1.

Commodity and Commodities market

1.1 INTRODUCTION

India, a commodity based economy where two-third of the one billion population depends on
agricultural commodities, surprisingly has an under developed commodity market. Unlike the physical
market, futures markets trades in commodity are largely used as risk management (hedging)
mechanism on either physical commodity itself or open positions in commodity stock.

For instance, a jeweler can hedge his inventory against perceived short-term downturn in gold prices
by going short in the future markets.

The article aims at know how of the commodities market and how the commodities traded on the
exchange. The idea is to understand the importance of commodity derivatives and learn about the
market from Indian point of view. In fact it was one of the most vibrant markets till early 70s. Its
development and growth was shunted due to numerous restrictions earlier. Now, with most of these
restrictions being removed, there is tremendous potential for growth of this market in the country.

1.2 COMMODITY

A commodity may be defined as an article, a product or material that is bought and sold. It can be
classified as every kind of movable property, except Actionable Claims, Money & Securities.

Commodities actually offer immense potential to become a separate asset class for market-savvy
investors, arbitrageurs and speculators. Retail investors, who claim to understand the equity markets,
may find commodities an unfathomable market. But commodities are easy to understand as far as
fundamentals of demand and supply are concerned. Retail investors should understand the risks and
advantages of trading in commodities futures before taking a leap. Historically, pricing in commodities
futures has been less volatile compared with equity and bonds, thus providing an efficient portfolio
diversification option.

In fact, the size of the commodities markets in India is also quite significant. Of the country's GDP of
Rs 13, 20,730 crore (Rs 13,207.3 billion), commodities related (and dependent) industries constitute
about 58 per cent.

Currently, the various commodities across the country clock an annual turnover of Rs 1, 40,000 crore
(Rs 1,400 billion). With the introduction of futures trading, the size of the commodities market grows
many folds here on.

1.3 COMMODITY MARKET

Commodity market is an important constituent of the financial markets of any country. It is the market
where a wide range of products, viz., precious metals, base metals, crude oil, energy and soft
commodities like palm oil, coffee etc. are traded. It is important to develop a vibrant, active and liquid
commodity market. This would help investors hedge their commodity risk, take speculative positions in
commodities and exploit arbitrage opportunities in the market.

Table: 1
Turnover in Financial Markets and Commodity Market
(Rs in Crores)
S No. Market segments 2002-03 2003-04 2004-05 (E)
1 Government Securities Market 1,544,376 (63) 2,518,322 (91.2) 2,827,872 (91)
2 Forex Market 658,035 (27) 2,318,531 (84) 3,867,936 (124.4)
3 Total Stock Market Turnover (I+ II) 1,374,405 (56) 3,745,507 (136) 4,160,702 (133.8)
I National Stock Exchange (a+b) 1,057,854 (43) 3,230,002 (117) 3,641,672 (117.1)
a)Cash 617,989 1,099,534 1,147,027
b)Derivatives 439,865 2,130,468 2,494,645
II Bombay Stock Exchange (a+b) 316,551 (13) 515,505 (18.7) 519,030 (16.7)
a)Cash 314,073 503,053 499,503
b)Derivatives 2,478 12,452 19,527
4 Commodities Market NA 130,215 (4.7) 500,000 (16.1)
Note: Fig. in bracket represents percentage to GDP at market prices
Source: Sebi bulletin

1.4 Its EVOLUTION IN INDIA

Bombay Cotton Trade Association Ltd., set up in 1875, was the first organized futures market. Bombay
Cotton Exchange Ltd. was established in 1893 following the widespread discontent amongst leading
cotton mill owners and merchants over functioning of Bombay Cotton Trade Association. The Futures
trading in oilseeds started in 1900 with the establishment of the Gujarati Vyapari Mandali, which
carried on futures trading in groundnut, castor seed and cotton. Futures' trading in wheat was existent
at several places in Punjab and Uttar Pradesh. But the most notable futures exchange for wheat was
chamber of commerce at Hapur set up in 1913. Futures trading in bullion began in Mumbai in 1920.
Calcutta Hessian Exchange Ltd. was established in 1919 for futures trading in raw jute and jute goods.
But organized futures trading in raw jute began only in 1927 with the establishment of East Indian
Jute Association Ltd. These two associations amalgamated in 1945 to form the East India Jute &
Hessian Ltd. to conduct organized trading in both Raw Jute and Jute goods. Forward Contracts
(Regulation) Act was enacted in 1952 and the Forwards Markets Commission (FMC) was established in
1953 under the Ministry of Consumer Affairs and Public Distribution. In due course, several other
exchanges were created in the country to trade in diverse commodities.

1.5 Structure of Commodity Market

1.6 Different types of commodities traded

World-over one will find that a market exits for almost all the commodities known to us. These
commodities can be broadly classified into the following:

Precious Metals: Gold, Silver, Platinum etc

Other Metals: Nickel, Aluminum, Copper etc
Agro-Based Commodities: Wheat, Corn, Cotton, Oils, Oilseeds.
Soft Commodities: Coffee, Cocoa, Sugar etc
Live-Stock: Live Cattle, Pork Bellies etc
Energy: Crude Oil, Natural Gas, Gasoline etc

1.7 Different segments in Commodities market

The commodities market exits in two distinct forms namely the Over the Counter (OTC) market and
the Exchange based market. Also, as in equities, there exists the spot and the derivatives segment.
The spot markets are essentially over the counter markets and the participation is restricted to people
who are involved with that commodity say the farmer, processor, wholesaler etc. Derivative trading
takes place through exchange-based markets with standardized contracts, settlements etc.

