The study conducted on the Commodities market gives an exhaustive idea regarding the risks associated with commodities exchanging and stresses more on the hedging procedure and Arbitrage utilizing the futures, which helps in reducing the loss to a negligible degree to shield the interests of the investors.
Commodities markets have been portrayed as ceaseless sale markets and as clearing houses for the most recent data about free market activity. They are the meeting places of purchasers and sellers of a consistently extending rundown of commodities that today incorporates agricultural items, metals, oil, financial instruments, foreign exchange and stock indices.
A commodity futures trade goes about as a commercial center for people interested by arbitrage. The elements driving arbitrage are the distinctions and view of differences of the equilibrium prices dictated by free market activity at different locations.
For the futures markets, the arbitrage exercises are brought out through the exchange of paper promissory notes to sell or purchase an item at a settled upon price at a future date. As people with various view of where demand and supply right now and where demand and supply will be change later on, in the future, commodity prices are headed to equilibrium. As new data enters the market, people groups recognitions change and the way toward arbitraging starts once more.
Price risk can happen for various reasons. For rural items, price risk may happen because of dry season, near record produce, an increased demand, diminished international supply, and so on.
The commodity futures markets give a way to transfer risks between people holding the physical (hedgers) and different hedgers or people speculating in the market.
Futures trades exist and are effective in light of the rule that hedgers may do without some benefit potential in return for less risk and speculators will approach increased profit potential from accepting this risk.
Indian Commodity Market
The vast geographical extent of India and her huge population is aptly complemented by the size of her market. The broadcast classification of the Indian Market can be made in terms of the commodity market and the bond market. Here, we shall deal with the former in a little detail.
The commodity market in India comprises of all palpable markets that we come across in our daily lives. These markets act as institutions that help in facilitating the exchange of goods for money. The cost of goods is estimated in terms of domestic currency Indian Commodity Market can be subdivided into the following two categories:
• Wholesale Market
• Retail Market
The orthodox wholesale Indian market dealt with whole sellers who purchased goods from the manufacturers and agricultural farmers and then sold them to retailers after making profits or gains in the process. The goods were then sold to the consumers by the retailers.
Lately, the retail market (both unorganized and organised) has advanced by a wide margin. Truth be told, the development of the commodity market of India as of late is primarily based on the development created by the retail part. Relatively every commodity, both agricultural and industrial are currently being provided at all around appropriated retail outlets all through the nation.
Additionally, the retail outlets have a place with both the organised and also the unorganised areas. The unorganised retail outlets comprise of little shop proprietors who are price takers where customers confront an exceedingly aggressive price structure.
India, which is a commodity based economy where two-third of populace relies upon rural items, shockingly has a very under developed commodity market. Not at all like the physical market, are futures markets exchanges in commodities to a great extent utilized as risk management (hedging) component on either physical item itself or open positions in commodity market. For example, a jeweler can hedge his inventory against perceived short-term downturn in gold prices by going short in future markets.
The gradual evolution of commodity market in India has been of great significance for our countries economic prosperity. In the Indian commodity market there are so many varieties of products including agricultural products like rice, wheat, cattle, gold, silver, aluminum and many more. There are some delicate commodities also such as sugar, cocoa, and coffee, which are perishable, so cannot be put in stock for long time. The commodity futures exchanges were evolved in 1800’s with the sole objective of meeting the demand of exchangeable contracts for trading agricultural commodities. Commodities have gained importance with the development of commodity futures indexes along with the mobilization of more resources in the commodity market.
A commodity can be defined as an article, a product or material that is bought and sold. It can be classified as every kind of movable property, except Actionable Claims, Money & Securities. Currently, the various commodities across the country clock an annual turnover of Rs. 1,40,000 crore (Rs. 1,400 billion).
Leading Commodity Markets of the World
Some of the leading exchanges of the world are New York Mercantile Exchange (NYMEX), the London Metal Exchange (LME) and the Chicago Board of Trade (CBOT).
