Friday, May 5, 2006

All about commodity derivatives

May 05, 2005,, Co-author-Vivek Kaul

Trading in derivatives first started to protect farmers from the risk of the value of their crop going below the cost price of their produce. Derivative contracts were offered on various agricultural products like cotton, rice, coffee, wheat, pepper, et cetera.
The first organised exchange, the Chicago Board of Trade (CBOT) -- with standardised contracts on various commodities -- was established in 1848. In 1874, the Chicago Produce Exchange -- which is now known as Chicago Mercantile Exchange -- was formed (CME).
CBOT and CME are two of the largest commodity derivatives exchanges in the world.
The Indian scenario
Commodity derivatives have had a long and a chequered presence in India. The commodity derivative market has been functioning in India since the nineteenth century with organised trading in cotton through the establishment of Cotton Trade Association in 1875. Over the years, there have been various bans, suspensions and regulatory dogmas on various contracts.
There are 25 commodity derivative exchanges in India as of now and derivative contracts on nearly 100 commodities are available for trade. The overall turnover is expected to touch Rs 5 lakh crore (Rs 5 trillion) by the end of 2004-2005.
National Commodity and Derivatives Exchange (NCDEX) is the largest commodity derivatives exchange with a turnover of around Rs 3,000 crore (Rs 30 billion) every fortnight.
It is only in the last decade that commodity derivatives exchanges have been actively encouraged. But, the markets have suffered from poor liquidity and have not grown to any significant level, till recently.
However, in the year 2003, four national commodity exchanges became operational; National Multi-Commodity Exchange of India (NMCE), National Board of Trade (NBOT), National Commodity and Derivatives Exchange (NCDEX) and Multi Commodity Exchange (MCX).
The onset of these exchanges and the introduction of futures contracts on new commodities by the Forwards Market Commission have triggered significant levels of trade. Now the commodities futures trading in India is all set to match the volumes on the capital markets.
Investing in commodity derivatives
Commodity derivatives, which were traditionally developed for risk management purposes, are now growing in popularity as an investment tool. Most of the trading in the commodity derivatives market is being done by people who have no need for the commodity itself.
They just speculate on the direction of the price of these commodities, hoping to make money if the price moves in their favour.
The commodity derivatives market is a direct way to invest in commodities rather than investing in the companies that trade in those commodities.
For example, an investor can invest directly in a steel derivative rather than investing in the shares of Tata Steel. It is easier to forecast the price of commodities based on their demand and supply forecasts as compared to forecasting the price of the shares of a company -- which depend on many other factors than just the demand -- and supply of the products they manufacture and sell or trade in.
Also, derivatives are much cheaper to trade in as only a small sum of money is required to buy a derivative contract.
Let us assume that an investor buys a tonne of soybean for Rs 8,700 in anticipation that the prices will rise to Rs 9,000 by June 30, 2005. He will be able to make a profit of Rs 300 on his investment, which is 3.4%. Compare this to the scenario if the investor had decided to buy soybean futures instead.
Before we look into how investment in a derivative contract works, we must familiarise ourselves with the buyer and the seller of a derivative contract. A buyer of a derivative contract is a person who pays an initial margin to buy the right to buy or sell a commodity at a certain price and a certain date in the future.
On the other hand, the seller accepts the margin and agrees to fulfil the agreed terms of the contract by buying or selling the commodity at the agreed price on the maturity date of the contract.
Now let us say the investor buys soybean futures contract to buy one tonne of soybean for Rs 8,700 (exercise price) on June 30, 2005. The contract is available by paying an initial margin of 10%, i.e. Rs 870. Note that the investor needs to invest only Rs 870 here.
On June 30, 2005, the price of soybean in the market is, say, Rs 9,000 (known as Spot Price -- Spot Price is the current market price of the commodity at any point in time).
The investor can take the delivery of one tonne of soybean at Rs 8,700 and immediately sell it in the market for Rs 9,000, making a profit of Rs 300. So the return on the investment of Rs 870 is 34.5%. On the contrary, if the price of soybean drops to Rs 8,400 the investor will end up making a loss of 34.5%.
If the investor wants, instead of taking the delivery of the commodity upon maturity of the contract, an option to settle the contract in cash also exists. Cash settlement comprises exchange of the difference in the spot price of the commodity and the exercise price as per the futures contract.
At present, the option of cash settlement lies only with the seller of the contract. If the seller decides to make or take delivery upon maturity, the buyer of the contract has to fulfil his obligation by either taking or making delivery of the commodity, depending on the specifications of the contract.
In the above example, if the seller decides to go for cash settlement, the contract can be settled by the seller paying Rs 300 to the buyer, which is the difference in the spot price of the commodity and the exercise price. Once again, the return on the investment of Rs 870 is 34.5%.
The above example shows that with very little investment, the commodity futures market offers scope to make big bucks. However, trading in derivatives is highly risky because just as there are high returns to be earned if prices move in favour of the investors, an unfavourable move results in huge losses.
The most critical function in a commodity derivatives exchange is the settlement and clearing of trades. Commodity derivatives can involve the exchange of funds and goods. The exchanges have a separate body to handle all the settlements, known as the clearing house.
For example, the seller of a futures contract to buy soybean might choose to take delivery of soyabean rather than closing his position before maturity. The function of the clearing house or clearing organisation, in such a case, is to take care of possible problems of default by the other party involved by standardising and simplifying transaction processing between participants and the organisation.
In spite of the surge in the turnover of the commodity exchanges in recent years, a lot of work in terms of policy liberalisation, setting up the right legal system, creating the necessary infrastructure, large-scale training programs, et cetera still needs to be done in order to catch up with the developed commodity derivative markets.
Also, trading in commodity options is prohibited in India. The regulators should look towards introducing new contracts in the Indian market in order to provide the investors with choice, plus provide the farmers and commodity traders with more tools to hedge their risks.
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