Indian Commodity Market Vs Global Commodity Market by fdv96518


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									                                        Commodities Derivative
                                        hedging: Portfolio and
                                        By Mr. Kumar Dasgupta and Dr. Chiragra Chakrabarty

“Commodities have been the bedrock of civilization. Ever since we arrived, our existence
has been defined by a quest for control over geological resources – call it oil, gold,
copper or even exotics like uranium. Man has undertaken treacherous expeditions and
fought battles to discover and conquer commodities. Civilisations rise and fall, and
economies prosper based on their ability to harness energy, mine metals, and cultivate
agricultural produce. Interesting to note: the progress of mankind has been marked
through the ages with different commodities – Stone Age, Bronze Age, Iron Age, and
now Nuclear Age. The enigma, called commodities, has determined the fate and wealth
of nations for eons and would continue to do so in future…”

1.   Introduction to Commodity Derivatives                      vehicles for accumulation of significant wealth for
     Markets                                                    individuals. Some of the most enduring fortunes
                                                                have been built with commodities. Among the
1.1. Commodities derivatives markets are deep and               stars in the galaxy, Mayer Rothschild single-
     broad, presenting both challenges and                      handedly built the banking empire by providing
     opportunities in their wakes. It has been the              vault facilities for storing bullion during World
     experience of participants that they have been             War II. John D. Rockefeller created the first true
     besieged by the vastness of the market and the             corporate, Standard Oil Co., by exploring crude
     types of underlying assets available. Despite              oil. Andrew Carnegie conglomerated the steel
     millennia of commerce in commodities, we are               industry in the United States to form US Steel.
     still perplexed by questions such as: “what should         Abdel-Aziz-Al-Saud, the founding father of Saudi
     we trade in?”, “how much do we buy or sell?”, “how         Arabia, created one of the most influential
     do we give or take delivery of commodities?”,              nations on energy products. Jim Rogers, the
     “when is the ideal time to enter and exit the              Ambanis, the Tatas and Laxmi Mittal have all
     market”, and so on. These asymptomatic                     become legends because they had the foresight
     behaviours of intermediaries and investors have            to invest in commodities.
     given naissance to the major commodity
     markets, as we know them today. From the             1.3. With a growing population of over one billion
     mandis in Asia and Africa to the sophisticated            (2001 census), India would remain one of the
     electronic platforms in the Western world,                largest markets for traders in global commodities,
     commodities trading has come a long way. The              with metals and energy playing a crucial role in
     mode of exchange of the value of commodities              the growth and development of the industrial
     has also seen a transformation over the ages —            sector of the Indian economy and agricultural
     from the rudimentary barter system, trade was             products. At this juncture, institutional
     revolutionised by the introduction of money, and          development of commodity markets will: (a)
     yet again with the advancement in electronic              create a “near-perfect” market situation, (b)
     transfer of credits called dematerialisation.             enable wider participation by different segments
                                                               of the economy, (c) create a global hub for trading
1.2. While it is true that commodities have dictated           in commodities due to its strategic geographical
     the economic passions of sovereign and non-               location, and (d) make India a potential “price
     sovereign nations, they have also acted as the            setter” for many commodities.

