Introduction to Commodity futures In India
Unknown to us the commodities that have always been a part of our
day-to-day existence are also one of the finest investment avenues
available. The wheat in our bread, the cotton in our clothes, our gold
jewels, the oil that runs our cars, etc; are all traded across the world
in major exchanges.
Over the ages, commodities have been the basis for trade and industry.
They have spurred commerce, encouraged exploration and altered the
histories of nations. Today, they play a very important role in the
world economy with billions of dollars of these commodities traded each
day on exchanges across the world.
Commodities today have become an attractive investment vehicle. In the
current investment scenario, it is increasingly getting difficult for
individuals and institutions to create a well-balanced investment
portfolio. With uncertainty in interest ratio, it is tough for the
investor to beat the ever-rising inflation. Averse to being over exposed
to equity markets, the investors are left with limited choices... Well
no more!
Brief History of Commodity Trading and Commodity Exchanges
Trading in commodities futures has a long history. Though the modern trade in commodity futures
could trace its origins back to the 17th century in Osaka, Japan, there
is evidence to suggest that a form of futures trading in commodities
existed in China 6000 years earlier. Organized trading on an exchange
started in 1848 with the establishment of the Chicago Board of Trade
(CBOT).
The first milestone in the 125 years rich history of organized trading
in commodities in India was the constitution of the Bombay Cotton Trade
Association in the year 1875. India had a vibrant futures market in
commodities till it was discontinued in the mid 1960's, due to war,
natural calamities and the consequent shortages.
Recent Developments in India
The advent of economic liberalization helped the cause of laying emphasis on the importance of commodity trading.
By the beginning of 2002, there were about 20 commodity exchanges in
India, trading in 42 commodities, with a few commodities being traded
internationally.
Commodities futures contracts and the exchanges they trade in are
governed by the Forward Contracts (Regulation) Act, 1952. The regulator
is the Forward Markets Commission (FMC), a division of the Ministry of
Consumer Affairs, Food and Public Distribution.
In 2002, the Government of India allowed the re-introduction of
commodity futures in India. Together with this, three screen
based,nation-wide multi-commodity exchanges were also permitted to be
set up with the approval of the Forward Markets Commission. These are:
1. National Commodity & Derivative Exchange (www.ncdex.com)
This exchange was originally
promoted by ICICI Bank, National Stock Exchange (NSE), National Bank for
Agriculture and Rural Development (NABARD) and Life Insurance
Corporation of India (LIC). Subsequently other institutional
shareholders have been added on. NCDEX is popular for trading in
agricultural commodities.
This exchange was originally
promoted by Financial Technologies Limited, a software company in the
capital markets space. Subsequently other institutional shareholders
have been added on. MCX is popular for trading in metals and energy
contracts.
3. National Multi Commodity Exchange of India (www.nmce.com)
This exchange was originally
promoted by Kailash Gupta, an Ahmedabad based trader, and Central
Warehousing Corporation (CWC). Subsequently other institutional
shareholders have been added on. NMCE is popular for trading in spices
and plantation crops, especially from Kerala, a southern state of India.
In terms of market share, MCX is today the largest commodity futures
exchange in India, with a market share of close to 70%. NCDEX follows
with a market share of around 25%, leaving the balance 5% for NMCE.
Commodity Futures Contract
A commodity futures contract is a commitment to make or accept
delivery of a specified quantity and quality of a commodity during a
specific month in the future date at a price agreed upon when the
commitment is made.
Commodities traded in the commodity exchanges are required to be
delivered at the contracted price, ignoring all the changes in the
market prices. Both the participants (Buyers & Sellers) are allowed to
liquidate their respective positions by way of cash settlement of price
between the contracted and liquidated price, no later than the last
trading session of the specified expiry date.
An effective and efficient market for trading in commodities futures
requires:
Volatility in the prices of the underlying commodities.
Large numbers of buyers and sellers with diverse risk profiles(hedgers, speculators and arbitrageurs).
The underlying physical commodities to be fungible, i.e. they should be exchangeable.
Features of commodity futures
1. Organized :
Commodity Futures contracts
always trade on an organized exchange, e.g. NCDEX, MCX, etc in India and
NYMEX, LME, COMEX etc. internationally.
2. Standardized :
Commodity Futures contracts are highly standardized with the quality, quantity, and delivery date, being predetermined.
3. Eliminates Counterparty Risk :
Commodity Futures exchanges use
clearing houses to guarantee that the terms of the futures contract are
fulfilled. The Clearing House guarantees that the contract will be
fulfilled, eliminating the risk of any default by the other party.
