A Study on the Introduction of Options in Indian Commodity Exchanges

8/14/2019 A Study on the Introduction of Options in Indian Commodity Exchanges

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A STUDY ON THE INTRODUCTION OFOPTIONS IN INDIAN COMMODITY

EXCHANGES

- A REPORT

By,

Vinu Baby

07BS4887

IBS Chennai


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A STUDY ON THE INTRODUCTION OFOPTIONS 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


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ACKNOWLEDGEMENT

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 worldand the classroom sessions.

I profusely thank Mr. S Sathyanarayanan , Senior VP, for allowing me to carry outthe summer internship training at Anand Rathi Financial Services Ltd. He alsoprovided 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 thistraining with valuable inputs.

I would like to sincerely thank Mr. S Senthilraja , Human Resource Manager, forproviding me with all the facilities and helping me in getting useful informationregarding the working of stock broking industry.

I express my deepest and most sincere thanks to Prof. A Venkata Subramanian , myfaculty guide, who acted as a continuous source of motivation and encouragement. Iam thankful for all the guidance provided by him in completing the projectsuccessfully.

Its been very kind of all the employees of the Company for having helped me withthe project and in the process of learning.

Vinu Baby

Summer trainee

Place : Chennai

Date : 20 th May 2008


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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 tr ading

Other Major Studies

Challenges facing the market

Global trends in future markets and the road ahead for India

Findings

Suggestions

Reference


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Objective

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.

Scope

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.


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Methodology

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.


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Limitations

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.


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Introduction about commodity trading

Ever since the dawn of civilization, commodities trading has become an integral 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 commodityrefers 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 implementingstringent 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.


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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 mankinds 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.


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Leading Commodity Exchanges

Most of the worlds largest commodity exchanges a re located in and around UnitedStates of America. New York Mercantile Exchange (NYMEX) is the worlds largest

physical commodity futures exchange. It was founded in the year 1882 and handlesbillions of dollars worth energy products, metals and other commodities being boughtand sold on the trading floor and overnight electronic trading computer systems.Trading is conducted in the NYMEX in two divisions the NYMEX division, whichtrades energy, platinum and palladium, and the COMEX division, which trades rest of the metals.

Another major commodity exchange is Chicago Mercantile Exchange (CME), whichtrades commodities as well as financial products. New York Board of Trade (NYBOT) is a wholly owned subsidiary of Intercontinental Exchange (ICE). It is aphysical commodity futures exchange located in New York City. It deals mainly withagricultural products.

A very famous commodity exchange outside United States which deals mainly withmetals is London Metal Exchange (LME). It is the worlds largest market in Optionsand 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 DerivativesExchange Limited (NCDEX) and Multi Commodity Exchange of India Limited (MCX), both incorporated in the year of 2003. Apart from these, there are around 21regional commodity exchanges in India. In total, there are 23 commodity Exchangesin India.


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Evolution and History of the Commodity Markets in India

Commodity futures markets l argely remain underdeveloped in India. This is in spite of the countrys 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 theagricultural sector in the post-independence era. In reality, the production anddistribution of several agricultural commodities is still governed by the state andforwards as well as futures trading have only been selectively introduced withstringent regulatory controls. Free trade in many commodity items remains restrictedunder the Essential Commodities Act (ECA), 1955, and forwards as well as futurecontracts 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 thesetting up of the Bombay Cotton Trade Association Ltd. Following widespreaddiscontent among leading cotton mill owners and merchants over the functioning of the Bombay Cotton Trade Association, a separate association, Bombay CottonExchange Ltd., was constituted in 1983. Futures trading in oilseeds originated with thesetting up of the Gujarati Vyapari Mandali in 1900, which carried out futures tradingin ground nuts, castor seeds and cotton. The Calcutta Hessian Exchange Ltd. and theEast 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 theauspices of East India Cotton Association (EICA). Before the Second World Warbroke 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 andCalcutta. 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 andFuture Markets under the union list. As a result, the regulation and development of the commodities futures markets were defined solely as the responsibility of thecentral government. A bill on forward contracts was referred to an expert committeeheaded by Prof. A.D. Shroff and selected committees of two successive parliamentsand finally, in December 1952, the Forward Contracts (Regulation) Act was enacted.The Forward Contracts (Regulation) rules were notified by the central government in1954. The futures trade in spices was first organised by the India Pepper and Spices

Trade Association (IPSTA) in Cochin in 1957. However, in order to monitor the pricemovements of several agricultural and essential commodities, futures trade was


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completely banned by the government in 1966. Subsequent to the ban of futures trade,many traders resorted to unofficial and in formal trade in futures. However, in Indiasliberalization epoch as per the June 1980 Khusro committees recommendations, thegovernment reintroduced futures on selected commodities, including cotton, jute,

potatoes, etc.

Following the introduction of economic reforms in 1991, the Government of Indiaappointed 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 expandingits coverage to agricultural commodities, along with silver. In order to boost theagricultural sector, the National Agricultural Policy 2000 envisaged external anddomestic market reforms and dismantling of all controls and regulations in theagricultural commodity markets. It also proposed an expansion of the coverage of futures markets to minimize the wide fluctuations in commodity prices and forhedging the risk arising from extreme price volatilities.


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At present, there are 23 exchanges operating in India and carrying out futures tradingactivities in as many as 146 commodity items. As per the recommendation of theFMC, 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-commodityexchanges. MCX commenced trading in November 2003 and NMCE in November2002 and NCDEX in December 2003.

