Inter-commodity

When one considers a different commodity on the same

exchange having the same cash flow or in the same category,
then an inter-commodity arbitrage can be created. For instance,
an arbitrage between cotton, cottonseed, cotton oilseed and cake
can be created in order to benefit from the price difference.

Take the example where the price of cottonseed in the February 2014 futures contract is around
Rs 1,950 metric ton on the NCDEX, and the price of cottonseed oil cake in the February contract
is around Rs 1,560 per metric ton currently, the price difference between the commodities is Rs
390 per metric ton. Now, if the arbitrageur thinks that the difference will increase or decrease as
per the market condition, he can buy the cottonseed February contract and sell the cottonseed oil
cake February contract in case of an expected rise in the difference, and vice versa.

4.11Gaining from arbitrage in commodities

No risks and no returns, is the basic investment theory. However, there are fleeting moments
when risks could be lowered and returns maximized. Welcome to the world of arbitrage.
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 fledgling commodity markets in India, this opportunity has been providing avenues
that not many have explored. “One can expect on an average 25-30% returns from the arbitrage
in commodities. However, at off-price aberrations, returns can be as high as 50% and 70%, “ said
Anand James, commodities manager, Geojit Commodities, a brokerage house.
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 at 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
 Step1: 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 December 2019 and is available at
Rs 8924 per 10 grams.
 Step2: At the same the investor enters into a contract to sell gold in November 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 8960, which is higher
that the amount on the MCX.
 Step 3: On October 19, it is seen that the rates for the gold contracts on both the
exchanges have moved On the MCX the Gold December contract became Rs 8,902,
losing Rs 22 per 10 gms. And on the NCDEX, the price for the Gold November contract
has gained by Rs 97 to become Rs 8,863.
 Step 4: Now the arbitrageur will sell the contract on MCX and lose Rs 22. At the same
time he will liquidate the Gold November contract and gain Rs 97. Totally, the investor
will stand to gain Rs 75 from this transaction.
Considering margin based trading and other transaction costs, the return in a period of a month is
estimated to be around 7.5%.
Factors causing imbalance Imbalances 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,” said James.
On the other exchanges, this might not be the case. There are specific commodities that have low
volumes on different exchanges. For example, agri commodities like pepper, have larger trading
volumes on the NCDEX while MCX in international commodities. So wherever 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.
In markets where the window of opportunity, that is the difference in prices between exchanges,
is slim, arbitrages gain by pumping in more money. Smart arbitrageurs track different exchanges
simultaneously and then cash in by making a fast move. A little delay and the imbalance could
get corrected and the riskless opportunity could turn the other way.
Many a times, transaction costs dampen the arbitrage opportunity.
Typically, brokers charge 0.05% of the total trading value. This charge can be reduced as
arbitrages increase the volume of trade. In many cases brokers charge as low as Rs 50 for a lot.
Then there are the taxes as well. Other costs involved are exchange charges at 0.006%, service
tax and educational cess at 12.24% and stamp duty at 0.01%.
International experience suggests that as a result of arbitrage, prices of commodities in different
markets tend to converge to the same price, in all the markets, in each category. In fact, the speed
at which prices converge is a measure of market efficiency.
To make most of this opportunity, investors need to have access to technology and will have to
be completely informed about the market conditions and forces. The speed of the transactions
and the transaction costs could be the deciding factor.
Investors would do well by using the advisory services that are available nowadays. While doing
so, demand total transparency from the advisors and remember that such opportunities are only
temporary.