4. Facilitates Margin Trading :
Commodity Futures traders do
not have to put up the entire value of a contract. Rather, they are
required to post a margin that is roughly 4 to 8% of the total value of
the contract (this margin varies across exchanges and commodities). This
facilitates taking of leveraged positions.
5. Closing a Position :
Futures markets are closely
regulated by government agencies, e.g. Forward Markets Commission (FMC)
in India, Commodity Futures Trading Commission in (CFTC) USA, etc. This
ensures fair practices in these markets.
6. Regulated Markets Environment :
Commodity Futures contracts are highly standardized with the
quality, quantity, and delivery date, being predetermined.
7. Physical Delivery :
Actual delivery of the
commodity can be made or taken on expiry of the contract. Physical
delivery requires the member to provide the exchange with prior delivery
information and completion of all the delivery related formalities as
specified by the exchange.
Market Participants - Hedgers, Speculators and Arbitrageurs
An efficient market for commodity futures requires a large number of market participants with diverse risk profiles. Ownership of the underlying commodity is not required for trading in commodity futures. The market participants simply need to deposit sufficient money with brokerage firms to cover the margin requirements. Market participants can be broadly divided into hedgers, speculators and arbitrageurs.
Hedgers :
They are generally the commercial producers and consumers of the traded commodities. They participate in the market to manage their spot market price risk. Commodity prices are volatile and their participation in the futures market allows them to hedge or protect themselves against the risk of losses from fluctuating prices. For e.g. a copper smelter will hedge by selling copper futures, since it is exposed to the risk of falling copper prices.
Speculators :
They are traders who speculate on the direction of the futures prices with the intention of making money. Thus, for the speculators, trading in commodity futures is an investment option. Most Speculators do not prefer to make or accept deliveries of the actual commodities; rather they liquidate their positions before the expiry date of the contract.
Arbitrageurs :
They are traders who buy and sell to make money on price differentials across different markets. Arbitrage involves simultaneous sale and purchase of the same commodities in different markets. Arbitrage keeps the prices in different markets in line with each other. Usually such transactions are risk free.
The market functions because of the differing risk profiles of the market participants. The fluctuation in commodity prices represents both, a risk and a potential for profit. The hedgers transfer this risk by foregoing the associated profit potential. The speculators assume this risk in the hope of realizing profits by predicting price movements. The arbitrageurs make the process of price discovery more efficient.
Commodity Futures as an Investment Avenue
Commodity futures are globally recognized to be a part of every successful and diversified investment portfolio. The fact that the returns from most of the commodities in the last 53 years from 1951 to 2006 have been higher than the global inflation rate, establishes that investments in commodity are an effective hedge against inflation.
Some of the reasons that make investing in commodity futures an attractive preposition are described below:
Leverage :
Commodity Futures trading is done on margins. The investor only deposits a fraction of the value of the futures contract with the broker to cover the exchange specified margin requirements. This gives the investor greater leverage and thus the ability to generate higher returns.
Liquidity :
Unlike investment vehicles like real estate, investments in commodity futures offer high liquidity. It is equally easy to both buy and sell futures and an investor can easily liquidate his position whenever required. There is also another advantage of being able to use the profits from a trade elsewhere, without having to close the position.
Diversification :
Investments in commodity markets are an excellent means of portfolio diversification. For example, gold prices have historically shown a low correlation with most other asset prices (such as equities) and thus offer an excellent means for portfolio diversification.
Inflation Hedge :
As the commodity prices determine price levels and consequently inflation, investing in commodity futures can act as a hedge against inflation.
Physical Gold :
Physical Gold is a product by which retail and high net worth investors can take investment positions in dematerialized physical gold using the futures market. In this product, the investor can hold physical gold, in a safe deposit vault approved by the exchange, which is reflected in the investor's demat account. The main features of this are:
- Liquidity
- Assurance of purity
- Transparency of rates
- Safety
These features have attracted a large number of clients to the product since its introduction. Many brokers offer a full package of services associated with the Physical Gold contract, including acting as commission agent to take care of sales tax / VAT related issues.
Commodities traded in Commodity Exchanges :
Large numbers of commodity are traded on commodity exchanges in around the world. The commodities are classified on the basis of their use and consumption. Further classification is based on the characteristics of the commodity.
Some of the commodities traded on various futures exchanges are as follows:
Foodstuff :- Coffee, Sugar, Cocoa, Maize, Rough rice, Soybean, Wheat, Sunflower Oil, Barley, Orange Juice
Industrial Metals:- Copper, Lead, Zinc, Tin, Aluminium, Nickel, Recycled
Precious Metal:- Gold, Platinum, Palladium, Silver
Energy:- Crude Oil, Natural Gas
Types of Commodity Futures Markets
The futures market for a commodity can be normal or inverted.
