Indian Commodity Derivatives – A steady bull run ?

V.Shunmugam and DG Praveeni Retail investors and institutional funds (if allowed) would be wary of trading in commodity derivatives due to fear of ending up in delivery and lack of an efficient portfolio that would keep up the growth momentum in 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 bull run in the Indian commodities compared with the global markets. Investing in commodity indices that are efficiently designed for such purposes would serve the dual purpose of removal of the fear of physical deliveries and would yield them better returns with a moderate risk. Such commodity indices not only provide an investment opportunity, but also provide with an alternative risk mitigation mechanism for investors with intention to spread their eggs across different commodity baskets. This would also help mitigate risks for those with exposure to more commodity related industries such as Refineries, Copper wire manufacturers, edible oil crushers/refiners. As such, investing in indices is not a new phenomenon to the investors in India, as indices designed based on spot and futures securities market are commonly traded in the Indian stock exchanges. However, globally commodity derivative indices are different from their financial derivative counterparts in that their underlying physical/futures markets in commodities ranges 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 from different 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 Commodity Index (S&PCI), Rogers International Commodity Index (RICI), and Deutsche Bank Liquid Commodity Index (DBLCI). An interesting feature in these commodity indices is that, unlike stock indices, all are based on futures contract prices due to the non-availability of reliable spot prices of commodities at short regular intervals. According to Goldman Sachs, about $80 billion have been invested globally in the commodity derivatives of which 60 percent (about $48 billion) has been invested in passive index-tracking instruments. Of these, a bulk has been invested in instruments linked to the Goldman Sachs Commodity Index (GSCI), DJAIGCI, and RCRBCI that are traded on global benchmark exchanges – CME, CBOT and NYBOT respectively. Apart from futures and options, huge investments have been done on these commodity indices through over-the-counter instruments such as swaps and structured notes.

Trading houses and derivatives dealers are the principal players involved in trading and designing of these instruments. 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 retail investors interested in accessing global commodity markets through index funds. These funds either invest in futures markets directly or Over-The-Counter instruments or both for their commodities exposure. Recently, Scudder’s Commodity Securities Fund, a path-breaking and an innovative fund based
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on commodity derivatives associated with GSCI benchmark (50 percent) and the shares of companies involved in commodity-based industries, (50 percent) was launched. However, the current RBI regulations do not allow individuals and entities from India to participate in trading in these global indices or 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; hence construction of index based on this data is simple and continuous. Contrarily, cash prices of commodities are not readily available on a continuous basis. To have an index that is indicative of the fundamentals and actively tradeable, it would be better to construct an index using futures prices rather than cash prices in the absence of effective spot exchanges for commodities in the country, commodity futures traded on an organized platform provides the best platform to base the indices. However, futures contract expires on the date of their maturity. In order to have continuous futures prices, commodity indices are constructed in such a way that futures prices of given maturities (preferably near (front) months) are considered and all are replaced with (rollover to) the subsequent month’s contracts during a definite rollover period. The popularity of the commodity futures indices would have wide implications on the futures industry as well. Investment in indices is normally a long-term strategy that could help increase open up interests in futures contracts for various commodities as investor gain better grip of the fundamentals. A significant spurt in trading activity could be witnessed during the rollover days, when traders rolled over their positions 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 increase the trading activity in nearest deferred month contracts as well during the roll-over period. Another interesting proposition could be that the trading and investment community would get new trading opportunities whereby they can take the strategic positions in both the indices and the underlying commodities 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 Sachs Commodity 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 done for 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 was created in 1991. The weights are assigned to the underlying commodities based on their average production value in the last five years of available data. The trading interest (liquidity) on the exchanges is also considered for the composition of index basket. Weights and composition are reviewed and reassigned annually. The commodity basket for this index is unlimited, which means there would not be any cap 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 its index weight to commodities in energy sector. The futures on GSCI are listed on Chicago Mercantile Exchange (CME).

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Dow Jones AIG Commodity Index (DJ-AIGCI): was created in 1998. A section of institutional investors keenly follow this index of 19 commodities. The weights to the underlying commodities are assigned and re-adjusted annually based on average global production and average trading volume over the recent five years. Unlike GSCI, this is primarily designed for diversity i.e. moderate risk with secured but low returns. No single commodity can have more than 15% or less than 2% of the index. Further, no one 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 funds looking 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 commodity futures traded on benchmark exchanges. CRB, was traded first on New York Board of Trade (NYBOT) in 1986, was renamed to the Reuters CRB index in 2001 and then now renamed again to the Reuters/Jefferies CRB index. Reuters announced major revision in the index in partnership with Jefferies Financial Group. . Rogers International Commodity Index (RICI): was developed in 1998 by Jim Rogers to record the price movements of raw materials on a worldwide basis. It contains the largest commodity basket among the popular commodity indices with 35 commodities. Weights for the underlying are assigned according to their importance in international commerce. RICI is rebalanced monthly. The Rogers International Commodity TRAKRS Index (popularly known as Rogers TRAKRS), which is a total return index that will equal the product of Rogers International Commodity Index (RICI) and the Multiplier, plus the Amortizing spread is traded at the Chicago Mercantile Exchange (CME

