Commodities Futures Trading

5.1.Key functions  of  commodity  futures  trading

The two major economic functions of a commodity futures trading are price risk management and price discovery. A futures exchange carries out these twin functions by providing a trading platform that brings buyers and sellers together. The price risk management is considered to be the most important function of a commodity futures market. The hedging is used to manage price risks. It allows transfer of price risk to other agents who are willing to bear such risks.

The hedgers, in principle, buy futures contracts for protection against rising commodity prices and sell futures for protection against falling prices or to get a guaranteed price in the future. Hedgers use futures market to protect themselves against price adverse changes and are often interested in taking or making physical delivery of the underlying commodity at a specified price. On the other hand, speculators, gamblers and other non-commercial players trade futures contracts strictly to make profits by betting on price movements. Such players have no interest in taking possession of the underlying commodity.

Initially, commodity futures markets were created for the benefits of hedgers  who would like to get guaranteed prices for their product. The commodity futures market can be potentially beneficial to producers and users of who can pass the price risk on an expected purchase or sale of physical commodity to other agents who participate in these markets without any physical backing.

The premise of hedging is the key reason behind the existence of commodity futures exchanges. It has greater significance in a country like India where over 60 percent of the population is dependent on agriculture and farmers face various kinds of uncertainties and risks including price risk. In India, the original purpose behind re-introduction of futures trading was to help farmers hedge against potential risks arising out of price movements in agricultural commodities.

The farmers can participate in futures market to manage price risk arising from decline and rise in commodity spot prices in the future. For instance, a guar farmer faces the possibility of incurring a loss on account of decline in guar seed prices at harvest time. At the time of sowing, the guar farmer can reduce or eliminate his risk by entering into a futures contract to sell guar seed at Bikaner exchange at a certain fixed price. By doing this, the farmer has hedged his exposure to changes in guar prices; he is no longer affected by adverse price changes in prices of guar, because he is guaranteed to get the price quoted in the futures contract. This strategy is known as a short hedge.

In India, however, such type of direct participation by farmers is seldom seen because farmers have little knowledge of futures markets. Besides, trading in future markets is cumbersome as it involves meeting various membership criteria, bank transaction norms, daily payments of margins, etc. In the US, however, big farmers and agribusiness corporations do take part in the futures markets.

On the other hand, a soya seed manufacturer plans to buy soya seeds in the future may suffer a loss on account of an increase in soya seed prices. To minimize or eliminate the risk, the manufacturer may enter into a futures contract to buy the soya seed at a certain fixed price. This strategy is known as a long hedge.

Just like a soya farmer, an airline can also hedge its operating costs by using a futures contract to lock in the price on future delivery of jet fuel, which alone may account for 30-50 percent of its operating costs.

Commodity futures price, the price agreed upon by the parties for the future transaction, is a market estimate about the future price of the underlying commodity. It reflects the price expectations of both buyers and sellers for a time of delivery in the future. It may be higher or lower than the spot price of the commodity in the spot market. Thus, the futures price could be used as an estimate of the spot price of a commodity at some future date. However, futures prices keep changing until the last date of the futures contract subject to additional information about demand and supply.

The continuous flow of information makes the process of price discovery dynamic in a commodity futures market. For instance, the price of March futures contract of soya seed will reflect the opinions of buyers and sellers about the value of the soya seed when the contract expires in March. The March futures prices may go up or down with the availability of new information. The price signal can provide a direction to a farmer about what a commodity will be worth at a future point of time and, on the basis of future prices, he can take decisions on what to produce  on the likely prices in the near future. If price signals given by long-duration new season futures contract of soya seed mean high prices in the future, the farmers can allocate more land/resources for growing soya, and vice versa. Hence, the farmers can benefit from the dissemination of the futures prices.

5.2.Which  commodites  are  suitable  for  futures  trading

Some of the necessary pre-conditions required for futures trading in a commodity include:

• There should be large demand for and supply of the physical commodity and no individual or group of persons acting in concert should be in a position to influence the demand or supply, and consequently the price substantially;

• There should be fluctuations in prices of that commodity. If the prices of a particular commodity are relatively stable, there is very less price risk involved in that commodity, and therefore, trading in that commodity is less meaningful;

• The market for the physical commodity should be free from substantial government control. The commodities where prices are determined by government policies should not be traded on the exchanges;

• The commodity should have long shelf life;

• The commodity should be capable of standardization and gradation. Since the contracts traded on the exchange are standardized, the commodities to be traded should be capable of standardization as well as of a standard quality ;

• The regulatory authorities should have powers and willingness to enforce new regulations and laws and exercise appropriate oversight of trading on the futures exchange with powers to curb market abusive practices;

• The delivery points where farmers need to physically deliver the underlying commodity should not be too far away from the harvest place. In India, the market regulator – Forward Markets Commission – decides the suitability of a commodity to be traded on the exchange.

5.3.Difference  between  “Underlying” & “Contract”

A commodity available for futures trading is called an “underlying”, i.e., the commodity based on which the derivatives’ value is derived from. There can be different futures contracts for the same underlying depending on location and expiry date.

For instance, in the contract NCD-FUT-GARSEDJDR-20-OCT-2013 the “NCD” stands for NCDEX (refers to the commodity exchange), “FUT” stands for futures, “GARSEDJDR” for guar seed (underlying commodity), “JDR” for Jodhpur (location where the commodity will be delivered) and “20-OCT-2013” for its expiry date.

5.4.What  is  Convergence?

Theoretically speaking, the difference between spot and futures contract should decline over the life of a contract so that spot and futures prices are the same on the date of maturity of the contract. This is known as “convergence” of spot and futures prices, though the futures market and spot market operate as separate entities.

In reality, price discrepancies between these two markets may exist due to excessive speculation and price manipulation in the futures markets. It has been estimated that about 75 percent of all futures contracts in the world fail due to their inability to accurately reflect spot market conditions. The threat that a commodity will not be delivered as foreseen in the contract is an important factor for preventing price convergence between the spot and futures markets.

The regulatory authorities and futures exchanges can facilitate proper price convergence by ensuring that there is a credible threat of delivery of commodities. The threat of delivery is an important factor for facilitating price convergence between the spot and futures markets. It discourages the market participants from manipulating futures prices. Without the threat of delivery, futures contracts may not serve as a tool for price discovery and price risk management. Other measures to curb excessive speculation include imposition of position limits and higher margins.