Embed Doc
Copy Link
Readcast
Collections

CommentGo Back

Download

102 A, Landmark, Suren Road, Chakala, Andheri (E), Mumbai - 400 093Phone No.: +91 22 6649 4000, Fax No.: +91 22 6649 4151, Website: www.mcxindia.com

Indian Commodity Derivatives – A steady bull run ?

V.Shunmugam and DG Praveen

Retail investors and institutional funds (if allowed) would be wary of trading in commodity derivatives dueto fear of ending up in delivery and lack of an efficient portfolio that would keep up the growth momentumin their value of investment in commodities. Hence an approach has been made here to compare one of the Indian commodity indices (MCX Comdex) and its global counterparts to find if there is a steady bullrun in the Indian commodities compared with the global markets. Investing in commodity indices that areefficiently designed for such purposes would serve the dual purpose of removal of the fear of physicaldeliveries and would yield them better returns with a moderate risk. Such commodity indices not onlyprovide an investment opportunity, but also provide with an alternative risk mitigation mechanism forinvestors with intention to spread their eggs across different commodity baskets. This would also helpmitigate risks for those with exposure to more commodity related industries such as Refineries, Copperwire manufacturers, edible oil crushers/refiners. As such, investing in indices is not a new phenomenon tothe investors in India, as indices designed based on spot and futures securities market are commonlytraded in the Indian stock exchanges. However, globally commodity derivative indices are different fromtheir financial derivative counterparts in that their underlying physical/futures markets in commoditiesranges from paper pulp to gold, pork bellies to live cattle and crude oil.Globally, there are about ‘half a dozen’ popular indices that reflect the futures prices of commodities fromdifferent underlying markets. The list includes indices such as Goldman Sachs Commodity index (GSCI),Dow Jones-AIG Commodity Index (DJ-AIGCI), Reuters CRB Commodity Index (RCRBCI), S&P CommodityIndex (S&PCI), Rogers International Commodity Index (RICI), and Deutsche Bank Liquid CommodityIndex (DBLCI). An interesting feature in these commodity indices is that, unlike stock indices, all arebased on futures contract prices due to the non-availability of reliable spot prices of commodities at shortregular intervals.According to Goldman Sachs, about $80 billion havebeen invested globally in the commodity derivativesof which 60 percent (about $48 billion) has beeninvested in passive index-tracking instruments. Of these, a bulk has been invested in instruments linkedto the Goldman Sachs Commodity Index (GSCI), DJ-AIGCI, and RCRBCI that are traded on globalbenchmark exchanges – CME, CBOT and NYBOTrespectively. Apart from futures and options, hugeinvestments have been done on these commodityindices through over-the-counter instruments such asswaps and structured notes.Trading houses and derivatives dealers are the principal players involved in trading and designing of theseinstruments. Apart from this, smaller funds such as Pimco’s Commodity Real Return Strategy Fund,Oppenheimer’s Real Asset Fund, and Rogers International Raw Materials Funds are available to retailinvestors interested in accessing global commodity markets through index funds. These funds eitherinvest in futures markets directly or Over-The-Counter instruments or both for their commoditiesexposure. Recently, Scudder’s Commodity Securities Fund, a path-breaking and an innovative fund based

102 A, Landmark, Suren Road, Chakala, Andheri (E), Mumbai - 400 093Phone No.: +91 22 6649 4000, Fax No.: +91 22 6649 4151, Website: www.mcxindia.com

on commodity derivatives associated with GSCI benchmark (50 percent) and the shares of companiesinvolved in commodity-based industries, (50 percent) was launched. However, the current RBIregulations do not allow individuals and entities from India to participate in trading in these global indicesor global funds tracking these indices.

How are Commodity Indices different from Stock Indices?

The cash prices of the exchange-traded stocks are available on a regular and continuous basis; henceconstruction of index based on this data is simple and continuous. Contrarily, cash prices of commoditiesare not readily available on a continuous basis. To have an index that is indicative of the fundamentalsand actively tradeable, it would be better to construct an index using futures prices rather than cashprices in the absence of effective spot exchanges for commodities in the country, commodity futurestraded on an organized platform provides the best platform to base the indices. However, futures contractexpires on the date of their maturity. In order to have continuous futures prices, commodity indices areconstructed in such a way that futures prices of given maturities (preferably near (front) months) areconsidered and all are replaced with (rollover to) the subsequent month’s contracts during a definiterollover period.The popularity of the commodity futures indices would have wide implications on the futures industry aswell. Investment in indices is normally a long-term strategy that could help increase open up interests infutures contracts for various commodities as investor gain better grip of the fundamentals. A significantspurt in trading activity could be witnessed during the rollover days, when traders rolled over theirpositions into new contracts. As the indices undertakes the movements in the nearest deferred months,funds would like to hold positions in those underlying contracts. And, in the process this would increasethe trading activity in nearest deferred month contracts as well during the roll-over period. Anotherinteresting proposition could be that the trading and investment community would get new tradingopportunities whereby they can take the strategic positions in both the indices and the underlyingcommodities to profit out of the mismatched pricing between the two instruments

