Opportunities for Physical Trading Vs Futures Trading

Gopal Naik

Professor, IIM Bangalore

Futures Trading

• An agreement priced and entered on an exchange to trade at a specified time in future a commodity of specified quality– Standardization of contract– Trading in exchange– Clearinghouse

Futures Forwards

• Organized Exchange• Standardized contract• More liquid• Low search cost

• OTC • Customised contract• Less liquid • High search cost

Futures Trading

• Conversion of cash price risk into basis risk

• Higher liquidity

• Low transaction cost

• Low default risk

Hedging

• Motivation for Hedging

• Types of Hedges– Merchant Hedging– Producer Hedging– Processor Hedging

Inter-temporal Cash & Futures Price Relationships (1)

Dec

Feb Apr Nov

…...

Pric

e

May

May Futures Price in Apr

July Futures Price in Apr

Jul …...

Cash Price 1

Inter-temporal Cash & Futures Price Relationships (2)

Dec

Feb Apr Nov

…...

Pric

e

May

May Futures Price in Apr

July Futures Price in Apr

Jul …...

Bas

is

Dec

Feb Apr Nov

…...

May Jul …...

Cash Price 1

Inter-temporal Cash & Futures Price Relationships (3)

Dec

Feb Apr Nov

…...

Pric

e

May

May Futures Price in Apr

July Futures Price in Apr

Jul …...

Bas

is

Dec

Feb Apr Nov

…...

May Jul …...

Cash Price 1

Cash Price 2

Mustard Feb 2006 Contract - NCDEX

305

310

315

320

325

330

335

340

345

350

355

2/1/

2006

6/1/

2006

11/1

/200

6

16/1

/200

6

20/1

/200

6

25/1

/200

6

31/1

/200

6

4/2/

2006

9/2/

2006

14/2

/200

6

18/2

/200

6

Cas

h /

Fu

ture

s (C

lose

)

Close Spot

-5

0

5

10

15

20

2/1/

2006

6/1/

2006

11/1

/200

6

16/1

/200

6

20/1

/200

6

25/1

/200

6

31/1

/200

6

4/2/

2006

9/2/

2006

14/2

/200

6

18/2

/200

6

Cas

h / F

utur

es (C

lose

)

Basis

Hedging Strategies

• Basis risk

• Strategies

Trade Value (Rs Million)

Ratio of Trade Value to

Commodity value

Commodity

2004 % of Total

Trade Value 2005

% of Total Trade Value

Commodity Market value

(Rs. Million) 2004 2005

Castor seed 14730 2.11 11948 0.33 9881 1.49 1.21

Gaur seed 352353 50.44 1249351 34.04 10505 33.54 118.93

Raw jute 5112 0.73 13867 0.38 28144 0.18 0.49

Soya oil 47029 6.73 286372 7.80 40850 1.15 7.01

Sugar M 3046 0.44 131986 3.60 299981 0.01 0.44

Sugar-S 229 0.03 1201 0.03 299981 0.00 0.00

Urad 15235 2.18 187644 5.11 27452 0.56 6.84

Rice 11086 0.30 773837 0.00 0.01

Cotton 52601 7.53 274093 7.47 196696 0.27 1.39

Palm oil 1427 0.04 1700 0.00 0.84

Chana 71818 10.28 273792 7.46 81478 0.88 3.36

Mustard seed 8613 1.23 86256 2.35 77761 0.11 1.11

Rubber 309 0.04 567 0.02 39076 0.01 0.012

Coffee 3170 0.09 23917 0.00 0.13

Soya bean 16590 2.38 361358 9.85 78098 0.21 4.63

Maize 84864 2.31 66839 0.00 1.27

Wheat 107119 15.34 456897 12.45 529150 0.20 0.86

Pepper 3713 0.53 27051 0.74 4287 0.87 6.31

Chilli 56455 1.54 17761 0.00 3.18

Jeera 151206 4.12 9967 0.00 15.17

Volume(LT) of Futures Trading

05

1015202530

Lakh

Ton

nes

Value (Rs Crores) of Futures Trading

0

5

10

15

20

Pepper Turmeric RedChillies

Jeera Cardamom

Rs

in C

rore

s

FT in relation to Production

0

5

10

15

20

Pepper Turmeric Red Chillies Jeera Cardamom

Series Code Volume (MT) Physical Delivery % of Delivery

May-03 32 -- -- Jun-03 130 29 22.31 Jul-03 104 6 5.77

Aug-03 851 42 4.94 Sep-03 728 23 3.16 Oct-03 1861 71 3.82 Nov-03 1265 41 3.24 Dec-03 4152 81 1.95 Jan-04 1828 17 0.93 Feb-04 1399 8 0.57 Mar-04 5478 60 1.10 Apr-04 4285 28 0.65 May-04 53893 332 0.62 Jun-04 25154 320 1.27 Jul-04 9188 225 2.45

