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Whitepaper

Commodity Futures Markets in


India: Riding the Growth Phase
Dr. Alok Kumar Mishra

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Executive Summary
Commodity derivatives play a pivotal role in the price risk management process especially in any agricultural surplus
country. As unique hedging instruments derivatives such as forwards, futures, swaps, options and exotic derivative
products are extensively used in the global market. However, Indian market is limited to commodity futures only. The
present study is an investigation into the present status, growth constraints and developmental policy alternatives for
commodity futures markets in India. The study has surveyed the various publicly available websites of recognized
commodity exchanges and their organizational and the regulatory set up for futures trading.
Also, as the factors that drive commodity prices are observed to be different from the factors that drive equity prices,
commodities are perceived to be effective diversifying agents. This study explores the advantages of adding
commodities to a portfolio of equities in Indian context based on empirical data and quantifies the diversification
benefit and downside risk protection the commodities offer in portfolio context. The study concluded that the less-
than-perfect or negative correlation of commodities with equities makes them an excellent candidate for
diversification. This diversification benefit was demonstrated in two ways. First, it was observed that by adding
commodity futures to a portfolio of equities enhance the risk-adjusted return of a portfolio. Second, it was observed
that adding commodity futures to equity portfolios provides a significant downside protection and enhances skewness
and kurtosis of the return distribution.
Key Words: Diversification Benefit, Downside Protection, Portfolio Efficient Frontier
JEL Classifications: C22, G18

Overview of the Commodity Markets in India


A commodity futures market (or exchange) is, in simple terms, defined as a public market where commodities are
contracted for purchase or sale at an agreed price for delivery on a specified date. This purchase or sale of
commodities must be made through a broker who is a member of an organised exchange and the purchase should
be made under the terms and conditions of a standardised futures contract.
The gradual evolution of commodity markets in India has been of great significance for both the country’s general
economic prosperity and the financial sector in particular. From an investment standpoint, a commodity is considered
as an alternate asset class and investing in commodity futures is appealing to investors as commodities have a
significantly lower degree of association with other traditional asset classes and offer an effective hedge against
inflation. Besides being a unique hedging instrument, it also provides for efficient portfolio management arising from
diversification benefits, which result in improved returns to domestic as well as international investors.
The commodity futures market as an asset class provides commercial commodities’ producers and consumers with a
means to transfer price risk to speculators who have no direct commercial interest in the commodities themselves.
Producers’ hedge price risk by taking short positions in future contracts on the commodity that they produce. A
similar hedge requires consumers to seize long positions in the futures contracts on their consumption commodities.
Arbitrageurs and speculators choose to take either long or short positions on a commodity futures contract based on
their market perception.
Unlike the stock market, which has a net positive supply, commodity futures have a net supply of zero. Thus, there is
no ‘long-only’ market portfolio of commodity futures contracts that investors should use as a default passive strategy.
It may not be a surprise that the relationship among various players in the futures markets can create situations in
which long-only strategies may fail to generate consistent risk premiums, even in commodity bull markets.
Further, as per the economic theory and empirical evidence, commodity future prices tend to exhibit momentum.
Therefore, when a commodity future price exhibits an upward trend, it makes sense to take a long position and vice
versa.
Evolution and History of the Commodity Markets in India
Commodity futures markets largely remain underdeveloped in India. This is in spite of the country’s long history of
commodity derivatives trade as compared to the US and UK. A major contributor to this fact is the extensive
government intervention in the agricultural sector in the post-independence era. In reality, the production and
distribution of several agricultural commodities is still governed by the state and forwards as well as futures trading
have only been selectively introduced with stringent regulatory controls. Free trade in many commodity items

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remains restricted under the Essential Commodities Act (ECA), 1955, and forwards as well as future contracts are
limited to specific commodity items listed under the Forward Contracts (Regulation) Act (FCRA), 1952.
The evolution of the organised futures market in India commenced in 1875 with the setting up of the Bombay Cotton
Trade Association Ltd. Following widespread discontent among leading cotton mill owners and merchants over the
functioning of the Bombay Cotton Trade Association, a separate association, Bombay Cotton Exchange Ltd., was
constituted in 1983. Futures trading in oilseeds originated with the setting up of the Gujrati Vyapari Mandali in 1900,
which carried out futures trading in ground nuts, castor seeds and cotton. The Calcutta Hessian Exchange Ltd. and
the East India Jute Association Ltd. were set up in 1919 and 1927 respectively for futures trade in raw jute. In 1921,
futures in cotton were organised in Mumbai under the auspices of East India Cotton Association (EICA). Before the
Second World War broke out in 1939, several futures markets in oilseeds were functioning in the states of Gujarat
and Punjab. Futures markets in Bullion began in Mumbai in 1920, and later, similar markets were established in
Rajkot, Jaipur, Jamnagar, Kanpur, Delhi and Calcutta. In due course, several other exchanges were established in
the country, facilitating trade in diverse commodities such as pepper, turmeric, potato, sugar and jaggery.
Post independence, the Indian constitution listed the subject of “Stock Exchanges and Future Markets” under the
union list. As a result, the regulation and development of the commodities futures markets were defined solely as the
responsibility of the central government. A bill on forward contracts was referred to an expert committee headed by
Prof. A.D. Shroff and selected committees of two successive parliaments and finally, in December 1952, the Forward
Contracts (Regulation) Act was enacted. The Forward Contracts (Regulation) rules were notified by the central
government in 1954. The futures trade in spices was first organised by the India Pepper and Spices Trade
Association (IPSTA) in Cochin in 1957. However, in order to monitor the price movements of several agricultural and
essential commodities, futures trade was completely banned by the government in 1966. Subsequent to the ban of
futures trade, many traders resorted to unofficial and informal trade in futures. However, in India’s liberalisation
epoch, as per the June 1980 Khusro committee’s recommendations, the government reintroduced futures on
selected commodities, including cotton, jute, potatoes, etc.
Following the introduction of economic reforms in 1991, the Government of India appointed an expert committee on
forward markets under the chairmanship of Prof. K.N. Kabra in June 1993. The committee submitted its report in
September 1994, championing the reintroduction of futures, which were banned in 1966, and expanding its coverage
to agricultural commodities, along with silver. In order to boost the agricultural sector, the National Agricultural Policy
2000 envisaged external and domestic market reforms and dismantling of all controls and regulations in the
agricultural commodity markets. It also proposed an expansion of the coverage of futures markets to minimise the
wide fluctuations in commodity prices and for hedging the risk arising from extreme price volatilities.
Why Commodity Futures?
It is important to understand why commodity futures are required and the role they can play in risk management. It is
widely known that the price of commodities, shares and currencies follow a non-linear trend over a period of time.
The possibility of adverse price changes in futures increases the risks involved in any business. Derivatives are used
to eliminate or reduce price risks arising from unforeseen price changes. A derivative is a financial contract whose
price is derived from the price of an underlying asset. Further, futures contracts are an improved variant of forward
contracts. They are agreements to purchase or sell a given quantity of a commodity at a pre-determined price, with
settlement expected to take place at a future date. As compared to forwards, futures contracts are standardised in
terms of quality and quantity, and the place and date of delivery of the commodity. According to the definition of the
Forward Market Commission (FMC), a futures contract is a highly standardised contract with certain distinct features,
which include the followings:
 Futures trading are necessarily organised under the auspices of a market association so that such trading is
confined to or conducted through members of the association in accordance with the procedures laid down in the
rules and bye-laws of the association.
 It is invariably entered into for a standard variety known as the ’basis variety’ with permission to deliver other
identified varieties known as ’tenderable varieties’.
 The units of price quotation and trading are fixed in these contracts, and parties to the contracts are not capable
of altering these units.
 The delivery periods are specified.