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            1.4. The paper has been divided into five sections.                             Rs.33,162.07 billion in 2008-09. The growth
                 While section 2 draws a comparison of Indian                               charted by the Indian commodity exchanges can
                 markets with international markets, the use of                             be summarised in Table 1.1.
                 commodity derivatives in portfolio management
                 is explained in section 3. Section 4 depicts the
                                                                                       Table 1.1: Turnover of the Indian Commodity
                 methodology and issues related to the
                 measurement of hedge effectiveness. Section 5 is                      Derivative Exchanges
                 devoted to conclusion.                                                 Year                           Turnover (in Rs. Billion)
                                                                                        2002-03                                  665.30
            2.        Indian Markets vs. International Markets –
                                                                                        2003-04                                1,293.64
                      Where We Stand
                                                                                        2004-05                                5,717.59
            2.1. If we look at our history, Indian market                               2005-06                               21,551.22
                 participants have had the experience of trading                        2006-07                               36,769.27
                 in commodity derivatives for ages. Even during                         2007 -08                              40,659.89
                 the long period of ban, there were reports of                          2008-09 (Nov. 2008)                   33,162.07
                 parallel markets in commodity derivatives. It is
                                                                                     Source: MCX, NCDEX, NMCE & NBOT
                 interesting to note that, in 2002, just after the ban
                 was lifted and the Government approved the
                 launch of national-level trading platforms, the                     2.3. The Group on Forward and Futures Markets, 2001,
                 Indian commodity market took a quantum jump.                             has estimated that the contribution of
                 Industry observers were left wondering as to how                         commodity derivatives exchanges would be as
                 India could pull off a coup d’état in such a short                       high as 10% of Gross Domestic Product (GDP) by
                 time. The question which was, and perhaps still                          the year 2007 compared with a nominal of 1.2% of
                 lingers (even after five years of operation) is: Is                      GDP in 1999. Compared by volumes (the number
                 such a progress sustainable and what are the                             of contracts traded), nine of the world’s top 22
                 obstacles that need attention if the market has to                       major commodity derivatives exchanges are in
                 realise its full potential?                                              developing countries. And interestingly, three of
                                                                                          them are based in India (MCX1, NCDEX2 and
            2.2. Since 2002 there has been a revival of commodity                         NMCE3). Further, one of these exchanges (MCX)
                 derivatives markets in India, both in terms of                           features in the world’s top 10, overtaking long-
                 commodities allowed for futures trading and                              established and mature institutions such as the
                 volumes of the trade. Let us consider some                               Tokyo Commodity Exchange and New York Board
                 statistics. While in 2001-02 futures trading was                         of Trade. A figurative assessment is given in Table
                 allowed only in eight commodities, the count                             1.2. The figures include the volumes in terms of
                 jumped to 109 in 2008-09. The value of trading in                        contracts traded in the first half of 2009. The
                 Rupee-denominated terms saw a quantum jump                               volumes in terms of USD or INR are not
                 from about Rs.350 billion in 2001-02 to                                  considered within the scope of this study.

              Table 1.2: Turnover of Global Commodity Derivatives Exchanges
                 Rank                                       Exchange                           Country
                                                                                                              (number of contracts traded)
                  1           New York Mercantile Exchange (NYMEX)                                 USA                   206,010,205
                  2           Dalian Commodity Exchange (DCE)                                     China                  170,869,127
                  3           Shanghai & Hong Kong Futures Exchange (SHFE)                        China                  151,544,472
                  4           Zhengzhou Commodity Exchange (ZCE)                                  China                  93,213,149
                  5           Chicago Board of Trade (CBoT)                                        USA                   83,233,736
                  6           ICE Futures, Europe                                              Belgium.                  78,372,945
                  7           Multi Commodity Exchange of India (MCX)                             India                  77,742,706
                  8           London Metal Exchange (LME)                                          UK                    55,185,086
                  9           ICE Futures U. S. (erstwhile New York Board of Trade)                USA                   25,271,245
                  10          Tokyo Commodity Exchange (TOCOM)                                  Japan                    14,643,397
            Source: Industry Analysis

            Multi Commodity Exchange of India Limited, Mumbai (
            National Commodity and Derivatives Exchange Limited, Mumbai (
            National Multi Commodity Ex change of India Limited, Ahmedabad (

