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By, Vinu Baby 07BS4887 IBS Chennai
A STUDY ON THE INTRODUCTION OF OPTIONS IN INDIAN COMMODITY EXCHANGES - A REPORT
By, Vinu Baby
A report submitted in partial fulfillment of the requirements of the MBA program
Distribution List: Mr. M. Frederics, Anand Rathi Financial Services Prof. Venkata Subramanian, IBS Chennai
―Success is not a destination, but a journey‖. While I reach towards the end of this journey, I realize I may not have come this far without the guidance, help and support of people who acted as guides, friends and torch bearers along the way. Working at Anand Rathi Financial Services was indeed been a pleasurable experience. It enabled me to bridge the gap between the practical aspect of the corporate world and the classroom sessions. I profusely thank Mr. S Sathyanarayanan, Senior VP, for allowing me to carry out the summer internship training at Anand Rathi Financial Services Ltd. He also provided me with a lot of information, which contributed to value addition. I express my sincere gratitude to Mr. M Frederics, Business Development Manager (Commodities), for having been so co-operative and guiding me all through this training with valuable inputs. I would like to sincerely thank Mr. S Senthilraja, Human Resource Manager, for providing me with all the facilities and helping me in getting useful information regarding the working of stock broking industry. I express my deepest and most sincere thanks to Prof. A Venkata Subramanian, my faculty guide, who acted as a continuous source of motivation and encouragement. I am thankful for all the guidance provided by him in completing the project successfully. It‘s been very kind of all the employees of the Company for having helped me with the project and in the process of learning.
Vinu Baby Summer trainee
Place : Chennai Date : 20 th May 2008
TABLE OF CONTENTS
Acknowledgement Executive summary Objective Scope Methodology Limitations Introduction about commodity trading Leading Commodity Exchanges Evolution and History of the Commodity Markets in India Structure, Conduct and Current Status of the Commodity Futures Markets in India Benefits of Commodity Trading Commodity Derivatives Futures Options Basic terminology Offset of an Option Exercising an Option Reading Option quotes Evaluating Option Prices Using options to insure against falling prices Using options to insure against rising prices
Options – A better investment arena Introduction of Options in India Impact of various studies and researches Report on Commodity Futures – Abhijit Sen Committee Steps to minimize the potential risks of derivatives trading Other Major Studies Challenges facing the market Global trends in future markets and the road ahead for India Findings Suggestions Reference
Indian commodity exchanges are still in their nascent stages when compared to its global peers. Even though trading is happening in large volumes in these exchanges, they are lagging behind in a lot of aspects like infrastructure, delivery and settlement mechanism etc. The number of products in Indian commodity exchanges are also very less. The project aims at studying the scope and possibility of introducing Options as a derivative trading product in Indian commodity exchanges. Options are already in use in leading commodity exchanges round the globe. They are not only used as a trading product, but also as a hedging mechanism. It has proved to be an effective risk minimizing tool. The fact that Commodity Exchanges are much more volatile than Stock Exchanges, emphasize the need of introduction of Options in these exchanges. The working mechanism of Options is explained in the report. It is also explained how Options can be used as a hedging instrument against rising or falling prices. It helps the farmers as insurance for their agricultural produce against price fluctuations. The project also analyzes major research reports published in the area of Indian Commodity exchanges and the futures trading to study the relationship between futures trading and Inflation. Finally, the findings and suggestions of the research are given. It includes suggestions to revive commodities exchanges, introduce new derivative trading products, develop the infrastructure and to spread awareness among participants. So, in a nutshell, the project deals with Options, its trading mechanism and the scope of its introduction in Indian Commodity Exchanges.
1. To study the working of Options as a derivative trading product in foreign Commodity Exchanges. 2. To analyze the scope and possibility of introducing Options in Indian Commodity Exchanges.
Options are a derivative trading product which is likely to be introduced in Indian commodity exchanges in the near future. The project explains the working mechanism of Options as a price hedging instrument. So, this project will help the participants of the commodity markets to know in detail about Options and to enhance their awareness regarding derivatives trading. For the company, it gives an edge in understanding the working of Options if it is introduced in Indian exchanges. It also gives the company a first mover advantage at the time of introduction of this derivative instrument as the company would be already be equipped and aware of this.
The project is done mainly by collecting and analyzing secondary data. The major sources of these data are websites of foreign commodity exchanges where Options have already been established. A fair amount of data is collected from magazines and other academic publications to obtain data regarding the working of Options and current happenings in this field. Another source of data is the website of Planning Commission, from where various reports were collected. The primary data is the expert opinions and views. These data are collected through emails and interactions with experts. The experts consist of professionals working in commodity exchanges and broking houses and those who have done extensive research on the topic.
1. There is limited literature in India regarding Commodity Options and the information from foreign sources need not necessarily reflect how they will be used in Indian context. 2. Experts contacted might not have direct experience with Commodity Options as they are not used in Indian Exchanges. It may be reflected in their opinions. 3. The course of project may be too short to conduct an extensive in-depth study. 4. The product may not work exactly like that in foreign exchanges as it may be affected by Indian market conditions. 5. The regulatory framework in India may vary from that in use in foreign exchanges.
Introduction about commodity trading
Ever since the dawn of civilization, commodities trading has become an inte gral part in the lives of mankind. The very reason for this lies in the fact that commodities represent the fundamental elements of utility for human beings. The term commodity refers to any material, which can be bought and sold. Over the years, commodities markets have been experiencing tremendous progress, which is evident from the fact that the trade in this segment is standing as the boon for the global economy today. The promising nature of these markets made them an attractive investment avenue for investors. Earlier investors invested in those companies, which specialized in the production of commodities. This accounted for the indirect investment in commodity assets. But, with the establishment of commodity exchanges, a shift in the investment patterns of individuals has occurred as investors started investing directly in commodities rather than in the companies which produced them. The establishment of these exchanges has benefitted both the producers and traders in terms of high profits and low transaction costs. Commodity exchanges play a vital role in ensuring the transparency in transactions and disseminating prices. The commodity exchanges ensured the standard of trading by maintaining settlement guarantee funds and implementing stringent capital adequacy norms for brokers. In the light of these developments, various commodity based investment products were created to facilitate trading and risk management. The commodity based products offer a offer a huge array of benefits that include offering risk-return trade-offs to investors, providing information, on market trends and assisting in farming asset allocation strategies. Commodity investments are always considered as defensive because during the times of inflation, which adversely affects the performance of stocks and bonds, investment in commodities enabled the investors to defend the performance of their portfolios. Another major leap in the development of commodities markets is the growth in commodities derivative segment. Derivatives are instruments whose value is determined based on the value of an underlying asset. Derivatives are useful for both the producers and traders for the mitigation of risk in their business. Forwards, futures and options are some of the well known derivative instruments widely used by traders in the commodities markets. Derivatives trading has a long history. The first recorded incident of commodities derivatives can be traced back to the times of ancient Greece.
In the year 1688, De la Vega reported the trading in ‗time bargains‘ which was a commonly used term for options and futures in those days. Though the first recorded futures trade has was said to have happened in Japan in during the 17 th century, evidences reveal that the trading in rice futures was existent in China, 6000 years ago. Trading in futures is an outcome of the mankind‘s efforts towards maintaining the flow of supply of seasonal commodities throughout the year. Farmers derived the real benefits of derivatives contracts by assuring the desired prices are paid for their products. The volatility of prices made the commodity derivatives not only significant risk hedging instruments but also strategic investment assets. Slowly, traders and speculators who never intended to take the delivery of goods e ntered commodities trading. They traded in these instruments and made and made their margins by taking the investment asset advantages of price volatility in commodity markets.
Leading Commodity Exchanges
Most of the world‘s largest commodity exchanges are located in and around United States of America. New York Mercantile Exchange (NYMEX) is the world‘s largest physical commodity futures exchange. It was founded in the year 1882 and handles billions of dollars worth energy products, metals and other commodities being bought and sold on the trading floor and overnight electronic trading computer systems. Trading is conducted in the NYMEX in two divisions – the NYMEX division, which trades energy, platinum and palladium, and the COMEX division, which trades rest of the metals. Another major commodity exchange is Chicago Mercantile Exchange (CME), which trades commodities as well as financial products. New York Board of Trade (NYBOT) is a wholly owned subsidiary of Intercontinental Exchange (ICE). It is a physical commodity futures exchange located in New York City. It deals mainly with agricultural products. A very famous commodity exchange outside United States which deals mainly with metals is London Metal Exchange (LME). It is the world‘s largest market in Options and Futures contracts on metals and base metals. There are more exchanges which deal in commodities like Chicago Board of Trade (CBOT), Kansas City Board of Trade (KCBT), Tokyo Grain Exchange (TGE) etc. Leading commodity exchanges in India are National Commodity and Derivatives Exchange Limited (NCDEX) and Multi Commodity Exchange of India Limited (MCX), both incorporated in the year of 2003. Apart from these, there are around 21 regional commodity exchanges in India. In total, there are 23 commodity Exchanges in India.
