Commodity Futures in India

Rajesh Chakrabarti College of Management, Georgia Tech

800 West Peachtree Street, Atlanta GA 30332, USA

Tel: 404-894-5109 Fax:404-894-6030

E-mail: rajesh.chakrabarti@mgt.gatech.edu

Abstract: Financial derivatives, futures and options, have emerged as widely traded instruments around the world, including emerging markets. Commodity futures form a small part of that trading but have important hedging implications for agricultural producers and consumers. In India, trading in futures was banned for decades before it was again made legal in mid-90s. Since then commodity futures trading is conducted in over 25 exchanges, with four major multi-commodity exchanges set to dominate trading in the future. The exchanges vary in their contract specifications and settlement rules. Keeping pace with the rest of the world, Indian futures exchanges are also increasingly taking to the Electronic Communication Network (ECN) framework for trading.

Commodity Futures in India 1. Background – Commodities derivative trading around the world Financial markets help transfer risk from some agents to other. One is hard pressed to think of a business venture more risk-prone than agriculture. The quantity of the produce is uncertain and so is the price. Throughout the life of a crop, therefore, the growers as well as the potential customers have to make decisions that are inherently risky given the uncertainty associated with agriculture. It is hardly a surprise then, that commodity futures have been among the earliest derivatives thought of by man and the daily trading volume of agricultural commodity futures worldwide runs into several billion dollars. Futures and options constitute the most active derivatives trading markets round the world. The volume of future contracts traded around the globe in the first half of 2003 was 1,436.1 million contracts, up over 36% from the corresponding figure a year ago. Out of this, slightly over 5% (which is still a whopping 75 million contracts) consisted of agricultural commodities. This recorded a rise of slightly over 25% over its previous year’s figure1. Figure 1 shows trading volume in the most active futures markets in the world. Eurex, the European electronic exchange connecting over 700 centers around the world is clearly the leader, dealing exclusively in financial futures.

[Figure 1 about here]

The idea of trading futures may be traced to forward contracts as far as back to around 2000 BC in China. In essence, a future is a contract to deliver a specified amount of a certain commodity at a particular date for a specified price. Box 1 explains the fundamentals of a future contract. A forerunner and close relative of the future contract was the forward contract. The differences between forward and future contracts are explained in Box 2 below.

[Box 1 about here] [Box 2 about here]

The beginnings of the modern worldwide futures markets can be traced to Chicago, that had emerged as an important agricultural commodity trading center in the early 1800s. In 1848, eleven years after Chicago became a city, the Chicago Board of Trade (CBOT) was founded as a commodity exchange. Forward contracts where traded along with “spot” commodities in the beginning years, but their lack of standardization was soon proving to be a hindrance to their liquidity and trading. So in 1865, the CBOT came up with a futures contract that standardized quality, quantity and other features of the forward contracts. The futures market received a major boost over a century later, in the early 1970’s, not from any major innovation in the agricultural/commodity sector but because of the increased volatility in exchange rates as the Bretton Woods system broke down and in interest rates during the rocky 1970s. As risk in financial markets increased, there was an acute need for hedging instruments and a panoply of financial futures were designed and started trading heavily in the USA as well as in other developed countries. Though commodity futures, which lie at the root of the development of the futures market worldwide, may have been created primarily out of the hedging needs of the 1 Futures Industry (www.futuresindustry.org)

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buyers and sellers, over 95% of the trading volume in futures comprise speculative trades. This is because the nature of future trading lends itself easily to speculative motives and allows speculators, who are willing to take on risks in expectation of profits, take on large positions for very little investment. In other words, future markets allow for highly leveraged trading, because of a feature of the futures markets known as marking to market that changes the settlement price on the futures contract being traded every day. Box 3 explains how marking to market works and why it is important to the smooth functioning of the futures markets.

[Box 3 about here] The most important economic function that agricultural commodity futures markets serve is that it enables farmers as well as buyers to hedge price risk. Interestingly enough, the exact mechanism of hedging with futures does not even necessitate delivering on the futures contract. Box 4 explains how this works.

[Box 4 about here] Speculative trading in futures markets have received a boost in recent years with

managed funds focusing specifically on futures contracts. Like in any other market, however, speculation has its risks in the futures markets as well and given its high leverage a wrong bet has the potential of having devastating effect on the speculators’ fortune. [Box 5 about here]

2. Commodity futures markets in India

Accounting of a quarter of the nation’s GDP and providing employment to about two-thirds of its labour force, agriculture’s importance to the Indian economy can hardly be exaggerated. Also, compared to many other activities, agriculture continues to be a risky occupation in India. In spite of the role of government agencies to act as a buffer and help stabilize market prices, agricultural prices in India continue to be volatile and the output heavily dependent on weather conditions.

In spite of the critical importance of agriculture in India, till recently there was no large nation-wide commodity market. Commodity trading has traditionally been dispersed and fragmented across the country with regional commodity markets and local mandis accounting for all trading, with the regional markets, working pretty much in isolation from one another. The reason for this is not difficult to find. Physical warehousing and transportation problems as well as information problems hindered the development of a national market. As a result, agricultural prices varied greatly across the country with some parts of the nation burdened with excess supply of the same produce that was in severe need in some other parts. Clearly, the distributional benefits of a market system remained untapped because of such fragmented trading in agricultural produce. Market fragmentation paved the way for acute foodgrain shortages and poverty among the growers of the same crops to exist simultaneously.