As compared to 59 commodities in January 2005, 94 commodities were traded inDecember 2006 in the commodity futures market. These commodities included majoragricultural commodities such as rice, wheat, jute, cotton, coffee, major pulses (suchas 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, naturalgas 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) andchana (10 percent). A temporary ban was imposed on futures trading in urad and turdal in January 2007 to ensure orderly market conditions. An efficient and well-organised commodities futures market is generally acknowledged to be helpful inprice discovery for traded commodities. The turnover and volume of commodityfutures compared to international indices are explained in the following tables and

figures:

Turnover of Indian Commodity exchanges

Exchanges 2004 05 2005 06 2006 07 2007 08

Multi Commodity Exchange (MCX) 165,147 961,633 1,621,803 2,505,206NCDEX 266,338 1,066,686 944,066 733,479

NMCE (Ahmedabad) 13,988 18,385 101,731 24,072

NBOT (Indore) 58,463 53,683 57,149 74,582

Others 67,823 54,735 14,591 37,997All Exchanges 571,759 2,155,122 2,739,340 3,375,336


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Benefits of Commodity Trading

Apart from regulating the commodity markets, the growth of the market will providethe producers and traders the opportunity to benefit from price discovery and price

risk management. At a macroeconomic level, these markets can make the economicactivity more vibrant and facilitates the integration of producers and traders on aninternational level. For a producer, the availability of commodity futures helps inestimating the future price of the particular price of the particular commodity and cantherefore decide between the competing commodities to choose from. At the sametime, it will also provide an indication to the national government regarding the likelycrop structure of the country and thereby assess the impact of changing croppreferences among the producers.

From the insiders point of view, futures trading enables them to have an advanceindication of the likely price. This will form the basis for them to quote realistically inthe international market. At the same time, they can hedge against the price risk byoperating in the futures market. The futures market also benefits the farmers who arestrong participants of spot market. Because some people are trading in the commodityfutures market, they influence to a greater extent the movement of prices. Anypositive change in the price of the particular commodity will equally benefit the spottrader.

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 inthe futures markets is regulated through regulatory measures such as preventing thetraders from over trading, imposing price limits to prevent abnormal pricefluctuations, and imposing financial restraints etc.


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(called a seat) on the exchange. Thus, the general public buys or sells futures contractsthrough a broker who has access to a seat on the exchange.

Although the procedures involved in actually trading futures contracts may appearcomplex, knowledge of only a few basic marketing concepts is needed to understandthe idea of hedging. Through the broker, it is possible to sell a futures contract (take ashort 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 soldin cash markets. It is important to keep in mind that the futures contract is a formalagreement, and you can agree to sell something in a future time period even when youdont have something to sell now. If prices decline between the time you sell and buythe futures contract, you then buy the contract at a price below your sale price. Youreceive the gain associated with this sell high - buy low transaction. If you initiallysell a futures contract (a short position) and the price increases, you must buy at thehigher price . You suffer the loss associated with this sell l ow - 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 pricechanges 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 incura loss on the buy high - sell low transaction. If you take a long position and priceincreases, you gain from the buy low sell high transaction. Buying or sellingfutures contracts requires the service of a broker with access to the exchange wherefutures contracts are traded. Your broker conducts trades on your behalf per yourinstructions. You pay a fee to the broker (a commission) for executing an order to buyor sell a futures contract. Like payment for any service, commissions vary by broker.Commissions are normally quoted for entering and closing a futures position (called around turn).

Since all traders with a futures position can potentially suffer losses, all traders mustput up a deposit (a margin ) to ensure all losses will be paid. A margin is the moneydeposited by both the buyer and seller to guarantee performance under the terms of thefutures contract. Minimum margins are established by each commodity exchange, butindividual brokers may have higher margin requirements. This initial margin istypically a small portion of the total value of the contract, and may not cover a traderstotal loss over time. Therefore, a margin call is a request for additional money thefutures trader must deposit if adverse price moves significantly devalue the initialmargin 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),


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the broker asks for more money. That is, you receive a margin call from your brokerand 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 othermarket, price changes in the two markets must be related. This price relationshipbetween the cash and futures market is measured by a concept called basis . Basis isthe difference between the price at cash market and the futures price (that is, cashprice 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 beoffset by favorable price moves in the futures market. If the two markets arent relatedin some way, hedging doesnt work. Thus, measuring and understanding basis is thekey 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 pricedeclines relative to the futures price. A strengthening basis occurs when the cash priceincreases relative to the futures price.


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Options

A commodity option is a two-party agreement that gives the buyer (or holder) theright, 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 underlyingfutures contract). The futures position will be provided at a specified price (called thestrike price or exercise price), and the right exists until a pre-established date (calledthe expiration date). Although expiration dates vary, most options on grain futuresexpire during the last week of the month before the contract month of the underlyingfutures contract.

An option is purchased from an option seller (called the writer or grantor). The writerof 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 goingmarket price (called the premium ). If cash grain prices move unfavorably, you mayuse the option to obtain the protection associated with a futures position. The optionseller is obligated to provide you with the futures position at the strike price. However,you dont want the protection associated with a futures position if cash grain pricesmove favorably. As the holder of the option, you are not obligated to take a futuresposition. Thus, options are similar to purchasing insurance. You pay the premium, butyou may or may not need the protection of the underlying futures position.