Evolution and History of the Commodity Markets in India
Commodity futures markets largely remain underdeveloped in India. This is in spite of the country‘s long history of commodity derivatives trade as compared to the US and UK. A major contributor to this fact is the extensive government intervention in the agricultural sector in the post-independence era. In reality, the production and distribution of several agricultural commodities is still governed by the state and forwards as well as futures trading have only been selectively introduced with stringent regulatory controls. Free trade in many commodity items remains restricted under the Essential Commodities Act (ECA), 1955, and forwards as well as future contracts are limited to specific commodity items listed under the Forward Contracts (Regulation) Act (FCRA), 1952. The evolution of the organized futures market in India commenced in 1875 with the setting up of the Bombay Cotton Trade Association Ltd. Following widespread discontent among leading cotton mill owners and merchants over the functioning of the Bombay Cotton Trade Association, a separate association, Bombay Cotton Exchange Ltd., was constituted in 1983. Futures trading in oilseeds originated with the setting up of the Gujarati Vyapari Mandali in 1900, which carried out futures trading in ground nuts, castor seeds and cotton. The Calcutta Hessian Exchange Ltd. and the East India Jute Association Ltd. were set up in 1919 and 1927 respectively for futures trade in raw jute. In 1921, futures in cotton were organized in Mumbai under the auspices of East India Cotton Association (EICA). Before the Second World War broke out in 1939, several futures markets in oilseeds were functioning in the states of Gujarat and Punjab. Futures markets in Bullion began in Mumbai in 1920, and later, similar markets were established in Rajkot, Jaipur, Jamnagar, Kanpur, Delhi and Calcutta. In due course, several other exchanges were established in the country, facilitating trade in diverse commodities such as pepper, turmeric, potato, sugar and jaggery. Post independence, the Indian constitution listed the subject of ―Stock Exchanges and Future Markets‖ under the union list. As a result, the regulation and development of the commodities futures markets were defined solely as the responsibility of the central government. A bill on forward contracts was referred to an expert committee headed by Prof. A.D. Shroff and selected committees of two successive parliaments and finally, in December 1952, the Forward Contracts (Regulation) Act was enacted. The Forward Contracts (Regulation) rules were notified by the central government in 1954. The futures trade in spices was first organised by the India Pepper and Spices Trade Association (IPSTA) in Cochi n in 1957. However, in order to monitor the price movements of several agricultural and essential commodities, futures trade was
completely banned by the government in 1966. Subsequent to the ban of futures trade, many traders resorted to unofficial and informal trade in futures. However, in India‘s liberalization epoch as per the June 1980 Khusro committee‘s recommendations, the government reintroduced futures on selected commodities, including cotton, jute, potatoes, etc. Following the introduction of economic reforms in 1991, the Government of India appointed an expert committee on forward markets under the chairmanship of Prof. K.N. Kabra in June 1993. The committee submitted its report in September 1994, championing the reintroduction of futures, which were banned in 1966, and expanding its coverage to agricultural commodities, along with silver. In order to boost the agricultural sector, the National Agricultural Policy 2000 envisaged external and domestic market reforms and dismantling of all controls and regulations in the agricultural commodity markets. It also proposed an expansion of the coverage of futures markets to minimize the wide fluctuations in commodity prices and for hedging the risk arising from extreme price volatilities.
Structure, Conduct and Current Status of the Commodity Markets in India
Broadly, the commodities market exists in two distinct forms—the over-the-counter (OTC) market and the exchange based market. Further, as in equities, there exists the spot and the derivatives segme nts. Spot markets are essentially OTC markets and participation is restricted to people who are involved with that commodity, such as the farmer, processor, wholesaler, etc. A majority of the derivatives trading takes place through the exchange-based markets with standardized contracts, settlements, etc. The exchange-based markets are essentially derivative markets and are similar to equity derivatives in their working, that is, everything is standardized and a person can purchase a contract by paying only a percentage of the contract value. A person can also go short on these exchanges. Moreover, even though there is a provision for delivery, most contracts are squared-off before expiry and are settled in cash. As a result, one can see an active participation by people who are not associated with the commodity. The typical structure of commodity futures markets in India is as follows:
Ministry of Consumer Affairs
Other Regional Exchanges
At present, there are 23 exchanges operating in India and carrying out futures trading activities in as many as 146 commodity items. As per the recommendation of the FMC, the Government of India recognized the National Multi Commodity Exchange (NMCE), Ahmadabad; Multi Commodity Exchange (MCX) and National Commodity and Derivative Exchange (NCDEX), Mumbai, as nation-wide multi-commodity exchanges. MCX commenced trading in November 2003 and NMCE in November 2002 and NCDEX in December 2003. As compared to 59 commodities in January 2005, 94 commodities were traded in December 2006 in the commodity futures market. These commodities included major agricultural commodities such as rice, wheat, jute, cotton, coffee, major pulses (such as urad, arahar and chana), edible oilseeds (such as mustard seed, coconut oil, groundnut oil and sunflower), spices (pepper, chillies, cumin seed and turmeric), metals (aluminium, tin, nickel and copper), bullion (gold and silver), crude oil, natural gas and polymers, among others. Gold accounted for the largest share (31 percent) of trade in terms of value, followed by silver (19 percent), guar seed (11 percent) and chana (10 percent). A temporary ban was imposed on futures trading in urad and tur dal in January 2007 to ensure orderly market conditions. An efficient and wellorganised commodities futures market is generally acknowledged to be helpful in price discovery for traded commodities. The turnover and volume of commodity futures compared to international indices are explained in the following tables and figures: Turnover of Indian Commodity exchanges Exchanges
Multi Commodity Exchange (MCX) NCDEX NMCE (Ahmedabad) NBOT (Indore) Others All Exchanges
2004 – 05 2005 – 06 2006 – 07 2007 – 08
165,147 266,338 13,988 58,463 67,823 571,759 961,633 1,066,686 18,385 53,683 54,735 2,155,122 1,621,803 944,066 101,731 57,149 14,591 2,739,340 2,505,206 733,479 24,072 74,582 37,997 3,375,336
Benefits of Commodity Trading
Apart from regulating the commodity markets, the growth of the market will provide the producers and traders the opportunity to benefit from price discovery and price risk management. At a macroeconomic level, these markets can make the economic activity more vibrant and facilitates the integration of producers and traders on an international level. For a producer, the availability of commodity futures helps in estimating the future price of the particular price of the particular commodity and can therefore decide between the competing commodities to choose from. At the same time, it will also provide an indication to the national government regarding the likely crop structure of the country and thereby assess the impact of changing crop preferences among the producers. From the insiders‘ point of view, futures trading enables them to have an advance indication of the likely price. This will form the basis for them to quote realistically in the international market. At the same time, they can hedge against the price risk by operating in the futures market. The futures market also benefits the farmers who are strong participants of spot market. Because some people are trading in the commodity futures market, they influence to a greater extent the movement of prices. Any positive change in the price of the particular commodity will equally benefit the spot trader. Though futures trading benefits a wide section of population, the extreme case of misuse of trading is also possible. Just like stock markets, the unwanted speculation in the futures markets is regulated through regulatory measures such as preventing the traders from over trading, imposing price limits to prevent abnormal price fluctuations, and imposing financial restraints etc.