Leading Commodity Markets of India
The government has now allowed national commodity exchanges, similar to BSE & NSE, to come up and let them deal in commodity derivatives in an electronic trading environment. These exchanges are expected to offer nation-wide anonymous, order driven, screen based trading system. The Forward Markets Commission (FMC) will regulate these exchanges.
Consequently four commodity exchanges have been approved to commence business in this regard. They are:
• Multi Commodity Exchange (MCX) located in Mumbai
• National Commodity and Derivatives Exchange Ltd. (NCDEX) located in Mumbai
• National Board of Trade (NBOT) located at Indore
• National Multi Commodity Exchange (NMCE) located in Ahmedabad.
Statutory Framework to Regulate Commodity Futures in India
Commodity futures contracts and the commodity exchanges are regulated by the government under the Forward Contracts (Regulation) Act, 1952. The nodal agency to regulate the future market is the Forward Markets Commission (FMC), situated in Mumbai, which functions under the aegis of the ministry of consumer affairs.
A Commodities Exchange is a place where different commodities and their derivative items are traded. Almost all commodity markets across the globe trade in agriculture products and other items (like wheat, sugar, maize, cotton, wheat cocoa, coffee, oil, metals etc.) and such contracts based on them. These contracts can include spot prices, forwards, futures and options on futures.
Among the four exchanges discussed above MCX and NCDEX are used more. These are discussed below:
National Commodity & Derivative Exchange Limited (NCDEX)
National Commodity & Derivatives Exchange Limited (NCDEX) is a professionally managed on-line multi commodity exchange. The shareholders of NCDEX comprises of large national level institutions, large public sector bank and companies. It is promoted by ICICI Bank Limited (ICICI), Life Insurance Corporation of India (LIC), National Bank for Agriculture and Rural Development (NABARD) and National Stock Exchange of India Limited (NSE). Canara Bank, Punjab National Bank (PNB), CRISIL Limited, Indian Farmers Fertiliser Cooperative Limited (IFFCO), Goldman Sachs, Intercontinental Exchange (ICE), Shree Renuka Sugars Limited, Jaypee Capital Services Limited and Build India Capital Advisors LLP, Oman India Joint Invesmtnet Fund, IDFC Private Equity Fund III by subscribing to the equity shares have joined the initial promoters as shareholders of the Exchanges.
NCDEX is a nation-level, technology driven de-mutualised on-line commodity exchange with an independent Board of Directors and professional management – both not having any vested interest in commodity markets. It is committed to provide a world-class commodity exchange platform for market participants to trade in a wide spectrum of commodity derivatives driven by best global practices, professionalism and transparency.
NCDEX is regulated by Securities and Exchange Board of India. NCDEX is subjected to various laws of the land like the Securities Contracts (Regulation) Act, 1956, Companies Act, Stamp Act, Contract Act and various other legislations.
NCDEX headquarters are located in Mumbai and offers facilities to its members from the centres located throughout India. As of March 31, 2015, the Exchange offered trading in 26 commodities, which included 21 agricultural commodities, 2 bullion commodities, 2 metals and 1 commodity in energy & polymer sector.
Multi Commodity Exchange of India Ltd. (MCX)
The Multi Commodity Exchange of India Limited (MCX), India’s first listed exchange, is a state-of-the-art, commodity futures exchange that facilitates online trading, and clearing and settlement of commodity futures transactions, thereby providing a platform for risk management. The Exchange, which started operations in November 2003, operates under the regulatory framework of Securities and Exchange Board of India (SEBI).
MCX offers trading in varied commodity futures contracts across segments including bullion, ferrous and non-ferrous metals, energy and agricultural commodities. The Exchange focuses on providing commodity value chain participants with neutral, secure and transparent trade mechanisms, and formulating quality parameters and trade regulations, in conformity with the regulatory framework. The Exchange has an extensive national reach, with 1731 members, operations through 475,519 trading terminals (including CTCL), spanning over 1811 cities and towns across India.
