Business8Potential and Strategy th March 2004
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Invitation to IIM-A Commodity MarketsGraduates
17th July, 2004
Indian Financial Markets and Regulators
Ministry of Finance Ministry of Consumer Affairs
National Housing Bank
Insurance Regulatory Development Authority (IRDA) Pension Funds
Company Law Board
FMC
Housing Finance Companies
Insurance
Corporates
Commodity Markets
SIDBI
RBI
SEBI
NABARD
State Financial Institutions
Banking / NBFCs
Capital Markets
Co-operative Banks & Regional Rural Banks
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The Indian Definition: FCRA (1952)
Goods
“Every kind of movable property other than actionable claims, money and securities.”
Securities
“Shares, scrips, stocks, bonds, debentures, debentures –stocks or other marketable securities of a like nature in or any incorporated company or any other body corporate and also government securities.”
Inclusive definitions-Gaps exist
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Objectives of Commodity trading
Leads to price discovery Provides hedging option A smart investment choice Integrates players and markets Improves cropping pattern
….a win-win, or Pareto optimal, state
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What are the risks in commodities?
Commodity enterprises face three classes of risk: Price risk – risk relating to movements in the world price, the exchange rate and the basis between local and world prices) Yield/Output risk (eg from weather) Political risk Exchange to facilitate hedgers to mitigate price risk Insurance and exchange traded derivatives to be made available for mitigating yield risk
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Forwards
A bilateral agreement in which the buyer and seller agree upon the delivery of a specified quantity and quality of an asset at a specified date and agreed price Traded on an OTC between two FIs or one FI and a client Price of contract is called a delivery price: usually is equal to spot price plus cost of carry Contracts are custom designed Actual delivery has to take place No margin systems exist here No exchange guarantee
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Futures
Are exchange traded versions of forward contracts
Time, place and delivery price fixed between buyer and seller Buyer is taking a long position Seller takes a short position Contracts have standard specifications Brings in hedgers, speculators and those who want to discover prices Margin system reduces risk, provides liquidity and reduces volatility
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Margin Requirements
Initial margin at time of contract Maintenance margin which is lower than initial margin Additional margin in volatile times Mark-to-market margin on a daily basis
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Exchange Vs bilateral trading
Exchange
Common platform for all traders Price transparency Low transaction costs
Bilateral trading
Restricted access Traded prices unknown to other players High cost and time consuming negotiations
Absence of counter party credit Counter party credit risk risk Market prices available to wider Difficulty in price dissemination world Standardized contract size Customized contracts
Exchange - a common meeting ground for all industry participants
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Types of trading
Open-outcry
Participants congregate in a “ring” to discover prices Physical presence in exchange premises required Price quotations / traded prices not transparent Cannot facilitate on-line real time price dissemination Monitoring of member’s positions and risk management practices cumbersome
Online trading
Participants put orders on-line to discover prices Orders routed through electronic networks Quotations and traded prices available on-line Real time price dissemination possible On-line monitoring of member positions
Other functions such as margining and mark-to-market are similar
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Capital Market vs. Commodities
Capital Market Prices movements based on the expectation of future performance Commodities Price movements are purely based on the supply and demand Seasonality
Price changes can also be due Price changes are due to changes policy changes to corporate actions Dividend announcements Change in tariffs / duties etc Bonus shares / stock splits Predictability of futures performance is reasonably high History of management performance to support
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Predictability of future prices are not in the control Failure of Monsoon Formation of El-ninos at pacific
Options
Gives holder the right but not the obligation to buy or sell an asset at a known fixed price for a premium Call option gives the buyer (of option) the right to buy an asset by a certain date
The seller has the obligation to sell the asset
Put option gives the buyer the right to sell the underlying asset
