets, contract designs and other requirements of trading on
these markets should be simple and easy to enable farmers to participate in
these markets. The contract designs should be tailored to meet the needs of the
physical market.
The farmers should be given access to information. Moreover, they need to be
empowered to use this information. Empowerment is a much more difficult
task than making information available.
The farmer is less likely to participate directly as these markets are complex;
they need to be tracked continuously to take benefit out of them. The support
infrastructure of warehousing and commodity finance is inadequate. Moreover,
at the early stage of development of these markets, where liquidity in many
commodities is low and they are prone to high impact costs. The awareness and
knowledge of accessing these markets among farmers is yet not adequate. So,
FMC and exchanges should take necessary measures to spread awareness.
Before taking any steps to lift the ban on the four delisted commodities , the
government should take necessary steps. A cautious approach is to be adopted
for revival of futures trade in these commodities rather than have to confront a
stop go situation again in the future.
Options on commodities‘ can be another hedge instrument suitable for
farmers‘ needs. However, complex Options products may be difficult to
comprehend and not suitable for farmers‘ needs. In case of agri-commodities, it
will be suitable to allow only Simple Options for some time till market attains
maturity of operations and regulations. It is also important that the farmers
attain adequate understanding of the markets and of techniques to use them.
Since the premium on options may be high, farmers‘ costs of accessing these
markets should be minimized by waiving transaction charges/taxes or even
by granting subsidies out of tax collection/ transaction charge collection for
genuine hedge purposes by the farmers. The money from proposed CTT can be
used for it.
Before introducing Options trading in the major food grains, an assessment
should be made of the possibility of FCI acting as the writer of ‘Call’ and
‘Put’ options in these commodities. This could reduce the cost of operations
and stabilize market operations.
References
Publications
Business world
www.commodityonline.com
www.mcxindia.com
www.ncdex.com
www.nymex.com
www.lme.co.uk
www.ces.uga.edu
www.cboe.com