There is peril as well as profit in riding the leverage tiger

DNA, 24th May 2006

It has happened before, and it's happening again. Futures markets were widely blamed for the Black Monday crash in the US in October 1987 - even though research has shown that futures cannot be blamed for the unfortunate turn of events then. Similarly, futures are being blamed now for the falling indices in India. Let us examine how trading in futures has an impact on the cash markets.

Let us take, for example, the Reliance Industries share for the past one month.On April 24, 2006, the share closed at Rs 977 in the spot market and Rs 988 in the futures market. Buoyed by the positive market sentiment, investors bought into the Reliance stock futures in the hope that its price will rise in the future, and then they can offset or close their positions in the futures market by selling.

People prefer to take a long position in the futures market as they have to pay only a small margin for the contracts rather than the entire amount. For example, an investor can buy one lot of Reliance futures consisting of 600 units by paying a margin of around 28% on the total contract value.

The total contract value would amount to Rs 5,92,800 (Rs 988 x 600 = Rs 5,92,800). The investor, though, needs to pay only Rs 1,65,984 (5,92,800 x 0.28). To buy the same number of shares in the spot market, the investor would have had to pay Rs 5,86,200 (977 x 600) on the same day.

Now, say, an investor has bought in one lot of Reliance futures contracts by paying a margin of Rs 1,65,984. He is of the view that the price of the futures contracts will keep rising. And indeed they do, till May 12, 2006, after which they start falling. The investor thinks that it is just a temporary downward move and does not square off his position.

But the markets continue to fall. On May 22, 2006, all hell broke lose and the Sensex lost more than 1,000 points during intra-day trading. The Reliance futures price also took a heavy beating and closed the day at Rs 928. On account of the daily mark-to-market system in the derivatives segment, the investor receives margin calls as the value of his investment falls.

Mark-to-market essentially is a term used for adjusting the value of an investor's investment on a daily basis. Here, the difference between the settlement price (the closing price of the futures contract) of the previous day and the settlement price of today is settled in cash daily. So if the price of the futures is falling, the investor needs to deposit cash with his broker, who, in turn, needs to deposit it with the clearing house.

Now, the investor has three choices. If he has the cash to meet the margin call, he pays the money to the broker who will then deposit it with the clearing house. Second, he can square off his position by selling one lot of futures contracts and can book a loss on his position (loss of (Rs 988-Rs 928) x 600=Rs 36,000).

Thirdly, if he holds Reliance shares or any other shares in the spot market, he can sell them and raise the money to meet the margin call. Most of the investors fall in the second and the third category. They either square off their positions on their own or the brokers do it compulsorily if the investor fails to deposit the margin call or they sell shares in the spot market to meet the margin call in the futures market.

In both the circumstances, there is selling pressure on the spot market. When an investor squares off his futures position by selling futures contracts, there is a drop in the futures price due to selling pressure on the futures contracts. If the futures prices drop, and they start selling at a price which is lower than the cash market, the market players will start buying in the futures market and selling in the spot market. This will create a selling pressure on the cash market, sending the prices down.

Similarly, there is selling pressure on the cash market if investors start selling their shares in the spot market to raise cash in order to meet the margin calls in the futures market. And so, futures market influence the spot market.

Note: Stock and futures prices have been rounded of.

Lamhe

Choti choti baatein, ban jaati hain yaadein
Bhooli bisri yaadein, ban jaatey hain saharey.
Saharon se guzarish hai, kabhi na hona fanaa.
Jeevan ke har lamhe thaam kar meri baahein dena mujhe panaah.
Woh har lamha jo beet gaya hai
Usse yeh arja hai meri samaye rahna dil me meri, dhadkanon ki tarah.
Jo kabhi juda huey mujhse, meri saanse bhi saath le jaana.

All about commodity derivatives

May 05, 2005, www.rediff.com, 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.

A Short History of Nearly Everything-Bill Bryson

If someone knows of a better book which talks about the evolution of the Universe, explains important discoveries in physics, chemistry, geology and palaeontology more lucidly than this book, please let me know. I am not a science person.

This is the first time I am hooked on to a book on science. Newton, Einstein, Marie Curie, Charles Darwin...names that I had forgotten soon after the 10+2 exams, are once again intriguing me. Questions like the mass of the Earth, the age of the Earth, the size of the Earth, how did it come into existence...how about our Solar System? How big is it? How far are the planets from the Earth? What if the planets collide with each other? Will they in the first place? And many more such Questions, have been answered much before the so called revolution in technology and the age of computers.

The dedication with which many of the names who find mention in the book used to work is amazing. Probably its because for many of them finding answers to these questions was a hobby rather than a job. And their hobbies became their passion. This once again reinforces my point that in order to make a difference, we must do things that make us happy rather than working just for money.