Benefits to the Industry from Futures Trading
• Hedging the price risk associated with futures contractual commitments
• Spaced out purchases possible rather than large cash purchases and its storage
• Efficient price discovery prevents seasonal price volatility
• Greater flexibility, certainty and transparency is procuring commodities would aid bank lending.
• Facilitate informed lending.
• Hedged positions of procedures and processors would reduce the risk of default faced by banks.
• Lending for agricultural sector would go up with greater transparency in pricing and storage.
Difference Between Cash and Futures Market
Cash market is the market for buying and selling physical commodity at a negotiated price. Delivery of the commodity takes place immediately.
Futures market is the market for buying and selling standardized contract of the commodity at a pre-determined price. Delivery of the commodity takes place during a future delivery period of the contract if the option of delivery is exercised.
Commodity Futures and Price Risk Management
The two major economic functions of a commodity futures market are price risk management and price discovery. Among these, the price risk management is by far the most important, and is the backbone of a commodity futures market. The need for price risk management, through what is commonly called “hedging”, arises from price risks in most commodities. The larger, the more frequent and the more unforeseen is the price variability in a commodity, the greater is the price risk in it. Whereas insurance companies offer suitable policies to cover the risks of physical commodity losses due to fire, pilferage, transport, mishaps etc., they do not cover similarly the risks of value losses resulting from adverse price variations. The reason for this is obvious. The value losses emerging from price risks are much larger and the probability of the recurrence is far more frequent than the physical losses in both the quantity and quality of goods caused by accidental fires and mishaps, or occasional thefts.
In a liquid market, the number of speculators (people looking to profit from price fluctuations) far outnumbers the number of hedgers (those protecting themselves against price risks)
It is the act of reducing uncertainty about future (unknown) price movements in a commodity (rubber, tea, etc.), financial security (share, stock etc.) and foreign currency. This can be done by undertaking forward sales or purchases of the commodity, security or currency in the forward market; or by taking out an option which limits the option holder’s exposure to price fluctuations.
Hedging shuns the risk of price change and look for ways to transfer it, while speculations assumes the risk of price change by taking one position (either long or short) in a market, and waiting for the price of their commodity to go in “their” direction. Hedging, on the other hand, has a position, either long or short, usually in the cash market, and attempts to limit the risk of price change loss by entering into an opposite and approximately equal position in another market (usually futures or options).
For instance, if a manufacturer of copper wires expects the copper prices to rise in the next three months, he will buy a position in the futures market at current prices to offset the likely price increase. Similarly, if the prices are likely to fall, he will sell in the futures market at current prices against the physical goods he holds.
Every large buyer, seller and processor of commodities needs to hedge against price volatilities throughout the year. Though seasonal price fluctuations can be anticipated, the intensity of volatility cannot be predicted. Besides, there are many factors other than the seasonality that cause price volatility. Therefore, there is constant need for hedging.
All large buyers, sellers and processors and users of commodities need to hedge because they all stand vulnerable to price volatility. They include: commodity producers, large consumers, manufacturers for whom a commodity is major raw material, processors of commodities, importers, exporters, traders and so on.
In case of futures, the party hedging would have to pay a margin – a percentage cost of the contract value (usually between 5-8%). For options, they would have to pay a premium, which is market-driven. Over and above this, a brokerage fee is due.
Hedging is generally not considered risky if it is based on covering short-term requirements. However, if the hedging party places a wrong bet, then they may miss out on potential savings. For instance, if a copper manufacturer has a capacity of 200 tons and decides to sell 300 tons on the futures exchange the remaining 100 tons is considered as speculation in the market. If prices fall then he stands to benefit, however if prices go up the 200 tons he produces can be delivered on the exchange but he would have to incur losses on the additional 100 tons.
Arbitrage denotes the purchase and simultaneous sale of the same commodity in different commodity markets in order to take advantage of differences in commodity prices between the two markets.