In the last 25 years, derivatives have become increasingly important in the world of trading. Futures and Options are now traded actively on many exchanges. A derivative can be defined as a financial instrument whose value depends upon (or derives from) the value of other basic underlying variables. Very often, the variables underlying derivatives are the prices of traded assets. For example, a commodity option is a derivative whose value is dependent on the price of a stock. The underlying variable can be anything. Active trading is happening in credit derivatives, electricity derivatives, weather derivatives, insurance derivatives etc. many new types of interest rate, foreign exchange and equity derivative products have been created. Derivatives are not only used as trading products, but also for hedging the position of the producer or trader against unexpected market conditions. Hedging is defined as taking simultaneous but equal and offsetting positions on the cash and futures markets. The basic idea behind hedging is to hold opposing positions in the two markets at the same time. Each market position offers protection from an adverse price change in the other market. The cash market position (that is, for example, holding or growing grain) is a necessary part of the producer. This cash market position puts the producer at risk from a decline in grain prices. Taking an offsetting position in the futures market is a ‗hedge‘ against the potential for a harmful move in the cash market price. At the same time, the cash market position (holding or growing the grain) can protect him from losses on the futures market. Futures and Options are the two major derivative mechanisms. Futures A futures contract is a standardized contract that is traded on a futures market exchange. The contract specifies the commodity, place of delivery, quality, and time of delivery. Quality if the commodity will not be stated in the contracts listed, but these specifications are an explicit part of each contract. Price is the only essential component of the futures contract that is not pre -specified. Price is determined by the interaction of buyers and sellers in a location (called the trading pit) designated by the exchange. The exchange establishes the time periods when trading takes place, develops and enforces other rules associated with trading, and provides additional services needed by traders. The actual buying and selling that occurs in the trading pit is done by individuals that have purchased the right to trade
(called a seat) on the exchange. Thus, the general public buys or sells futures contracts through a broker who has access to a seat on the exchange. Although the procedures involved in actually trading futures contracts may appear complex, knowledge of only a few basic marketing concepts is needed to understand the idea of hedging. Through the broker, it is possible to sell a futures contract (take a short position) today with the understanding that you must offset the short position (that is, buy the contract) at a later date. The idea of selling something (going short) before you buy something may seem strange, especially if you have traditionally sold in cash markets. It is important to keep in mind that the futures contract is a formal agreement, and you can agree to sell something in a future time period even when you don‘t have something to sell now. If prices decline between the time you sell and buy the futures contract, you then buy the contract at a price below your sale price. You receive the gain associated with this ―sell high - buy low‖ transaction. If you initially sell a futures contract (a short position) and the price increases, you must buy at the higher price. You suffer the loss associated with this ―sell low - buy high‖ transaction. As a futures trader, it is also possible to buy a futures contract (take a long position) with the understanding that you must offset with a sell at a later date. Impacts of price changes from this long position are just the opposite of those discussed for the short (sell) position above. That is, if you take a long position and price declines, you incur a loss on the ―buy high - sell low‖ transaction. If you take a long position and price increases, you gain from the ―buy low – sell high‖ transaction. Buying or selling futures contracts requires the service of a broker with access to the exchange where futures contracts are traded. Your broker conducts trades on your behalf per your instructions. You pay a fee to the broker (a commission) for executing an order to buy or sell a futures contract. Like payment for any service, commissions vary by broker. Commissions are normally quoted for entering and closing a futures position (cal led a round turn). Since all traders with a futures position can potentially suffer losses, all traders must put up a deposit (a margin) to ensure all losses will be paid. A margin is the money deposited by both the buyer and seller to guarantee performance under the terms of the futures contract. Minimum margins are established by each commodity exchange, but individual brokers may have higher margin requirements. This initial margin is typically a small portion of the total value of the contract, and may not cover a trader‘s total loss over time. Therefore, a margin call is a request for additional money the futures trader must deposit if adverse price moves significantly devalue the initial margin deposit. If the market moves against your position by an amount such that your initial margin may not cover additional losses (called the maintenance margin),
the broker asks for more money. That is, you receive a margin call from your broker and the additional money is required to keep your futures position. Since the idea of hedging is for losses on one market to be offset by gains in the other market, price changes in the two markets must be related. This price relationship between the cash and futures market is measured by a concept called basis. Basis is the difference between the price at cash market and the futures price (that is, cash price minus the futures price). This relationship (or basis) is a particularly important concept in effective hedging. The whole purpose behind hedging is for adverse price moves in the cash market to be offset by favorable price moves in the futures market. If the two markets aren‘t related in some way, hedging doesn‘t work. Thus, measuring and understanding basis is the key to successful hedging. Basis is normally calculated as your local cash price minus the nearby futures price. Basis is often quoted as over (a positive basis) or under (a negative basis). ―Over‖ or ―under‖ refers to the cash price being above or below the futures price, respectively. Basis relationships change over time. A weakening basis occurs when the cash price declines relative to the futures price. A strengthening basis occurs when the cash price increases relative to the futures price.
A commodity option is a two-party agreement that gives the buyer (or holder) the right, but not the obligation, to take a futures position. This potential position can be either a short or a long position in a designated futures contract (called the underlying futures contract). The futures position will be provided at a specified price (called the strike price or exercise price), and the right exists until a pre-established date (called the expiration date). Although expiration dates vary, most options on grain futures expire during the last week of the month before the contract month of the underlying futures contract. An option is purchased from an option seller (called the writer or grantor). The writer of an option has the obligation to provide the option holder with the futures position at the agreed-upon strike price. As the buyer, you purchase the option at the going market price (called the premium). If cash grain prices move unfavorably, you may use the option to obtain the protection associated with a futures position. The option seller is obligated to provide you with the futures position at the strike price. However, you don‘t want the protection associated with a futures position if cash grain prices move favorably. As the holder of the option, you are not obligated to take a futures position. Thus, options are similar to purchasing insurance. You pay the premium, but you may or may not need the protection of the underlying futures position. Two types of options are available for each underlying futures contract. The purchase of a put option gives the holder the right to a short futures position at the strike price. The seller of the put must provide the holder with the specified short futures position. The purchase of a call option gives the holder the right to a long futures position at the strike price. In this case, the seller of the call option must provide you as the holder with the specified long futures position. Purchasing a put option (the right to sell a futures position) protects you as the holder of the put against falling cash prices. If prices fall, you have the right to a short futures position at the higher strike price. A short futures position at a high price means you can offset with a buy at the current lower market price and receive the gain. Purchasing a call option (the right to buy a futures position) protects you as the holder of the call against rising prices. If prices rise, you have the right to a long futures position at the lower strike price. A long futures position at a low price means you can offset with a sell at the current higher market price and receive the gain. A call option can also be used as a fairly low risk strategy to participate in market price gains after your physical commodity has been sold.
There are technical terms used in Option contracts. The common words used in an Option contract are explained below. Strike Price The "specified price" in the option is referred to as the exercise price or strike price. This is the price at which the underlying commodity can be exchanged and is fixed f or any given option, put or call. There are several options with different strike prices traded during any period of time. As a general rule, the more volatile the price is for the underlying commodity, the greater the number of options at different strike prices that will be available for trade. If the price of the underlying commodity changes over time, then additional strike prices may be traded. Underlying Commodity The underlying commodity for the commodity option is not the commodity itself, but rather a futures contract for that commodity. For example, a June chilli option will actually be an option for a June delivery chilli futures contract. In this sense, the options are on futures and not on the physical commodity. Buyers and Sellers In the option market, as in every other market, every transaction requires both a buyer and a seller. The buyer of an option is referred to as an option holder. Holders of options may be either seekers of price insurance or speculators. The seller of an option may also be either a speculator or one who desires partial price protection. Whether one chooses to buy (hold) or sell (write) an option depends primarily upon his/her objectives. The market will contain many insurers and price speculators, each providing a service to the other. Expiration Options on agricultural commodities have futures contracts as the underlying commodity. Futures contracts have a definite predetermined maturity date during the delivery month. So too, options will have a date at which they mature and expire. For example, a Rs.5,100 June chilli Option is an Option to buy or sell one June chilli futures contract at Rs.5,100. The option can be exercised by the holder on any business day until mid-May at which time the option expires. Trading in most options will not be conducted during the futures contract delivery month. Upon expiration, the Option becomes worthless.
Option Premiums The option (put or call) writer or grantor is willing to incur an obligation in return for some compensation. The writer of an option is an option seller. The compensation is called the option premium. Using the insurance analogy, a premium is paid on an insurance policy to gain the coverage it provides and an option premium is paid to gain the right granted in the option. The premium is determined by public outcry and acceptance in an exchange trading pit, and like all commodity prices, can be expected to change daily. While the interaction of supply and demand for options will ultimately determine the option premium, two major factors will interact to affect the level of prices. 1. Intrinsic Value. Intrinsic value is the difference between the strike price of the option and the price of the underlying commodity. For example, take a June chilli put option. Strike price = Rs.5,400 and Current price of the underlying commodity = Rs.5,300. The option could be sold for at least Rs.100 since others would be willing to purchase the right to sell at Rs.5,400 when the market is currently Rs.5,300. The Rs.100 is said to be the intrinsic value. As long as the market price on the underlying commodity is below the strike price on a put option, the option will have intrinsic value. Of course, the converse of the price relationship is true for a call option. A call option has i ntrinsic value when the market price is above the strike price. Any option that has intrinsic value is said to be "in-the-money." When the market price of the commodity and the strike price are equal, the option is said to be "at-the-money" and the intrinsic value is zero. When the market price on the underlying commodity is above the strike price on a put option, there is no intrinsic value and the option is said to be "out-of-the-money." The converse of this price relationship would be true for a call option. 2. Time to expiration of the option The second factor that will influence the Option premium is the length of time to expiration of the option. Assuming all else is held constant, Option premiums will usually decrease as the length of time until expiration decreases. This phenomenon is called the time value of an option.