2.4. In retrospect, MCX Comdex fell by 24% during                 Table 1.4: Global Sector-wise Futures &
     2008 — somewhat lower compared with the                      Options Volume
     decline in international commodity futures
     indices of Dow Jones AIG Commodity Index Cash                 Sector                       Contracts Traded in Millions
     Index (DJAIG) at 36.6% and Reuters/Jefferies                  Sector Equity Index                       6,488.62
     Commodity Research Bureau (RJCRB) at 36%. For                 Individual Equity                         5,511.19
     a comparative analysis of MCX Comdex with the
                                                                   Interest Rates                            3,204.84
     other global indices, we have recalibrated the
                                                                   Agriculture                                 888.83
     base period of all the indices to 100 from June
     2005. Levels are calculated as in January 2009,               Energy                                      580.40
     tabulated in Table 1.3.                                       Foreign Currency                            577.16
                                                                   Precious Metals                             180.37
Table 1.3: Comparison of MCX Comdex with                           Non – Precious Metals                       175.79
major global commodities indices                                   Other                                        45.50
                         Levels in          Levels in              TOTAL                                  17,652.70
                        June 2005         January 2009
  RJCRB                    100              128.7134            Note: Prices of commodities and indices are taken from January
                                                                2006 to June 2009.
  DJAIG                     100             102.7972
  Comdex                    100             128.5218
Source: Industry Analysis                                       2.7. Clocking an impressive growth within five years,
                                                                     this transformation has expanded the breadth
2.5. Even if we undertake a comparison of the share of               and intensity of potential impacts that a
     equity market investors’ wealth in GDP with that                commodity derivatives exchange can make on
     of the commodity futures markets, we find that                  underlying commodity sectors as well as the
     India ranks quite high among all countries. The                 economy. In a comparison of the Indian
     ratio of India’s market capitalisation to GDP                   commodity derivatives market with the
     touched a historical high of 165% in early 2008.                international markets, we find that there is a need
     While this is a substantially sharp rise, India is still        for elevating the products base of the exchanges
     in the fifth position, behind Hong Kong,                        in India. Limited commodities are limiting
     Singapore, Switzerland and Taiwan, some of                      industry participation. In the new economy
     which have ratios in excess of 200%. The value of               paradigm, banks are engaging in warehouse
     investors’ wealth in Rupee-denominated spot                     receipt financing and collateral management.
     market turnover terms is approximately                          Now, with the participation of banks, this industry
     Rs.30,860.75 billion in 2008-09 (excluding assets               is bound to flourish.
     under management of fund management
     houses). The derivatives segment of the                    2.8. There is a need for strengthening the regulatory
     historically more mature Indian equity markets                  framework of the market. The government's
     ranks seventh (S&P CNX Nifty Futures) and tenth                 approval to the amendment of Forward
     (S&P CNX Nifty Options), respectively, in terms of              Contracts (Regulation) Act, through an
     turnover ratio when compared to the top 20                      ordinance, paves the way for introduction of
     derivatives exchanges globally. The Indian                      long-awaited ‘options’ trading in commodity
     commodity derivatives exchanges, on the other                   derivatives. The move will certainly deepen
     hand, are among the top 10 in terms of volumes                  commodity markets, make them more mature
     generated.                                                      and spur wider participation in derivatives
                                                                     trading on the domestic commodity exchanges.
2.6. A snapshot of the global volumes of futures and                 If the move is symptomatic of the government's
     options contracts traded across the asset classes               softening stance towards commodity exchanges
     will ingrain an impression of what we are looking               and commodity futures, it must be hailed as one
     at. Table 1.4 shows the sectoral break-up of                    of the most pragmatic pieces of economic
     volumes in terms of million contracts traded                    legislation. Moreover, the existing national-level
     and/or cleared on 69 exchanges worldwide for                    exchanges support a strong and advanced
     the year ended March 2008.                                      technology-driven platform.