Seller has the obligation to buy the asset
Could be American option where right can be exercised before expiry date or an European option where it is exercised at the end of life of contract
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Market Structure…
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Commodity markets in India
Spot trading mostly in regional mandis & unorganized markets Markets fragmented and isolated Reduced Government procurement activity Mostly restricted to cereals as of date MSP distorting markets in favour of food grains Restrictions on inter-state movement and warehousing of commodities Futures trading largely regionalized & based on pit trading
There is an overwhelming need to develop commodity futures markets as a stabilizing influence
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Mandi trading in India
Over 7000 Mandis Trading in 140 crops Farmers, Licensed Traders, Brokers & Wholesale Dealers Mandi Inspectors issue type & quantity certificate Mandi fees : Transaction fee, Taxes; total varies between 4% and 12% Trading, Clearing and Settlement Governance : State Agricultural Marketing Boards (SAMB), Mandi Board (Farmers, Traders, State) Secretary, Clerks and Inspector Issues in price dissemination, standards, certification and warehousing
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Commodity futures
Precious Metals Agriculture
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Other Metals Energy
Potential trade in commodities (Rs. in Billion)
Current physical trade volumes 5 times multiple Delivery Base (5% of Market)
Bullion Metals Agriculture Energy Total
400 600 5,000 5,000 11,000
2,000 3,000 25,000 25,000 55,000
100 150 1,250 1,250 2,750
Internationally the multiple for physical versus derivatives is much higher (In TOCOM Gold contract, the multiple is 70 times upwards)
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Volumes as on March 2003
Commodity Exchange NBoT, Indore NMCE, Ahmedabad Ahmedabad Commodity Exch. Rajdhani Oil & OilSeeds Vijai Beopar Ch., Muzzaffarnagar & Bullion Rajkot Seeds Oil IPSTA, Cochin Chamber of Commerce, Hapur Bhatinda Om and Oil & Oilseeds Others (mostly inactive) Products
Soya, Mustard Multiple Castor, Cotton seed Mustard Gur Castor, Groundnut Pepper Gur, Mustard Gur
Approx Annual Vol. (Rs bn) 800 400 35 35 25 25 25 25 15 15
TOTAL 1400 * Current futures volumes are miniscule compared to underlying spot - annualized
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market volumes and the potential
Indian Commodity Futures Exchanges FMC
Commodity Exchanges National exchanges Regional exchanges
NCDEX
NMCE
MCX
NBOT
20 Other Regional Exchanges
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Functions of an Exchange
Product Conceptualization and Design Price Discovery & Dissemination Robust Trading & Settlement systems Management of Counter party Credit Risk Self Regulation to ensure
Overview of Trading and Surveillance Audit and review of Members Enforcement of Exchange rules
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An Exchange provides a a common meeting ground for all industry participants
National Level versus Regional Exchanges
Multi commodities
Transparency Screen based trading Professionally run Best practices pursued Innovative products Large expanding volumes
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Current Mindsets
Commodity exchanges are speculative markets not meant for actual users If commodity exchanges do not enable physical delivery, they are then only for speculators Awareness lacking amongst actual users
Interest rate, exchange rate risk actively managed, but not commodity risk
Main impediments centred around safety, transparency and taxation issues
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Benefits to actual users
Farmers: Price hedging Contract farmers: Price hedging Metal manufacturers: Forward sale of production Metals consumers/farm produce consumers: Forward purchase of inputs Gold users: Hedging price for future
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Price variations (Average annual %)
Cotton FY00 FY01 FY02 FY03 FY04 1.5 6.6 -6.0 -2.3 11.5 Zinc 10.5 -0.03 -24.8 -6.4 15.7 Steel 6.1 -8.6 31.2 9.5 36.0 Rubber 3.3 -1.9 5.9 21.8 42.2 Copper 5.6 8.0 -15.4 3.9 29.0
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Industry Perspective
Industry Raw materials PBT (FY03) to COS % Rs cr 62% 54% 88% 86% Impact of 5% rise in raw mat prices (Rs -2265 cr) - 1429 +200 148 76 -1667 -566 -216
Textiles Steel Edible oils Gems and jewellery
Source: CMIE
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Do actual users use Exchange platforms for physical delivery?
They can, but do not..
View taking Stocking sub-optimal
Reasons
Grades Logistics costs Sales tax/octroi Set off not permitted Most actual users use exchanges for hedging
For commodity needs, bilateral arrangements preferred
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Investors’ story..