The telecommunication revolution that swept through the country in the 90’s, including the advent of the Internet, reduced the information problem and set the stage for establishment of national-level commodity markets in India. The physical encumbrances to storing and moving bulky and perishable agricultural commodities persist and their removal would lead to a strengthening of the national markets.

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Commodity derivatives are not exactly new to India. In fact forward trading in commodities existed in India from ancient times (it is mentioned in Kautilya’s Arthashastra) and the first modern futures market was established in 1875 for cotton contracts by the Bombay Cotton Trade Association, just a decade after CBOT traded its first future. Oilseed and food grain futures followed and before the Second World War, futures were being traded on commodities like wheat, rice, sugar, groundnut, groundnut oil, raw jute, jute products and castor seed as well as precious metals. During World War II futures trading was prohibited to contain runaway speculation and illegal hoarding. After independence, the Forward Contracts (Regulation) Act was enacted in 1952 to regulate the trading in forward and futures trading. The Forward Markets Commission which oversees forward trading was instituted a regulatory body the following year. The Act applied to all contracts whereby the delivery of goods occurs after a period longer than 11 days. Futures contracts were viewed as a subset of standardized forward contracts and were never formally defined in the Act. The task of the Commission is to monitor and regulate the trading of forward contracts since manipulation in these markets are likely to create severe imbalances with adverse welfare effects.

Nevertheless, Indian markets did not really blossom over the following four decades. Regulators viewed markets in general with suspicion and derivatives markets as the terrain of unscrupulous speculation. Price control was also a central feature of economic policy during much of this period. This overly regulated nature of the economy did not bode well for the development of these markets. In 1966 futures trade was altogether banned to give effective powers of governmental price control. A few select commodities saw a reintroduction of futures in 1980 following the Khusro committee report.

All that began to change with the liberalization of the Indian economy in the early 1990’s. In 1993 the Kabra committee was appointed to look into forward markets. The committee recommended in 1994 that all futures banned in 1966 be reintroduced as well as many others added. Six years later, the National Agricultural Policy 2000 envisioned the removal of price controls in agricultural markets and widespread use of futures contracts. Since its establishment in 1995, the separate Department of Consumer Affairs, set up within the Ministry of Consumer Affairs, Food and Public Distribution, has been working at the promotion of futures trading. Its efforts included the reforming and strengthening the existing commodity exchanges. In late 2003, the agricultural commodities market was estimated at $ 30 billion. Many, including Reliance chairman Mukesh Ambani, believe that with a booming futures market, the physical agricultural spot market could grow ten-fold. According to Mr. Ambani, the commodity futures market has the potential to grow to a $600 billion market.2

In recent years, several derivatives exchanges have sprouted across the country facilitating trading in agricultural commodities, as well as commodity futures. Table 1 provides a list of exchanges where commodity futures are traded.

[Table 1 about here] Of these exchanges, the four national level commodity exchanges are the most

important. They have been granted the “nation-wide multi-commodity” status and they

2 “Commodity futures $600 bn market: Ambani”, Rediff.com, Nov. 19, 2003 (www.rediff.com/money/2003/nov/19commodity.htm)

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are rapidly emerging as the major centers of commodity futures trading. Some of their features are described in table 2 below.

[Table 2 about here] 3. A Glimpse of future trading in India The Futures Contract:

Commodity futures contracts vary depending upon the exchange and the commodity in question. The exact design of a contract is driven by the rules and bye-laws of the exchange where it is traded. Consider, for instance, the soy bean futures contract on the National Commodities and Derivatives Exchange, Mumbai (NCDEX) shown in table 3.

[Table 3 about here] As is evident from table 3, the futures contract specifies several aspects of the contract. The standardized unit of trading and delivery eases price quoting and facilitates trading. Specification of the different quality parameters is essential in the case of commodities when the underlying asset is inherently heterogeneous. The contract also specifies the range of variation in quantity that can be within the acceptable range. If a seller delivers a product that falls below the acceptable quality or quantity ranges, the buyer can refuse the delivery as settlement of the contract. Delivery centers are specified as well to take into account possible issues with transportation costs.

Several other elements mentioned in the contract relate to the trading rules for the specific contracts in the relevant exchange. The tick size and price bands address market microstructural issues and prevent excessive price volatility and market manipulation. Individual and broker position limits prevent market manipulation by a single buyer or broker. Table 3 also tells us the calendar for trading of contracts and specifies the number of contracts that are active at a point in time.

[Table 4 about here] Now compare this contract with a soybean futures contract from another national futures exchange, the National Multi-Commodity Exchange, Ahmedabad (NMCE) shown in Table 4. Quite a few differences in the specifications immediately catch our attention. The NMCE contract, for instance trades under quite different trading rules compared to that at NCDEX. The tick size is larger and the price band more stringent. Contracts vary, obviously, according to commodities as well. Let us consider, for instance, a sugar contract from the NCDEX (Table 5). Its acceptable quantity variation is larger than that for soybean and its unit of trading is ten times that of the soybean contract at the same exchange. The place for delivery is different as well (Muzaffarnagar, Delhi and Kolkata as opposed to Indore for soy bean).