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        3.       W h y Yo u r Po r t f o l i o S h o u l d I n c l u d e   3.4. Furthermore, on examining the correlations of
                 Commodities Derivatives                                        oil-based futures contracts with energy-related
                                                                                and non-energy-related stock, bond, real estate
        3.1. In our country, direct commodity investment has                    and commodity markets, and CPI, results confirm
             not been a major part of the investors’ pool. In                   that, except in periods of extreme energy price
             recent times, however, commodity-linked assets                     movement, many traditional forms of indirect
             have increased the number of available                             energy investments such as natural resource
             commodity-based products. Empirical studies                        mutual funds and energy-based common stocks
             have shown that investment in commodities                          are not correlated with energy price movements.
             results in significant diversification benefits.                   This is as expected. Given the risk management
             These benefits are traced to the unique exposure                   and firm diversification abilities of most
             of commodity investment to macroeconomic                           corporations, unless the price change in the
             variables, as well as the potential to capture a                   underlying commodity is structural and long
             positive ‘roll return’. But the principal thought                  lasting, short-term changes in commodity prices
             lingers: why should the investor think about                       may have little impact on a firm's equity
             diversifying the portfolio through investments in                  performance.
             commodity-linked instruments? The answer lies
             in the fact that direct or indirect investments in            3.5. It was also confirmed that in addition to energy-
             the commodities market actually increase the                       based “passive” long-only commodity indices
             Sharpe ratio of the portfolio and significantly                    offering returns not available in traditional equity
             reduce the annualized volatility. A few studies                    investments, “active” long/short energy traders
             have been cited.                                                   offer returns (positive returns in markets with
                                                                                declining energy prices) not available in long-
        3.2. The diversification benefits of commodities have                   only commodity indices or traditional
             been studied in length and breadth, and across                     commodity-based equity investments.
             the continents. Studies have found that the
             inclusion of portfolios of long commodity futures             3.6. The principal argument for investing in
             contracts (CRB and GSCI) improves the risk and                     commodities is that investing in assets that rise in
             return performance of stock and bond portfolios                    price with inflation provides a natural hedge
             for the period 1970 through 1990. It was                           against losses in equity and debt holdings that
             observed that the improvement is more                              typically lose value during periods of unexpected
             pronounced for the 1970s than the 1980s due to                     inflation. The studies have spanned across years
             the high inflation of the 1970s with commodities                   of high inflation such as 1978, 1983, 1998 and
             acting as a natural inflation hedge. Futures prices                2000. In continuation with the evidences
             were also found to have little value in predicting                 presented, we present our case by demonstrating
             inflation. Tests were performed on the theory of                   that during a same period analysis, equities show
             storage and present empirical evidence that in                     a n e g at i ve co r re l at i o n w i t h i n f l at i o n .
             periods of increasing volatility and risk,                         Commodities indices have shown a greater
             convenience yields increase for a wide variety of                  independence from inflation. This contradicts the
             metals prices.                                                     popular belief that commodity derivatives put
                                                                                inflationary pressures on the economy. We have
        3.3. Academicians have identified business cycle                        compared MCX Comdex with the BSE Sensitive
             component in the variation of spot and futures                     Index and inflation respectively for a period
             prices of industrial metals. The theory of storage                 spanning June 2005 to January 2009, the findings
             splits the difference between the futures price                    of which are tabulated in Table 1.5
             and the spot price into the forgone interest from
             purchasing and storing the commodity, storage                   Table 1.5: Comparative Analysis of BSE Sensex,
             costs and the convenience yield on the inventory.               MCX Comdex and Inflation
             The question of whether commodities represent                                              BSE        MCX
             a separate asset class has been extensively                                                                         Inflation
                                                                                                       Sensex     Comdex
             debated.                                                        BSE Sensex                 1.000        -               -
                                                                             MCX Comdex                 0.210       1.000            -
                                                                             Inflation                 (-)0.01     (-)0.08         1.000
                                                                           Source: Industry Analysis