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Investors
Portfolio diversifiers
Lower margins Lower risk Better risk-adjusted returns
Mutual funds on the anvil PDs have sought enlargement of roles
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Volumes in Commodity Derivatives Worldwide
Derivatives volumes of non-US exchanges in the last decade has been increasing
Source : World Federation of Exchanges, various websites
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Comparison of Commodities & Equities
Average 20 day historical volatility (1/91 till 8/02) Equity Commodity
Commodities have less volatility compared to equity
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Volatility comparison - Summary
Average annual volatility Sensex or Nifty - 25-30% Govt Sec Index - 5-10% Gold - 12-18% Silver - 15-25% Cotton - 10-12% Oil seeds - 15-20% Commodities are less volatile compared to equity market, but more volatile as compared to G-Sec’s
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Correlation: 1997-03
Correlation coefficients in Indian m arkets Gold Silver Stocks Bonds Gold 1 0.089 0.206 0.741 Silver 1 -0.099 0.146 Stocks 1 0.112 Bonds 1
Data: LBMA bullion prices, NSE Nifty, NSE G-Sec Index
Benefit of diversification can be seen from the
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Risk Adjusted Returns
Risk-Adjusted Returns:1997-03
Portfolio structure 100% Stock Portfolio Stocks (50% ) & Gold (50% ) Portfolio Stocks (50% ) & Silver (50% ) Portfolio 100% Gold Portfolio 100% Silver Portfolio 100% Bonds Portfolio Bonds (50% ) & Gold (50% ) Portfolio Bonds (50% ) & Silver (50% ) Portfolio
Ab s Cum ulative Returns
73.70% 47.80% 48.30%
Risk of Risk Adjusted portfolio Return 3.017 24.43% 3.326
14.37%
3.634
13.29%
21.80% 22.90% 25.20% 23.50% 24.00%
7.92% 8.79% 6.58%
2.001 1.742 3.182 2.673 3.647
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NCDEX Value Proposition…
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Why NCDEX
Create a player without trading interest Foster professionalism and transparency Inculcate international best practices
Demutualisation Technology platforms Information dissemination without noise Low cost solutions
Nation-wide reach and consistent offering Bring together names the market can trust
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NCDEX – Current shareholders
17%
17%
10%
14%
17%
17%
7%
Canara Bank to take additional stake
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Consortium brings ….
Institution building expertise Commitment to the agri sector Nation-wide reach Ability to bring in capital Technology and Risk Management skills
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Governance
Independent Board Professionally managed organization Executive Committee Other Committees Membership Product Risk Management Arbitration
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Commodities selected in Phase I
Bullion Gold Silver
Soya bean Soya oil Rapeseed/Mustard Seed
Agri-Commodities
Rapeseed / Mustard Seed Oil Crude Palm oil RBD Palmolein Cotton
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Commodities introduced in Phase II
Rubber Jute Pepper Chana (Gram) Guar Wheat
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Commodities in Phase III
Rice, wheat Turmeric, chillies Base metals
Aluminium, Copper, Zinc and Nickel
Coffee Tea Other edible oil products
Groundnut, Sunflower, Castor
Seed, oil & cakes Energy products Commodity Indices and weather derivatives
Agri-commodity index, Metal Commodity index
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NCDEX Landmarks….
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Spot Prices: The only real-time source
NCDEX initiatives – Price discovery
Spot price polling from traders, exporters, mandis etc with multiple polling centers Partners: CMIE and CRISIL market wire
Bootstrapping to eliminate manipulation effect Price collection from trade associations
The challenge ahead is price dissemination
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Special mention by Economic Survey
Innovative spot prices polling process introduced by NCDEX Robustness of systems
Convergence/closeness of the traded futures prices and the final settlement prices
“Has given a new level of near real-time access to reliable prices from agricultural markets in the country. This marks a milestone for the statistical system in agriculture, and sets the stage for modern development of commodity derivatives markets despite the presence of a fragmented OTC spot market”
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Price Dissemination: Implemented
Real-time price dissemination
Extranet Website (www.ncdex.com) Tie-up with Reuters, Telerate Corporate tie-ups for rural kiosks
ITC E-choupals
Newspapers, Agri journals AgmarkNet Kissan call centres
Basic idea is to encourage farmers to choose cropping pattern based on future and not past prices
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Price Dissemination: In process
Proposed vehicles of price dissemination
APMC boards at mandis Agri extension service providers
Mahindra Shubhlabh, Rallis etc
Govt. office outlets
Post offices
Bank branches FMCG dealer points