[Table 5 about here] Trading Systems in Exchanges: Till recently, all trading in commodity futures took place just the way the physical commodities themselves have always traded, through an “open outcry” system. Of late, however, there is a distinct move towards “de-materialization” or online electronic

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trading. Three of the four major national-level exchanges use screen-based electronic trading and the oldest (NBOT) is moving towards it as well. In most of the other regional exchanges, trading takes place primarily through an open outcry system. Apart from the trading that goes on in the exchanges, there is a significant gray market outside the exchanges where futures change hands. According to some estimates, trading in the gray market may account for as much as 25-30% of the total futures trading in India. A complex and potentially problematic part of futures trading is the settlement of futures contracts. It must be borne in mind, that a relatively small fraction of the futures traded actually come up for delivery – most are “squared off” before maturity. For those sellers who intend to deliver on their contracts exchanges follow more or less the same system. Usually about a week before the maturity of the futures contract, the sellers and buyers have to notify the exchange whether they want to deliver/take delivery on the contract or “square it off” on maturity, i.e. pay/accept cash. The exchange then matches up the buyers and sellers intending on making delivery. The actual delivery almost always takes the form of warehousing receipts. A warehousing receipt is a receipt issued by a government recognized warehouse, certifying that a certain quantity of an agricultural commodity is kept in storage there. The receipt itself is negotiable and is acceptable as settlement of claims. Margins in India typically fall in the 5-10% range and one can start trading in commodities with as low a balance as Rs. 5,000. In addition there are brokerage and other fees. Brokerage charges usually range from 0.10-0.25 per cent of the contract value and generally higher for a contract resulting in delivery. There are also transaction charges of approximately Rs 6 to Rs 10 per contract. The brokerage varies from commodity to commodity and is below maximum limits set by the relevant exchange. The organization and governance of futures exchanges: In India futures exchanges, like other financial exchanges have been traditionally run as self-regulating associations of traders and brokers under the overall guidance of the Forward Market Commission rules and regulations. Most regional exchanges still retain that form of organizational structure. They are managed by a board of directors comprising largely the members of the trading association, supplemented by independent public representatives. The four national-level exchanges, however, have external promoters and shareholders, with the majority stake often coming from public sector financial institutions. This is also reflected in their board composition. The board appoints a management team that runs the day-to-day affairs of the exchange. In most cases, the exchanges have different committees to look into the various functions like floor trading, setting of settlement price for the day, settlement and delivery of contracts etc. Clearinghouses associated with the different futures exchanges play a crucial role in the futures market. They take the counter-party position in futures contracts thus guaranteeing against the counter-party default risk. Presently, many exchanges have their internal clearing houses. However, there are recommendations (as, for instance, in the World Bank report of Frida Youssef (2000)) to set up a National level clearing house facility whose services could be availed by all futures exchanges.

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4. Global trends in future markets and the road ahead for India As the futures market emerge and bloom in India, financial markets all over the world are being rapidly transformed by the Internet revolution. Participation level of individuals, organization of trading, speed of price discovery are all undergoing major changes and Indian markets have to rapidly adjust themselves to these changes. As the multi-commodity national-level commodity exchanges become important and gain volume, an important question 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 converge to 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 more national-level exchanges. There is therefore a distinct possibility of integration in terms of exchanges. There are however, issues about standards that need to be tackled before the commodity futures markets become more integrated. Till the integration happens, we should expect to see important changes in the existing regional exchanges. Faced with competition from nation-wide exchanges, they would have to improve their technology, transparency and methods of operation in the short run if they are serious about staying in business. Also with the continued acceptance and popularity of institutionalized commodity futures trading, probably the bulk of informal futures trading will slowly be absorbed in the regulated, through-exchange trading as the price and liquidity benefits outweigh the added transaction costs. That would, indeed, be a positive development for all concerned. Perhaps the biggest event in financial markets around the world – not just commodities or futures markets but securities markets as well – in recent years has been the emergence of Electronic Communication Networks (ECNs). Box 6 explains the nature and benefits of ECNs. The ECN-type organization of futures markets is likely to be the next step as trading moves away from open outcry trading floors to screen-based trading. Perhaps an electronic limit order book is the unavoidable destiny of all trading be it in equities or in futures. There are however issues with opening the doors of an exchange of the general public without the intermediation of exchange “member” brokers. Exchange brokers, with sizeable deposits with the exchange, provide guarantee for the transactions. Alternative mechanisms need to be brought in place for honoring contracts if the ECN model is to be adopted in India.

[Box 6 about here] An already observable shift is occurring in the ownership structure and corporate governance of exchanges. Commodity exchanges, like their equity counterparts used to b owned and run by associations of brokers. This raised several transparency and governance issues for exchanges and increased the possibility of price manipulations and unethical practices that Indian markets are so notorious for. Improved corporate governance is essential for the development of commodity futures trading in India and perhaps the first and most important step in that direction is to separate the ownership and management of exchanges from the participating brokers. In other words, the “self-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 the global markets, its effects are likely to become visible in the commodities futures markets as well. With the increasing role of multi-national corporations in the agricultural and food processing as well as international trade, the connection between commodity prices in India and world prices are becoming increasingly linked. There is also an increasing need for participating clients to hedge and speculate on Indian commodity prices in relation to world prices rather than in isolation. Even now, most opening trades in commodities markets take their price cue from the commodities markets at Kuala Lampur, Malaysia. It is reasonable, then, to expect that with time, the linkage between Indian commodity prices and futures prices will be even more connected with world prices and possibly trading itself would be international. In the global scenario, there has been an emergence of alliances of futures markets. The Globex Alliance led by CME, Matif and SIMEX and the CBOT/Eurex alliances have futures exchanges worldwide as partners. It is likely that Indian exchanges would also form partnerships 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. A category of futures that have are extremely popular in developed countries will perhaps make their appearance in India too. These are the weather derivatives, which are 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 rainfall related risks that are concomitant with Indian agriculture. In about a decade’s time, commodity futures in India have come a long way from the domain of barely legal bets to trading on multi-commodity national level exchanges with sophisticated products, technology and contract specifications. Its rise offers participants 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 amidst the users of futures markets, hopefully that will change soon as the futures rise in popularity and stature. Then they would truly make a difference where it matters most.