Two types of options are available for each underlying futures contract. The purchaseof 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 t he right to a long futures position at thestrike price. In this case, the seller of the call option must provide you as the holderwith the specified long futures position.

Purchasing a put option (the right to sell a futures position) protects you as the holderof 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 youcan 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 holderof the call against rising prices. If prices rise, you have the right to a long futuresposition at the lower strike price. A long futures position at a low price means you canoffset with a sell at the current higher market price and receive the gain. A call optioncan also be used as a fairly low risk strategy to participate in market price gains afteryour physical commodity has been sold.


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Basic Terminology

There are technical terms used in Option contracts. The common words used in anOption 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 forany given option, put or call. There are several options with different strike pricestraded during any period of time. As a general rule, the more volatile the price is forthe underlying commodity, the greater the number of options at different strike pricesthat will be available for trade. If the price of the underlying commodity changes overtime, then additional strike prices may be traded.

Underlying Commodity

The underlying commodity for the commodity option is not the commodity itself, butrather a futures contract for that commodity. For example, a June chilli option willactually be an option for a June delivery chilli futures contract. In this sense, theoptions 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 optionmay also be either a speculator or one who desires partial price protection. Whetherone chooses to buy (hold) or sell (write) an option depends primarily upon his/herobjectives. The market will contain many insurers and price speculators, eachproviding a service to the other.

Expiration

Options on agricultural commodities have futures contracts as the underlyingcommodity. Futures contracts have a definite predetermined maturity date during thedelivery 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 chillifutures contract at Rs.5,100. The option can be exercised by the holder on anybusiness day until mid-May at which time the option expires. Trading in most optionswill not be conducted during the futures contract delivery month. Upon expiration ,the Option becomes worthless.


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For example , in March the time premium on a Rs.5,100 May chilli option will be lessthan the premium on a Rs.5,100 August option, because the option with a longer timeto expiration has a greater probability of moving in-the-money than the option withless 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 infutures prices and change the value of the option. As a result, the option writerdemands 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-the-money" 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 isdone to avoid losing any remaining time value and the resultant decisions, margindeposits and commissions from assuming a futures market position. The option couldbe resold to another trader at a premium at least equivalent to the intrinsic value thatresults from an "in-the-money" price relationship. Since the option markets providethe opportunity to secure price insurance, they can be expected to operate in a mannerthat 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 strikeprice June chilli put option for a premium of Rs.50 while the current market value wasRs.5,200. During the life of the option, the current market price falls to Rs.4,800 andthe put option has moved into-the-money with a current premium of Rs.330 per 100kg (Rs.300 intrinsic value and Rs.30 time value). The original option buyer could sellthe option through a broker to another trader. Using the above numbers, the traderwould 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 byexercising 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, theholder 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 thesame price. Then both positions are adjusted to reflect the current futures settlementprice. It is rational to exercise a put option only when the market price is below thestrike price so the holder's futures position will show a profit. The futures position of


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the grantor will show an equivalent loss. At this point, the option contract has beenfulfilled 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 havea short (sell) futures position at a price of Rs.5,100. Using the above numbers, ourtrader 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, thetrader may be required to post additional margin money with the broker formaintenance of the futures position. Furthermore, he would incur an additionalbrokerage commission for liquidation of his futures contract. With a liquid optionsmarket, it appears that an offsetting trade within the options market is more

advantageous than exercising.READING OPTION QUOTES

SOYA BEAN OPTION QUOTESFriday May 19, 2007

SOYA BEANS (CBOT) 5,000 bu.; cents per bu.

Strike Price Calls-Settle Puts-Settle

Sep-c Nov-c Jan-c Sep-p Nov-p Jan-p

6.25 -- -- -- -- 14 --

6.50 -- 56 -- 16 22 --

6.75 44 43 42 27 34 34

7.00 34 34 33 39 49 48

7.25 25 26 25 55 65 63

7.50 18 20 20 74 83 ---

Futures Settlement Prices:

Sept-$6.93 Nov-$6.85 Jan-$6.94

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 contractscould be traded. The futures settlement price for each of these contracts is listed belowthe 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 separateoption contracts that are tradeable. Here six different strike prices are shown for bothcalls and puts. The example prices show a total of 36 option contracts; 18 call options

and 18 put options.


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The prices listed under the columns headed Call-Settle and Put-Settle are premiumsthat were determined through trading that day at the exchange. No trading occurred incontracts indicated by the dashed lines. Price differentials of one-fourth of a cent areused. 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 Novemberfutures 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 remainingin the option.

The November $6.75 put is "out-of-the-money." That is, it has no intrinsic value andthe prudent person would not exercise R at the given futures market price. Eventhough it has no intrinsic value; there is still a time value associated with it asindicated by its $.34 premium. There are about five months before expiration in whichmarket prices could fall below the $6.75 strike price and thus make it an "in-the-money option. The premium quoted reflects that time value.


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Evaluating Option Prices.

For selecting the best suitable Option, the Option prices are to be evaluated. Whileevaluating 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 theselection of the appropriate option contract month . To do this, select the optionwhich will expire closest to but not before the time the physical commodity will besold or purchased. For example , if soya beans will be harvested and sold inNovember, the January option would be appropriate. The November option wouldgenerally not be chosen since trading on it will have ceased prior to the actual harvestand sale.

