In 2003, prohibition on futures trading was removed and three national exchanges, Multi Commodity Exchange Ltd. (MCX), National Commodity & Derivatives Exchange Ltd. (NCDEX) and National MultiCommodity Exchange of India Ltd. (NMCE) were set up for wide network coverage, and transparent trading. Currently, six national level exchanges and 11 regional exchanges are facilitating trading in various futures contracts, covering food grains, oil seeds, sugar, spices, energy, metals and gas sectors. However, trading in some commodities has been suspended from time to time based on the perception that trading in futures contracts has increased the volatility and price in the spot market, which lead to higher inflation. Table-1 provides the list of commodities suspended after the inception of national exchanges. Several studies have examined the argument, that futures trading increase the inflation or the spot price and volatility but could not find any conclusive empirical evidence in support of the argument (e.g, Nath and Lingareddy, 2008; Pavaskar and Ghosh, 2008).
Given the fact that commodities have emerged as an alternative investment class, commodity markets across the world are heading towards financialization. Technological innovations and upgradations has made information flow from one market to another very fast. Therefore, market linkages across the world is increasing and hence finding support of such argument is not easy. Suspension of trading in any commodities always creates uncertainty about the regulations in the market which may affect liquidity and other characteristics of the market. Therefore such steps by the regulators should be taken with utmost care. However, since the inception of commodity futures in 2003, a phenomenal growth has been witnessed in terms of volume and value of trades. Trades in commodity futures have gone up from INR 5.7 lakh crore to in 2003 to 181.3 lakh crore in 2011-12. Table-2 Provide the trade volume in last decade in Indian commodity market.
Functioning of futures Market
Futures market broadly helps in price discovery process and risk management. In futures market, investors take positions by depositing only a small amount (margins), as compared to spot market where investors need to pay/receive the full amount of the commodity. Also, in futures market, investors do not need the storage capacities as they can square-off their positions through cash settlement. Low transaction cost infuses more liquidity in futures market. Therefore, participants in futures market have more incentives to act aggressively as soon any news/information arrives in the market, resulting in fast price discovery in futures market than the spot market. Price discovery process helps the producers in two ways. First, they take an informed decision about the fair price of their product in spot market. Second, producers can decide (at the time of sowing) which commodity they would prefer to sow (out of available alternatives) as the future (near harvest time) expected price are available in the futures market. For example, suppose March is the sowing time of two crops and futures contract price at the time of harvesting (say in October) is available. Then the producer can take an informed decision about which crop he/she would prefer to sow. Futures market provides a mechanism of transferring the price risk as well. For example, producers can transfer the risk of lower future price by taking short position in futures market. The phenomenon that involves a short position in futures contracts when the hedger already owns or expected to sell the asset in future in known as short hedge. For example, the current spot price of the crop is S1 per unit and the futures contract price is F1. Then by taking the short position in futures contracts the producer can lock in the price F1 (ignoring the basis risk; which is defined as the difference between the futures price and the spot price at the time of maturity). In case, if the price of the commodity goes down in future, through short position in futures contracts the producer will gain which will compensate for the losses incurred by selling in produce in the spot market. Similarly if investors believe that they need to purchase a certain asset in future he may go for long hedge in order to avoid the risk of price rise in near future. However, delivery mechanism, availability of futures contracts for a given quality (grade), location of delivery makes the task more difficult.
Challenges in Functioning of Futures Market
Despite the fact that commodity market has witnessed huge volumes, there are concerns whether commodity market has achieved its intended goals. Is the commodity market successful in providing better price discovery? Does commodity market providing instruments for hedging to the farmers, processors, exporters, retail chain operators and other participants? Do speculators have dominated the overall market? Studies find that futures price provides better price discovery and there is an information flow from futures markets to spot markets (Kumar, 2007; Elumalai et al., 2009). Aggarwal et al. (2004) analyzed the information share between futures and spot market for agricultural, metal and crude oil sectors. They find that futures market dominates spot market in discovering news/information arrival. This means that any news/information arrived in the market is first captured by the futures market and then pass to the spot market. U of futures trading in transfer of risk through hedging in Indian commodity market is doubtful as most of the contracts are cash settled and very few contracts are settled through delivery. Table-3 provides a snapshot of the commodities and number of contracts delivered at MCX in the month of June 2015.
Other problems faced by the producer while hedging is, quality of the crop does not match with the quality accepted for delivery in futures contract. Also, because of market inefficiencies, basis risk is high in Indian context. Agarwal et al. (2013) find very low hedging effectiveness for eight commodity contracts. “Hedging effectiveness is defined as the proportion of variance that is eliminated by hedging” (Hull, 2009). In order to reduce the basis risk the role of arbitrageurs are very important as they take simultaneous positions in spot and futures market in order to get benefits of the anomalies in these markets if any. This helps in reducing the basis risk. However, the act of arbitrageurs depends upon the transaction cost, which significantly depends upon the liquidity of the market. In short, in the last decade commodity market in India has witnessed a rapid growth. Suspension of trading in few commodities has put a question mark on the functioning of Indian commodity market. Banning trading in futures contract without solid empirical support and justification should be avoided. FMC should take more severe regulatory measures while banning commodities from trade. Commodity futures market is providing a mechanism for a better and transparent price discovery for the traded commodities. However, liquidity and higher transaction costs are still a concern for the market participants. To improve the liquidity in the market wider participation of banks, FIIs, mutual funds etc. is required. Also, in order to improve the risk management practices, trading for commodity options, which has been allowed by the FMC, may be started.
Note: Reproduced from Artha, July 2015
Article By:Vivek Rajvanshi
Assistant Professor, Finance and Control, IIM Calcutta
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