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Box 1: The basics of a future contract In its essence a future is a contract to deliver a specified quantity of a commodity at a specified date for a certain price. The specified date in the future contract is the expiration date of the future. It is the date after which the future contract ceases to exist. The future price times the quantity of the commodity specified in the contract is known as the notional value of the contract. For example a soybean contract selling at the Chicago Board of Trade is written for a quantity of 5,000 bushels of soybean. On September 23, 2004, the closing price of November 2004 soybean future was $5.37¾ making the notional value of the contract $ 26, 887.50. Future contracts are bought and sold regularly on exchanges. The seller (or writer) of a future contract thus promises to deliver the quantity of the commodity traded on the expiration date while the buyer promises to buy the commodity at the specified price. Since the future is essentially a promise, no money changes hands during a futures transaction. The actual transaction is scheduled to happen on the expiry date. As an insurance against non-fulfillment of contract however, there is a margin requirement, and traders in futures have to maintain a small portion of the notional value of the contract with their brokers (members of the exchange where the future trades). This margin, however, is a deposit and sometimes it even earns interest. So this should not be considered to be a payment for the future contract. There are two important features of a future contract. Firstly, the specifications of a future contract, except for the price are standardized. Thus a soybean future trading at the Chicago Board of Trade always entails the same quantity (5,000 bushels) of soybeans. Expiry dates are also specified. At a given time, there may be several soybean futures selling at the Chicago Mercantile Exchange expiring at different months in the future. However all futures expiring on September 2005, for instance will expire on the exact same day in September 2005. The precise day of the month when the future expires is set and known well in by the relevant exchange’s calendar (which typically follows a rule like “Wednesday before the last trading day of the month”). Another interesting feature of a futures contract is it always has the exchange (or its “clearing house”) as one party of the contract. For instance when one sells or writes a future, the contract is made between the seller and the clearing house. Similarly for the buyer. Thus, when two people decide of buy and sell a future contract, it gives rise to two future contracts, one between the seller and the clearing house and one between the clearing house and the buyer. This is done to remove the counter-party risk – the risk that the counter-party to the contract may actually not deliver on the future when the time comes and this enhances the liquidity of futures. Futures are written on a wide variety of commodities and financial assets. Trading in agricultural commodities (which category itself spans a wide spectrum from orange juice to cottonseed oil and soybean to livestock) today comprise only about 5% of total futures trade in the world. Precious metals, oil, currencies, major stock indices, individual stocks,

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interest rates and weather are all fair game for future contracts and account for most of the trading volume in futures. Basically anything involving uncertainty that can be objectively resolved in the future is a legitimate underlying asset for futures. In this sense, they provide an opportunity for betting, much like the informal and illegal “satta” trading that has flourished in different parts of India for several decades. Online markets have existed for futures on US Presidential elections (the Iowa Electronic Markets) for several elections now and recently “Saddam securities” – futures on Saddam Hussein – were being actively traded on the online exchange, Tradesports.com! (These latter contracts were simple bets that promised the buyer of a contract $10 if Saddam Hussein ceased to be the leader of Iraq by the expiration date of the contract. December 2002, March 2003 and June 2003 contracts were actively trading at one point. See Leigh et al (2003).) Box 2: Forwards versus Futures Forwards and futures are both contracts to purchase a specified quantity of a good at a specified date in the future. Thus they are identical in their essence. Forward transactions have been around much longer (dating back to 2000 BC in China) than futures and have been the forerunner of futures. Yet, today it is the futures, which dominate trading in this class of instruments. The essential feature that distinguishes futures from forwards is the standardization of the former. As we discussed in Box 1, futures contracts are standardized in terms of the quantity of goods to be traded as well as the expiry date. In the case of forward contracts, both these features vary from contract to contract so each forward contract can be potentially customized to the needs of the buyer and seller. This standardization works wonders for tradability and liquidity of the future contracts. Because of its customized nature, forward contracts are hard to unravel. So if a person, after entering into a forward contract, wants to change his mind and get out of it, the only way he can do that is by convincing (i.e. by paying a premium) to the counter-party to agree to nullify the contract. In case of futures, on the other hand, a person in a similar situation can simply turn around and sell his contract (or offset it, in futures parlance) to someone else and is immediately freed from all obligations of the contract. Because of the liquidity improvements stemming from standardization, futures are very attractive to speculators who plan to hold them for short periods of time and offset them before their expiry. The presence of such speculators in the market in turn creates even more liquidity of the futures as well over 90% of the total trade in futures is done by speculators. Thus the main difference between forwards and futures is that of standardization and liquidity. These features have made futures the instrument of choice for hedgers and speculators worldwide, while forward markets have remained insignificant in comparison.