For example, in March the time premium on a Rs.5,100 May chilli option will be less than the premium on a Rs.5,100 August option, because the option with a longer time to expiration has a greater probability of moving in-the-money than the option with less time. Therefore, it is worth more on that factor alone. The longer the time period, the greater the chance that events will occur that could cause substantial movement in futures prices and change the value of the option. As a result, the option writer demands a greater premium to assume the larger risk of writing a longer term option. "Out-of-the-money" options have a value which reflects only time value. "In-themoney" options possess both time value and intrinsic value. OFFSET OF AN OPTION The method by which most holders of "in-the-money" options will realize any accrued profit is by resale of the option. This is referred to as "off-setting" an option position. Most option buyers will offset their position rather than exercise the option. This is done to avoid losing any remaining time value and the resultant decisions, margin deposits and commissions from assuming a futures market position. The option could be resold to another trader at a premium at least equivalent to the intrinsic value that results from an "in-the-money" price relationship. Since the option markets provide the opportunity to secure price insurance, they can be expected to operate in a manner that allows for reinsurance or resale of the option to another party. For example, assume a chilli grower purchased an "out-of-the-money" Rs.5,100 strike price June chilli put option for a premium of Rs.50 while the current market value was Rs.5,200. During the life of the option, the current market price falls to Rs.4,800 and the put option has moved ―into-the-money‖ with a current premium of Rs.330 per 100 kg (Rs.300 intrinsic value and Rs.30 time value). The original option buyer could sell the option through a broker to another trader. Using the above numbers, the trader would realize a return of 330 – 50 = Rs.270. EXERCISING AN OPTION Another method by which the holder of an option could realize accrued profit is by exercising the option. The decision to exercise an option lies only with the holder. If the decision is made to exercise, the following procedures are followed. For a put, the holder is assigned a short (sell) position in the futures market equal to the strike price. At the same time, the option grantor is assigned a long (buy) futures position at the same price. Then both positions are adjusted to reflect the current futures settlement price. It is rational to exercise a put option only when the market price is below the strike price so the holder's futures position will show a profit. The futures position of
the grantor will show an equivalent loss. At this point, the option contract has been fulfilled and both parties are free to trade their futures contracts as they see fit. Using the above example, if the put option was exercised, our trader would now have a short (sell) futures position at a price of Rs.5,100. Using the above numbers, our trader would realize a net return of 5,100 – 4,800 – 50 = Rs.250, which is less than the proceeds obtained from the sale of the option. In addition, the trader may be required to post additional margin money with the broker for maintenance of the futures position. Furthermore, he would incur an additional brokerage commission for liquidation of his futures contract. With a liquid options market, it appears that an offsetting trade within the options market is more advantageous than exercising. READING OPTION QUOTES
SOYA BEAN OPTION QUOTES Friday May 19, 2007 SOYA BEANS (CBOT) 5,000 bu.; cents per bu. Strike Price Sep-c 6.25 6.50 6.75 7.00 7.25 7.50 --44 ½ 34 25 18 ½ Calls-Settle Nov-c -56 ½ 43 ½ 34 26 ½ 20 ½ Jan-c --42 33 25 20 Sep-p -16 27 39 ½ 55 ½ 74 Puts-Settle Nov-p 14 ½ 22 ½ 34 49 65 83 Jan-p --34 48 63 ½ ---
Futures Settlement Prices: Sept-$6.93 ½ Nov-$6.85 ¼ Jan-$6.94 ¾ The date, May 19, 2007, is the date on which the trading occurred. The months SEP, NOV and JAN represent three futures delivery months on which option contracts could be traded. The futures settlement price for each of these contracts is listed below the main table. Six different strike prices are shown for each option contract month. Using the November option month for an example, there are actually many separate option contracts that are tradeable. Here six different strike prices are shown for both calls and puts. The example prices show a total of 36 option contracts; 18 call options and 18 put options.
The prices listed under the columns headed Call-Settle and Put-Settle are premiums that were determined through trading that day at the exchange. No trading occurred in contracts indicated by the dashed lines. Price differentials of one-fourth of a cent are used. The premium on the $7.00 November put option is $0.49 per bushel (named a "November 7 dollar put"). This would represent a total premium of $0.49 X 5,000 bushels = $2,450. This option is "in-the-money" since the strike price is greater than the November futures contract settlement price. The intrinsic value is $7.00 - $6.8525 = $0.1475. The remainder of the premium, $0.49 - $.1475 = $0.3425 is the time value remaining in the option. The November $6.75 put is "out-of-the-money." That is, it has no intrinsic value and the prudent person would not exercise R at the given futures market price. Even though it has no intrinsic value; there is still a time value associated with it as indicated by its $.34 premium. There are about five months before expiration in which market prices could fall below the $6.75 strike price and thus make it an "in-themoney option. The premium quoted reflects that time value.
Evaluating Option P rices.
For selecting the best suitable Option, the Option prices are to be evaluated. While evaluating Option contracts and prices, there would arise two critical questions. 1. What do varying strike prices mean as far as price insurance? 2. How does a producer actually secure this insurance? First, let's consider a method for evaluating the price insurance levels being offered. There are three steps to consider in evaluating options prices. The first factor is the selection of the appropriate option contract month. To do this, select the option which will expire closest to but not before the time the physical commodity will be sold or purchased. For example, if soya beans will be harvested and sold in November, the January option would be appropriate. The November option would generally not be chosen since trading on it will have ceased prior to the actual harvest and sale. The second step is to select the appropriate type of option. If the producer wishes to insure products against price declines, then he or she would be interested in buying a put (the right to sell). If the producer‘s motive is to insure future commodity purchases against price increases, then the purchase of a call (the right to buy) will be needed. To continue the above example, if a soya bean producer wishes to insure the beans he will be selling in November, then he will be interested in purchasing the right to sell a January (put) option. The third step to consider in evaluating option prices is to calculate the minimum cash selling price (MSP) being offered by the put option selected. Or, for a call option, the maximum purchase price (MPP) would need to be calculated. These calculations can be accomplished in fi ve steps and will be illustrated using the preceding sample quotes.
JANUARY SOYA BEAN PUT OPTION PREMIUMS JANUARY FUTURES SETTLEMENT $6.94 ¾ Strike prices $6.75 $7.00 $7.25 Puts Settlement 34 48 63 ½
1. Select a strike price within the option month. For instance, a $7.00 January put. 2. Subtract the premium from the strike price for a put, or add the premium for a call. In the example, a $7.00 January put cost $0.48 per bushel. So, $7.00 - $0.48 = $6.52 per bushel. 3. Subtract (for a put) or add (for a call) the "opportunity cost" of paying the premium for the period it will be outstanding. For example, if the option premium of $.48 per bushel is paid in May and the option is liquidated by offsetting in November, an interest cost for the 6 month period needs to be added. If borrowed funds are used and the interest rate is twelve percent, (for example), then the cost would be one percent per month or six percent for six months. The interest cost associated with a $0.48 per bushel put option premium wo uld be $0.03 (0.48 x 0.06) per bushel. This leaves a net price of $6.52 - $0.03 = $6.49. 4. Subtract (for a put) or add (for a call) the commission fee for both buying and offsetting the option. Assume the brokerage firm charges $100.00 per round turn for handling each option contract. The per bushel commission fee would be $0.02 ($100 for 5000 bushels). The net price is now $6.49 - $0.02 = $6.47. 5. One final adjustment must be made to these prices. The option strike price must be localized to reflect the difference between prices at the major commodity markets and the local cash market. To localize the price, we must subtract the expected harvest time basis. Basis is the difference between the local price and futures market delivery point price at delivery time. This basis reflects the price differences between the large national and local markets. By adjusting the option price for basis, a minimum selling price can now be obtained for a put or a maximum purchase price obtained for a call. For example, if the normal harvest basis is $0.30 under, then the likely minimum local cash price becomes $6.47 - $0.30 = $6.17 +. The plus sign refers to the fact that this is the minimum price expected from a cash sale protected by a purchased put option.
Minimum Selling Prices for Put Options with Different Strike Prices Strike Prices $6.75 $7.00 $7.25 Premiums -.34 -.48 -.63 ½ Interest -.02 -.03 -.04 Commission Basis -.02 -.02 -.02 -.30 -.30 -.30 Minimum Selling Price $6.07 $6.17 $6.255
--------------------------------Dollars Per Bushel--------------------------------
Using options to insure against falling prices
Consider a put purchase for price insurance in soya beans. Assume that a farmer plants soya beans in May expecting to harvest 10,000 bushels of soya beans in November. He must recognize that other than weather, his biggest risk during the production season is not knowing the price he will get for his beans at harvest. Farmer wishes to reduce this risk by "insuring" a future price that will cover production costs. He can do this by purchasing 2 January soya bean put options (options to sell 10,000 bushels of January soya bean futures) at a strike price of $7.00 per bushel. As a result, Farmer has established a minimum cash price for his soya beans of $7.00 per bushel minus the premium, less the normal local basis while retaining upside price potential. Example 1 shows the result if prices increase during the production period. Example 2 shows the result of prices decrease. In each case, the cost of price insurance - the premium and other costs - was $0.53 cents per bushel and the actual difference between his local cash price and the national market prices (basis) was -$.30 as he anticipated.
Example 1 - Put Option When Prices Rise Date May 15 Cash Market Soya bean Option Market
Expects to produce 10,000 bushels Buy 2 January soya bean put options at a soya beans for November harvest. $7.00 per bushel strike price, premium paid Expect minimum sale price of $6.17 is $0.48 per bushel. Commission and interest are $0.05. Expected basis = $0.30 Harvest and sell 10,000 bushels soya beans at $7.80 a bushel. January soya bean futures trading at $8.10. Let Jan. soya bean option expire.
