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Commodity Markets Challenges and Arbitrage Opportunities An

Insight into Commodity Trading Business in India

*Prof. (Dr.) G.S. Popli

**Prof. Sima Singh

ABSTRACT

The concept of commodity futures is not new in India. However commodity futures trading in

India remained in a state of hibernation for four decades, which was market by suspicion on thebenefits of futures trading. This is now replaced by policy, institutional and market activism in

the last few years. Thus now the commodities have started to be bigger than stocks. This is intandem with the ongoing global and domestic reforms in agriculture and allied sectors. TheIndian Govt. has also reduced its direct market intervention. Now it is encouraging private

participation based on market forces. This had led to increased exposure of agricultural produce

to price and other market risks which consequently emphasis the importance of futures marketsfor price discovery and price risk management.

This paper makes a modest attempt to analyse the current scenario of commodity trading inU.S.A, U.K, and India. It also examines the relationship between the future and spot price of

two commodity exchanges in India. It finds out the possibility of arbitrage gain between the twoCommodity Exchanges of India i.e. MCX, and NCDEX.

The purpose of this paper is to analyse the efficiency of agricultural markets by accessing therelationships between futures prices and spot prices of major agricultural commodities in India.It reveals that there is a positive correlation between future and spot prices of the commodities.

It was also observed that there is possibility of arbitrage in those commodities which are tradedat both NCDEX and MCX Commodity Exchanges.

Keywords: Spot Prices, Future Prices, Commodities, Derivatives, Arbitrage,

Correlation and Volatility.

*Prof. (Dr.) G.S. Popli Director and Professor, Delhi School of Professional Studies and Research,

New Delhi India.

** Prof. Sima Singh, Asstt. Professor, Delhi School of Professional Studies and Research,

New Delhi India.

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Introduction

A future contract is an agreement between a buyer and a seller that calls for the seller to deliver to the

buyer a specified quantity and grade of an identified commodity, at a fix time in future and at a price

agreed at the time the contract is entered into. A commodity futures contract is a contract to buy or sell a

specific commodity in future at a price which is decided at the time of making such a contract.

In the last two decades, the futures markets have experienced a remarkable growth all over the world in

size, trading, volume and acceptance by the business community. Major reforms have been initiated in

commodity futures markets in India since the last few years. New contracts with new products alongwith

entirely new possibilities in the futures markets have become the reality now. Subsequent to

liberalization of Indian economy in 1991, a series of steps were taken to liberalise the Commodity

Forward Market.

The UNCTAD and World Bank joint Mission, in the Report India: Managing Price Risk in India's

Liberalized Agriculture: Can Futures Market Help? (1996) highlighted the role of futures markets asmarket based instruments for institutional capacity of the Regulator and the Exchanges for efficient

performance of these markets. Another major policy statement, the National Agricultural Policy, 2000,

also expressed support for commodity futures. The Expert Committee on Strengthening and Developing

Agricultural Marketing (Guru Committee: 2001) emphasized the need for and role of futures trading in

price risk management and in marketing of agricultural produce. This Committees Group on Forward

and Futures Markets recommended that it should be left to i n t e r e s t e d exchanges to decide the

appropriateness/usefulness of commencing futures trading in products based on concrete studies of

feasibility on a case-to-case basis.

Mechanism of Spot and Future Markets

The Spot Market is a market of commodities or securities in which goods are sold for ready cash and

delivered immediately. This is known as a Spot Market. This is so because the transactions take place

then and their only i.e. on the spot. For example merchants and traders go to the fields and buy the

standing crops or the freshly reaped crops at the spot. Since cash changes hands it is also called a Cash

Market and since stock is physically delivered it is also called physical market.

Futures contracts are bought and sold by a large number of individuals, business organizations,

Governments and others for a variety of purposes. As opposed to spot markets, deals are stuck for future

actions in the future markets. A future contract can be defined as a type of financial contract by which

parties agree to exchange financial instruments like securities or physical commodities for future delivery

at a pre-settled price. The Commodities in the future markets are expected to be delivered within a monthor so. A future contract gives the holder the obligation to buy or sell. Both parties to the contract must

fulfill the contract. Here everything is in a fluid state until the security or commodity reaches the buyer's

hands and the consideration reaches the other party. The future date is called delivery date and a final

settlement date. The pre set price is called futures price. The price of the underlying asset on the delivery

date is called the settlement price.