MCX COMDEX (MCXCOMDEX): was created in June 2005. It reflects the price actions of commodity MCX futures traded on the Multi Commodity Exchange of COMDEX India (MCX). Similar to the GSCI, the index does not RICI have any limit on the number of underlying commodities. Currently, it consists of ten commodities RJ/CRB selected based on their liquidity. Equal weights are assigned at group level (energy, agriculture and metals). It relies on a unique combination of liquidity DJ-AIGCI on MCX and physical market size to determine its component weightings. Only near or near deferred GSCI contract months are taken for the index computation. Gold, Silver and Copper represent metal group, while 0% energy and agriculture groups are comprised of crude oil, and soyoil, cottonseed oilcake, wheat, rubber, urad and guarseed. The index is not traded on any of the exchanges in India, as the present regulation does not allow trading markets.

33.3 44.0 39.0 33.0 74.2 20% Energy 40%

33.3 21.1 20.0 40.7

33.3 34.9 41.0 26.3 10.8 15.0 60% 80% 100%

Metals

Agriculture

on index in the Indian commodity

The idea behind the common weighting approach is to allow markets to have a say in determination of the relative significance of the various commodities. By relying on factors that are both endogenous to the

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futures market (liquidity) and exogenous (physical market), the effect of its dominance in the physical markets would be taken care. Among the benchmark indices covered for the study it was found that only MCX Comdex and RICI had positive returns for the period between December – December till date (05-06) (see Table I below). Indian benchmark, MCX COMDEX provided the highest annualized return of about 18.33 percent with a moderately higher annualized risk (19.31 percent). MCX COMDEX was followed by the RICI with an annualized return of 5.56 percent (annualized risk – 17.04 percent). The other benchmarks showed negative returns, ranging between 1 percent and 7 percent. This implies that the Indian index made a steady bullish run at a time compared with its global counterparts most of whom were in the negative return zone. Table 1: Risks and Returns – MCX Comdex VS Global Benchmark Indices
GSCI Annualized Return Annualised Risk A. Max/Min return (on closing) Max. per day drawdown Return/Risk Ratio Return from the date of MCX COMDEX inception (I.e. June '05) -1.35% 21.84% 22.87% -3.77% -6.18% DJAIG -5.21% 17.81% 18.41% -3.06% -29.26% RICI 5.56% 17.04% 18.05% -2.85% 32.63% CRB -6.70% 16.82% 21.34% -2.91% -39.84% COMDEX 18.83% 19.31% 34.24% -5.05% 97.50%

18.10%

9.11%

11.98%

1.90%

35.20%

Looking at the basket of commodities considered for these indices, the over emphasis on energy made GSCI highly volatile compared with others with an annualized risk of 22.87 percent. The high volatility reduced the return-risk ratio to – 1.35. Measured in terms of return to risk ratio, MCX COMDEX tops the charts leaving behind its counter parts with the highest return of 97.5 percent, though with a risk of 100 percent. Despite the closed borders for trading in various commodities, MCX COMDEX had a very high correlation with its global counterparts ranging from 66.1 percent to 82.7 percent (Table 2) due to its unique combination consisting of commodities from metals, energy, and agricultural verticals representing the entire range of primary commodities. Surely, through its innovative design comprising of various primary commodities, MCX Comdex had not only proven that the Indian commodities had a steady bull run in the international markets during the last one year, but also that it is a better barometer of the primary commodities price complex by having better correlation with its global counterparts. Table 2: Correlation between COMDEX and Global Benchmark Commodity Indices
GSCI GSCI DJAIG RICIX CRB COMDEX 100.0% DJAIG 93.3% 100.0% RICI 90.7% 86.9% 100.0% CRB 95.3% 96.4% 90.2% 100.0% COMDEX 75.2% 82.7% 66.1% 76.4% 100.0%

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For further information please contact: Ravi Muthreja Head, Communications, MCX Phone No.: +91 22 66497000 Mobile No.: +91 9867726000 Email: Ravi.muthreja@mcxindia.com

i Authors are Chief Economist and Manager, Multi Commodity Exchange of India Limited, respectively. Views expressed above are personal. They can be contacted at v.shunmugam@mcxindia.com or Praveen.d@mcxindia.com for any further clarification.

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