Nov. 15 Results
Cash price + gain or loss in options Offset premium received - original premium market = actual price received for paid plus costs = 0 - .53 = $-.53 beans = $7.80 - .53 = $7.28
In Example 1, as futures and cash prices rise, the options end up out-of-the-money and are allowed to expire. But despite the premium and other cost of $0.53 per bushel, the rise in cash prices resulted in a realized price of $7.28 per bushel. The net price would have been $7.80 per bushel had the put not been bought, emphasizing that the use of options may not maximize price at any point in time. Options may be highly effective over time in assuring a more stable income and avoiding disastrous losses resulting from dramatic price level changes.
Example 2 - Put Option When Prices Fall Date May Cash Market Expect to produce 10,000 bushels soya beans for November harvest. Expect minimum sale price of $6.17. Soya bean Option Market Buy 2 January soya bean put options at a $7.00 per bushel strike price, premium paid is $0.48 per bushel. Commission and interest cost are $0.05. Expected basis = -$0.30.
Nov. 15 Harvest and sell 10,000 bushels Sell 2 January soya bean put options at a $7.00per soya beans at $5.30 per bushel. bushel strike price and receive a premium payment of $1.44 bushel.*** Results Cash price + gain or loss in options market = Actual price received for beans = $5.30 + $.91 = $6.21 Offset premium received - original premium paid = $1.44 - $0.53 = $.91
*** January soya bean futures assumed to be trading at $5.60 per bushel, giving the put option an intrinsic value of $1.40 per bushel. It is further assumed that the put had a time value of $0.04 per bushel. The total premium would, therefore, be $1.44. In Example 2, futures prices fell along with cash prices. The put option at a strike price of $7.00 per bushel was iii-the-money in November. The put was offset by selling two January soya bean put options for a premium of $1.44 per bushel. The offset resulted in a $.91 per bushel gain ($1.44 premium resale -$O.53 original premium and costs paid) which, when added to the cash price of $5.30, gave Farmer a realized price of $6.21 per bushel. The net price received is $.04/bu. greater than the expected minimum sale price established in May due to the additional $.04/bu. time value received from the offset. Had the put not been bought, the realized cash price would have been $5.30 per bushel.
Using options to insure against rising prices
Users of agricultural commodities, such as grain for feed use, may desire insurance against price increases on anticipated future purchases. For example, consider a shopkeeper who thinks that he can make profit if he could purchase 5,000 bushels of corn for not more than the current price of $3.40 per bushel. The existing stock will be sufficient till the end of February, and the corn will need to be purchased at that time. The shopkeeper would be satisfied with the expected return and desires to insure against an increase in the price of corn. Since the call option provides the right to purchase corn at a specified price in the future, he will be interested in purchasing a call option. Also, the March option contract month would be the appropriate month to select as it matures closer to, but not before, the time when corn will be purchased. The operator now needs to determine the one strike price that will meet his objective of buying corn for no more than $3.40 per bushel. Each strike price can be evaluated by the following formula: Maximum Purchase Price = Premium + Brokerage + Opportunity + Basis The producer can normally purchase corn for $0.20 over the March futures in late February, can buy and sell an option contract for $100 ($0.02 per bushel for 5,000 bushels), and has an opportunity cost of 1 % per month. An example of a March corn call option might result in the following maximum purchase prices.
Illustration of Calculation of Maximum Purchase Prices Utilizing a Call Option Strike Price Premium Brokerage Fee Opportunity Cost Basis Maximum Purchase Price ----------------------------Dollars Per Bushel---------------------------$2.80 2.90 3.00 3.10 3.20 +0.43 +0.26 +0.18 +0.13 +0.07 +0.02 +0.02 +0.02 +0.02 +0.02 +0.01 +0.005 +0.004 +0.003 +0.001 +0.20 +0.20 +0.20 +0.20 +0.20 $3.46 3.385 3.404 3.453 3.491
Only the $2.90 strike price will allow the shopkeeper to lock in a maximum buying price for his corn needs that meets his objective. He buys one $2.90 March corn call option and forwards a check for $1,400. ($1,400. = 5,000 bushels x $0.26 + $100.00 brokerage fee). By utilizing the $2.90 call option, the shopkeeper can now be sure he will not pay more than $3.385 for his corn needs should corn prices rise, but may still buy corn for less if corn prices fall. The following illustrations show the results obtained if prices rise and if they fall.
Example 1 - Call Option When Prices Rise Date Cash Corn Market Options Market Buy one $2.90 March corn call options for $0.26 premium and $0.025 cost. Expected basis = +$0.20. March corn futures $3.60. Sell one $2.90 March corn call options for $0.70. Gain or loss = offset premium received original premium paid plus cost = $0.70 0.285 = + $0.415.
January 5 Will need 5,000 bushels corn on February 25. Expected maximum purchase price of $3.385 Feb. 25 Purchase 5,000 bushels of corn locally for $3.80 per bushel. Cash price paid - options gain or + options loss = net price paid. = $3.80 = 0.415 = $3.385 per bushel.
Example 2 - Call Option When Prices Fall Date Cash Corn Market Options Market
January 5 Will need 5,000 bushels corn on Buy one $2.90 March corn call option for Feb. 25. Expect maximum purchase $0.26 premium and $0.025 cost. Expected price of $3.385. basis = + $0.20. Feb. 25 Cash corn price $2.60 March corn futures $2.40. $2.90 March corn call option is out-of-the-money and expires worthless. Gain or loss = offset premium received original premium paid plus cost = 0 - $0.285 = -$0.285.
Cash price paid - options gain or + option loss = net price paid. =$2.60 + 0.285 = $2.885 per bushel
Options – A better investment arena
While futures offer price protection by allowing the holder of a futures contract to lock in a price level, a major appeal of options is that the holder of an options contract is afforded price protection, but still has the ability to participate in favorable market moves. Because the buyer of an options contract has the options contract but not the obligation to perform, he incurs no expenses beyond the initial premium. Therefore, if the market moves against a position, and a trader holds on to this option, the maximum cost is the price he has already paid for the option. On the other hand, if the market moves in favor of a position, the virtually unlimited profit potential to the buyer of an options contract is parallel to a futures position, net of the premium paid for the options contract. Therefore, protection from unfavorable market moves is achieved at a known cost, without giving up the ability to participate in favorable market moves. Futures Vs Options Futures Risk Unlimited risk on long and short positions Establishes fixed price Required on long or short positions Options Defined and limited on purchases of puts and calls; unlimited on sale Establishes floor or ceiling price protection Futures style margins for sellers, margin contained in the cost of premium for buyers Multiple hedging strategies
Price Protection Margin
Long, short, spread
While the loss that can be incurred on an Options contract is limited to the premium, the loss that can be incurred on a Futures contract is the opportunity cost resulting from locking in a price and forfeiting the benefits of favorable market moves. So, as far as farmers and manufacturers are considered, Options are more beneficial than futures.
Introduction of Options in India
Trading in commodity options contracts has been banned since 1952. The market for commodity derivatives cannot be called complete without the presence of this important derivative. Both futures and options are necessary for the healthy growth of the market. While futures contracts help a participant (say, a farmer) to hedge against downside movements, it does not allow him to reap the benefits of an increase in prices. So, using a future contract, a farmer can only hedge against price falls. If the prices are going up in contrast to his predictions, the farmer cannot really take advantage of the situation. Similarly, using futures, a buyer can only lock the rise of price of a commodity which he intends to buy in near future. It is an obligation to buy the underlying commodity. If the prices are going down as against his predictions, he will not be able to reap gains by taking advantage of the situation as it is necessary to perform the contract. Options help the participant in such conditions. It does not create an obligation. But the introduction of Options is still in papers only. Recently, Government delisted four commodities from being traded in exchanges. As there are still controversies that futures trading fuels inflation in the country, it will not be very easy for the Government to introduce Commodity Options. For commodity derivatives to work efficiently, it is necessary to have a sophisticated, cost-effective, reliable and convenient warehousing system in the country. So, the Government has to ensure that before introducing more complex derivative instruments. No doubt, there is an immediate need to bring about the necessary legal and regulatory changes to introduce commodity options in the country. The matter is said to be under the active consideration of the Government and the options trading may be intr oduced in the near future.
Impact of various studies and researches
There are a lot of studies and research works carried out in the area of Commodity Futures Markets in India. These findings and suggestions obviously have an impact on the likeliness towards Introduction of Options in Indian Exchanges. So, a detailed analysis is made on some of these studies and the research reports published by various scholars. The major committee which studied the Commodity Futures market in India recently is Abhijit Sen Committee. The Committee submitted a report on 29th April 2008. This report is supposed to be an important one which may influence the decision of the Government as to introduce Options in India. Analysis of some other studies which were conducted in this arena is also made to know more about the findings of these researches. These studies include one which was done by IIM Bangalore, to find out the impact of futures trading on Commodities. Their objective was to compare post-futures and pre-futures price fluctuations of various commodities. Another major research is a study by Sahi and Gurpreet on the influence of commodity derivatives on volatility of underlying. In this study, the researchers found that there is an unidirectional relationship between the volume of futures traded and the spot price volatility. A very recent study on Commodity Derivative Market and its Impact on spot market was conducted by GC Nath and Thulasamma Lingareddy, which was published early this year. This study compares the prices of underlying commodities in pre-futures period with that of post-futures period. As these studies are considered to be important with regard to this research, these reports are studied analyzed and the major findings are included here.