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Review of Literature

The following studies have investigated the role of futures market in discovery of future stock price inU.K. and U.S. Stensis (1983), Anselin, L. (1988), Pierson G. (1996), Privilos, T and R.C. Duncan

(1991), Aseh E and Guttormscn, Bafels j. (1991), Baro R.J and X Sala-Martin (1992), Protopapadkis et

al (1986), Garbade and Sibler (1983), Chan (1992), Joel (1995), Jian (2001) and Menkovid (2003) had

observed that the Futures Market lead the Spot Market.

Cox (1976) observed that in many markets, forward trading is stabilizing whereas Figlewski (1981)

and Simpson and Ireland (1985) found that the opposite is true. Kenyon, Bainbridge, and Ernst

(1991) apply actual post cash settlement futures price data.

Varangis and Larson (1996) cited several examples in the case of cotton and oil in Mexico and Algeria,

where producers are represented by their agents who trade on their behalf. In doing so, minimum prices

for output could be guaranteed and thus, risk is reduced for an individual trader for the cost of a small

premium. Other such examples are provided by Claessens and Duncan (1993) and World Bank (1999).

According to Pennings and Leuthold (1994) hedging effectiveness is related to trading volume and this

relationship is more prominent when the hedging effectiveness takes market depth risk into account.

Robinson (1993) analysed the daily stock price volatility on the London Stock Exchange during the

period 1980-1993 to measure the effect of the futures on the cash market volatility. He concluded that the

index futures contracts had reduced the volatility significantly, by 17%.

Singh (2000) probed Hessian cash price variability before and after the introduction of futures trading

(88-97). He concluded that the Futures Market has reduced the price volatility in the Hessian spot

market, Dasgupta (2004) who observed a co-movement among futures prices, production decisions and

inventory decisions, Yang (2005) who concluded that an unexpected increase in futures trading volume

caused an increase in spot price volatility and Sahi (2006) who observed that the volatility had not

changed with the introduction of futures in wheat, turmeric, sugar, cotton, raw jute and soya oil.

Bose (2007) examined the characteristics of return volatilities in the equity market and the index-futures

market in India. He found that the futures market played a leading role in absorbing the information, thus

reducing the intensity of the spot market volatility.

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Bhatacharya, Mihir (2009) investigated the impact of the introduction of the Nifty Index Futures on the

Indian Stock Market by using the GARCH Model and found no structural change after the introduction of

the futures trading on the Nifty.

Barik (2011) investigated the impact of the derivative trading over the Indian Stock Market by taking into

account five individual stocks in which the derivatives trading had been introduced and four individual

securities in which the derivative trading had not been introduced. The study revealed that the volatilityhad decreased.

The Abhijit Sen panel has also concluded that the data available in this regard was not sufficient to come

up with conclusive evidence. He however has suggested in separate note that a ban on Wheat, Rice, Gur

and Urad trading should continue; singling wheat for special mention.

The literature reviewed above has yielded mixed results regarding the impact of the futures market

trading over the spot market volatility. This necessitates further examination of the relationship between

the futures market and the spot market volatility by considering developing countries, different time

periods and available data.

Defining the Problem : Convergence of Spot and Future Prices:

From the analysis of the literature mentioned above, we can observe that there are two strands on the

price formation process of commodity future prices. First, in which, the inter-temporal relationship

between cash and future prices have been explained by the cost of carry of the commodity, i.e. future

prices should never be less than the spot price plus storage and interest cost. It has been observed that

spot market significantly followed the futures market and the futures market price the prospective

spot market price changes. In this case, basis is expressed as a sum of an expected premium and an

expected change in the spot price.

For the future price to be an unbiased predictor of subsequent spot price, i.e., E, (P (t, 7) equals zero, the

future price should lead the spot price (Garbade and Silber, 1983). There are also some arguments infavour of opposite hypothesis, that spot price leads future prices (Silvapulle and moosa, 1999,

Quan, 1992, Moosa, 1996). The spot prices can be price leading if the convenience yield is high enough.