3.7. Adding commodities to an equity portfolio can           4.   How Effective is “Highly Effective” –
     minimise the damage during economic crises or                An Accounting Perspective
     downturns. As commodities have the ability to
     react favourably to economic downturns or               4.1. Normally there are three common methodologies
     macroeconomic conditions unfavourable to                     for testing and analysing hedge effectiveness —
     equities, they are a perfect contender for                   the dollar-offset method, the variability-reduction
     reducing downside risks. The ability to protect the          method, and the regression method.
     value of investment in chaotic markets is the key
     to any diversification.                                 4.2. The above methods to an extent have also been
                                                                  enshrined in the new accounting norms dealing
3.8. Perhaps the major advantage of diversifying an               with such types of instruments. The new
     equity portfolio using commodities is the                    accounting norms for derivative instruments and
     mitigation of management risk. In any portfolio              hedging activities were issued because the
     management, risk seeps in from the style                     effects of the increasing quantity and variety of
     incorporated by the fund manager. Even though,               derivatives used by companies were not always
     in a given period, a fund manager investing in               transparent in their financial statements. These
     equities may give higher returns, the impression             standardise the accounting treatment for
     of the company management may have its                       derivative instruments by requiring all entities to
     effects on the financial statements during the               report derivatives as assets and liabilities on the
     same period. The return from the equity is subject           balance sheet at their fair value.
     to company policies, valuations, industry-wide
     conditions and management styles. These are             4.3. However, the new accounting norms also
     systemic risks associated with the equity market.            recognise hedges that are put in place by entities
     In the commodity market, however, the prices are             and try to reflect the economics of such hedges in
     dependent purely on demand and supply                        the financial statements. It basically allows for
     conditions. The macroeconomic variables                      three accounting models for hedges — a fair
     determine the prices and the behaviour of                    value hedge model, a cash flow hedge model and
     commodities. In a nutshell, investing in                     a net investment hedge model — with the first
     commodities automatically mitigates the                      two being most commonly used. A fair value
     abovementioned risks.                                        hedge offsets the price risk of a recognised asset
                                                                  or liability or an unrecognised firm commitment.
3.9. However, it is also emphasised that price risk               A cash flow hedge offsets the variability of the
     management may not always be the most                        cash flows of a balance sheet item or a forecasted
     important benefit. Commodity derivative                      transaction. If a derivative qualifies for hedge
     exchanges can yield other critical impacts:                  accounting and the hedge is deemed to be
     b ro a d e n a cce s s to m a r k e t s ; e m p owe r        “highly effective”, the standard permits entities to
     participants to take better decisions; reduce                match the timing of the gains and losses on the
     information asymmetries that have previously                 hedged item and with the gains and losses on the
     advantaged more powerful market actors;                      derivative positions in their profit or loss account.
     upgrade procurement, storage, grading and                    Or, in other words, the accounting captures the
     technology infrastructure; and expand access to              economics of the hedge whereby an entity has
     cheaper sources of finance. Last but not the least,          mitigated its exposure to commodity price risks
     these exchanges enable entities to create a                  through commodity derivative instruments.
     hedge against their exposures to the vagaries of
     commodity price movements.                              4.4. In principle, a hedge is highly effective if the
                                                                  changes in the fair value or the cash flow of the
3.10. But the moot question is: how effective is the              hedged item and the hedging derivative offset
      hedge created by commodity derivatives? The                 each other. To qualify a derivative position for
      next section tries to answer this question.                 hedge accounting, the hedging entity must
                                                                  specify the hedged item, identify the hedging
                                                                  strategy and the derivative, and document by
                                                                  statistical or other means the basis for expecting
                                                                  the hedge to be highly effective in offsetting the
                                                                  designated risk exposure. This documentation
                                                                  step is called prospective testing, and it must be
                                                                  done to justify continuing hedge accounting. The
                                                                  hedger must also regularly perform retrospective
                                                                  testing to determine how effective the hedging
                                                                  relationship has actually been.