The second step is to select the appropriate type of option . If the producer wishes toinsure products against price declines, then he or she would be interested in buying aput (the right to sell). If the producer s motive is to insure future commoditypurchases against price increases, then the purchase of a call (the right to buy) will beneeded. To continue the above example , if a soya bean producer wishes to insure thebeans he will be selling in November, then he will be interested in purchasing the rightto sell a January (put) option.

The third step to consider in evaluating option prices is to calculate the minimumcash selling price (MSP) being offered by the put option selected . Or, for a calloption, the maximum purchase price (MPP) would need to be calculated. Thesecalculations can be accomplished in five steps and will be illustrated using thepreceding sample quotes.

JANUARY SOYA BEAN PUT OPTION PREMIUMSJANUARY FUTURES SETTLEMENT $6.94

Strike prices Puts Settlement

$6.75 34

$7.00 48

$7.25 63


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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 thepremium 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 usedand the interest rate is twelve percent, (for example), then the cost would be onepercent 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. Thisleaves 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 andoffsetting the option. Assume the brokerage firm charges $100.00 per round turn forhandling each option contract. The per bushel commission fee would be $0.02 ($100for 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 belocalized to reflect the difference between prices at the major commodity markets andthe local cash market. To localize the price, we must subtract the expected harvesttime basis . Basis is the difference between the local price and futures market deliverypoint price at delivery time. This basis reflects the price differences between the largenational and local markets. By adjusting the option price for basis, a minimum sellingprice 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 localcash 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 Premiums Interest Commission Basis Minimum Selling Pr ice

--------------------------------Dollars Per Bushel--------------------------------

$6.75 -.34 -.02 -.02 -.30 $6.07

$7.00 -.48 -.03 -.02 -.30 $6.17

$7.25 -.63 -.04 -.02 -.30 $6.255


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Using options to insure against falling prices

Consider a put purchase for price insurance in soya beans. Assume that a farmerplants 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 theproduction season is not knowing the price he will get for his beans at harvest. Farmerwishes 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 sell10,000 bushels of January soya bean futures) at a strike price of $7.00 per bushel. As aresult, Farmer has established a minimum cash price for his soya beans of $7.00 perbushel minus the premium, less the normal local basis while retaining upside pricepotential.

Example 1 shows the result if prices increase during the production period. Example 2shows the result of prices decrease. In each case, the cost of price insurance - thepremium and other costs - was $0.53 cents per bushel and the actual differencebetween his local cash price and the national market prices (basis) was -$.30 as heanticipated.

Example 1 - Put Option When Prices Rise

Date Cash Market Soya bean Option Market May 15 Expects to produce 10,000 bushels

soya beans for November harvest.Expect minimum sale price of $6.17

Buy 2 January soya bean put options at a$7.00 per bushel strike price, premium paidis $0.48 per bushel. Commission and interestare $0.05. Expected basis = $0.30

Nov. 15 Harvest and sell 10,000 bushelssoya beans at $7.80 a bushel.

January soya bean futures trading at $8.10.Let Jan. soya bean option expire.

Results Cash price + gain or loss in optionsmarket = actual price received forbeans = $7.80 - .53 = $7.28

Offset premium received - original premiumpaid plus costs = 0 - .53 = $-.53

In Example 1, as futures and cash prices rise, the options end up out-of-the-money andare allowed to expire. But despite the premium and other cost of $0.53 per bushel, therise in cash prices resulted in a realized price of $7.28 per bushel. The net price wouldhave 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 effectiveover time in assuring a more stable income and avoiding disastrous losses resulting

from dramatic price level changes.


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Example 2 - Put Option When Prices Fall

Date Cash Market Soya bean Option Market

May Expect to produce 10,000

bushels soya beans forNovember harvest. Expectminimum sale price of $6.17.

Buy 2 January soya bean put options at a $7.00 per

bushel strike price, premium paid is $0.48 perbushel. Commission and interest cost are $0.05.Expected basis = -$0.30.

Nov. 15 Harvest and sell 10,000 bushelssoya beans at $5.30 per bushel.

Sell 2 January soya bean put options at a $7.00perbushel strike price and receive a premium paymentof $1.44 bushel.***

Results Cash price + gain or loss inoptions market = Actual pricereceived 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 theput option an intrinsic value of $1.40 per bushel. It is further assumed that the put hada 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 strikeprice of $7.00 per bushel was iii-the-money in November. The put was offset byselling two January soya bean put options for a premium of $1.44 per bushel. Theoffset resulted in a $.91 per bushel gain ($1.44 premium resale -$O.53 originalpremium and costs paid) which, when added to the cash price of $5.30, gave Farmer arealized price of $6.21 per bushel. The net price received is $.04/bu. greater than theexpected minimum sale price established in May due to the additional $.04/bu. timevalue received from the offset. Had the put not been bought, the realized cash pricewould have been $5.30 per bushel.


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Only the $2.90 strike price will allow the shopkeeper to lock in a maximum buyingprice for his corn needs that meets his objective. He buys one $2.90 March corn calloption and forwards a check for $1,400. ($1,400. = 5,000 bushels x $0.26 + $100.00brokerage 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 stillbuy corn for less if corn prices fall. The following illustrations show the resultsobtained if prices rise and if they fall.

Example 1 - Call Option When Prices Rise

Date Cash Corn Market Options Market

January 5 Will need 5,000 bushels corn onFebruary 25.Expected maximum purchaseprice of $3.385

Buy one $2.90 March corn call options for$0.26 premium and $0.025 cost.Expected basis = +$0.20.