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 The seller in a futures market has the choice to decide whether to deliver goods against outstanding sale
contracts. In case he decides to deliver goods, he can do so not only at the location of the association through
which trading is organised but also at a number of other pre-specified delivery centres.
 In futures markets, the actual delivery of goods takes place only in a minimum number of cases. Transactions
are mostly squared up before the due date of the contract and contracts are settled by the payment of
differences without any physical delivery of goods taking place.
Unlike the physical market, a well developed and effective commodity futures markets facilitate the offset of
transactions without impacting physical goods until the expiry of a contract. Futures contracts are designed to deal
directly with the credit risk involved in the locking of prices and obtaining forward cover. Futures markets attract
hedgers to cover their price risks and encourage competition from other traders who possess market information and
price judgment. As observed from the cross-country experiences of active commodity futures market, it helps in
efficient price discovery of the respective commodities and does not impair the equilibrium prices of commodities in
the long run. In futures markets, speculators also play a pivotal role in providing liquidity to the markets and may
sometimes benefit from the price movements. At the same time, they do not have a systematic casual influence on
prices.
Commodities are accepted as a separate asset class with a unique and distinct source of return. It is well
documented that the statistical properties of commodities yield risk reduction benefits for a portfolio invested mainly
in financial assets. An inverse relationship between return and volatility is observed in the commodity markets as
compared to the stock markets. This implies that if the commodity market returns are negatively correlated with those
of traditional financial assets, the introduction of commodities in those portfolios may result in the diversification of
risks. Thus, an investor can take full advantage of the unique statistical properties of commodity investments by
adding commodity assets to a financial-only portfolio.
Regulations of Commodity Futures
In general, commodity futures trading, merchandising and stockholding of many commodities in India have always
been regulated through various legislations such as the Essential Commodities Act (ECA), 1955, Forward Contract
(Regulation) Act (FCRA), 1952 and Prevention of Black-marketing and Maintenance of Supplies of Commodities Act,
1980. The FCRA, 1952 envisages a three-tier regulation for commodity futures trading in India. These are (a) an
association recognised by the Government of India on the recommendation of the FMC, (b) the FMC and (c) the
central government. As per the act, the exchange that organises forward trading in regulated commodities can
prepare its own rules (Articles of Association) and bylaws and regulate trading on a day-to-day basis. The FMC
approves those rules and byelaws and provides a regulatory overview. The ECA, 1955 came into powers to control
production, supply, distribution, etc. of essential commodities for maintaining or increasing supplies and for securing
their equitable distribution and availability at fair prices. Using the powers under the ECA, 1955, various departments
of the central government have issued control orders for regulating production, distribution and quality of products,
movements, etc. pertaining to the commodities that are essential and administered by them.
All types of forward contracts in India are governed by the provisions of FCRA, 1952. The act categorised
commodities into three groups based on the extent of regulation: (a) the commodities in which futures trading can be
organised under the auspices of a recognised association (b) the commodities in which futures trading is prohibited
(c) the free commodities which are neither regulated nor prohibited. However, options in goods are prohibited by the
FCRA, 1952 but the ready delivery contracts remain outside its purview. The ready delivery contract, as defined by
the act, is the one that provides for the delivery of goods and payment of a price, either immediately or within a
period not exceeding 11 days after the date of the contract. All ready delivery contracts where the delivery of goods
and/or payment for goods is not completed within 11 days from the date of the contract are defined as forward
contracts. The act classifies forward contracts into two—specific delivery contracts and those excluding specific
delivery contracts or futures contracts. Specific delivery contracts are forward contracts that provide for the actual
delivery of specific qualities or types of goods during a specified time period at a price fixed thereby or to be fixed in
the manner thereby agreed and in which the names of both the buyer and the seller are mentioned. Specific delivery
contracts are distinguished as transferable and non-transferable. The distinction between the transferable specific
delivery (TSD) contracts and non-transferable specific delivery (NTSD) contracts is based on the transferability of the
rights or obligations under the contract. Forward trading in TSD and NTSD contracts are regulated by FCRA, 1952.
As per section 15 of the act, every forward contract in notified goods (currently 36 commodity items), which is
entered into except those between members of a recognised association or through or with any such member, is
treated as illegal or void. As per the section 17(1) of the act, 82 items are prohibited from entering into forward
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contracts. Section 18(1) of the act exempts NTSD contracts from regulatory provisions. However, over the years,
regulatory provisions of the act were applied to the NTSD contracts, and 79 commodity items are currently prohibited
from NTSD contracts under section 17 of the act. Moreover, another 15 commodity items have been brought under
the regulatory provisions of section 15 of the act, out of which trading in NTSD contracts has been suspended for 12
items. At present, the NTSD contracts in cotton, raw jute and jute goods are permitted only between, through or with
the members of the associations specifically recognised for the purpose.
The Forward Contract Regulations Act (1952) has been amended over the years. Various committees have worked
on and reshaped the act in varying capacities. An example is the Kabra Committee in 1993, which proposed
strengthening of the FMC and a few amendments to the Forward Contracts (Regulation) Act, 1952. The major
amendments included allowing options in goods, increase in outer limit for delivery and payment from 11 days to 30
days for the contract to remain as a ready delivery contract and registration of brokers with the FMC. The
government accepted most of these recommendations and futures trading have been permitted in all recommended
commodities except bullion and basmati rice.
The FMC has imposed several regulatory measures that are implemented in developed markets such as daily mark
to market margining, time stamping of trades, innovation of contracts and creation of a trade guarantee fund, back-
office computerisation for the existing single commodity exchange and online trading for the new exchanges,
demutualisation for the new exchanges, one-third representation of independent directors on the boards of existing
exchanges, etc. Though these measures were intended to promote financial integrity, market integrity and
transparency, most of these have met with strong resistance from the trade. The exchanges, therefore, had to be
virtually forced into adopting some of the measures by the regulatory dictate. The exchanges have attributed the
subsequent fall in the volume of trade to the introduction of these measures. Exchanges such as the Bombay
Commodity Exchange and Kanpur Commodity Exchange, which implemented most of these reforms, were literally
deserted by all traditional players.
The government has taken a landmark decision to deregulate long duration margining contracts (non-transferable
specific delivery contracts) from the purview of the Forward Contracts (Regulation) Act, 1952. There is a need for
radically pruning the negative list of commodities in which futures trading is not allowed. The reasons, whether right
or wrong, which led the government to ban a large number of commodities no longer exist today. Prior to 1960,
futures trading used to be conducted in traditional commodities at the conventional places of trading as per the set
terms and conditions. When futures trading in these traditional commodities was prohibited, either non-transferable
specific delivery contracts or futures trading in the commodities of minor nature which had no tradition of futures
trading were used as a guise for conducting futures trading in traditional commodities. Most of these minor
commodities were included in the negative list to prevent such disguised trading. Now that most of these
conventional commodities such as edible oil and cotton are legally allowed, the need for using minor commodities as
a guise has disappeared.
Secondly, futures trading can generally be conducted only in commodities, which have competitive markets. It is
necessary that the market forces of demand and supply largely determine the prices. India has already made a
transition from being a food importing country to a food surplus country. The Government will have to substantially
dilute the administered price mechanisms and integrate the internal food grains market with the global markets. The
shortage conditions have changed, in addition to the perception that futures market is volatile, aggravating the impact
in a shortage situation. It is appreciated in the policy circles that even in a shortage situation, futures markets help to
balance the demand for the commodity and has a salutary impact of reducing intra-seasonal price-spread.
The integration of the spot and futures markets is another critical factor for the growth of commodity futures in India.
The spot market in commodities is controlled to a large extent by the state governments. There are restrictions on
stockholding, turnover and the movement of goods. Variations exist in the duties levied by the different state
governments. This fragments the commodity spot markets and impedes the commodity futures markets from
reaching the market players outside the boundaries of the states or zones in which the exchanges are located.
Despite these largely uncontrollable factors causing fragmented spot markets, it is necessary to address other issues
that contribute to this fragmentation. The prices of commodities are influenced by their quality, grade, seasons of
production, the quality of storage and warehousing, etc. Unlike securities, commodities are available in different
grades and qualities. As commodities are bulky, there are difficulties involved in transportation, which affect spatial
integration. These issues can be addressed by introducing a nation-wide warehouse receipt system.