Such a transfer of funds is risk-free, because an arbitrageur will only switch from one market to another if prices in both markets are known and if the profit outweighs the costs of the operation.
Opportunities for arbitrage tend to be self-correcting, due to the increased demand for the commodity, there is an upward pressure on its price in the market where it is bought, whereas the increased supply in the market where it is sold results in a downward price movement.
Modern computer technology has accelerated the arbitrage mechanism, reducing the opportunity for exploiting price differences.
In futures markets, cash and carry arbitrage exploits a situation where the price of a particular future is higher than the spot price of the underlying commodity namely by buying the physical commodity and simultaneously selling a future.
Cash and carry arbitrage with futures on commodities is rare, since the purchase and delivery of the underlying commodity is onerous. It is more frequently used with financial and currency futures.
Gaining From Arbitrage
No risks and no returns, is the basic investment theory. However, there are fleeting moments when risks could be lowered and returns maximized.
In arbitrage, combinations of matching deals are struck that capitalize upon the imbalance, the profit being the difference between the market prices. An arbitrageur would typically buy a particular commodity at a lower price on one exchange and sell it on another where it fetches them a higher price. This creates a natural hedge and therefore the risk is low.
Arbitrage happens in most of the markets like equities, currencies and commodities. And in the case of the fledging commodity markets in India, this opportunity has been providing avenues that many have explored. “One can expect on an average 25-30% returns from arbitrage in commodities. However, at off-price aberrations, returns can be as high as 50% and 70%.
Arbitrageurs in the commodity markets look for three places to make a killing. They look at the trapping price differences between the spot and futures market, they then look differences between two different national exchanges and then between two international exchanges
For example, let us look at an instance, which persisted on the exchanges a month ago.
Step 1: An investor buys a gold futures contract listed on Multi-Commodity Exchange (MCX), a national commodity exchange that offers investors access to various commodities. This contract is supposed to mature in October 2016 and is available at Rs. 13,151 per 10 grams.
Step 2: At the same time the investor enters into a contract to sell gold in September on the National Commodity and Derivatives Exchange, another national commodity exchange in India. The price in this case for a similar quantity of gold is Rs. 13, 187, which is higher than the amount on the MCX.
Step 3: On August 14, it is seen that the rates for the gold contracts on both the exchanges have moved. On the MCX the Gold October contract became Rs. 13, 129, losing Rs. 22 per 10 gms, and on the NCDEX, the price for the Gold September contract has gained by Rs. 75 from this transaction.
Step 4: Now the arbitrageur will sell the contract on MCX and lose Rs. 22. At the same time he will liquidate the Gold September contract and gain Rs. 97. Totally, the investor will stand to gain Rs. 75 from this transaction.
Factors causing imbalance in prices are caused by several disparities. Structural disparity between exchanges is one such. Volume on NCDEX is not deep. So a trader sells a commodity on this exchange, prices fall steeply on the exchange.
On the other exchanges, this might not be the case. These are specific commodities that have low volumes on different exchanges. For example, agricultural commodities
like pepper have larger trading volumes on the NCDEX while MCX in international commodities. So whenever there are low volumes, there are volatile changes in prices, thereby creating disparity.
Differences in the expiry dates of contracts on exchanges can also create imbalances. Then there are technical possible demand and supply disruptions that have a direct effect on commodity prices.
Investment Opportunities Through Arbitrage
The investment opportunities for traders in the Indian Commodity Market under
1. Arbitrage b/w Physical & Futures
When market trend is formed speculators often buy futures of commodity at premium. In these situations an investor can buy that commodity in physical and sell it future through commodity exchanges.
2. Arbitrage b/w Exchange to Exchange
At sometimes in a particular exchange a particular commodity is available at discount as compared to other exchanges in these circumstances a prudent investor can buy that particular commodity in exchange where it is available at cheaper rate and sells the same at other exchange where it gets the higher returns.