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Box 3: Trading in futures: Marking to market and speculation Trading in futures differs from trading in equity and other securities in an important way. Futures are marked-to-market everyday, a feature that creates massive leverage in trading in futures. Here is how it works. Let us say that at 10 am Monday, September 20, 2004 the soybean futures price at Chicago Board of Trade for a contract ending November 2004, is $5.66. What that really means is that a contract for delivering 5000 bushels of soybeans on the settlement date in November 2004 just sold for a price of $ 5.66 per bushel. Let John be a person purchasing the future and Sheila a person selling it. Now let us at closing on Monday, the future price rises to $ 5.71 per bushel. What marking to market means is that the contract that John bought and the one that Sheila sold are now cancelled and replaced with a new contract at the closing price (the closing price is not necessarily the last trade of the day, there are rules and conventions for deciding that). Now that means if both people hold on to their contracts till maturity and futures prices did not change at all (a very unlikely situation), John would have to pay 4 cents more than he bargained for per bushel of soybean (and Sheila would be getting the same amount more). In order to compensate them for this change John is paid, right away, the difference in the notional amount of his contracts – $200 (i.e. $ 0.04 times 5,000 bushels of soybeans, the size of the contract). Similarly, Sheila has to pay up that same amount of money, immediately. The money is deducted from Sheila’s margin account and debited to John’s. Let us say, they both offset their positions the first thing on Tuesday and for simplicity let their selling price be the same as Monday’s closing price. Now consider the rates of return, for John and Sheila. Since rates of returns the calculated on the profit from roundtrip trades divided by the amount of money invested, the rates of return for John and Sheila, are, strictly speaking, undefined. This is because John really never paid anything for the futures (ignoring the broker’s commission). He had only put up some money with his broker as margin. Even if the margin money is considered an investment, the percentage gain for John for a single day is (assuming a 5% margin rate) is 14%! Clearly, such returns are next to impossible in most other markets. Of course, for a wrong bet, like Sheila’s, the rate of return is -14%. Thus what the marking-to-market mechanism along with the margin system does is increase the leverage for trading (making them that much riskier). This feature makes futures the favored instrument among speculators who can make more with futures (if their bets prove right) than with any other instrument. A natural question that arises is about the reason for having the marking to market practice. The reason becomes clear when we consider the real-life story of Nick Leeson and the fall of Barings Bank, banker to, among others, the Queen of England. In 1987, 27 –year-old Nick was trading futures for Barings Bank at Singapore and bet heavily on the Nikkei index futures. The Nikkei fell, but Nick hid his losses with some crafty (and highly irregular) accounting practices and went on betting on the Nikkei futures. The

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Nikkei continued falling and Barings’ losses mounted. When it all came to light, Barings’ total losses amounted to $ 610 million, sinking the over-two-centuries- old institution. Nick Leeson went to prison for his wrongdoings, ING bought up Barings for a princely sum of $1. The only institution that went relatively unscathed through the whole ordeal was the futures exchange, which had collected on all but the last day’s losses from Barings Bank. This is because of the marking-to-market feature, which forced Barings to pay up the losses, as they occurred, rather than let them accumulate. What may seem puzzling, after this discussion, is how futures could serve as effective hedging instruments if the prices of the contract do not stay fixed. To understand this let us go back to the example of John and Sheila once more. Let us assume that Sheila is a soybean grower trying to hedge the price risk of her crop. So she sells a futures contract – 5,000 bushels of soybean at $ 5.66 per bushel. Now that the price changes on Monday, she has to pay up $ 200 immediately. However, what she gets for that is a revised contract with a higher sale price, with the gain in the futures price exactly offsetting the money she has to pay. Thus if she holds on to the contract till maturity, regardless of the price variation and marking to market, the total cash flow to her (the sum of her gains or losses on her margin account and the final settlement price times the quantity when she makes delivery on the futures contract) will remain exactly $ 28,300, the amount that she had sold the futures for. Thus, in spite of the marking-to-market feature, futures fulfill their function as hedging instruments. The marking-to-market feature just makes them great for speculation too.

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Box 4: Hedging with futures Consider a farmer expecting a soybean harvest in 3 months. Let us say the present time is September, so the farmer faces risk in the variability of December soy bean price. Let us say the soybean price now is $ 5.50 per bushel while the December soybean futures price is $ 5.55 per bushel. This difference of 5 cents between the futures price and the spot price is called basis. Now as time passes, the magnitude of the basis declines, or the spot and the futures prices converge. This is intuitive as the basis is driven by interest costs and expected price movements before maturity. So while we do not know how the spot and futures prices would move between now and maturity of the contract, we can be sure of one thing. On the day of maturity of the contract, the two prices must be the same, as there is no difference between transaction in a futures contract maturing today and that in a spot contract. So our farmer sells a December futures contract at $ 5.55 a bushel. Let us say on the day of maturity of the contract, the spot price (and hence the futures price of the maturing contract, too) is $5.40 per bushel. Because of marking to market, the farmer must have earned the 15 cents decline in price per bushel during the 3 months life of the contract. On the day of the maturity, he can choose either to fulfill the contract and deliver on it or just to square off the contract and sell his produce in the spot market. It really makes no difference which choice he makes, except that sometimes the futures contract delivery may require him to transport his produce to a center further away from his own market of choice. In that case he can reverse the contract and sell his crop in his local market (assuming that the price in the local market is same as that in the location of the future’s designated center). By doing this, he has still ensured a cash flow of $5.55 per bushel of his crop whereas the spot price he actually sold at was 15 cents lower. Thus he has used the futures market to hedge his risk. The advantage of futures market over forwards is easy to understand if we consider the case of an output risk. Suppose halfway through the crop season, the farmer has to lower the estimate of his crop yield. If he were in a forward contract, he would find it difficult to reduce his delivery commitments. In the case of futures, he can “square off” part of his position to have only the necessary delivery commitments that is commensurate with his new yield expectations.