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Under the warehouse receipt system, the warehouses which meet the prescribed standards of storage, preservation,
testing, grading and certification would be licensed by the Central Regulatory Authority and the warehouse receipts
issued by these warehouses would become negotiable. The Central Regulatory Authority would evolve the system of
inspection, monitoring and surveillance to ensure that the licensed warehouses comply with the prescribed standards
and warehouse receipts issued by them truly reflect the quality, quantity and ownership of the goods. Commodity
exchanges could create a marketplace for trading and settlement of warehouse receipts to facilitate hassle-free
trading in commodities. This would improve the collateral value of the goods and consequently, the credit flow to the
commodity sector, obviating the need for distress sale by farmers and even by some mills, who/which do not have
the waiting capacity due to inadequate liquid assets necessary for meeting the immediate consumption/working
capital needs.
Structure, Conduct and Current Status of the Commodity Futures Markets in India
Broadly, the commodities market exists in two distinct forms—the over-the-counter (OTC) market and the exchange-
based market. Further, as in equities, there exists the spot and the derivatives segments. Spot markets are
essentially OTC markets and participation is restricted to people who are involved with that commodity, such as the
farmer, processor, wholesaler, etc. A majority of the derivatives trading takes place through the exchange-based
markets with standardised contracts, settlements, etc. The exchange-based markets are essentially derivative
markets and are similar to equity derivatives in their working, that is, everything is standardised and a person can
purchase a contract by paying only a percentage of the contract value. A person can also go short on these
exchanges. Moreover, even though there is a provision for delivery, most contracts are squared-off before expiry and
are settled in cash. As a result, one can see an active participation by people who are not associated with the
commodity. The typical structure of commodity futures markets in India is as follows:

Figure 1: Structure of the Commodity Market

Ministry of Consumer Affairs

FMC

Commodity Exchanges

National Exchanges Regional Exchanges

NCDEX MCX NMCE NBOT 20 Other


Regional Exchange

At present, there are 23 exchanges operating in India and carrying out futures trading activities in as many as 146
commodity items. As per the recommendation of the FMC, the Government of India recognised the National Multi
Commodity Exchange (NMCE), Ahmadabad; Multi Commodity Exchange (MCX) and National Commodity and
Derivative Exchange (NCDEX), Mumbai, as nation-wide multi-commodity exchanges. MCX commenced trading in
November 2003 and NMCE in November 2002 and NCDEX in December 2003.
As compared to 59 commodities in January 2005, 94 commodities were traded in December 2006 in the commodity
futures market. These commodities included major agricultural commodities such as rice, wheat, jute, cotton, coffee,
major pulses (such as urad, arahar and chana), edible oilseeds (such as mustard seed, coconut oil, groundnut oil
and sunflower), spices (pepper, chillies, cumin seed and turmeric), metals (aluminium, tin, nickel and copper), bullion
(gold and silver), crude oil, natural gas and polymers, among others. Gold accounted for the largest share (31
percent) of trade in terms of value, followed by silver (19 percent), guar seed (11 percent) and chana (10 percent). A
temporary ban was imposed on futures trading in urad and tur dal in January 2007 to ensure orderly market
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conditions. An efficient and well-organised commodities futures market is generally acknowledged to be helpful in
price discovery for traded commodities.
The growth in the commodity derivatives trading witnessed in 2005-06 continued through 2006-07. The total volume
of trade increased sharply from Rs 1.29 lakh crore in 2003-04 to Rs 27.39 lakh crore in 2006-07 (till December 2006).
In the first 9 months of 2006-07, the volume of trade already exceeded the Rs 21.55 lakh crore achieved in the 12
months of 2005-06. The turnover as a proportion of the GDP increased from only 4.7 percent in 2003-04 to 18.3
percent in 2004-05 and further to 76.8 percent in 2005-06. The growth in the volume of trading has been primarily
propelled by Multi Commodity Exchange, Mumbai (MCX) and National Commodity Derivatives Exchange, Mumbai
(NCDEX). These two exchanges account for a large share of the number of contracts traded on the exchanges. The
daily average volume of trade in the commodity exchanges in December 2006 was Rs 12,000 crore.
The total turnover of the Indian commodity market was Rs 3,375336 lakh crore in the 11 months till November 2007.
MCX emerged as the largest commodity futures exchange comprising a 74.22-percent share of the commodity
market in India, followed by NCDEX with a 21.73- percent share. The total value of trading at the commodity
exchanges during the second fortnight of November 2007 was Rs1, 69,561.93 crore. The value of trade from 2 April
2007 to 30 November 2007 for the financial year 2007-08 was Rs 24, 38,388.91 crore. Gold, silver and crude
recorded the highest turnover in MCX, while in NCDEX, soy oil, guar seed and soybean and in NMCE, pepper,
rubber and raw jute were the most actively traded commodities. Even though there are 23 commodity exchanges
operating in India, MCX, NCDEX, NMCE and NBOT together contribute more than 98 percent of the market. For the
last five years, the Indian commodity market has shown tremendous growth in terms of both value and the number of
commodities traded. As the largest commodity futures exchange during 2006-07, both in terms of turnover and
number of contracts, the growth of MCX is comparable with some of the international commodity futures exchanges
such as Dow Jones AIG Commodity Index (DJAIG) and Reuters/Jefferies Commodity Research Bureau (RJCRB).
The turnover and volume of commodity futures compared to international indices are explained in the following tables
and figures:

Table 1: Turnover of Indian Commodity Exchanges


Indian Commodity Futures Market (Rs Crores)
Exchanges 2004-2005 2005-2006 2006-2007 2007-2008
Multi Commodity Exchange (MCX) 165147 961,633 1,621,803 2,505,206
NCDEX 266,338 1,066,686 944,066 733,479
NMCE(Ahmadabad) 13,988 18,385 101,731 24,072
NBOT(Indore) 58,463 53,683 57,149 74,582
Others 67,823 54,735 14,591 37,997
All Exchanges 571,759 2,155,122 2,739,340 3,375,336

Figure 2: Graphical Representation of the Turnover of the Indian Commodity Exchanges

All Exchanges

4,000,000
3,375,336
3,500,000
Turnover In Crores

3,000,000 2,739,340

2,500,000 2,155,122
2,000,000
1,500,000
1,000,000
571,759
500,000 129,364
66,530
0
2002-2003 2003-2004 2004-2005 2005-2006 2006-2007 2007-2008

Year

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Figure 2 shows that the Indian commodity market expanded from 66,530 crores in 2002-2003 to 3375336 (crores) in
2007by approximately 50 times in a short span of 5 years.

Figure 3: Percentage Share of the Turnover of the Indian Commodity Exchanges

Percentage share of Exchanges(2007)


2.21%
0.71% 1.13%
21.73%

74.22%

Multi Commodity Exchange (MCX) NCDEX NMCE(Ahemdabad) NBOT(Indore) Others

Figure 4: MCX COMDEX vs. Other Global Indices (base unit, days and major unit, months on X-
axis)

450 3,000

427.61
400
2,500

350 2,306.77
2,000
Index V alue

300 Index Value


1,500
250

1,000
200

177.247 500
150

100 0
Nov-05

Nov-06

Nov-07
Jun-05
Jul-05

Jan-06

Jun-06
Jul-06

Jan-07

Jun-07
Jul-07
Aug-05
Sep-05
Oct-05

Dec-05

Feb-06
Mar-06
Apr-06
May-06

Aug-06
Sep-06
Oct-06

Dec-06

Feb-07
Mar-07
Apr-07
May-07

Aug-07
Sep-07
Oct-07

CRB index DJ AIG Index Comdex

For a comparative analysis of Comdex with other global indices, we have recalibrated the base period of all the
indices to 100 from June 2005. At the end of November 07, the following levels were recorded for these indices.