Feb. 25 Purchase 5,000 bushels of cornlocally for $3.80 per bushel.

March corn futures $3.60.Sell one $2.90 March corn call options for$0.70.

Results Cash price paid - options gain or+ options loss = net price paid.= $3.80 = 0.415 = $3.385 perbushel.

Gain or loss = offset premium received -original premium paid plus cost = $0.70 -0.285 = + $0.415.

Example 2 - Call Option When Prices Fall

Date Cash Corn Market Options Market

January 5 Will need 5,000 bushels corn onFeb. 25. Expect maximum purchaseprice of $3.385.

Buy one $2.90 March corn call option for$0.26 premium and $0.025 cost. Expectedbasis = + $0.20.

Feb. 25 Cash corn price $2.60 March corn futures $2.40. $2.90 March corncall option is out-of-the-money and expiresworthless.

Results Cash price paid - options gain or +option loss = net price pa id.

=$2.60 + 0.285 = $2.885 per bushel

Gain or loss = offset premium received -original premium paid plus cost = 0 - $0.285= -$0.285.


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Options A better investment arena

While futures offer price protection by allowing the holder of a futures contract tolock 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 marketmoves. Because the buyer of an options contract has the options contract but not theobligation 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, themaximum 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 unlimitedprofit potential to the buyer of an options contract is parallel to a futures position, netof 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 participatein favorable market moves.

Futures Vs Options

Futures Options

Risk Unlimited risk on long andshort positions

Defined and limited onpurchases of puts and calls;unlimited on sale

Price Protection Establishes fixed price Establishes floor or ceilingprice protection

Margin Required on long or shortpositions

Futures style margins forsellers, margin contained inthe cost of premium forbuyers

Hedging Long, short, spread Multiple hedging strategies

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 resultingfrom locking in a price and forfeiting the benefits of favorable market moves.

So, as far as farmers and manufacturers are considered, Options are more beneficialthan futures.


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Introduction of Options in India

Trading in commodity options contracts has been banned since 1952. The market forcommodity 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 againstdownside movements, it does not allow him to reap the benefits of an increase inprices.

So, using a future contract, a farmer can only hedge against price falls. If the pricesare 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 acommodity 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 willnot be able to reap gains by taking advantage of the situation as it is necessary toperform the contract. Options help the participant in such conditions. It does not createan obligation.

But the introduction of Options is still in papers only. Recently, Government delistedfour commodities from being traded in exchanges. As there are still controversies thatfutures trading fuels inflation in the country, it will not be very easy for theGovernment to introduce Commodity Options. For commodity derivatives to work efficiently, it is necessary to have a sophisticated, cost-effective, reliable andconvenient warehousing system in the country. So, the Government has to ensure thatbefore introducing more complex derivative instruments.

No doubt, there is an immediate need to bring about the necessary legal and regulatorychanges to introduce commodity options in the country. The matter is said to be underthe active consideration of the Government and the options trading may be introducedin the near future.


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Impact of various studies and researches

There are a lot of studies and research works carried out in the area of CommodityFutures 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 reportspublished by various scholars. The major committee which studied the CommodityFutures market in India recently is Abhijit Sen Committee. The Committee submitteda report on 29 th April 2008. This report is supposed to be an important one which mayinfluence 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 whichwas done by IIM Bangalore, to find out the impact of f utures 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 foundthat there is an unidirectional relationship between the volume of futures traded andthe spot price volatility.

A very recent study on Commodity Derivative Market and its Impact on spot marketwas conducted by GC Nath and Thulasamma Lingareddy, which was published earlythis year. This study compares the prices of underlying commodities in pre-futuresperiod with that of post-futures period.

As these studies are considered to be important with regard to this research, thesereports are studied analyzed and the major findings are included here.


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support for the claim that opening up of futures markets spurred inflation. Also,significantly, all sensitive commodities (i.e. food grains and sugar) recorded someacceleration in inflation after the start of futures trading.

However, a revealing feature of this data is that of the 14 commodities in whichacceleration took place in post-futures period, 10 had suffered negative inflationduring the pre-futures period. It is possible in such cases that the acceleration ingrowth rate of WPI in these commodities is simply rebound and catch-up with thetrend, 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 hadunusually high pre-futures inflation at over 10%. In these cases, too, it is possible thatwhat is being observed is simply reversion to a more normal level of inflation. In bothcases, there is the problem that the period during which futures markets have been inoperation is much too short to discriminate adequately between the effect of openingup futures markets and what might simply be normal cyclical adjustments.

An analysis was also carried out at macro rather than specific commodity level taki ngAugust 2004 as the cut-off point to divide pre-futures and post-futures periods. This isthe middle month of the second quarter (July-Sept) of 2004-05 when, takingacceleration in total futures trading volume as the barometer, such trading picked upreasonably. After taking equal observations for both pre and post futures period, trend

growth rates for both periods were calculated. This was done for(i) The weighted average WPI of the 21 selected commodities that have

significant futures trading(ii) All primary agricultural goods (i.e. Food and Non-Food Articles in the

WPI Primary Articles Group) and(iii) The weighted composite index of the 87 processed and unprocessed

agricultural commodities. It was observed that not only did inflationaccelerate 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 afterintroduction of futures trading and appear to have benefited traders more than farmers,it does not necessarily follow that introduction of futures trading was the causativefactor. The price discovery expected from futures trading should ideally lead to betterutilization of available information regarding how supply and demand conditions arelikely to evolve; and arbitrage, through speculation and hedging, should ideally affectspot prices only to the extent of bringing these in line with evolving fundamentals andthe cost of holding physical stocks.