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Box 5: Sweet Future? Speculation in sugar contracts

The New York Board of Trades, where 80% of sugar trades take place, saw its open interest in the raw sugar futures contract climb to a record high of over 273,000 contracts in February 2003 from which it fell a sharp 22% in a matter of two and half months. Most certainly the initial rise was partly fuelled by uncertainties created by the prospects of war in Iraq as well as the Brazilian sugar producers’ promise to raise their supply to domestic ethanol producers. However, it was also exacerbated by the involvement of investment funds in speculation whose departure brought the level of trading (and prices) crashing down. The rise of managed funds created for betting in futures markets has added new force to speculation and volatility. Though financial futures are their instruments of choice, commodity futures are being used too, particularly because of their low correlation with financial and currency futures. Such speculators often bet on short-term technical analyses of future price trends rather than fundamentals.

Of course, speculation is all about taking risks and strategies fail roughly as often as they succeed. Global supply of sugar, for instance, has been surplus for several years and sugar prices have remained within bounds. Supplies of commodities like sugar, which has a growing cycle of over a year and a half, react very slowly to price changes. Expected glitches in transportation (like the expected fallout of Iraq invasion) may however cause temporary price swings.

NYBOT’s No. 11 world raw sugar contract and LIFFE’s no. 5 white sugar contract account for most of the sugar futures trading in the world. A lot of trading is done just to arbitrage away price differences between these contracts. But other than that, the LIFFE contract is far less attractive to speculators given its limited liquidity and shorter horizon.

Source: Bennett Voyles, “Product Profile: Why Bears Like Sugar”, FI Magazine, May/June 2003

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Box 6: Electronic Communications Networks (ECNs) ECNs are electronic markets where participants submit their limit orders, i.e. prices at which they are willing to buy/sell a specified quantity of securities or commodities. The resulting electronic limit order book – the list of such buy and sell orders – is on continuous public display at the website of the ECN and is updated on a real-time basis. Participants can place orders directly at the ECN’s website. Several such ECNs have come into existence in recent years and are supplementing as well as competing with the established exchanges. Archipelago, Island and RediBook are some of the more famous ECNs that are challenging the might of some of the world’s leading stock exchanges like the NYSE and NASDAQ. The main advantages of trading on ECNs include a reduction in the spread charged by brokers and market makers as well as after-hours trading. Also ECNs can, function without any geographical limitations, attracting participants located time zones away from one another including, at least in principle, international investors. In spite of their obvious advantages, it is probably safe to say that ECNs are still in their nascent stage with relatively fewer participants than in established exchanges. After all, the economics of exchanges is driven by the economics of networks, where the benefits increase disproportionately with the number of participants. However, it is perhaps only a matter of time when a few of the ECNs will emerge as the world’s leading securities exchanges.

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Futures trading volume around the world

0 50 100 150 200 250 300 350 400

Others

NEW YORK BOARD OF TRADE

NATIONAL STOCK EXCHANGE OF INDIA

STOCKHOLMSBÖRSEN

OSAKA SECURITIES EXCHANGE

SHANGHAI FUTURES EXCHANGE

INTERNATIONAL PETROLEUM EXCH.

CENTRAL JAPAN COMMODITY EXCH.

SINGAPORE EXCHANGE

SYDNEY FUTURES EXCHANGE

LONDON METAL EXCHANGE

KOREA STOCK EXCHANGE

THE TOKYO COMMODITY EXCHANGE

BM&F

NEW YORK MERCANTILE EXCHANGE

MEXICAN DERIVATIVES EXCHANGE

EURONEXT

CHICAGO BOARD OF TRADE

CHICAGO MERCANTILE EXCHANGE

EUREXEx

chan

ge

Millions of contracts

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Table 1: Exchanges and Commodities where futures contracts are traded.

EXCHANGE

COMMODITY

India Pepper & Spice Trade Association, Kochi (IPSTA)

Pepper (both domestic and international contracts)

Vijai Beopar Chambers Ltd., Muzaffarnagar Gur, Mustard seed

Rajdhani Oils & Oilseeds Exchange Ltd., Delhi Gur, Mustard seed its oil & oilcake

Bhatinda Om & Oil Exchange Ltd., Bhatinda Gur

The Chamber of Commerce, Hapur Gur , Potatoes and Mustard seed

The Meerut Agro Commodities Exchange Ltd., Meerut Gur

The Bombay Commodity Exchange Ltd., Mumbai Oilseed Complex

* Castor oil international contracts

Rajkot Seeds, Oil & Bullion Merchants Association, Rajkot

Castor seed, Groundnut, its oil & cake, cottonseed, its oil & cake, cotton (kapas) and RBD palmolein.