Table 2: MCX COMDEX vs. Other Global Indices (after converting to the same base period)
Indices June 2005 November 2007
CRB 100 145.5006
DJ AIG Index 100 115.9349
Comdex 100 145.1009

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Figure 5: MCX COMDEX vs. Other Global Indices (after converting to the same base period)
(base unit, days and major unit, months on X-axis)

160

150

140

130

120

110

100

90

80
Nov -05

Nov -06

Nov -07
J un-05
J ul-05

J an-06

J un-06
J ul-06

J an-07

J un-07
J ul-07
A ug-05
S ep-05
Oc t-05

Dec -05

Feb-06
M ar-06
A pr-06
M ay -06

A ug-06
S ep-06
Oc t-06

Dec -06

Feb-07
M ar-07
A pr-07
M ay -07

A ug-07
S ep-07
Oc t-07
CRB DJ AIG Index Comdex

From the above table and graph, it can be clearly inferred that the performance of both CRB and COMDEX in
comparison to DJAIG are outstanding during the period from June 2005 to November 2007.
Though India is an agricultural surplus country, trading in non-agricultural commodities have been dominating from
2006-07 onwards. The volumes of non-agricultural commodities are almost twice that of agricultural commodities
during the same period. This is clearly evident from the Figure 6.

Figure 6: Growth in the Volume of Agricultural and Non-agricultural Commodities (2004-05 to


August 2007)

Growth of Agri Vs Non Agri

FY to Aug 07 4.12 10.71

2006-07 13.17 23.59


Year

2005-06 11.92 9.63

2004-05 3.9 1.8

0 5 10 15 20 25 30 35 40
Rs. in lakh Crore (Source: FMC)

Agri Non Agri

Trading, Settlement and Risk Management of Commodity Futures


As described earlier, the Indian commodity exchanges have witnessed a sharp surge in trade volumes and turnover
in recent years. Consequently, the stakes are higher than ever before. Investment in commodity futures is now
serving as a noticeable alternative to traditional investments in stock markets. Further, with a progressive FDI policy
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for commodity markets on the anvil, investor prerequisites include transparency and assurance on the enforcement
of future contracts. While the FMC serves as a regulatory body, the exchange defines its own day-to-day functioning,
which encompasses setting the norms of trading and settlement, insuring adequate arrangement for surveillance and
following the best practices for risk management, which are premeditated to be in line with international standards.
Futures trading in commodities results in transparent and fair price discovery on account of large-scale participation
of entities associated with different value chains. This reflects upon the views and expectations of a wide section of
investors related to that commodity. It provides an effective platform for price-risk management for all segments of
players ranging from producers, traders, processors, exporters/importers and the end-users of a commodity.
The delivery and settlement procedure differs for each commodity in terms of quality implications, place of delivery,
options, penalties and margins, and are defined comprehensively by the exchanges. Members of an exchange can
perform and clear transactions in only those contracts which are exchange specified and approved by the FMC.
Margin Requirements
With respect to the contracts that are transacted in the exchanges, buyers and sellers will be required to maintain a
certain amount as initial margin, including special margin (as applicable) on their respective future positions. These
margins vary for each commodity and for different contract months depending upon factors such as market volatility,
government policies, macro-economic factors, international price movements, etc.
Margin provisions, subject to margin requirements, are determined by applying the methodology as specified by the
exchange and are settled by the clearing house of the exchange. For example, the exchange can levy an initial
margin on derivatives contracts using the concept of Value at Risk (VaR) or any other concept as prescribed.
Additional margins are levied for deliverable positions on the basis of VaR from the expiry of the contract till the
actual settlement date, including a mark-up in case of default. The estimated margin (based on the prescribed
methodology) may be on gross position basis, net position basis, client level basis or in any other manner determined
by the exchange.
Every clearing member is also required to maintain an appropriate margin account with the clearing house of the
exchange against the aggregate open positions cleared by the clearing member in respect of (i) the clearing
member’s own account, (ii) for other members of the exchange with whom the clearing member has an agreement
and, (iii) clients, where applicable.
Margin accounts of all exchange members are marked daily to the market and the exchange members are required
to pay the amount prescribed by the clearing house. The entire day’s trades and open positions on the exchange are
marked to closing price for the respective futures contract, on the basis of which the hypothetical gain or loss is
estimated. The investor is required to collect or make compensation for this amount at the end of each trading day.
The exchange also prescribes additional or special margins as may be considered necessary during the delivery
period and emergencies. Every member of the exchange executing transactions on behalf of clients is required to
regularly (time interval is exchange specified) collect the margins from their clients against their open positions.
Relevant authorities also have the right to affect marking to market and settlements through the clearing house more
than once during the course of a working day, if deemed fit on account of market risks and other parameters;
settlement of differences due on outstanding transactions shall be made by clearing members through the clearing
house. This provision prevents the possibility of a potential loss where any of the contracts’ participants might default
on their contractual obligations. The exchange enforces disciplinary action on any member or a client when they fail
to pay the variation margin that is required to maintain the minimum margin requirements. This may even include
suspension of the exchange members.
Clearing and Settlement
All futures contracts are settled through the clearing house of each exchange. The settlement, clearing and
guaranteeing services of the clearing house can be obtained exclusively by the clearing members. The clearing
house also registers the financial performance of the contracts entered into on the exchange. Each exchange has a
set eligibility criterion for a person to be qualified as a clearing member.
In order to facilitate smooth clearing and settlement, all exchange members participating in futures trading are
required to have bank accounts with designated clearing banks as may be advised by the exchange. All members
are required to strictly follow the instructions issued by the exchange regarding the operation of such bank accounts,
minimum balance, segregation of clients’ fund and own fund, etc. They should also submit an irrevocable mandate in