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Steps to minimize the potential risks of Derivatives trading

1. Pace and sequence o f 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 longhistory of ban in forward trading when the perception about these markets was notgood. That perception has not gone away totally. Even today people express theirdoubts about the need and efficacy of these markets. Therefore, it becomes all themore important that these markets are set up on a strong foundation. There shouldnot occur any mishap or mischief which may discredit the market as a whole. TheGovernment/Regulator/Exchanges should be able to explain that the markets arebeneficial to all groups and if there are any transitional costs, these are theminimum and will be more than compensated with the overall benefit to theeconomy and the stakeholders.Before taking any steps to lift the ban on the four delisted commodities, thegovernment should take necessary steps. A cautious approach is to be adopted forrevival of futures trade in these commodities rather than have to confront a stop gosituation again in the future.

2. Regulatory frameworkIn order to defend the market against criticism, it is essential to minimize thepotential adverse impact of futures trading on prices of agricultural products. Thisrequires properly functioning and regulated markets. There is a need for a clearand unambiguous regulatory framework. The broad parameters of the functioningof the markets have to be clearly laid down. The regulatory authority sho uld havethe capacity and the power to discipline the market. Once these pre-requisite are inplace they will not only help in controlling aberrations in the market but also helpthe government and the regulator to explain to various stakeholders at large anyabnormal behavior in the market that might occur as a result of some basicfundamental 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 upunder this act.

3. Derivatives Markets to be Anchored to Physical Spot-MarketsThe derivative market has to be anchored to physical cash market. The physicalspot 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. Futuresmarkets can act as a catalyst of change for spot markets and nothing more.

Whenever futures markets try to grow faster than the under-developed physicalmarkets of underlying commodities, the mismatch between the two gets widened,


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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 geographicalregions 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 toexpedite this, a substantial part of the transaction tax which is now being imposedon futures markets should be earmarked for development of the required physicalmarket infrastructure.

4. Speculation an Integral part of Efficient Futures Market

The commodities with a history of high price volatility are prone to excessivespeculative interests which open up futures market to the charge of distortingprices 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 withsuspicion. It must be remembered that if only the farmers and consumers were tooperate on the agricultural commodity markets, there is likely to be mismatch intheir respective marketing strategies and therefore, they would not be able totransact business at any given point of time since the total volume of businesswould be very thin. The market would, therefore, become illiquid. Hence,speculators step into to provide the transaction matching through risk transfer andconsequential liquidity. In a free market with availability of technology forinstantaneous flow of information speculative funds cannot bring secular price riseas supply responses (through inventory unloading, imports and production) arefast. It is opacity or non-availability of efficient markets, like futures markets thatgives power to the manipulator-speculator. On the other hand, an efficient andtransparent market with sufficient depth of participation will encourageresponsible and informed speculation.

5. Consultative Mechanism for Development of the marketThe exchanges as well as FMC should have a strong back up of domain knowledgeof commodities which are traded on the exchange platforms. The knowledge of fundamental economic characteristics of production, marketing and use of thecommodity so as to understand the factors influencing their prices is of utmostimportance. Once a proper contract design of a product is in place, the surveillanceof 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.


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Other Major Studies

A number of studies and researches were made on the Commodity Futures market andits 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 hasinfluenced Commodity prices or not. It further went up when the government plannedto ban futures trading on a few commodities. Since the introduction of Futures, theprices of underlying commodities were shooting up. The findings of a few importantstudies are analyzed to know the influence of Futures trading on Commodity Prices.

Impact of Futures Trading in Commodities A Study by IIMBangalore

FMC had commissioned a study by the Indian Institute of Management, Bangalore(IIMB) to study the impact of Futures Trading in some important agriculturalcommodities. Only those commodities in which future trading had attained reasonablevolume 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 higherprice 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 bygovernment 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 offeredfor the next year. In case of guar grown mainly in the arid regions of Rajasthan, anormal monsoon gives a production that would meet the demand of guar seed for twoto three years. The price increase in the year 2005-06 followed low carry-over stocksand increased export demand. In case of wheat, the high increase in prices after 2005followed low production and low stock availability with the government. Tur showeda sharp increase in prices during 2006 following low stocks and production. Urad alsoshowed continuous production decline 2004 onwards and a rise in the prices. Changesin fundamentals (mainly from the supply side) were thus found important in causingthe higher post-futures price rise, with government policies also contributing, and therole 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 involatility for gram, excepting an abnormal rise in FY 2006-07, or for tur and sugar. Incase 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


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price volatility (especially for wheat but also of gram) was associated with an increasein seasonality of prices so that farmers gained less than traders; and (ii) a tendency forretail margins to increase so that volatility increase was even more for retail pricesthan 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 IndianCommodity Exchanges do not satisfy a fairly minimal condition for these to beattractive for hedging by those holding physical commodities. A generally acceptedmeasure 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, andbasis 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), andbecomes more attractive the lower the basis risk. The IIMB study found that not onlywas basis risk high for commodities studied, this was higher than price risk for manycontracts.

Despite these rather negative results on functioning of futures markets, the IIMB studydoes highlight one very significant positive development following the recent growthof modern Exchanges. It notes that the growth of these Exchanges appears to havehelped in integrating geographically separated markets.

