Futures contracts in tea by HC120704141152


									    Risk management through
introduction of futures contracts
              in tea

     An attempt at solving the
      heterogeneity problem
  What is a futures contract?
• Commodities are often contracted for
  delivery in the future at a fixed price. When
  this is done informally, the word forward
  contract is used to describe the transaction.
• However, when the transaction is organized
  and regulated by a recognized exchange, in a
  standard size and delivery period, with an
  implicit performance guarantee through the
  institution of a clearing house, the same is
  called a futures contract in the underlying
      Why the need for such

• The reason why such transactions
  are made is that the seller is a hedger
  and the buyer is a speculator, or, vice
 Futures on intangible assets
• Observation of this fact resulted in the
  invention of index futures, and futures on
  other non deliverable assets, where actual
  delivery is not an option (pun intended!).
  Examples are S&P index futures where
  the stock index is the underlying asset,
  crude oil basket futures, where a specified
  basket of oil prices is the underlying asset
    What kind of assets lend
 themselves to futures trading?
• Since a futures contract is an insurance
  related transaction, it stands to reason that
  futures contracts on assets with zero or
  very low variability might neither be
  popular (high trading volume), nor
  effective ( a successful hedge).
  Conversely, futures contracts on highly
  variable underlying assets should be both
  popular and effective.
 The different kinds of variability
• There are different kinds of variability in
  asset prices. This could be random non
  cyclical, random cyclical, intra year pattern
  cyclical, inter year pattern cyclical, or
  monotone trend.
Futures as a hedge vs futures as
 an instrument for speculation
• Agricultural commodity futures have been the
  means by which a limited number of traders
  stabilized future prices and enabled farmers to
  finance investments in future crop production.

• However, speculative purchases of index futures
  that have no purpose other than to make money for
  the speculator, who hold their contracts to drive up
  spot prices with the intention not of selling the
  commodities in the real market, but of unloading
  their holdings onto an artificially inflated market, at
  the expense of the ultimate consumer, may have a
  profoundly destabilizing effect on the spot market..
    Examples of speculation in
• If speculation is the major cause rather than
  supply/demand factors for transactions in any
  commodity market, spot prices may shoot upin
  the short term, but would be expected to fall
  dramatically when the market corrects itself.
• As an example, assets allocated to commodity
  index trading strategies in the USA increased
  from $13 billion to $300 billion between 2003
  and 2008 and the prices of the 25 underlying
  commodities increased 200% over the same
An idea of the size of speculation
     The challenge of devising
          futures for tea
• The tea industry unlike commodities like
  coffee, cocoa, and rubber, or food crops
  like wheat or corn has no precedent
  anywhere in the world to drawn upon and
  hence the complexity of developing the
  framework for a tea futures exchange. In
  both the following suggested scenarios,
  due approval from the Forward Markets
  Commission of the respective country will
  have to be obtained.
Why tea futures would be useful
• Tea prices show both random and cyclical
  variability. Theoretically, trading futures in tea would
  be a useful hedging instrument available to
  producers to insure themselves against price risk.
• However, informal systems of entering into forward
  contracts with reputed buyers of bulk tea already
  exist in the Indian market and for futures contracts
  to be used popularly as a hedge, they would have to
  offer superior cover compared to the existing
  forward booking. For speculators, who would take
  the long position in these contracts, the depth and
  liquidity of the market would be a crucial
  determinant of their popularity.
The magnitude of the problem
• Since tea is heterogeneous both over season and
  region, and even intra region depending on the stock
  from which harvest was made and the periodicity of
  the harvest, it would be impossible to define a
  quality for delivery or even for squaring one’s

