Commodity Market: A View


By:

A. Sathish Kumar
M.Com., MBA(fin)
Asst. Professor & Head
Department of Business Management
Vivekananda PG College
Karimnagar-505 001 (AP)
E-mail:
sarita_peddi@yahoo.co.in
 


Investment in India has traditionally meant property, gold and bank deposits.  The more risk-taking investors choose equity trading.  But commodity trading forms a part of conventional investment instruments.  As a matter of fact, future trading in commodities was banned in India in mid-1960 due to excessive speculation.  In February 2003, the government revoked the ban and threw open futures trading in 54 commodities in bullion and agriculture.  It gave the go-ahead to four exchanges (The National Commodity and Derivative Exchange (NCDEX), The Multi Commodity Exchange of India (MCX), The National Multi Commodity Exchange of India (NMCE) and The National Board of Trading in Derivatives (NBOT)) to offer online trading in commodity derivatives products.

What makes commodity trading attractive?

* A good low-risk portfolio diversifier
* A highly liquid asset class, acting as a counterweight to stocks, bonds and real estate.
* Less volatile, compared with, equities and bonds.
* Investors can leverage their investments and multiply potential earnings.
* Better risk-adjusted returns.
* A good hedge against any downturn in equities or bonds as there is little correlation with equity and bond markets.
* High co-relation with changes in inflation.
* No securities transaction tax levied.

Investors' choice:

The futures market in commodities offers both cash and delivery-based settlement.  Investors can choose between the two.  If the buyer chooses to take delivery of the commodity, a transferable receipt from the warehouse where goods are stored is issued in favour of the buyer.  On producing this receipt, the buyer can claim the commodity from the warehouse.  All open contracts not intended for delivery are cash-settled.  While speculators and arbitrageurs generally prefer cash settlement, commodity stockists and wholesalers go for delivery.  The option to square off the deal or to take delivery can be changed before the last day of contract expiry.  In the case of delivery-based trades, the margin rises to 0-25% of the contract value and the seller is required to pay sales tax on the transaction.

Trading in any contract month will open on the twenty first day of the month, three months prior to the contract month.  For example, the December 2004 contracts open on 21 September 2004 and the due date is the 20-day of the delivery month.  All contracts settling in cash will be settled on the following day after the contract expiry date.  Commodity trading follows a T+1 settlement system, where the settlement date is the next working day after expiry.  However, in case of delivery-based traders, settlement takes place five to seven days after the expiry.

Tradable Commodities:

World-over one will find that a market exits for almost all the commodities.  These commodities can be broadly classified into the following:

Precious Metals: Gold, Silver, Platinum etc.
Other Metals: Nickel, Aluminum, Copper etc.
Agro-Based Commodities: Wheat, Corn, Cotton, Oils, Oilseeds etc.
Soft Commodities: Coffee, Cocoa, Sugar etc.
Live Stock: Live Cattle, Pork Bellies etc.
Energy: Crude Oil, Natural Gas, Gasoline etc.

Returns from Commodity trading:

Absolute returns from stocks and bonds are definitely higher than pure commodities.  But commodity trading carries a lower downside risk than other asset classes, as pricing in commodity future is less volatile compared to equities and bonds.  While the average annual volatility is 25-30% in benchmark equity indices like the BSE Sensex or NSE's Nifty, it is 12-18% in gold, 15-25% in silver, 10-12% in cotton and 5-10% in government securities.

According to study, if an investor had put his money only in silver and bonds from 1997-2003, his absolute returns would above been 24%.  Commodities are also good bets to hedge against inflation.  Gold offers good protection against exchange rate fluctuations, and, in particular, against fluctuations in the value of the US dollar against other leading currencies.  However, unlike stocks, commodity prices are dependent on their demand-supply position, global weather patterns, government policies related to subsidies and taxation and international trading norms as guided by the World Trade Organisation (WTO).