Influence of Commodity Derivatives on Volatility of Underlying Astudy by Sahi, Gurpreet S.

In another study, covering wheat, sugar, turmeric , raw cotton, raw jute and soya beanoil, Sahi found that while the nature of spot price variability may not have changedsignificantly with onset of futures trading, certain findings were consistent with

destabilizing effect of futures trading on agricultural commodity markets. Forexample, unexpected increases in futures trading volumes were found to have asignificant unidirectional causal effect increasing spot price volatility in all thesecommodities except raw cotton. Similarly, a causal effect was found from unexpectedincrease in open interest to increased spot price volatility for all these commoditiesexcept raw cotton and sugar.


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Commodity Derivative Market and its Impact on Spot Market Astudy 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 2004to January 2007 as compared to either the pre-futures period January 2001 toSeptember 2004 or during February 2007 to October 2007 when futures trading insome of these commodities was suspended. They also report tests of causality thatshow that the volume of futures trading had positive and significant causal impact onboth 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 wasambiguity in case of wheat, probably because of fall in supply.

Another interesting finding of the study was that there is a lead-lag relationshipbetween futures trading and spot price volatility. It suggests that speculative activity infutures market can destabilize spot prices and therefore warns against aggressiveattempts to expand futures trading, especially if driven not by those who manage pricerisks in physical trade by hedging in futures markets but by speculators or others

based on exaggerated claims regarding futures markets efficacy.


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Challenges facing the market

Commodity exchanges in Indian are still at a nascent stage, and there are numerousbottlenecks 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 theycan paralyze the agricultural futures markets, much against the objective of agricultural liberalization. The main problem is that the commodity markets are underthe control of Government.

Towards the growth of any market, the trading conditions or the terms and conditionsof 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 contractspecifications, 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 leveland the exchange level, attracting small traders and farmers into commodity futurestrading becomes impossible. Especially in a country like India, where corporatefarming is absent and predominant section of the farmers own small agricultural lands,meeting the specifications of the contract becomes difficult. Such farmers prefer spotmarkets rather than commodity markets for trading. Even the small traders refrainfrom 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 ininfrastructure exception to a few large exchanges like National CommodityDerivatives Exchange (NCDEX) and Multi Commodity Exchange (MCX).Infrastructure requirements like warehousing facilities, clearing house and moderntrading ring are absent in majority of the exchanges. As a result, majority of theexchanges have to depend on a few commodities and consequently, the turnover islow.

Warehousing facilities is one major impediment to the growth of commodity markets

in India. Though Government organization, Food Corporation of India, plays a vitalrole in storage of commodities, the infrastructure does not support future tradingadequately. For the commodity futures to work effectively, the seller must deposit thedeposit the commodity traded in a warehouse and the buyer should take physicaldelivery of the commodity in a warehouse at a location of his choice. However, atpresent, only a few warehouses can handle such kind of delivery requests and that toofor specific commodities. Because of lack of adequate warehousing facilities that canensure the quality standards of the commodities traded, traders and farmers still prefer

local rural markets for trading the commodities. This factor is hindering theemergence of nation-wide commodity market in India.


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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 geographicalspreading of the exchanges is important for the development of nation-wide

commodity market, there is no real integration among the existing exchanges. Andmost of these exchanges except NCDEX and MCX still practice outcry system of trading, it is cumbersome to trade i n these specialized exchanges.

As a result of these small exchanges spreading across the nation and specializing inselect few commodities, the turnover, volume of trade and the revenues of exchangesare all low. It is very difficult for the exchanges to sustain the momentum and providevalue added services to the market functionaries with such low revenues. In order toovercome the problem of multiple commodity exchanges, many economists have

suggested the integration of the exchanges and consolidation and then in the laterstage opt for demutualization of exchanges similar to the Chicago MercantileExchange and International Petroleum Exchange. The integration of exchanges andclearing 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 thetrading and traders because of their technology and national-wide trading terminals.As a result, those exchanges have s ucceeded to gain the required financial strength.


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Global trends in derivatives markets and the road ahead for India

As the derivatives market emerge and bloom in India, financial markets all over theworld are being rapidly transformed by the Internet revolution. Participation level of

individuals, organization of trading, speed of price discovery are all undergoing majorchanges and Indian markets have to rapidly adjust themselves to these changes.

As the two national level commodity exchanges gain momentum, an importantquestion 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 convergeto 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 morenational-level exchanges. There is therefore a distinct possibility of integration in

terms of exchanges. There are however, issues about standards that need to be tackledbefore the commodity futures markets become more integrated.

Till the integration happens, we should expect to see important changes in the existingregional exchanges. Faced with competition from nation-wide exchanges, they wouldhave to improve their technology, transparency and methods of operation in the shortrun if they are serious about staying in business. Also with the continued acceptanceand popularity of institutionalized commodity futures trading, probably the bulk of informal futures trading will slowly be absorbed in the regulated, through-exchangetrading as the price and liquidity benefits outweigh the added transaction costs. Thatwould, indeed, be a positive development for all concerned.

Perhaps the biggest event in financial markets around the world not justcommodities or futures markets but securities markets as well in recent years hasbeen the emergence of Electronic Communication Networks (ECNs). In Indianexchanges, the outcry system has already been replaced by the ECN system.