According to Pindyck (2001), the spread between the future prices and spot price gives a direct measure

of the marginal value of the storage for a commodity termed alternatively as marginal convenience

yield (MCY). Future price could be greater or less than the spot price depending on the magnitude of the

net (of storage costs) MCY.

If the future prices are a reflection of future demand and supply conditions of the market then they are

considered to exert influence on the inventory holding. If future prices are falling, it indicates that either

future demand would fall or future supply would ease. This would induce traders to reduce inventory

stock, which eventually results in fall in spot prices.

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Objectives of the Study

To analyse the market fluctuation in India, UK and US for a particular period of time. To find out the reasons for fluctuations in Indian Commodity Future Markets. To find out the bottlenecks in the growth of Commodity Futures Markets in India. To offer suggestions for improvement of Commodity Futures Markets in India.

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Data Source and Time Period

The data of U.S.A and U.K. Commodity Futures Trading Markets has been analysed to observe the

movements of trading during the year 2011. Further, the data of MCX and NCDEX has also been

correlated in order to find out the possibility of the arbitrage gain. The data was not available for the

certain period as for that period the commodity was taken out from the trading by the Government. If themarkets are frictionless and functioning efficiently, changes in the log-spot prices and changes in the log-

futures prices are expected to occur at same time, while the current change in the log-futures price is also

expected not to be related to previous changes in the log-spot price (and vice-versa).

We have used co integration model with simple Graph in this study to examine lead-lag relationship

between spot and futures prices. The regression analysis with linear relationship has been applied

between spot and forward prices of the commodities to analyse the available data.

Trend Analysis of Commodity Markets of USA, U.K. and India

Here some of the commodity markets of USA, UK and India have been analysed as per their

index fluctuations in the year 2011. Month wise data of these markets is appended below:

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Table No1: Fluctuations in index value of DJIA Futures ($10) an US based Commodity

Market. (During 2011)

Note: The final Index is calculated at close of trading on the calendar day that the front

month contract expires. The final Index represents the un-weighted average of allsettlement prices from the expiring 'front month' contract and is published in the DJIA

Futures ($10) website.

Month Year Index value

January 2011 8.3

February 2011 9.4

March 2011 14.5

April 2011 10.3

May 2011 10.1

June 2011 13

July 2011 13.1

August 2011 0

September 2011 0

October 2011 0

November 2011 0

December 2011 0

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Analysis :

We can observe from the analysis of the Index Values presented in table 1 that there was a clear

cut upward trend in the commodity price index. It rose to 14.5 in March 2011 from 8.3 in

January 2011 showing an increase of 74.70% and then came down to 10.1 in May 2011 decrease

of 30.34%. Again it showed and increasing trend and touched the level of 13.1 in July 2011, an

increase of 29.70 %. The reason behind this fluctuation has been given as the introduction of new

products in the commodity market. The data was not available for the remaining period as the

commodity trading was not permitted during that period.

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Table No 2: Fluctuations in index value of an UK based Commodity Market.

Note: The final Index is calculated at close of trading on the calendar day that the front

month contract expires. The final Index represents the average of all settlement prices from

the expiring 'front month' contract and is published to the website.


January 2011 49.84

February 2011 46.6

March 2011 51.74

April 2011 52.99

May 2011 51.47

June 2011 50.7

July 2011 47.23

August 2011 56.47

September 2011 55.28

October 2011 53.59

November 2011 48.43

December 2011 43.2

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Analysis :

This commodity market is operated in U.K. to deal major commodities. This Intercontinental

exchange market has its major operations in U.K. It is one of the largest and oldest commodity

exchange in Europe. In 2011 the market started with a steady rise of index value of 49.84 there

was a heavy fluctuation in this market on that year. As index value increased and attained its

peak level in August as the index touched the level of 56.46 showing an increase of 13.28%.

Then it had a great fall in index value in consecutive months and reached to its lowest level of

43.2 in December 2011, registering decrease of 23.80%. This has been reported as due to the

bankruptcy in UK during that particular period of time.