Performance Analysis of Global Benchmarks with MCX COMDEX

A comparative financial performance analysis of four benchmark commodity indices - Goldman SachsCommodity Index (GSCI), Dow Jones AIG Commodity Index (DJCI), Roger International Commodity Index(RICI) and Reuters/Jefferies CRB Index (R/J CRB) - and an Indian counterpart (MCXCOMDEX) were donefor the period December ’05 to December ’06 (till date) to look at their performance.

Goldman Sachs Commodity Index (GSCI):

is the most widely followed commodity index. This wascreated in 1991. The weights are assigned to the underlying commodities based on their averageproduction value in the last five years of available data. The trading interest (liquidity) on the exchanges isalso considered for the composition of index basket. Weights and composition are reviewed and re-assigned annually. The commodity basket for this index is unlimited, which means there would not be anycap on the number of underlying commodities in the index. At present, the GSCI contains 24 commodities,ranging from crude oil to live stock to precious metals. GSCI is highly volatile, as it gives nearly 75% of itsindex weight to commodities in energy sector. The futures on GSCI are listed on Chicago MercantileExchange (CME).

102 A, Landmark, Suren Road, Chakala, Andheri (E), Mumbai - 400 093Phone No.: +91 22 6649 4000, Fax No.: +91 22 6649 4151, Website: www.mcxindia.com

Dow Jones AIG Commodity Index (DJ-AIGCI):

was created in 1998. A section of institutionalinvestors keenly follow this index of 19 commodities. The weights to the underlying commodities areassigned and re-adjusted annually based on average global production and average trading volume overthe recent five years. Unlike GSCI, this is primarily designed for diversity i.e. moderate risk with securedbut low returns. No single commodity can have more than 15% or less than 2% of the index. Further, noone sector can hold more than 33% of the index. Implicitly, these rules curtail the volatility of the index,as against GSCI. However, this would generate interest in institutional1 investors such as pension fundslooking for a moderate return/risk ration. Futures on the DJ-AIGCI are traded at the Chicago Board of Trade (CBOT).

Reuters/Jefferies Commodity Research Bureau (R/J CRB) Index:

was developed originally in 1957.It is one of the most popular indicators of overall commodity prices. It reflects prices of 19 commodityfutures traded on benchmark exchanges. CRB, was traded first on New York Board of Trade (NYBOT) in1986, was renamed to the Reuters CRB index in 2001 and then now renamed again to theReuters/Jefferies CRB index. Reuters announced major revision in the index in partnership with JefferiesFinancial Group. .

Rogers International Commodity Index (RICI):

was developed in 1998 by Jim Rogers to record theprice movements of raw materials on a worldwide basis. It contains the largest commodity basket amongthe popular commodity indices with 35 commodities. Weights for the underlying are assigned according totheir importance in international commerce. RICI is rebalanced monthly. The Rogers InternationalCommodity TRAKRS Index (popularly known as

Rogers TRAKRS

), which is a total return index that willequal the product of Rogers International Commodity Index (RICI) and the Multiplier, plus the Amortizingspread is traded at the Chicago Mercantile Exchange (CMEMCX COMDEX (MCXCOMDEX): was created in June2005. It reflects the price actions of commodityfutures traded on the Multi Commodity Exchange of India (MCX). Similar to the GSCI, the index does nothave any limit on the number of underlyingcommodities. Currently, it consists of ten commoditiesselected based on their liquidity. Equal weights areassigned at group level (energy, agriculture andmetals). It relies on a unique combination of liquidityon MCX and physical market size to determine itscomponent weightings. Only near or near deferredcontract months are taken for the index computation.Gold, Silver and Copper represent metal group, whileenergy and agriculture groups are comprised of crudeoil, and soyoil, cottonseed oilcake, wheat, rubber, uradand guarseed. The index is not traded on any of theexchanges in India, as the present regulation does not allow trading on index in the Indian commoditymarkets.The idea behind the common weighting approach is to allow markets to have a say in determination of therelative significance of the various commodities. By relying on factors that are both endogenous to the