• The key to establishing a set of successful futures
  contracts is to have standardized lots of a given
  quality that are easily available for delivery. Tea may
  not conform to this criterion and contracts may have
  to be tailor made for individual gardens. The
  multiplicity of contracts will confound the market
  and prevent secondary trading.
 Option 1: A classic commodity
       futures initiative:
• Damodaran (March 2000), in a report to Tea
  Board India, had suggested a framework for
  developing commodity based futures contracts
  in tea, and had worked on segregating more
  than 50 grades on which such contracts could
  be traded. He came to the conclusion that such
  an initiative was indeed feasible since the spot
  market had sufficient volume, turnover and
  liquidity, was adequately regulated, operated
  under a few centralized umbrellas, and also had
  inbuilt quality regulation mechanisms in the
  shape of brokers being the unspoken referees.
   Our suggestions if we go this
• The aim of establishing the contract should not be to
  ensure a supply of a specific grade of tea on a
  certain date to the buyer of the contract, but rather to
  reduce his risk by providing a mechanism to offset
  his short position.
• To ensure liquidity, a limited number of well defined
  contracts should be offered on grades or baskets of
  grades which are sufficiently distinct from each
  other. The delivery months should be spread
  through the year but should skip those months
  where pronounced upward or down ward price
  variance for the particular basket/grade is known to
  Further suggestions and some
     reservations on option 1
• The contract should be closed out either by actual
  delivery or by cash settlement. The goods supplied
  under the actual delivery option should be certified
  by an agency operating under the aegis of the
  futures market organizer, who could be the broker
  presently licensed by the auction organizer, who
  would have a dual role as the futures exchange.

• The clearing house could be the present auction
  settlement bank. The issues of variability of quality if
  actual delivery is taken, or the price of the category
  of tea if cash closing out is taken will remain as real
  hurdles to the smooth functioning of the system.
  Option 2: Develop a financial
         future on tea:
• The other way would be to have an index
  based futures contract where the index
  could be an auction average price for a
  defined category of tea.
• The great advantage of this would be a
  total transparency of the asset price at
  closing, and absence of any disputes
  regarding quality issues.
               Index selection
• The success of this futures market will depend
  critically on the selection of the correct index.
• We have a range of possible indices which are
  presently available and the desired qualities we
  require in our final choice of index are basically as
   – Index has sufficient market depth, in other words, spot
     transaction volume
   – Index has sufficient random and non seasonal variability.
     Overall auction averages generally show lower variance,
     and may not be directly suitable
   – Perhaps, a medium Assam index could be devised from the
     auction prices of a defined set of estates
  Index selection continued..
• Intra year weekly average prices vary
  more for some categories of tea compared
  with others. To elaborate, higher priced
  teas have higher variance in weekly
  averages than the common teas.
• It also makes sense to have at least two
  index futures contracts on offer, since
  price behavior of South Indian teas differ
  from that of the North.
Characteristics of an ideal index
• More research is needed to determine which
  widely traded category has the maximum
  random variability. Our index can be then based
  upon this specific category of tea, and its weekly
  auction average at one of major North Indian
  auction centers could serve as the index for the
  proposed tea futures contract.

• This financial derivative, if not misused, would
  be a useful instrument for both hedgers with
  positions in the physical stock of tea as well as
  speculators with views that are contrary to those
  of the hedger.
 Who would manage the futures
• In this scenario, the auction centers and
  associations may not be the ideal
  organizers of the futures exchange, having
  no experience in managing financial

• In India, an established stock exchange
  like National Stock Exchange may be
  more suitable.
                The risk
 While index futures designed as suggested
would eliminate structural problems in devising a
tea futures contract resulting from the
heterogeneity of tea, there is some evidence that
such commodity futures may act as a magnet for
large speculative investment, which might result
in medium term abnormal inflationary pressure
on the spot commodity price, followed by a
severe correction, in cases where the real
demand for the concerned commodity is weak.
Prompt continuous corrective action by the
designated watchdog should take care of this
• A decision to permit trading in futures
  contracts based on a suitable transparent
  tea price index at an existing stock
  exchange may be taken by the concerned
  authorities. The selected exchange could
  be authorized to take all downstream
  decisions regarding the details of this
  contract. The popularity of the contract
  could guide the future course of action.

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