NCDEX spot price can be used for valuation of collateral for commodity- based funding by financial
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NCDEX Approach to Warehousing
Accreditation of Warehouses: parameters based Promoting Collateral Management
The McDonald Approach
Robust grading by international agencies like Geochem, Dr. Amin etc. to assure quality Developing a scientific grading process for cotton
Project in co-ordination with CIRCOT
Dematerialisation of Warehouse receipts Reduction in physical/repayment risk to lead to lower lending rates
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Pilots in Futures
NCDEX project with GujCot
Hedging mechanism for farmers on NCDEX platform GujCot covers price risk Facilitates price dissemination at grass roots level
Two more cotton projects in Hyderabad and Warrangal
Options for farmers can be a substitute for MSP
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Some facts
1st to carry out delivery through dematerialized warehouse receipt for Feb’04 Gold contract In June, 21 kgs of gold and 10 tons of pepper delivered Warehouse accreditation Spot price data base built for last 10 years Presence in over 135 centers Over 1800 trading terminals 300 members enabled for trading as against target of 125 Evening session of trading introduced on Feb 23, 2004- up to 11.30 p.m. Saturday trading also introduced Working towards round-the-clock trading…
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Activity on NCDEX
Recoded peak traded volume of Rs 283 cr on July 7
Turnover of Rs 566 cr 60% share of bullion and agricultural commodities
Has highest open interest ratio to volume traded in gold and silver Average daily number of trades is around 6,500
Highest was above 17,000
Average daily number of orders is around 10,000
Highest was around 37,000
Average daily client participation of around 650
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Looking ahead…We are
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Educating corporates
Industry (data of 1500 companies) Agro/ FMCG/ Edible Oils Auto/Auto Ancil. Chemicals Construction Consumer Goods Engineering/Industrial G. Fertilizer/Pesticides Livestock/Leather Metals/Mining/Steel Packaging Oil/Petro/Refineries Sugar Textiles Transport % of Raw Material cost to Aggr. Turnover 70% 90% 65% 40% 50% 50% 45% 65% 70% 60% 85% 65% 90% 40%
Source of data – ICICI Bank Corporate Infobank
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Industry in India runs the raw material price risk, going Forward they can hedge this risk
Spreading awareness
Awareness Program during January – June 2004
Over 75 programs 5000 Participants
Expect to conduct 200 programs during FY05
To cover over 20,000 participants
Certification Exam already being conducted by NCFM
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Seeking changes in Banking Regulation
Aggregators
Banking Regulation Act to be modified
Accreditation of warehouses and quality of products
Furthers bank lending against commodities
Change in Priority sector norms
Lending against commodities to be considered priority sector lending
Banks to lend against bullion
Need for hallmarking
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Working towards Extension of players
Mutual funds
Commodities as an investment diversifier
FIIs
Either directly or through Indian arm
PDs Insurance firms Pension funds
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Changing the face of Warehousing
Electronic warehouse receipt (EWR) to be legally recognized EWR to be a negotiable instrument Depositories Act to be amended to cover commodities
SEBI to notify that FMC is regulatory body for demat commodities
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Inducing Policy changes
Introduction of options
Will ably substitute the MSP programme of government
Permit weather derivatives Redefining commodities
Goods not covered under ’securities’ Products not covered under SCRA
Physical delivery not to be mandatory
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Budget proposals relating to Commodities
Integration of commodity market with securities market Service tax on forward contracts to affect commodity brokers Significant omissions in light of other announcements
Weather derivatives Bank investment in commodities
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Thank you
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Polling centres
Commodities Mustard Seed / Rapeseed Expeller Mustard /Rapeseed Oil Soyabean Refined Soya Oil Crude Palm Oil RBD Palmolein Medium Staple Cotton Long Staple Cotton Priority Center Jaipur Jaipur Indore Indore Kandla Kakinada Bhatinda Ahmedabad Non-Priority Center Alwar, Sriganganagar Sriganganagar, Alwar Nagpur, Mumbai, Dhar, Dewas Mumbai, Nagpur, Dewas Kolkatta Mumbai, Chennai Abhor, Sirsa Surendranagar, Kadi (Guj)
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Polling Centre (Contd.)
Commodities
Chana Guar Jute Pepper Wheat Rubber
Center
Delhi, Indore
Jodhpur, Bikaner
Kolkata Kochi, Allepey, Angamaly Delhi, Khanna, Karnal, Bareilley, Kanpur, Shahjahanpur Kottayam, Kochi, Ernakulam, Palakkad
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