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        4.5. Defining and testing a measure of hedge                4.9. The other two methods of assessing hedge
             effectiveness represents an important and                   effectiveness i.e. the variability-reduction
             potentially challenging aspect of hedge                     method and regression analysis are closely
             accounting. Failure to meet the challenges hedge            related. The difference is that the variability-
             accounting presents may introduce substantial               reduction method assumes that the risk-
             volatility into reported earnings.                          minimising derivative position is equal and
                                                                         opposite to the hedged item in a one-to-one
        4.6. Highly effective hedge substantially offsets the            hedge.
             change in the fair value (or the cash flow) of the
             hedged item. That is, if the hedged item in a fair     4.10. If a one-to-one hedge performs perfectly, the
             value hedge appreciates by $100,000, then there              change in the value of the derivative exactly
             is some range of decline in values of the hedge              offsets the change in the value of the hedged
             that can be defined as substantially offsetting this         item. The variability-reduction method compares
             change. Defining this range is a matter of                   the variability of the fair value or the cash flows of
             subjective judgment. A highly effective hedge                the hedged (combined) position to the variability
             has been defined in literature as one that offsets           of the fair value or the cash flows of the hedged
             at least 80% of this change and no more than                 item alone. This method places greater weight on
             125%. Then the acceptable range of the change in             larger deviations than on smaller ones by using
             value for the derivative will be between                     the squared changes in value to measure
             (–)USD.80,000.00 and (–)USD.125,000.00.                      ineffectiveness. The preferred test statistic for this
             However, even when a hedge is determined to be               method is the proportion of the hedged item’s
             highly effective, there could be an impact on                mean-squared deviation from zero that the
             current earnings when there is not an exact offset           hedge eliminates. To calculate the test statistic,
             of the hedged risk. If, for example, the change in           subtract from one the ratio of the sum of the
             value of the derivative were (–)USD.110,000.00,              squared periodic changes in the hedge and the
             then the hedge would be highly effective,                    hedged item to the sum of the squared changes
             because this change in value falls within the                in the hedged item.
             specified range and hedge accounting would
             report an effect on income of                          4.11. The measure of hedging effectiveness using
             USD.(+100,000–110,000) = (–)USD.10,000.00. This              regression analysis is based on the regression line
             idea of offsetting has found its way into the hedge          in which the change in the value of the hedged
             effectiveness testing literature in the form of the          item is the dependent variable and the change in
             dollar-offset method of testing.                             the value of the derivative is the independent
                                                                          variable or vice versa. Given the definitions of X
        4.7. The dollar-offset method compares the changes                and Y, the slope of this regression equation
             in the fair value or the cash flow of the hedged             should be negative and close to (–)1.0. However,
             item and the derivative. The dollar-offset method            for the hedge to be considered effective it should
             can be applied either period by period or                    lie between -0.8 and -1.25. The interpretation of
             cumulatively. For a perfect hedge, the change in             the intercept term is also important. It is the
             the value of the derivative exactly offsets the              amount per (data measurement) period, on an
             change in the value of the hedged item.                      average, by which the change in value of the
             Therefore, the ratio of the cumulative sum of the            hedged item differs from the change in value of
             periodic changes in the value of the derivative              the derivative.
             and the cumulative sum of the periodic changes
             in the value of the hedged item will equal one in a    4.12. Ederington (1979) showed that the estimated
             perfect hedge (after multiplying the ratio by                slope coefficient is the variance-minimising
             negative one to adjust for the two sums having               hedge ratio. Consequently, the accounting
             opposite signs in a hedging relationship).                   literature explicitly allows for a hedge ratio that
                                                                          differs from 1.0.
        4.8. Anyone choosing this test should be aware that
             researchers question its reliability because of its
             excessive sensitivity to small changes in the value
             of the hedged item or the derivative. Canabarro
             (1999) showed that under reasonable
             assumptions about the distribution of changes in
             prices, the 80/125 standard rejects as ineffective
             36% of all hedges when the coefficient of
             determination (correlation squared) R2 is 0.98.

5.     Concluding Remarks

5.1. The need for commodity derivatives is                               5.2. As the recent global experience has exhibited,
     multifarious in a growing economy like India. Be it                      growth in derivative products without
     for ‘risk management’, ‘investment’, ‘portfolio                          corresponding development in regulation —
     diversification’ or to provide access to our                             both from a macroeconomic perspective and a
     producers to the most efficient markets in                               risk management perspective — is neither
     commodities, it is difficult to argue for other than                     desirable nor advantageous from the viewpoint
     an expansion of the availability of such products                        of long-term stability. In this arena, the new
     in the arena of exchange-traded instruments.                             literature on the accounting for such instruments
     However, as the above article demonstrates,                              is a welcome addition. What is also required is
     there has been unprecedented growth in this                              more detailed guidance from a risk management
     area over the last few years.                                            perspective by the Reserve Bank of India on the
                                                                              use of such products. It is only a combined
                                                                              approach that will lead to the establishment of
                                                                              stable and deep markets for commodities in
                                                                              India, which is essential for the long-term growth
                                                                              of our economy.

Mr. Kumar Dasgupta is Partner and Dr. Chiragra Chakrabarty is Associate Director, Price Waterhouse. Views expressed are personal.

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