Report on Commodity Futures – Abhijit Sen Committee
In the wake of consistent rise of rate of inflation during the first quarter of calendar year 2007 and responding to the concerns expressed at various forums, Parliamentary Standing Committee of the Ministry of Consumer Affairs Food and Public Distribution, appointed an Expert Committee under the Chairmanship of Prof. Abhijit Sen, Member of Planning Commission, to examine whether and to what extent futures trading has contributed to price rise in agricultural commodities. The objectives of the committee were: 1. To study the extent of impact, if any, of futures trading on wholesale and retail prices of agricultural commodities 2. Depending on this impact, to suggest ways to minimize such an impact 3. Make such other recommendations as the Committee may consider appropriate regarding increased association of farmers in the futures market/trading so that farmers are able to get the benefit of price discovery through Commodity Exchanges. In order to examine whether futures trade could have led to price rise in agricultural commodities, the committee has relied on WPI data as these are a closer proxy of producer prices of agricultural produce than retail prices. Of the 43 agricultural commodities that have futures trading, 24 commodities accounted for 98.7% of total value of futures trading of agricultural commodities in 2006 -07. Among the 24 commodities with major share in futures trade, 3 do not feature in the WPI basket at all. So, these 3 commodities were excluded and mapping was done of 21 commodities with regard to the events of futures trade in these. Annualized Trend Growth Rate and Volatility of WPI of Selected Agricultural Commodities in which Futures are traded were calculated. Both WPI trend growth rate as well as WPI vol atility was obtained for pre-futures period as well as post-futures period. The data showed that the annual trend growth rate in prices was higher in the post futures period in 14 commodities, viz. Chana, Pepper, Jeera, Urad, Chillies, Wheat, Sugar, Tur, Raw Cotton, Rubber, Cardamom, Maize, Raw Jute and Rice; and lower in 7 commodities, viz. Soya oil, Soya bean, Rape seed / Mustard seed, Potato, Turmeric, Castor seed, and Gur. The first set of commodities account for 48.2% of futures trading volume in agriculture and have a weight of 10.1% in the WPI. Corresponding figures for the second set are 21.3% and 1.7%. Since the number of commodities in which inflation accelerated is double the number in which this decelerated, and their weights are also much higher in both futures trading and in the WPI, there is some
support for the claim that opening up of futures markets spurred inflation. Also, significantly, all sensitive commodities (i.e. food grains and sugar) recorded some acceleration in inflation after the start of futures trading. However, a revealing feature of this data is that of the 14 commodities in which acceleration took place in post-futures period, 10 had suffered negative inflation during the pre-futures period. It is possible in such cases that the acceleration in growth rate of WPI in these commodities is simply rebound and catch-up with the trend, which in turn could have been aided by more efficient price discovery. Similarly, of the 7 commodities in which WPI growth was lower post-futures, 6 had unusually high pre-futures inflation at over 10%. In these cases, too, it is possible that what is being observed is simply reversion to a more normal level of inflation. In both cases, there is the problem that the period during which futures markets have been in operation is much too short to discriminate adequately between the effect of opening up futures markets and what might simply be normal cyclical adjustments. An analysis was also carried out at macro rather than specific commodity level taki ng August 2004 as the cut-off point to divide pre-futures and post-futures periods. This is the middle month of the second quarter (July-Sept) of 2004-05 when, taking acceleration in total futures trading volume as the barometer, such trading picked up reasonably. After taking equal observations for both pre and post futures period, trend growth rates for both periods were calculated. This was done for (i) (ii) (iii) The weighted average WPI of the 21 selected commodities that have significant futures trading All primary agricultural goods (i.e. Food and Non-Food Articles in the WPI Primary Articles Group) and The weighted composite index of the 87 processed and unprocessed agricultural commodities. It was observed that not only did inflation accelerate post-futures in every case; price volatility was also generally higher in the post-futures period.
However, although inflation in certain sensitive commodities did accelerate after introduction of futures trading and appear to have benefited traders more than farmers, it does not necessarily follow that introduction of futures trading was the causative factor. The price discovery expected from futures trading should ideally lead to better utilization of available information regarding how supply and demand conditions are likely to evolve; and arbitrage, through speculation and hedging, should ideally affect spot prices only to the extent of bringing these in line with evolving fundamentals and the cost of holding physical stocks.
Inflation and Specific Commodities. The futures on urad, tur wheat, rice etc were delisted from the Indian exchanges. The committee has studied each of these commodities to analyze the factors behind the inflation and to check whether futures trading has actually resulted in price rise. The report states that the price of tur was not influenced by the futures trading, but the domestic demand and supply. In the next year after the introduction of futures, the supply of tur was huge, which lead to a steep fall in price. And in 2007, its price again went up as the production was dull. This evidence contradicts the claim that futures trading caused excessive increase in tur prices. By considering exports and government stock change into account, total rice availability in the domestic market declined by over 5 million tonnes in 2005 but recovered well beyond the 2004 level in 2006 and increased further by more than 1.5 million tonnes in 2007. The price of rise does not increase marginally in any of these years and was increased only after the delisting of rice from futures trading. So, the report states that speculation in futures markets cannot be said to have exerted any strong upward pressure on spot prices of rice. Production of urad declined and was below the average production in the years 200405 and 2005-06. But it was recovered in 2006-07. The price of urad was behaving unusually. Thus, Urad inflation did flare up very unusually in the period when futures‘ trading was active (August 2004 to January 2007). But this was a period of below normal production and, although higher imports cushioned supply. Wheat production was a little bit fluctuating over these years. It went down in 2004 05 and then increased sharply. Exports were declined and as a result of these factors, market availability of wheat increased. But despite that, the inflation persisted. Wheat prices behaved unusually and annualized wheat WPI inflation at 9.8% during the 30 months when futures trading was liquid (August 2004 to February 2007) stands in sharp contrast to inflation in either the previous 30 months (1.5%) or in the year subsequent to de-listing (0.3%, y-on-y February 2008). The report states that Critics of futures trading have focused most on outcomes in wheat, and linked this not only with speculative gains at cost of both producers and consumers but also with failures in public grain management in the face of uncertainties in both domestic production and world trade.
The possible reasons for the rise in wheat prices are: 1. Price rise in the initial period was as a result of output decline in 2004-05. 2. The world wheat prices have played a significant role in igniting wheat prices in India. 3. The increased demand for wheat during the period. 4. Even though wheat was available in private market, the government stock of wheat was too low to meet the increased demand. 5. In 2006-07, even though the production was increased, the ratio of market arrivals to production was low as a result of private trade.