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Table No 3: Fluctuations in index value of MCX, Indian based Commodity Market.

Note: The MCX COMDEX is the simple weighted average of the three group indices -

MCX AGRI, MCX METAL &MCX ENERGY. The group indices are computed based onGeometric Mean.


January 2011 2765.02

February 2011 2719.47

March 2011 2533.03

April 2011 2547.23

May 2011 2597.74

June 2011 2588.92

July 2011 2831.22

August 2011 2885.97


October 2011 2995.59

November 2011 3039.66

December 2011 3151.06

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Analysis :

In India one of the main commodity markets is MCX. Since India consists of diverse cultures

and states, the COMDEX value will be always changing rapidly. So to make it accurate moreformulaes are used by traders. By analyzing this market on the basis of price index of 2011, we

can observe that this market had a very good start in January with 2765 points and the samereaction was observed as the index touched 2719.47 in Feb. 2012, decrease of 1.65%. From

March to June 2011, the market faced a great down ward position because of some Government

rules and restrictions for some goods. The index remained between 2533.03 and 2588.92 duringthis period, registering an increase of 2.13%. But after the situation and crisis got over, market

again started growing rapidly and reached to the level of 3151.06, an increase of 21.17%. The

Year 2011 was very good commodity market, as far as the MCX Market is concerned as it

registered an impressive growth of 13.96%.

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Table No 4 : Fluctuations in index value of NCDEX Indian based Commodity Market.


January 2011 1149.23

February 2011 1146.98

March 2011 1105.8

April 2011 1134.87

May 2011 1142.06

June 2011 1179.12

July 2011 1241

August 2011 1242.64


October 2011 1316.92

November 2011 1301.02

December 2011 1471.37

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Analysis :

This is also one of the biggest commodity markets in India. In India Since the weather andclimate keep on changing constantly, the price of the commodities also changes according to the

demand of the products in a particular season. So the market fluctuation is affecting the comdex

of this commodity market too. The market opened with the index value of 1149.23 in January

2011 and continued to grow up to October 2011 and reached at the level of 1316.92, an increase

of 14.59%. But after that the sudden hit of monsoon in India had affected price of commodities

and made a slight downtrend of 15 points and index value reached to 1301.02 in November

2011. But after the rescue the comdex reached its highest level of 1471.57 in December 2011 and

proved its usefulness in commodity exchange. The increase in percentage terms comes to 13.11.

The overall growth in the price index of this market in 2011 registered an increase of 28.04%.

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Interpretation of Results and Findings of the Study:

It can be observed that the Commodity Futures Market is volatile and there are high fluctuations in all the

compared markets i.e. USA, U.K. and the Indian Commodity Markets i.e MCX and INCDEX. The

commodities which are used for this study are Zink, Zeera, Channa, Natural Gas, Gold, Silver and Crude

Oil. These commodities have been selected due to their large trading pattern and their role in commoditymarkets. However, data for certain periods were not available due to ban on commodity trading imposed

by the Government. The results of data for these commodities are explained below:

Further, from the available data it can be said that there is wide range of variation in the spot and future

prices of these commodities. There are several reasons but the main reason has been observed to be the

ratio of open interest contracts to the total turnover. The data of NCDEX also shows the similar results

but the volatility is less with regards to spot and future price and the correlation between them is not the

same. It is observed that open interest contracts at the NCDEX are less as compared to the trading at

MCX. The spot and future prices are less volatile and it can help in prediction of future prices at the

NCDEX.

Further, the arbitrage opportunities were available during the different periods, as can be observed out

from the analysis of table no. 1 and 3. The trading in the channa was not available during certain periods.

So it was difficult to find out the proper arbitrage opportunity.

Volume of Trading in Indian Commodity Markets

Substantial changes have been witnessed in the value of trading in commodity future markets.