1.8 Leading commodity markets of world

Some of the leading exchanges of the world are New York Mercantile Exchange (NYMEX), the London
Metal Exchange (LME) and the Chicago Board of Trade (CBOT).

1.9 Leading commodity markets of India

The government has now allowed national commodity exchanges, similar to the BSE & NSE, to come
up and let them deal in commodity derivatives in an electronic trading environment. These exchanges
are expected to offer a nation-wide anonymous, order driven, screen based trading system for trading.
The Forward Markets Commission (FMC) will regulate these exchanges.

Consequently four commodity exchanges have been approved to commence business in this regard.
They are:

Multi Commodity Exchange (MCX) located at Mumbai.

National Commodity and Derivatives Exchange Ltd (NCDEX) located at Mumbai.
National Board of Trade (NBOT) located at Indore.
National Multi Commodity Exchange (NMCE) located at Ahmedabad.

Turnover on Commodity Futures Markets

(Rs. In Crores)

Exchange 2003-04 2004-05 FIRST Half

NCDEX 1490 54011
NBOT 53014 51038
MCX 2456 30695
NMCE 23842 7943
ALL EXCHANGES 129364 170720

1.10 Volumes in Commodity Derivatives Worldwide

2. Commodity Futures Trading in India

2.1 INTRODUCTION

Derivatives as a tool for managing risk first originated in the Commodities markets. They were then
found useful as a hedging tool in financial markets as well. The basic concept of a derivative contract
remains the same whether the underlying happens to be a commodity or a financial asset. However
there are some features, which are very peculiar to commodity derivative markets. In the case of
financial derivatives, most of these contracts are cash settled. Even in the case of physical settlement,
financial assets are not bulky and do not need special facility for storage. Due to the bulky nature of
the underlying assets, physical settlement in commodity derivatives creates the need for warehousing.
Similarly, the concept of varying quality of asset does not really exist as far as financial underlyings
are concerned. However in the case of commodities, the quality of the asset underlying a contract can
vary largely. This becomes an important issue to be managed.

2.2 Benefits to Industry from Futures trading.

* Hedging the price risk associated with futures contractual commitments.

* Spaced out purchases possible rather than large cash purchases and its storage.
* Efficient price discovery prevents seasonal price volatility.
* Greater flexibility, certainty and transparency in procuring commodities would aid bank
lending.
* Facilitate informed lending.
* Hedged positions of producers and processors would reduce the risk of default faced by
banks. * Lending for agricultural sector would go up with greater transparency in pricing and
storage.
* Commodity Exchanges to act as distribution network to retail agri-finance from Banks to rural
households.
* Provide trading limit finance to Traders in commodities Exchanges.

2.3 Benefits to Exchange Member

* Access to a huge potential market much greater than the securities and cash market in
commodities.
* Robust, scalable, state-of-art technology deployment.
* Member can trade in multiple commodities from a single point, on real time basis.
* Traders would be trained to be Rural Advisors and Commodity Specialists and through them
multiple rural needs would be met, like bank credit, information dissemination, etc.

2.4 Why Commodity Futures?

One answer that is heard in the financial sector is "we need commodity futures markets so that we will
have volumes, brokerage fees, and something to trade''. I think that is missing the point. We have to
look at futures market in a bigger perspective -- what is the role for commodity futures in India's
economy?

In India agriculture has traditionally been an area with heavy government intervention. Government
intervenes by trying to maintain buffer stocks, they try to fix prices, and they have import-export
restrictions and a host of other interventions. Many economists think that we could have major
benefits from liberalization of the agricultural sector.

In this case, the question arises about who will maintain the buffer stock, how will we smoothen the
price fluctuations, how will farmers not be vulnerable that tomorrow the price will crash when the crop
comes out, how will farmers get signals that in the future there will be a great need for wheat or rice.
In all these aspects the futures market has a very big role to play.

If you think there will be a shortage of wheat tomorrow, the futures prices will go up today, and it will
carry signals back to the farmer making sowing decisions today. In this fashion, a system of futures
markets will improve cropping patterns.

Next, if I am growing wheat and am worried that by the time the harvest comes out prices will go
down, then I can sell my wheat on the futures market. I can sell my wheat at a price, which is fixed
today, which eliminates my risk from price fluctuations. These days, agriculture requires investments
-- farmers spend money on fertilizers, high yielding varieties, etc. They are worried when making
these investments that by the time the crop comes out prices might have dropped, resulting in losses.
Thus a farmer would like to lock in his future price and not be exposed to fluctuations in prices.

The third is the role about storage. Today we have the Food Corporation of India, which is doing a
huge job of storage, and it is a system, which -- in my opinion -- does not work. Futures market will
produce their own kind of smoothing between the present and the future. If the future price is high
and the present price is low, an arbitrager will buy today and sell in the future. The converse is also
true, thus if the future price is low the arbitrageur will buy in the futures market. These activities
produce their own "optimal" buffer stocks, smooth prices. They also work very effectively when there
is trade in agricultural commodities; arbitrageurs on the futures market will use imports and exports to
smooth Indian prices using foreign spot markets.

In totality , commodity futures markets are a part and parcel of a program for agricultural
liberalization. Many agriculture economists understand the need of liberalization in the sector. Futures
markets are an instrument for achieving that liberalization.

Ankur Rajoria
Student(Batch-2006-SEM-III)
ICFAI Business School
ICFAI House, Nr. GNFC Tower, S.G. Highway, Bodakdev, Ahmedabad-380 054
E-mail: [email protected] / [email protected]
Mobile: 9898097790

Source : E-mail June 1, 2005

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