Steps to minimize the potential risks of Derivatives trading
1. Pace and sequence of market opening. New and modern technology-driven Exchanges with best international practices have come up. All these developments have taken place in the backdrop of a long history of ban in forward trading when the perception about these markets was not good. That perception has not gone away totally. Even today people express their doubts about the need and efficacy of these markets. Therefore, it becomes all the more important that these markets are set up on a strong foundation. There should not occur any mishap or mischief which may discredit the market as a whole. The Government/Regulator/Exchanges should be able to explain that the markets are beneficial to all groups and if there are any transitional costs, these are the minimum and will be more than compensated with the overall benefit to the economy and the stakeholders. Before taking any steps to lift the ban on the four delisted commodities, the government should take necessary steps. A cautious approach is to be adopted for revival of futures trade in these commodities rather than have to confront a stop go situation again in the future. 2. Regulatory framework In order to defend the market against criticism, it is essential to minimize the potential adverse impact of futures trading on prices of agricultural products. This requires properly functioning and regulated markets. There is a need for a clear and unambiguous regulatory framework. The broad parameters of the functioning of the markets have to be clearly laid down. The regulatory authority sho uld have the capacity and the power to discipline the market. Once these pre-requisite are in place they will not only help in controlling aberrations in the market but also help the government and the regulator to explain to various stakeholders at large any abnormal behavior in the market that might occur as a result of some basic fundamental demand and supply factors. The regulatory framework for the market is provided in the Forward Contract (Regulation) Act, 1952. The FMC (Forward Markets Commission) was set up under this act. 3. Derivatives Markets to be Anchored to Physical Spot-Markets The derivative market has to be anchored to physical cash market. The physical spot markets have large number of infirmities. Till these infirmities are reformed, it will be difficult for the futures market to progress far ahead of them. Futures markets can act as a catalyst of change for spot markets and nothing more. Whenever futures markets try to grow faster than the under-developed physical markets of underlying commodities, the mismatch between the two gets widened,
thereby opening up futures market to the criticism of being driven by speculators, even if benign and closely regulated. Futures markets efficiency is contingent on the efficiency of spot markets. Efficient spot markets reduce the cost of future- spot arbitrage. Efficient spot markets in commodities would require integration of markets across geographical regions and quality. This reduces the basis risk in the use of futures contracts. Integration of the spot markets requires development of rural communication, transport and storage infrastructure. The committee is of the view that in order to expedite this, a substantial part of the transaction tax which is now being imposed on futures markets should be earmarked for development of the required physical market infrastructure. 4. Speculation an Integral part of Efficient Futures Market The commodities with a history of high price volatility are prone to excessive speculative interests which open up futures market to the charge of distorting prices having no linkage to the fundamentals of the demand and supply factors. The presence of the speculators on the futures market is often looked upon with suspicion. It must be remembered that if only the farmers and consumers were to operate on the agricultural commodity markets, there is likely to be mismatch in their respective marketing strategies and therefore, they would not be able to transact business at any given point of time since the total volume of business would be very thin. The market would, therefore, become illiquid. Hence, speculators step into to provide the transaction matching through risk transfer and consequential liquidity. In a free market with availability of technology for instantaneous flow of information speculative funds cannot bring secular price rise as supply responses (through inventory unloading, imports and production) are fast. It is opacity or non-availability of efficient markets, like futures markets that gives power to the manipulator-speculator. On the other hand, an efficient and transparent market with sufficient depth of participation will encourage responsible and informed speculation. 5. Consultative Mechanism for Development of the market The exchanges as well as FMC should have a strong back up of domain knowledge of commodities which are traded on the exchange platforms. The knowledge of fundamental economic characteristics of production, marketing and use of the commodity so as to understand the factors influencing their prices is of utmost importance. Once a proper contract design of a product is in place, the surveillance of the market becomes easy. There should be a consultative group comprising of persons with proven domain knowledge of the commodity sector, both in the FMC as well as in the Exchanges.
Other Major Studies
A number of studies and researches were made on the Commodity Futures market and its impact on underlying commodity prices. There was a much wider scope for such kind of studies as there was always a debate going on whether Futures trading has influenced Commodity prices or not. It further went up when the government planned to ban futures trading on a few commodities. Since the introduction of Futures, the prices of underlying commodities were shooting up. The findings of a few important studies are analyzed to know the influence of Futures trading on Commodity Prices.
Impact of Futures Trading in Commodities – A Study by IIM Bangalore
FMC had commissioned a study by the Indian Institute of Management, Bangalore (IIMB) to study the impact of Futures Trading in some important agricultural commodities. Only those commodities in which future trading had attained reasonable volume were chosen for study. These commodities are gram, sugar, guarseed, wheat, urad and tur. The first conclusion of this study is that all these crops, except sugar, witnessed higher price increase in the post-exchange period compared to the pre-exchange period. However, as the study notes, sugarcane prices are to a large extent controlled by government and sugar prices play little role in determining the sugarcane prices, though they affect the payment capacity of the sugar mills and the prices to be offered for the next year. In case of guar grown mainly in the arid regions of Rajasthan, a normal monsoon gives a production that would meet the demand of guar seed for two to three years. The price increase in the year 2005-06 followed low carry-over stocks and increased export demand. In case of wheat, the high increase in prices after 2005 followed low production and low stock availability with the government. Tur showed a sharp increase in prices during 2006 following low stocks and production. Urad also showed continuous production decline 2004 onwards and a rise in the prices. Changes in fundamentals (mainly from the supply side) were thus found important in causing the higher post-futures price rise, with government policies also contributing, and the role of futures trading remains unclear. The IIMB study also finds that spot price volatility increased after introduction of futures in case of wheat and urad. However, it does not find any major change in volatility for gram, excepting an abnormal rise in FY 2006-07, or for tur and sugar. In case of guar seed, volatility was in fact found lower after introduction of futures trade. In an interesting extension to this, the study found evidence that (i) increased spot
price volatility (especially for wheat but also of gram) was associated with an increase in seasonality of prices so that farmers gained less than traders; and (ii) a tendency for retail margins to increase so that volatility increase was even more for retail prices than wholesale prices. In case of sugar also, although volatility of spot wholesale prices did not increase with introduction of futures, retail price volatility did increase. An important finding of the IIMB study is that many contracts traded on Indian Commodity Exchanges do not satisfy a fairly minimal condition for these to be attractive for hedging by those holding physical commodities. A generally accepted measure of whether a futures contract is attractive for hedging is its basis risk. Here basis is defined as the observed difference between spot and futures prices, and basis risk is measured by variance of this basis. Hedging can reduce price risks of commodity holding if basis risk is less than price risk (i.e. variance of spot prices), and becomes more attractive the lower the basis risk. The IIMB study found that not only was basis risk high for commodities studied, this was higher than price risk for many contracts. Despite these rather negative results on functioning of futures markets, the IIMB study does highlight one very significant positive development following the recent growth of modern Exchanges. It notes that the growth of these Exchanges appears to have helped in integrating geographically separated markets.
Influence of Commodity Derivatives on Volatility of Underlying – A study by Sahi, Gurpreet S.
In another study, covering wheat, sugar, turmeric, raw cotton, raw jute and soya bean oil, Sahi found that while the nature of spot price variability may not have changed significantly with onset of futures trading, certain findings were consistent with destabilizing effect of futures trading on agricultural commodity markets. For example, unexpected increases in futures trading volumes were found to have a significant unidirectional causal effect increasing spot price volatility in all these commodities except raw cotton. Similarly, a causal effect was found from unexpected increase in open interest to increased spot price volatility for all these commodities except raw cotton and sugar.
Commodity Derivative Market and its Impact on Spot Market – A study by Nath, G.C. and T. Lingareddy.
Another recent study on the commodity derivative market was that conducted by Nath, G.C. and T. Lingareddy, which was published very recently in January 2008. They could observe that both average price change and spot price volatility of urad, gram and wheat were higher by statistically significant margins during October 2004 to January 2007 as compared to either the pre-futures period January 2001 to September 2004 or during February 2007 to October 2007 when futures trading in some of these commodities was suspended. They also report tests of causality that show that the volume of futures trading had positive and significant causal impact on both the average level of spot prices and their volatility in case of wheat and urad though not in case of gram. Nonetheless, since some other tests were inconclusive, they concluded that while futures trading did lead to increase in urad prices there was ambiguity in case of wheat, probably because of fall in supply. Another interesting finding of the study was that there is a lead-lag relationship between futures trading and spot price volatility. It suggests that speculative activity in futures market can destabilize spot prices and therefore warns against aggressive attempts to expand futures trading, especially if driven not by those who manage price risks in physical trade by hedging in futures markets but by speculators or others based on exaggerated claims regarding futures markets efficacy.
Challenges facing the market
Commodity exchanges in Indian are still at a nascent stage, and there are numerous bottlenecks in the growth of the commodity futures market. The challenges facing the Indian Commodity markets are very serious in nature and cannot be ignored as they can paralyze the agricultural futures markets, much against the objective of agricultural liberalization. The main problem is that the commodity markets are under the control of Government. Towards the growth of any market, the trading conditions or the terms and conditions of contracts play a crucial role. The contracts should be market friendly in terms of attracting both the big and small traders alike. In majority of the contract specifications, it was found that the size is too big for small traders and producers to trade. Unless such finer aspects are dealt with proper attention at the regulatory level and the exchange level, attracting small traders and farmers into commodity futures trading becomes impossible. Especially in a country like India, where corporate farming is absent and predominant section of the farmers own small agricultural lands, meeting the specifications of the contract becomes difficult. Such farmers prefer spot markets rather than commodity markets for trading. Even the small traders refrain from trading owing to the capital constraints. Another key component required for the development of commodities market in India is the infrastructure. Though there are number of exchanges in India, they lack in infrastructure exception to a few large exchanges like National Commodity Derivatives Exchange (NCDEX) and Multi Commodity Exchange (MCX). Infrastructure requirements like warehousing facilities, clearing house and modern trading ring are absent in majority of the exchanges. As a result, majority of the exchanges have to depend on a few commodities and consequently, the turnover is low. Warehousing facilities is one major impediment to the growth of commodity markets in India. Though Government organization, Food Corporation of India, plays a vital role in storage of commodities, the infrastructure does not support future trading adequately. For the commodity futures to work effectively, the seller must deposit the deposit the commodity traded in a warehouse and the buyer should take physical delivery of the commodity in a warehouse at a location of his choice. However, at present, only a few warehouses can handle such kind of delivery requests and that too for specific commodities. Because of lack of adequate warehousing facilities that can ensure the quality standards of the commodities traded, traders and farmers still prefer local rural markets for trading the commodities. This factor is hindering the emergence of nation-wide commodity market in India.