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writing, enabling the exchange to debit and credit their settlement account electronically. They are therefore required
to keep their accounts adequately funded, to enable the exchange to recover its dues by debiting it.
Each clearing member has to submit all the trades executed by constituent members or clients with whom he has
such an agreement and assist the clearing house in a pre-arranged form and manner to effectively manage the
clearing facility.
The clearing house processes all transactions submitted and accepts only the net liability of the clearing member to
the clearing house. Once a contract is matched and marked to market by the clearing house, the exchange becomes
the counter party for all net financial liabilities of the clearing members in specified commodities or contracts in which
the exchange has decided to accept the responsibility of guaranteeing the financial obligations.
Delivery
The exchange may prescribe tender days and delivery period for each contract month during which a seller who
wishes to tender delivery may issue delivery orders through specific clearing members. Tender days and delivery
period end on or before the last day of trading of the relevant contract month.
All contracts outstanding at the end of the last trading day of the contract month of the maturing contract will be
closed-out at the due date rate as per the contract specifications. The relevant authority prescribes a penalty on
sellers with outstanding positions who fail to issue delivery orders; the exchange may financially compensate the
buyers who hold outstanding positions and intended to lift delivery but could not receive delivery orders against such
positions due to a failure on the part of the seller.
In Case of Cash Settlement
The buyer who fails to accept delivery orders is required to pay the difference between the settlement price and the
due date rate. In addition, the buyer will have to pay a penalty, as ascertained by the exchange. The seller, who
tenders the delivery document, is compensated with the penalty recovered from the buyer, while the delivery is
returned to the seller. Failure to pay the dues and penalties relating to such closing out within the stipulated period
causes the member to be declared a defaulter, and renders him liable for disciplinary action.
In Case of Physical Delivery
An exchange member desiring to tender goods against an open short position in the maturing contract sends delivery
orders to the clearing house through the clearing member up to such time on the stated tender days. The delivery
order forms duly signed by the sellers or seller’s representative, holding short open positions, should offer the
following particulars, in addition to the particulars in the delivery order:
 The quality and quantity of goods to be delivered
 Delivery order rate (to be filled in by the clearing house)
 Name of the seller issuing the delivery order
 Period of delivery
 The address or addresses of the warehouse(s) or any storage place where the goods are kept and the quantity
thereof at each warehouse
 The name and address of the seller’s representative who should be contacted by the buyer for collecting the
delivery
A seller is entitled to offer delivery only at the exchange determined the delivery centres. The delivery can be
tendered at these specified centres, strictly as per the contractual delivery procedure. Before tendering delivery, the
seller is also required to obtain a certificate from a surveyor empanelled by the exchange and this certificate has to
be accompanied with the delivery order being tendered to the clearing house. The surveyor’s certificate clearly
specifies the quality of the goods tendered and also confirms that such quality is tenderable as per the contract
specification of the exchange. In case of non-compliance with any of these conditions, the delivery order is rejected
and initiate clearing members shall, in turn, assign the full quantity of goods covered by the delivery orders to their
clients holding outstanding long positions.

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Additional practices
To facilitate transparency, a cost-effective trading system and to avoid information asymmetry, other functions of the
exchanges, with respect to trading include the determination of the transaction and clearing fees payable by the
members of the exchange for trading in different commodities and other charges that may be collected by the
exchange from members, registered non-members, participants, approved users, etc. Moreover, the exchange is
responsible for fixing the units of trading, the minimum and maximum quantity of contracts traded to be purchased or
sold and the limits on price fluctuations permitted in a day or for a particular time period for a particular commodity.
This is implemented to avoid acute price volatilities.
With the intention of carrying out periodic and specific checks and inspections related to procedures involved in
trading, price manipulation, price distortion and other trading malpractices, major national exchanges have a
vigilance committee in place. Commodity-specific experts constitute the senior executives in an exchange to identify
such malpractices and maintain an investor-consumer responsive trading environment.
Further, investor awareness in terms of the commodities trade jargon and risk implications form the focal areas of
each exchange. Information on these aspects is widely disseminated by the way of online and other media
publications, press releases, exchanges’ websites, etc. However, the procedure for the same may differ for each
exchange. Moreover, the risk disclosure document provides basic and important insight into the risks associated with
trading in commodity futures.
Constraints, Major Challenges and Policy Options of Commodity Futures
Commodity futures markets are the strength of an agricultural surplus country like India. Commodity exchanges play
a pivotal role in ensuring stronger growth, transparency and efficiency of the commodity futures markets. This role is
defined by their functions, infrastructure capabilities, trading procedures, settlement and risk management practices.
However, Indian commodity exchanges are still at a nascent stage of development as there are numerous
bottlenecks hampering their growth. The institutional and policy-level issues associated with commodity exchanges
have to be addressed by the government in coordination with the FMC in order to take necessary measures to pave
the way for a significant expansion and further development of the commodity futures markets. Some of the major
problems associated with commodity markets in India are discussed below:
Infrastructure: The lack of efficient and sophisticated infrastructural facilities is the major growth inhibitor of the
Indian commodity futures markets. Though some exchanges occupy large premises, they are deficient in terms of
the necessary institutional infrastructure, including warehousing facilities, independent and automated clearing
houses, transparent trading platforms, etc.
Trading System: Though the operations of national exchanges are carried out through the electronic trading system,
a majority of the regional exchanges continue to trade via the open outcry system. In order to attract a greater
number of investors towards sector-specific commodities, regional exchanges must introduce the electronic trading
system to assure the investors of transparency and fairly priced commodities.
Broking Community: Though a large number of members exist in the exchanges’ records, most of them are not
involved in trading due to the fact that the business is not highly profitable in comparison to equities. Therefore, it is
important to absorb a large number of broking firms that have diversified into stock broking and other related
businesses. To attract active traders to commodity futures, the regulatory authority needs to introduce a more
stringent code of conduct in setting standards for brokers, imposing capital adequacy norms, defining qualification
criteria, etc.
Controlled Market: Price variability is an essential pre-condition for futures markets. Any deviation in the market
mechanism or where the free play of supply and demand forces for commodities does not determine commodity
prices will dilute the variability of prices and potential risk. For a vibrant futures market, it is imperative that
commodity pricing must be left to market forces, without monopolistic government control. However, in India, scores
of commodities in which futures trading is permitted are still protected under the ECA, 1955.
Integration of Regional and National Exchanges: From a wider standpoint, it is essential to integrate the regional
exchanges with the national exchanges to achieve price discovery for regional exchanges to be driven by broad-level
prices prevailing at the national exchanges. Secondly, this integration will facilitate the creation of more efficient
markets as price discovery will become dependent on domestic demand and supply of commodities.