The Ahmedabad Commodity Exchange, Ahmedabad Castorseed, cottonseed, its oil and oilcake

The East India Jute & Hessian Exchange Ltd., Calcutta Hessian & Sacking

The East India Cotton Association Ltd., Mumbai Cotton

The Spices & Oilseeds Exchange Ltd., Sangli. Turmeric

National Board of Trade, Indore** Soya seed, Soyaoil and Soya meals. Rapeseed/Mustardseed its oil and oilcake and RBD Palmolien ( see table 3)

The First Commodities Exchange of India Ltd., Kochi Copra/coconut, its oil & oilcake

Central India Commercial Exchange Ltd., Gwalior Gur and Mustard seed

E-sugar India Ltd., Mumbai Sugar

National Multi-Commodity Exchange of India Ltd., Ahmedabad ** Several Commodities (see Table 3)

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Coffee Futures Exchange India Ltd., Bangalore Coffee

Surendranagar Cotton Oil & Oilseeds , Surendranagar Cotton, Cottonseed, Kapas

E-Commodities Ltd., New Delhi Sugar (trading yet to commence)

National Commodity & Derivatives , Exchange Ltd., Mumbai **

Several Commodities (see Table 3)

Multi Commodity Exchange Ltd., Mumbai ** Several Commodities (see Table 3) Bikaner commodity Exchange Ltd., Bikaner

Mustard seed its oil & oilcake, Gram. Guar seed. Guar Gum

Haryana Commodities Ltd., Hissar Mustard seed complex Bullion Association Ltd., Jaipur Mustard seed Complex

** Nation-wide Multi Commodity Exchange

Approved Exchanges coming up soon

Association Commodities M/s. NCS Infotech Ltd., Hyderabad

Sugar

United Planters Association of South India, Connoor

Tea

SGI Commodity Exchange, Mumbai

Soya bean Ground nut their oils and oilcakes.

Source: Ministry of Consumer Affairs, Food and Public Distribution, GOI website Information is valid as of July 2004. Visit the Forward Trading Commission website (www.fmc.gov.in) for later updates.

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Table 2: National-level Futures trading Exchanges in India

Exchange Location Year Started

Promoters Commodities Trading Mecha-

nism

Membership

National Multi-Commodity Exchange (NMCE)

Ahmedabad 2003 Central Warehousing Corp (CWC), National Agricultural Co-operative Marketing Federation (NAFED), Gujarat Agro Industries Corporation Ltd. (GAIC), Gujarat State Agricultural Marketing Board (GSAMB), National Institute of Agricultural Marketing (NIAM), Neptune Overseas Limited (NOL), Punjab National Bank (PNB)

Gur, RBD Pamolein, Groundnut Oil, Sunflower Oil, Rapeseed/Mustardseed, Rapeseed/Mustardseed Oil, Rapeseed/Mustardseed oil-Cake, Soy bean, Soy Oil, Copra, CottonSeed, Safflower, Groundnut, Sugar, Sacking, Coconut oil, Castorseed, Castor-oil, Groundnut oilcake, Cottonseed oil, Sesamum (Til or Jiljili), Sesamum oil, Sesamum OilCake, Safflower OilCake, Rice Bran Oil, Safflower Oil, Sanflower OilCake, Sunflower Seed, Pepper, Crude Palm Oil, Guarseed, CastorOil Cake, Cottonseed – Oilcake, Aluminium Ingots, Nickel, Vanaspati, Soybean Oilcake, Rubber, Copper, Zinc, Lead, Tin, Linseed, Linseed Oil, Linseed, Oilcake, Coconut Oilcake, Gram, Gold, Silver, Rice, Wheat, Cardamom, Kilo – Gold, Masoor, Urad, Tur / Arhar, Moong, Rapeseed – 42, Raw Jute

Screen-based trading

89

Multi-Commodity Exchange (MCX)

Mumbai 2003 Financial Technologies (India) Ltd., Sate Bank of India, Union Bank of India, Bank of India, Corporation Bank, Canara Bank

RBD Pamolein, Groundnut Oil, Pepper Domestic-MG1, Soy bean, Kapas, Castorseed, Castor-oil, Crude Palm Oil, Guarseed, Cottonseed – Oilcake, Nickel, Rubber, Copper, Tin, Gram, Gold, Silver, Gold-M, Rice, Wheat, Ref Soya oil – Indore, Urad, Tur / Arhar, Castorseed-5 , Silver-M, Steel – Flat, Steel – Long, Yellow Peas, Long Staple Cotton, Medium Staple Cotton

Screen-based trading

186

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Table 2 (Contd): National-level Futures trading Exchanges in India

National Commodities and Derivatives Exchange (NCDEX)

Mumbai 2003 ICICI Bank, NSE, NABARD, LIC, CRISIL, PNB, IFFCO, Canara Bank

S06 L S Cotton, J34 M S Cotton, Crude Palm oil, RBD P'Olein, EXP R/M oil, Rape/Mustard seed, Ref Soya oil, Soy bean, Pure Gold, Pure Silver, Pure Gold - 1 Kg, Pure Silver - 30 Kg (Mega), Rubber, Pepper, Gram(Chana), Guarseed, Jute (B twill-665 Gms), Turmeric, Castorseed, Raw Jute, GuarGum, Sugar M Grade, Urad, Sugar S Grade, Yellow Peas, Wheat SMQ, Soy Meal

Screen-based trading

378

National Board of Trade (NBOT)

Indore 1999 Rapeseed/Mustardseed, Rapeseed/Mustardseed Oil, Rapeseed/Mustardseed oil-Cake, Soy bean, Soy Meal, Soy Oil, Crude Palm Oil

Open outcry

71

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Table 3: Futures Contract Specifications – Soy Bean Contract on NCDEX

Trading system NCDEX's Trading System

Trading hours Trade timings on all trading days: Trading Hours : 10.00 a.m. to 4.00 p.m.; 5.00 p.m. to 11.00 p.m.Single Call Market (Closing session) for determination of Closing Price: 11.15 p.m. to 11.30 p.m. *

Unit of trading 10 Quintal (=1 MT) Delivery Unit 100 Quintal (=10 MT) Quotation/Base Value Rs per Quintal Tick size 5 paise

Price Band Limit 10%. Limits will not apply if the limit is reached during final 30 minutes of trading.