Another major challenge to the growth of the commodity markets is the number of exchanges itself. Among the 27 commodity exchanges operating in India, majority of the exchanges are specialized in trading a few commodities. While geographical spreading of the exchanges is important for the development of nation-wide commodity market, there is no real integration among the existing exchanges. And most of these exchanges except NCDEX and MCX still practice outcry system of trading, it is cumbersome to trade in these specialized exchanges. As a result of these small exchanges spreading across the nation and specializing in select few commodities, the turnover, volume of trade and the revenues of exchanges are all low. It is very difficult for the exchanges to sustain the momentum and provide value added services to the market functionaries with such low revenues. In order to overcome the problem of multiple commodity exchanges, many economists have suggested the integration of the exchanges and consolidation and then in the later stage opt for demutualization of exchanges similar to the Chicago Mercantile Exchange and International Petroleum Exchange. The integration of exchanges and clearing house can also solve the problem of warehouses to a significant extent. Currently, a few large exchanges like NCDEX and MCX are attracting bulk of the trading and traders because of their technology and national-wide trading terminals. As a result, those exchanges have succeeded to gain the required financial strength.
Global trends in derivatives markets and the road ahead for India
As the derivatives market emerge and bloom in India, financial markets all over the world are being rapidly transformed by the Internet revolution. Participation level of individuals, organization of trading, speed of price discovery are all undergoing major changes and Indian markets have to rapidly adjust themselves to these changes. As the two national level commodity exchanges gain momentum, an important question will arise about the viability and future of the several regional, often single commodity stand-alone exchanges in operation. After all, trades are likely to converge to exchanges that attract the most players and offer most liquidity, so clearly, some of the local exchanges will probably lose out or become associated with one or more national-level exchanges. There is therefore a distinct possibility of integration in terms of exchanges. There are however, issues about standards that need to be tackled before the commodity futures markets become more integrated. Till the integration happens, we should expect to see important changes in the existing regional exchanges. Faced with competition from nation-wide exchanges, they would have to improve their technology, transparency and methods of operation in the short run if they are serious about staying in business. Also with the co ntinued acceptance and popularity of institutionalized commodity futures trading, probably the bulk of informal futures trading will slowly be absorbed in the regulated, through-exchange trading as the price and liquidity benefits outweigh the added transaction costs. That would, indeed, be a positive development for all concerned. Perhaps the biggest event in financial markets around the world – not just commodities or futures markets but securities markets as well – in recent years has been the emergence of Electronic Communication Networks (ECNs). In Indian exchanges, the outcry system has already been replaced by the ECN system. An already observable shift is occurring in the ownership structure and corporate governance of exchanges. Commodity exchanges, like their equity counterparts used to be owned and run by associations of brokers. This raised several transparency and governance issues for exchanges and increased the possibility of price manipulations and unethical practices that Indian markets are so notorious for. Improved corporate governance is essential for the development of commodity futures trading in India and perhaps the first and most important step in that direction is to separate the ownership and management of exchanges from the participating brokers. In other words, the ―self-regulating‖ model is likely to give way to for-profit exchanges promoted by outside agencies and financial institutions and run by a team of professionals.
As the Indian economy and financial markets become increasingly integrated with the global markets, its effects are likely to become visible in the commodities futures markets as well. With the increasing role of multi-national corporations in the agricultural and food processing as well as international trade, the connection between commodity prices in India and world prices are becoming increasingly linked. There is also an increasing need for participating clients to hedge and speculate on Indian commodity prices in relation to world prices rather than in isolation. It is reasonable, then, to expect that with time, the linkage between Indian commodity prices and futures prices will be even more connected with world prices and possibly trading itself would be international. In the global scenario, there has been an emergence of alliances of futures markets. It is likely that Indian exchanges would also form partnerships with foreign exchanges allowing more sophisticated instruments enabling Indian traders to better hedge their international risks. Over time, new products are likely to be introduced in the Indian futures markets. A category of futures that have are extremely popular in developed countries will perhaps make their appearance in India too. These are the weather derivatives, which are now being offered in India as bank products but not actively traded in the bourses. If properly designed such futures can help farmers hedge the climate and rainfall related risks that are concomitant with Indian agriculture. In about a decade‘s time, commodity futures in India have come a long way from the domain of barely legal bets to trading on multi-commodity national level exchanges with sophisticated products, technology and contract specifications. Its rise offers participants in Indian agriculture a much needed way to hedge their risks. While as of now, small and medium farmers and farmer cooperatives are still hard to find amidst the users of futures markets, hopefully that will change soon as the futures rise in popularity and stature. Then they would truly make a difference where it matters most.
Futures‘ trading in commodities has a long tradition in India going back to 1875 when the Bombay Cotton Trade Association was set up. This was followed by a mushrooming of Exchanges throughout the country. Futures markets faced a lot of challenges since 1960s when they were accused of fuelling inflation and were perceived not to have any role as the State intervened directly in prices and distribution of large number of essential commodities which were short in supply. The market survived in the situation as very few commodities were permitted for futures trading. Adoption of liberal economic policies since 1991 gave fillip to efforts to open up futures trading, which culminated into total withdrawal of prohibition in 2003. Since then, Futures trading is undergoing fast changes. There has been a fall in agri-commodity volumes during 2007-08 over the previous year. This place was taken over by bullion and other metals. Negative sentiments have been created by the decision to de-list futures trade in some important agricultural commodities. Analysis of 21 agricultural commodities (accounting for about 98% of share in total futures trade in agricultural commodities) shows that the annual trend growth rate of prices accelerated after introduction of futures trading in the case of many more of these commodities than there were cases of deceleration. In particular, prices of all food grains accelerated in the post-futures period. The fact that agricultural price inflation accelerated during the post futures period does not, however, necessarily mean that this was caused by futures trading. A study of supply fundamentals (production, changes in inventory and international trade) show that changes in these also contributed to higher inflation during the period under consideration In contrast to the view that futures markets cause increases in prices, the most of the existing literature on the subject emphasizes that such markets help in price discovery, provide price risk management and also bring about integration of markets. Although the volume of futures trading in India has increased phenomenally in recent years, its ability to provide instruments of risk management has not grown correspondingly.
Reforming spot markets should be given top priority. Till the infirmities of spot markets are removed, it will be difficult for the futures market to progress far ahead of them. Another enabler of the market will be to upgrade the quality of regulation both by the FMC and by the Exchanges. An important element of this is to require exchanges to act as self regulatory organizations, capable of demonstrating fair play, objectivity and customer orientation. FMC should frame regulations on various aspects of market operations for transparent and efficient functioning of the market. The care should be taken to enable farmers and small operators to take benefit of these markets. Exchanges should be directed to design their market procedures and contracts such as to enable farmers an easy access to these market and protection against any market malpractices. There should be a consultative group comprising persons with proven domain knowledge of commodity sector both in the FMC as well as in the exchanges. The structure of markets, contract designs and other requirements of trading on these markets should be simple and easy to enable farmers to participate in these markets. The contract designs should be tailored to meet the needs of the physical market. The farmers should be given access to information. Moreover, they need to be empowered to use this information. Empowerment is a much more difficult task than making information available. The farmer is less likely to participate directly as these markets are complex; they need to be tracked continuously to take benefit out of them. The support infrastructure of warehousing and commodity finance is inadequate. Moreover, at the early stage of development of these markets, where liquidity in many commodities is low and they are prone to high impact costs. The awareness and knowledge of accessing these markets among farmers is yet not adequate. So, FMC and exchanges should take necessary measures to spread awareness. Before taking any steps to lift the ban on the four delisted commodities , the government should take necessary steps. A cautious approach is to be adopted for revival of futures trade in these commodities rather than have to confront a stop go situation again in the future.
Options on commodities‘ can be another hedge instrument suitable for farmers‘ needs. However, complex Options products may be difficult to comprehend and not suitable for farmers‘ needs. In case of agri-commodities, it will be suitable to allow only Simple Options for some time till market attains maturity of operations and regulations. It is also important that the farmers attain adequate understanding of the markets and of techniques to use them. Since the premium on options may be high, farmers‘ costs of accessing these markets should be minimized by waiving transaction charges/taxes or even by granting subsidies out of tax collection/ transaction charge collection for genuine hedge purposes by the farmers. The money from proposed CTT can be used for it. Before introducing Options trading in the major food grains, an assessment should be made of the possibility of FCI acting as the writer of ‘Call’ and ‘Put’ options in these commodities. This could reduce the cost of operations and stabilize market operations.
Publications The Options Course Options – Essential Concepts and Trading Strategies How I Trade Options Getting Started with Options, 5 th Edition Commodities Market – An introduction - George A Fontanills - McGraw Hill - John Najarian - Michael C Thomsett - ICFAI Publication
Magazines and Articles Indian Journal of finance - April – May, 2008 Understanding commodity derivatives Treasury Management Business world - Larry D Makus - ICFAI University Press
Internet web portals www.commodityonline.com www.mcxindia.com www.ncdex.com www.nymex.com www.lme.co.uk www.ces.uga.edu www.cboe.com
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