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Integration of the Spot and Futures Markets: The integration of the spot and futures market is another critical
factor for the expansion of the commodity futures market in India. The spot market in commodities is largely
controlled by the state governments. Restrictions exist on stockholding, turnover, and movement of goods, and
variations persist in the level of duties levied by the different state governments.
In spite of these constraints, Foreign Institutional Investors (FIIs), mutual funds and banks may soon become active
participants in the Indian commodity derivatives markets. The Reserve Bank of India (RBI), along with the Ministry of
Finance and Consumer Affairs, is considering a proposal to grant permission to overseas institutional investors to
hold stakes in the Indian commodity derivatives markets (Business Line, 23 February 2005). If these institutional
investors are permitted to operate in the Indian commodity derivatives markets, they could provide for the much
required breadth and depth to these markets. Moreover, since such a move would warrant the convergence of the
commodity derivatives markets with the financial derivatives markets, the commodity derivatives markets could reap
better gains. The Economic Survey for 2004-05 (pp.188) has rightly articulated that the convergence of commodity
futures markets with other derivatives markets will induce eminent economies of scale and has stressed that, ‘it
would help in the utilisation of capital and institution building, which has already taken place for the derivatives
markets for the purposes of India’s agricultural sector’.

Enhancing Diversification by Adding Commodity Futures in the Portfolio


Context: An Empirical Study in the Indian Context
The risk reduction benefit of diversification is an important tenet of finance. However, diversification studies typically
employ only stocks and bonds. Though a few studies have been carried out in the context of international markets on
the benefits of adding commodities to enhance equity diversification (typically only using a commodity index or one
category of futures to reduce risks), a meticulous study is conspicuously missing in the context of Indian markets. As
commodity futures prices are influenced by factors different from those that affect financial assets, commodity futures
are perceived to be excellent candidates for the diversification of equity and bond portfolios.
In this context, the study makes an attempt to empirically examine the diversification of benefits to an equity portfolio
by adding the commodity futures index as well as three categories of commodity futures. The second objective of the
study is to examine the reduction in downside risks by adding commodities as the diversifying agents to the equity
portfolio. The study considered the Sensex as the proxy for the equity portfolio and MCX COMDEX representing the
commodity futures index and three categories of commodity futures such as MCX Metal, MCX Energy and MCX
Agriculture. The study also considered inflation as one of the additional variables to examine the overall impact on
the portfolio. The period of the study spans from June 2005 to November 2007 and the nature of the data points are
monthly.
This study first compares the economic statistics of commodity futures to those for stocks. Next, it builds the portfolio
of equities and commodity futures. Lastly, it considers commodity futures as a defensive investment.
Economic Summary of Commodity Futures
Inflation Protection
Table 3 demonstrates that during the period of analysis (June 2005 – November 2007), stocks demonstrate a
negative correlation with that of inflation. This is in line with the observations made from the economies worldwide.
However, commodity futures indices, such as MCX COMDEX, MCX Metal, MCX Energy and MCX Agriculture
demonstrate even stronger negative correlation with inflation. This contradicts empirical findings in most of the
economies that the commodities are real assets and can be used as a hedge against inflation.

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Table 3: Correlation Matrix Of the Sensex, MCX COMDEX, MCX Metal, MCX Energy, MCX Agriculture and
Inflation
MCX
Sensex COMDEX MCX Metal MCX Energy Agriculture Inflation
Sensex 1.00
COMDEX 0.21 1.00
MCX Metal 0.32 0.78 1.00
MCX Energy 0.14 0.84 0.38 1.00
MCX Agri -0.17 0.58 0.36 0.32 1.00
Inflation -0.02 -0.15 -0.05 -0.17 -0.15 1.00

Table 3 further demonstrates that except for MCX Agriculture, all other commodity futures indices are positively
correlated with the Sensex.
Summary of Average Return and Volatility
Traditionally, we expect commodities to have high volatility and return than those of large capitalisation stocks.
Contrary to this expectation, MCX Metal and MCX Energy demonstrate high volatility but far lower returns as
compared to that of the Sensex, whereas MCX COMDEX and MCX Agriculture demonstrate low risk and low return
as compared to that of the Sensex (as shown in Table 4). MCX Metal outshines other commodity future indices with
a Sharpe ratio of 0.2169 (assuming a risk free rate of 6 percent), while MCX Energy performs the worst in terms of
risk-adjusted return with a Sharpe ratio of 0.0632. The Sensex, however, demonstrates the highest Sharpe ratio of
0.477. This is shown in the tables 5, 6, 7 and 8.

Table 4: Average Return and Risk of the Sensex, MCX COMDEX, MCX Metal, MCX Energy and MCX Agriculture
Sensex COMDEX MCX Metal MCX Energy MCX Agriculture
Average Return 0.03 0.01 0.02 0.01 0.01
Risk 0.06 0.05 0.06 0.07 0.04

Commodity Futures and Diversification Benefit


In this section, we consider how commodity futures perform when considered in the portfolio context. As depicted in
Table 4, the average return of diversified portfolios of large capitalisation stocks is 3 percent monthly for a volatility of
6 percent monthly and a Sharpe ratio of 0.477. The study also indicates that adding a small portion of commodity
futures in the portfolio considerably improves the risk-adjusted return over those produced by a 100 percent equity
portfolio.
Tables 5, 6, 7 and 8 demonstrate different combinations of weights of equities and several commodity futures indices
in a portfolio and the corresponding portfolio return, risk and Sharpe ratio. Figures 7, 8, 9 and 10 show the
corresponding efficient frontiers. From these tables and graphical representations, it can be inferred that except for
MCX Energy futures, other commodity futures have enhanced risk-adjusted returns when added to a pure-equity
diversified portfolio. A good example is a portfolio with an 83.7-percent allocation to equities and a 16.3-percent
allocation to MCX COMDEX futures, which enhances the Sharpe ratio from 0.0478 (100-percent equity diversified
portfolio) to 0.4817. A portfolio with an 86-percent allocation to equities and a 14-percent allocation to MCX Metal
futures enhances the Sharpe ratio to 0.4826, whereas a portfolio with a 67.6-percent allocation to equities and a
32.4-percent allocation to MCX Agriculture enhances the Sharpe ratio to 0.5034. The MCX Energy index, however,
fails to add any diversification benefit to the portfolio. This can be attributed to its very low return, very high volatility
and unfair reward for risk as compared to peer indices in spite of low positive correlation with returns from the
Sensex.
All these facts suggest that commodity futures are effective tools for portfolio diversification because of their less-
than-perfect (or negative, in the case of MCX Agri) correlation with returns from the Sensex. Figure 11 plots mean-
variance efficient frontier of all these portfolios. The figure suggests that best diversification is achieved with MCX
Agri futures.