An already observable shift is occurring in the ownership structure and corporategovernance of exchanges. Commodity exchanges, like their equity counterparts usedto be owned and run by associations of brokers. This raised several transparency andgovernance issues for exchanges and increased the possibility of price manipulationsand unethical practices that Indian markets are so notorious for. Improved corporategovernance is essential for the development of commodity futures trading in India andperhaps the first and most important step in that direction is to separate the ownershipand management of exchanges from the participating brokers. In other words, theself-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.


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As the Indian economy and financial markets become increasingly integrated with theglobal markets, its effects are likely to become visible in the commodities futuresmarkets as well. With the increasing role of multi-national corporations in theagricultural and food processing as well as international trade, the connection between

commodity prices in India and world prices are becoming increasingly linked. Thereis also an increasing need for participating clients to hedge and speculate on Indiancommodity 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 andfutures prices will be even more connected with world prices and possibly tradingitself 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 formpartnerships 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. Acategory of futures that have are extremely popular in developed countries willperhaps make their appearance in India too. These are the weather derivatives, whichare 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 rainfallrelated risks that are concomitant with Indian agriculture.

In about a decades time, commodity futures in I ndia have come a long way from thedomain of barely legal bets to trading on multi-commodity national level exchangeswith sophisticated products, technology and contract specifications. Its rise offersparticipants 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 amidstthe users of futures markets, hopefully that will change soon as the futures rise inpopularity and stature. Then they would truly make a difference where it matters most.


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Findings

Futures trading in commodities has a long tradition in India going back to1875 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 accusedof fuelling inflation and were perceived not to have any role as the Stateintervened directly in prices and distribution of large number of essentialcommodities which were short in supply. The market survived in the situationas very few commodities were permitted for futures trading.

Adoption of liberal economic policies since 1991 gave fillip to efforts to openup futures trading, which culminated into total withdrawal of prohibition in2003. Since then, Futures trading is undergoing fast c hanges.

There has been a fall in agri-commodity volumes during 2007-08 over theprevious year. This place was taken over by bullion and other metals. Negativesentiments have been created by the decision to de-list futures trade in someimportant agricultural commodities.

Analysis of 21 agricultural commodities (accounting for about 98% of share intotal futures trade in agricultural commodities) shows that the annual trendgrowth rate of prices accelerated after introduction of futures trading in the caseof many more of these commodities than there were cases of deceleration. Inparticular, prices of all food grains accelerated in the post-futures period.

The fact that agricultural price inflation accelerated during the post futuresperiod does not, however, necessarily mean that this was caused by futurestrading.

A study of supply fundamentals (production, changes in inventory andinternational trade) show that changes in these also contributed to higherinflation 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 inprice discovery, provide price risk management and also bring aboutintegration of markets.

Although the volume of futures trading in India has increased phenomenally inrecent years, its ability to provide instruments of risk management has notgrown correspondingly.


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Suggestions 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 farahead of them.

Another enabler of the market will be to upgrade the quality of regulation bothby the FMC and by the Exchanges. An important element of this is to requireexchanges to act as self regulatory organizations, capable of demonstrating fairplay, objectivity and customer orientation.

FMC should frame regulations on various aspects of market operations fortransparent and efficient functioning of the market. The care should be taken toenable farmers and small operators to take benefit of these markets. Exchangesshould be directed to design their market procedures and contracts such as to

enable farmers an easy access to these market and protection against anymarket malpractices.

There should be a consultative group comprising persons with proven domainknowledge of commodity sector both in the FMC as well as in the exchanges.

The structure of markets, contract designs and other requirements of trading onthese markets should be simple and easy to enable farmers to participate inthese markets. The contract designs should be tailored to meet the needs of thephysical market.

The farmers should be given access to information. Moreover, they need to beempowered to use this information. Empowerment is a much more difficulttask 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 supportinfrastructure of warehousing and commodity finance is inadequate. Moreover,at the early stage of development of these markets, where liquidity in manycommodities is low and they are prone to high impact costs. The awareness andknowledge 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, thegovernment should take necessary steps. A cautious approach is to be adoptedfor revival of futures trade in these commodities rather than have to confront astop go situation again in the future.


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Options on commodities can be another hedge instru ment suitable forfarmers needs. However, complex Options products may be difficult to

comprehend and not suitable for farmers needs. In case of agri -commodities, itwill be suitable to allow only Simple Options for some time till market attainsmaturity of operations and regulations. It is also important that the farmersattain adequate understanding of t he markets and of techniques to use them.

Since the premium on options may be high, farmers costs of accessing thesemarkets should be minimized by waiving transaction charges/taxes or evenby granting subsidies out of tax collection/ transaction charge collection forgenuine hedge purposes by the farmers. The money from proposed CTT can beused for it.

Before introducing Options trading in the major food grains, an assessmentshould be made of the possibility of FCI acting as the writer of Call andPut options in these commodities. This could reduce the cost of operationsand stabilize market operations.


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References

Publications

The Options Course - George A Fontanills

Options Essential Concepts and Trading Strategies - McGraw Hill

How I Trade Options - John Najarian

Getting Started with Options, 5 th Edition - Michael C Thomsett

Commodities Market An introduction - ICFAI Publication

Magazines and Articles

Indian Journal of finance - April May, 2008

Understanding commodity derivatives - Larry D Makus

Treasury Management - ICFAI University Press

Business world

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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A Study on the Introduction of Options in Indian Commodity Exchanges

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