Normal Futures Market
A normal futures market is one where the price of the nearby contract is less than the price of the distant futures contract. This is illustrated by the figure below, which shows the prices of gold futures in a normal market. The more distant the contract month, the higher is the contract price, in a normal market. The price difference between the futures contracts of different months is due to the cost of carry. The cost of carry is the cost incurred in carrying a commodity to some future date. It includes interest, insurance and storage costs. This is logically what should happen for all contracts since cost of insurance, interest and storage will be a finite positive number.
Inverted Futures Market
In an inverted futures market, the
price of the near contract is greater then the price of the distant
contract. As shown in the figure below, the more distant the contract,
the lower is the price.
An inverted futures market is seen when there are short term supply disruptions, resulting in shortages.
The Concept of Basis in Commodity Futures
Basis Defined
The difference between the local spot price (cash price) and the relevant
futures price of a commodity is called the commodity basis.
Basis = Spot price - Futures price
For example, if the spot landed price of gold in March is Rs. 9450/10gm and the
April gold futures price is Rs. 9400/10gm, then the basis is Rs. 50/10gm
(9450-9400). The basis can be positive or negative.
The spot price of a commodity is the prevailing cash price in the market. The
futures price is a representation of the market opinion of the spot price of
the commodity on some future date. Theoretically, the futures price and the
spot price are related in the following manner
Futures price = Spot price + Cost of carry
The cost of carry is the cost of carrying the commodity from the current month
to the month of delivery. This includes costs of storage, insurance, interest
etc. Thus usually, the price of a futures contract is higher than the
prevailing spot price. This condition is known as Contango.
The actual difference between the spot and the futures price may be different
from the cost of carry and can vary based on the demand and supply of the
underlying commodity at current and expected levels in the future. Thus it is
possible for the futures price to be less than the spot price. This condition
is called Backwardation. For e.g. the copper futures on NYMEX have mostly been
in backwardation since the 1950's.
Whether the market is in Contango or Backwardation, as the futures contract
approaches the expiry date, the spot and future prices converge.
Spot
Price <
Futures Price
|
Basis
|
Market Condition
|
Negative
|
Contango or Normal
|
Spot
Price <
Futures Price
|
Basis
|
Market Condition
|
Positive
|
Backwardation or Abnormal
|
The basis depends on the local spot market price and so it reflects the local
market conditions. It is affected by the following factors:
Weakening and Strengthening Basis
The basis can change in two directions, either increase or
decrease. An increasing basis means that the basis is becoming less negative or
more positive. This is called a strengthening or narrowing basis. A decreasing
basis means that the basis is becoming more negative or less positive. This is
called a weakening or widening basis.
Strengthen
Basis become more
positive or less negative
|
Weaken
Basis become more
negative or less positive
|
|
|
Cash price increasing faster
relative to futures price
|
Cash price decreasing faster
relative to futures price
|
Hedging and Basis
Basis is a crucial factor on which hedging decisions are based. The
matrix of sale and purchase for producers and consumers on basis is
given below:
Long Hedge
|
High Cash Price
|
Low Cash Price
|
Strong Basis
|
Delay Cash Purchase
No Hedging Required
|
· Delay Cash Purchase
· Hedge - Long Futures
|
Weak Basis
|
Purchase immediate
requirements only
|
Purchase as much as
possible and store or Hedge using futures
|
Short Hedge
|
High Cash Price
|
Low Cash Price
|
Strong Basis
|
Sell Product in Cash
|
· Sell Produce
· Re-own by going long on futures
|
Weak Basis
|
· Delay Cash Sales / Store Produce
· Hedge - Short Futures
|
Store for selling
later
|
The long hedger or the consumer of the commodity prefers for the
basis to weaken. In this scenario, the cash price will be lower than
futures and hence the hedger's procurement price in the spot market
will be less than the futures market.
The short hedger or the producer of the commodity prefers for the
basis to strengthen. In this scenario the cash price will be higher
relative to the future and the hedger realizes a higher selling price in
the spot market than the futures market.
How to Trade in Commodity Futures in India
With the setting up of nation-wide multi commodity
exchanges, a new avenue has been thrown open for Indian investors. These
exchanges have electronic trading and settlement systems making it easy to
trade in commodity futures. Trading on these exchanges does not require the
investor to possess physical stocks. In fact less than 1% of the total traded
volume involves the transfer of physical commodities.
Trading in commodity futures comprises of three simple steps.