Aug-04 18236 308 1.69 Sep-04 19078 221 1.16 Oct-04 158825 784 0.49 Nov-04 20307 276 1.36 Dec-04 16682 173 1.04 Jan-05 6564 348 5.30 Feb-05 14158 317 2.24 Mar-05 550394 1033 0.19 Apr-05 19932 516 2.59 May-05 270472 1558 0.58

Table 4.7. Quantity offered for delivery of Pepper at NMCE

Volume of Pepper Futures Trading

0

100000

200000

300000

400000

500000

600000

2003 2004 2005 2006

Year

Volu

me

(MT) Year

Volume

%Delivery for pepper

0

0.5

1

1.5

2

Year 2003 2004 2005

Year

%

Volume (Qtl) of Cardamom Futures Trading

0

50000

100000

150000

1 2 3

Year

volu

me(

qt)

% Delivery of Cardamom

0

0.5

1

1.5

Year 2004 2005

Year

%

Ratio of open interest and trade volume for Pepper seed at NCDEX and NMCE

NCDEX NMCE

Contracts N Mean

Std.

Deviation Contracts N Mean

Std.

Deviation

JUN04 54 7.09 10.87 JUN04 151 2.87 2.62

JUL04 78 5.80 8.62 JUL04 149 4.15 4.38

AUG04 104 11.38 36.43 AUG04 149 6.78 13.10

SEP04 94 8.47 13.02 SEP04 154 8.25 14.94

OCT04 129 7.85 8.59 OCT04 153 1.63 1.41

NOV04 158 18.11 28.77 NOV04 151 6.18 9.92

DEC04 147 12.42 15.36 DEC04 151 3.71 3.97

JAN05 153 13.45 18.92 JAN05 149 4.45 5.88

FEB05 150 11.08 14.32 FEB05 148 6.47 13.31

MAR05 149 6.32 13.08 MAR05 146 1.23 1.21

APR05 149 5.41 4.80 APRI05 147 4.80 6.56

MAY05 151 4.86 5.37 MAY05 149 1.70 1.56

JUN05 152 5.95 4.91 JUN05 150 6.35 10.44

JUL05 140 7.83 6.24 MAY03 6 0.19 0.25

JUN03 30 4.20 3.98

JUL03 42 1.34 1.24

AUG03 92 5.52 6.96

SEP03 108 3.52 3.34

OCT03 122 3.74 3.66

NCDEX MCX NMCE

Contracts Basis

Spot

prices

Ratio of

Basis

to Spot

prices

Basis Spot

prices

Ratio of

Basis

to Spot

prices

Basis Spot

prices

Ratio of

Basis

to Spot

prices

FEB04 308.08 400.70 76.89

MAR04 533.92 417.80 127.79 187.47 404.21 46.38

APRIL04 483.13 456.17 105.91 176.61 552.44 31.97

MAY04 409.64 485.99 84.29 191.50 550.23 34.80

JUNE04 186.65 143.54 130.03 327.68 341.02 96.09 233.63 427.85 54.61

JULY04 227.50 138.75 163.97 167.42 51.75 323.49 270.01 356.66 75.71

AUG04 301.60 176.00 171.36 328.73 76.79 428.07 408.54 351.24 116.31

SEP04 316.51 321.30 98.51 415.94 112.39 370.09 514.71 423.42 121.56

OCT04 389.46 417.26 93.34 433.29 292.56 148.10 521.82 393.07 132.75

NOV04 437.62 495.34 88.35 447.87 385.98 116.03 469.34 725.03 64.73

DEC04 334.56 480.21 69.67 397.43 399.72 99.43 349.47 508.94 68.67

JAN05 230.78 401.00 57.55 407.97 450.19 90.62 200.47 418.48 47.90

FEB05 210.58 347.92 60.53 430.97 386.68 111.45 174.04 366.40 47.50

MAR05 173.14 341.90 50.64 184.92 347.81 53.17 191.57 353.01 54.27

APRIL05 112.41 356.67 31.52 140.81 300.37 46.88 187.74 388.54 48.32

MAY05 118.97 305.52 38.94 189.35 242.89 77.96 223.85 370.95 60.35

JUNE05 122.91 272.55 45.10 159.62 243.04 65.68 210.29 299.26 70.27

JULY05 124.67 216.01 57.72 184.89 212.95 86.82 182.97 261.51 69.97

Table 3.13. Standard Deviation of basis and spot prices of pepper in National Exchanges

Opportunities

• Hedging– Carrying- Charge Hedge– Operational Hedge– Selective Hedge– Anticipatory Hedge– Cross Hedge

• Electronic spot market