Value of trading in commodity futures markets in NCDEX registered a sizeable growth. It

recorded trading from Rs. 7558657 Crores in 2005 to Rs.5233860 Crores in 2008 to Rs.9392880 Crores in 2010 and Rs. 15119563 in 2011. It increased by more than 100% from 2005

to 2011. The trading in Commodity market MCX also witnessed a sizeable growth. It increased

from Rs. 623574 Crores in 2005 to Rs. 4284653 Crore in 2008 to Rs. 8696869 Crores in 2010and to Rs. 1493285202 Crores upto 2011. The trading in this market has shown a remarkable

increase of 229% from 2005 to 2011. Similarly there is a quantum jump in the number of

commodities in which futures trading has been started as well as in the number of contracts. Thetrading in NCDEX Market and MCX Market is shown in the table below :

NCDEX MCX

Year Value( Lacs) Year

Value (Lacs)

2011 15119563 2011 1493285202

2010 9392880 2010 869686960

2009 6698670 2009 595665593

2008 5233860 2008 428465316

2007 6403064 2007 272982099

2006 10360995 2006 202566483

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2005 7558657 2005 62357456

(Source : Shares Khan Investments and Consultants, India)

Impediments to Growth of Commodity Futures in India

Though the commodity futures market in India is flourishing, the volumes are rising and day by day more

and more of investors are entering the market but still the markets suffers from a shortcoming as

compared to U.K. and U.S. Commodity future market :

1. Lack of price transparency.2. Different margin collection systems at different exchanges.3. Lack of contract and product standardization between exchanges. This leads to higher costs and

makes trading unprofitable. Hence, typically the number of active members in an exchange isonly 5% of total membership.

4. Inadequate regulatory measures to prohibit fraudulent deals.5. Lack of economics of scale. There are too many exchanges and very few commodities. This

splits volumes and makes some exchanges unviable.

6. Illegal Derivatives Markets which commenced due to the futures ban are the strongestcompetitors. In fact, Schadevan (2002) asserts that a black market exists inside the exchanges

themselves, as about 25% to 30% of the exchange trades go unreported.

7. Prohibitive Lot Sizes. Some of the lot sizes are too huge for smaller investors/farmers to trade in.Suggestions for Future Growth

The future growth in futures market may come from following :

Convergence of securities and commodity derivatives market. This would speed up thedevelopment of commodity derivatives market. Such convergence would also help in effective

utilization of electronic trading and clearing system and easy and transparent price discovery.

Increase in commodities traded in exchanges. In India already 29 commodity exchanges areworking but the commodities traded at them are only 100. Considering that it is pertinent that the

number of commodities must be increased as it would help in providing more trade and

increasing the trade volume.

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Introduction of price transparency through sound regulatory framework. Price transparency canalso be introduced by means of providing access to foreign derivative markets.

Online commodity exchanges need to revamp certain laws governing futures in commodities tomake the markets more attractive.

Establishment of an independent national level entity for clearing and settlement of commodityfutures contracts traded on different exchanges across the country and allowing and promoting

foreign institutional investors to invest in Indian commodity markets.

Removal of legal and tax bottlenecks.

Conclusions

It can be observed that the Commodity Futures Market is volatile and there are high fluctuations in all the

compared markets i.e. USA, U.K. and the Indian Commodity Markets i.e. MCX and INCDEX. However,

the Commodity Futures Trading in India is increasing tremendously now. In fact it has

increased by more than 229% during the last six years. In this study, the comparison has beenmade with the Commodity Future Markets of USA and U.K. also alongwith the two big markets

of Commodity Futures Trading in India. The Government of India should also amend some of

their policies by taking a clue from U.K. and U.S. Commodity Markets and make them

supportive and conducive to encourage investment in these markets. Only then we can expect

the huge investments in these markets. Since the money of the investors in these markets works

as a fuel for these markets, they should be educated and motivated well to invest their savings in

these markets. There should be some training programmes for the Marketers and Middlemen

and for traders and investors. Transparency and honest dealings should be ensured. The

investors should also make long term or medium term investments which will enable them to

avoid heavy fluctuations in their returns in future. The middleman also should be very loyal and

responsible to their clients and should try be a very good link between the traders and theinvestors to make sure that transactions takes place in a smooth manner. This will help in

increasing the flow of investment in the Commodity Future Markets in India.

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