- Step One: Choosing
a Broker
- Step Two: Depositing the
Margin
- Step
Three: Access to Information and a Trading Plan
- Process Flow In
Commodity Futures Trading
Step One: Choosing a Broker
The broker you choose should be a member of the exchanges you
wish to trade in. Other than this, one should keep the following factors
in mind while choosing a broker:
Competitive edge provided by the broker.
Broker's knowledge of commodity markets.
Credibility of the broker.
Experience of the broker.
Net-worth of the broker.
Quality of broker's trading platforms.
The relationship between the broker and the client is long-term. Thus
there must be a strong rapport, and mutual trust between the client
and the broker. Further, the client must communicate clearly to the
broker his needs and objectives for trading in commodities, whether
they are for the purpose of hedging, investment, etc. Further, your
objectives for entering the market provide you with a valuable
parameter to judge whether a broker fits your needs
Depositing margin in commodity trading
To begin trading, the investor needs
to deposit a margin with his broker.
Margin requirements are of two types, the initial margin and the maintenance
margin. These margin requirements vary across commodities and exchanges but
typically, the initial margin ranges from 5-10% of the contract value.
The maintenance margin is usually lower than the initial margin. The investor's
position is marked to market daily and any profit or loss is adjusted to his
margin account. The investor has the option to withdraw any extra funds from
his margin account if his position generates a gain. Also, if the account falls
below the maintenance margin, a margin call is generated from the broker and
the investor needs to replenish his account to the initial level.
Access to Information and a Trading
Plan
As commodity futures are not
long-term investments, their performance needs to be monitored. The investor
should have access to the prevailing prices on the exchanges as well as market
information that can help predict price movements. Brokers provide research and analysis to their clients. Other
information sources are financial dailies, specialized magazines on commodities
and the internet. Further, an investor requires a trading plan. Such a trading
plan can be developed in consultation with the broker. In any case, the
investor has to remember to ride his profits and cut his losses by using stop
loss orders.
Process Flow in Commodity Futures
Trading
After the process of opening account is done the investor may want to trade in commodity. IT is important to understand the process after the trade is placed.
An investor places a trade order with the broker (at the dealing desk) on phone. The dealer puts the order in exchange trading system. At the initiation of the trade, a price is set and initial margin money is deposited in the account. At the end of the day, a settlement price is determined by the clearing house (Exchange). Depending on if the markets have moved in favor or against the investors' position the funds are either being drawn from or added to the client's account. The amount is the difference in the traded price and the settlement price. On next day, the settlement price is used as the base price. As the spot market prices changes every day, a new settlement price is determined at the end of every day. Again, the account will be adjusted by the difference in the new settlement price and the previous night's price in the appropriate manner.
Dematerialization of commodity
contracts
Some basics for giving and taking
delivery of commodities in the Indian commodity futures
markets.
Dematerialization is the process of recording physical holdings (warehouse
receipts) in electronic form. It facilitates the easy transfer of holdings
through electronic mode. The investor opens an account with a depository
participant (DP) of NSDL, gets the goods to the warehouse and makes a request
for Demat credit. The warehouse accepts goods for storage and delivery. The
goods are assayed and the information is given to the NSDL via the Registrar
and Transfer Agent (R&TA). The R&TA is the link between the warehouse
and the depository. NSDL, upon confirmation from the R&TA, credits the ICIN
(a unique number allotted by NSDL for identification purposes) balance into the
Demat account of the client.
Entities in Dematerialization
Once the Client/investor wants to deliver goods on futures exchange S/he will come across various entities in the process, as shown in the chart above. The Depository Participants (DP) are market intermediaries between the client and National Securities Depository Ltd (NSDL). DP can be organisations involved in the business of providing financial services like banks, brokers, custodians, financial institutions etc. NSDL handles most of the securities and commodities held and settled in dematerialised form in the Indian market. Registrar & Transfer Agents (R&T) is a mean of continuous electronic communication between NSDL and issuer. Registrar & Transfer Agents control the number of commodities in demat form on a daily basis and daily reconciliation between NSDL and client. Exchange accredited warehouse accepts goods for storage / delivery, assaying and information given to NSDL via R&T agents.
Process Flow in
Dematerialization
Process Flow in Dematerialization
If the Client/investor wants to deliver goods on futures exchange S/he
will have to go through a defined process of Dematerialization. In
process of Dematerialization of the Commodity, the client has to submit
the commodities and a request form to the exchange accredited warehouse.
The warehouse checks the quality and quantity by assaying. Once the
assaying is successfully done, the warehouse sends the acceptance
information to NSDL (DP) via the registrar and transfer agent (R&T).
Once NSDL receives the confirmation from R&T agent, it credits ICIN
(a unique number allotted by NSDL for identification purposes) balance
into the Demat account of the client.
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