Introduction to Commodity futures In India

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.

2. Multi Commodity Exchange (www.mcxindia.com)

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.