Quality specification Moisture: 10% Max Sand/Silica: 2% Max Damaged: 2% Max Green Seed: 7% Max

Quantity variation +/- 2%

No. of active contracts At any date, 3 concurrent month contracts will be active. There will be a total of twelve contracts in a year.

Delivery Centers Indore

Opening of Contracts Trading in any contract month will open on the 21st day of the month, 3 months prior to the contract month i.e. Feb 2003 contract opens on 21st November 2002.

Due Date 20th day of the delivery months, if 20th happens to be holiday then previous working day.

Position limits Member-wise: Max (Rs. 40 crore, 15% of open interest) Client-wise: Max (Rs. 20 crore, 10% of open interest)

Premium/Discount None

* In addition to the trading hours mentioned above, trading on Saturdays is as follows: Trade timings: 10.00 a.m. to 2.00 p.m. Single Call Market (Closing session) for determination of Closing Price: 2.15 p.m. to 2.30 p.m. Source: NCDEX website (www.ncdex.com)

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Table 4: Futures Contract Specifications – Soybean Contract at NMCE Asset Code SOYS

Product Code SOYSF

Series Code SYSMMMYYYY

Trading System NMCE’s Derivatives Trading and Settlement System

Trading Hours Monday to Friday 10:00 am to 4:00 pm Saturday 10:00 am to 2:00 pm

Unit of Trading 1 MT

Delivery Unit 1 MT

Quotation/Base Value 20 Kgs

Tick Size 10 paise

Price Band 5% above and below the last traded price.

10% above and below the last closing price. Quality Specification Moisture – 10% Max

Sand/Silica – 2% Max Damaged – 2% Max

No. of delivery Contracts in a year Maximum 12 monthly or minimum 2 monthly contracts running concurrently.

Delivery Centers Indore

Opening of Contracts Trading in any contract month will open on the 16th day of the month, 12 months prior to the contract month.

Due Date 15th day of the delivery months if 15th happens to be holiday then previous working day.

Closing of Contract Squaring up of positions will be permitted between 10th and 15th of delivery month. No fresh positions building will be allowed. From 10th to the 15th of delivery month, seller can tender Warehouse Receipt for settlement and Warehouse Receipt will be accepted for settlement at closing price of the previous day.

Source: NMCE website (www.nmce.com)

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Table 5: Futures Contract Specifications – Sugar Contract on NCDEX Trading system NCDEX Trading System

Trading hours

Mondays through Fridays: Trading Hours - 10:00 am to 4:00 pm and 5:00 pm to 11:00 pm; Closing Session - 11:15 pm to 11:30 pm Saturdays: Trading Hours - 10:00 am to 2:00 pm; Closing Session - 2:15 pm to 2:30 pm; On the expiry date, contracts expiring on that day will not be available for trading after 4 p.m.

Basis Price Ex-warehouse basis Muzaffarnagar inclusive of all taxes

Unit of trading 10000 Kgs (=10 MT)

Quotation/base value Rs. per Quintal

Tick Size Re. 1.00

Ticker Symbol SUGARMMZR

Delivery Unit 10 MT net basis packed in 50 kgs new A Twill Bags / PP bags

Quality Specification

Sugar in crystal form manufactured by vaccum pan method of current season with : Moisture : 0.08% Max Polarisation : 99.80% Min ICUMSA : > or = 150 ICUMSA and < 200 ICUMSA as determined by GS2/3 METHOD 8 prescribed in Sugar Analysis ICUMSA Method Book Grade : M Grain Size : Medium as determined by the methods prescribed in IS:498-2003

Quantity Variation +/- 5%

Delivery Center Exchange certified warehouse in Muzaffarnagar *

Delivery Upon expiry of the contracts, if any Seller with open position desires to give delivery at a particular delivery center, then the corresponding Buyer with open position as matched by the process put in place by the Exchange shall be bound to settle by taking physical delivery

No. of Active contracts Maximum 12 contracts or minimum 2 contracts running concurrently

Opening of contracts October, November and December 2004 and April 2005 contracts to be launched on July 27, 2004. Subsequently trading in any contract month will open on the 21st of the month. If the opening day happens to be a non-trading day, contracts would open on the next trading day

Due Date 20th day of the delivery month. If 20th happens to be a holiday, then previous trading day. If 20th happens to be a Saturday or Sunday then the due date shall be the immediately last preceding trading day of the Exchange

Closing of contract All open positions will be settled as per general rules and product specific regulations

Price Band Limit 10% or as specified by Exchange from time to time. Limits will not apply if the limit is reached during final 30 minutes of trading

Position Limits Member-wise: Max (Rs. 20 Crores, 15% of open interest), whichever is higher; Client–wise: Max (Rs. 10 Crores, 10% of open interest), whichever is higher

Premium M grade sugar with ICUMSA 100 - 150 could be accepted as good delivery but with a premium of Rs. 25 per quintal

* Also deliverable at designated warehouses at Delhi and Kolkata subject to location premium/discount differences which shall be announced by the Exchange from time to time. Source: NCDEX website (www.ncdex.com)