Growth of commodity trading:

A soft interest rat regime and a weak US dollar ahs increased the demand for the commodities.  In a short span of over a year, online commodity markets are witnessing good growth in India.  The daily volume of trading of Rs.2500 crore at NCDEX alone has surpassed that of Rs.2000 crore on the Bombay Stock Exchange (BSE).  It registered a record daily traded volume of Rs.2617 crore on 8 December 2004. Commodities like chana, urad, soya bean oil, sugar, pepper, mustard seeds and wheat contributed to the balance trading volume.  MCX, on the other hand, has achieved a peak daily turnover of Rs.1889 crore.  Though the most popular commodities for trading in India are gold, silver, soya bean and guar gum, the market is divided equally between bullion and agricultural commodities in terms of trading volumes. 

Expecting the turnover on the three online commodity exchanges to spurt to Rs.10000 crore per day, banks are keen to tap the commodity trade-financing front.  Commercial banks are chasing the commodity industry with attractive lending rates between 8% and 8.5% as against the normal lending rate between 11% and 14%.

Problems galore:

The biggest danger to the galloping trading business in commodities is poor supervision.  Even though the commodity futures market is regulated by Forward market Commission, a proper regulatory system to supervise trades needs to be implemented.  This is because FMC, which functions under the administrative control of the Ministry of Food and Consumer Affairs, has no hands-on experience in monitoring electronic trading and detecting market manipulation.  For this reason, it was caught unawares earlier this year when a rubber dealer made several shady deals.

In June 204, the rubber dealer, registered with the Rubber Board, is understood to have entered a series of shady circular transactions with a sister firm on NMCE, creating a hefty difference of Rs.10 per kg between cash and futures prices.  FMC neither noticed the huge gap between cash and future prices nor bothered to investigate thereby signaling a relaxed regulatory regime in the commodities market, giving way to arbitrageurs and speculators.

NCDEX is also understood to have pressed for an amendment to the Banking Regulation Act to allow several branches of banks to act as intermediaries to enable farmers to insulate fro price fluctuations through futures trading.  Another herculean task in commodity trading is that of creating awareness and providing a transparent and user-friendly trading platform to investors.

Conclusion:

After almost two years that commodity trading is finding favour with Indian investors and is been seen as a separate asset class with good growth opportunities.  For diversification of portfolio beyond shares, fixed deposits and mutual funds, commodity trading offers a good option for long-term investors and arbitrageurs and speculators.  And, now, with daily global volumes in commodity trading touching three times that of equities, trading in commodities cannot be ignored by Indian investors.

Online commodity exchanges need to revamp certain laws governing futures in commodities to make the markets more attractive.  The national multi-commodity exchanges have unitedly proposed to the government that in view of the growth of the commodities market, foreign institutional investors, too, should be given the go-ahead to invest in commodity futures in India.  Their entry will deepen and broad base the commodity futures market.  As a matter of fact, derivative instruments, such as futures, can help India become a global trading hub for select commodities.

Commodity trading in India is poised for a big take-off in India on the back of factors like global economic recovery and increasing demand from China for commodities.  Considering the huge volatility witnessed in the equity markets recently with the Sensex touching 6900 level commodities could add the required zing to investors' portfolio.  Therefore, it won't be long before the market sees the emergence of a completely redefined set of retail investors.

References:

1. John C. Hull, "Introduction to Futures and Options Markets"(2/e):
   Prentice-Hall India Private Limited, New Delhi.
2. Roshini Rao, "Spicing up trading ": Capital Market (Dec 20,2004-Jan 2, 2005).
3.
www.ncdex.com
4.
www.mcx.com
 


A. Sathish Kumar
M.Com., MBA(fin)
Asst. Professor & Head
Department of Business Management
Vivekananda PG College
Karimnagar-505 001 (AP)
E-mail:
sarita_peddi@yahoo.co.in
 

Source: E-mail July 19, 2005

 

Back to Articles 1-99 / 100 onwards / Faculty Column Main Page

 

Important Note :
Site Best Viewed in Internet
Explorer in 1024x768 pixels
Browser text size: Medium