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Table 5: Analysis of the Sensex and MCX COMDEX Portfolios
Portfolio Weights Return Risk Sharpe Ratio
Sensex COMDEX
0.4295 0.5705 0.0219 0.0415 0.4077
0.4567 0.5433 0.0225 0.0418 0.4187
0.4839 0.5161 0.0231 0.0422 0.4288
0.5110 0.4890 0.0237 0.0427 0.4378
0.5382 0.4618 0.0243 0.0432 0.4459
0.5654 0.4346 0.0248 0.0438 0.4530
0.5925 0.4075 0.0254 0.0445 0.4592
0.6197 0.3803 0.0260 0.0452 0.4645
0.6469 0.3531 0.0266 0.0460 0.4689
0.6740 0.3260 0.0272 0.0469 0.4726
0.7012 0.2988 0.0277 0.0478 0.4756
0.7284 0.2716 0.0283 0.0488 0.4780
0.7555 0.2445 0.0289 0.0498 0.4797
0.7827 0.2173 0.0295 0.0509 0.4809
0.8098 0.1902 0.0301 0.0520 0.4817
0.8370 0.1630 0.0307 0.0532 0.4821
0.8642 0.1358 0.0312 0.0544 0.4820
0.8913 0.1087 0.0318 0.0557 0.4817
0.9185 0.0815 0.0324 0.0570 0.4811
0.9457 0.0543 0.0330 0.0583 0.4802
0.9728 0.0272 0.0336 0.0596 0.4792
1.0000 0.0000 0.0341 0.0610 0.4780
0.9457 0.0543 0.0330 0.0583 0.4802
0.9728 0.0272 0.0336 0.0596 0.4792
1.0000 0.0000 0.0341 0.0610 0.4780

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Figure 7: Efficient Frontier for the Sensex and MCX COMDEX Portfolios

Table 6: Analysis of the Sensex and MCX Metal Portfolios


Portfolio Weights Return Risk Sharpe Ratio
Sensex MCX Metal
0.5809 0.4191 0.0276 0.0504 0.4487
0.6009 0.3991 0.0279 0.0505 0.4536
0.6208 0.3792 0.0282 0.0507 0.4580
0.6408 0.3592 0.0285 0.0510 0.4621
0.6607 0.3393 0.0289 0.0512 0.4658
0.6807 0.3193 0.0292 0.0515 0.4691
0.7006 0.2994 0.0295 0.0519 0.4720
0.7206 0.2794 0.0298 0.0522 0.4745
0.7406 0.2594 0.0301 0.0527 0.4767
0.7605 0.2395 0.0304 0.0531 0.4785
0.7805 0.2195 0.0307 0.0536 0.4799
0.8004 0.1996 0.0310 0.0541 0.4811
0.8204 0.1796 0.0313 0.0547 0.4819
0.8403 0.1597 0.0317 0.0553 0.4824
0.8603 0.1397 0.0320 0.0559 0.4826
0.8803 0.1197 0.0323 0.0565 0.4826
0.9002 0.0998 0.0326 0.0572 0.4824
0.9202 0.0798 0.0329 0.0579 0.4819
0.9401 0.0599 0.0332 0.0586 0.4812
0.9601 0.0399 0.0335 0.0594 0.4803
0.9800 0.0200 0.0338 0.0602 0.4792

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Table 6: Analysis of the Sensex and MCX Metal Portfolios
Portfolio Weights Return Risk Sharpe Ratio
Sensex MCX Metal
1.0000 0.0000 0.0341 0.0610 0.4780
0.9601 0.0399 0.0335 0.0594 0.4803
0.9800 0.0200 0.0338 0.0602 0.4792
1.0000 0.0000 0.0341 0.0610 0.4780

Figure 8: Efficient Frontier for the Sensex and MCX Metal Portfolios

Table 7: Analysis of the Sensex and MCX Energy Portfolios


Portfolio Weights Return Risk Sharpe Ratio
Sensex MCX Energy

0.6175 0.3825 0.0246 0.0487 0.4033

0.6358 0.3642 0.0251 0.0489 0.4111

0.6540 0.3460 0.0255 0.0491 0.4185

0.6722 0.3278 0.0260 0.0493 0.4254

0.6904 0.3096 0.0264 0.0497 0.4319

0.7086 0.2914 0.0269 0.0500 0.4378

0.7268 0.2732 0.0274 0.0504 0.4433

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Table 7: Analysis of the Sensex and MCX Energy Portfolios
Portfolio Weights Return Risk Sharpe Ratio
Sensex MCX Energy

0.7450 0.2550 0.0278 0.0509 0.4484

0.7632 0.2368 0.0283 0.0514 0.4529

0.7815 0.2185 0.0287 0.0519 0.4570

0.7997 0.2003 0.0292 0.0524 0.4607

0.8179 0.1821 0.0296 0.0531 0.4639

0.8361 0.1639 0.0301 0.0537 0.4668

0.8543 0.1457 0.0305 0.0544 0.4693

0.8725 0.1275 0.0310 0.0551 0.4714

0.8907 0.1093 0.0314 0.0558 0.4732

0.9089 0.0911 0.0319 0.0566 0.4746

0.9272 0.0728 0.0323 0.0574 0.4758

0.9454 0.0546 0.0328 0.0583 0.4767

0.9636 0.0364 0.0332 0.0592 0.4773

0.9818 0.0182 0.0337 0.0601 0.4778

1.0000 0.0000 0.0341 0.0610 0.4780

0.9636 0.0364 0.0332 0.0592 0.4773

0.9818 0.0182 0.0337 0.0601 0.4778

1.0000 0.0000 0.0341 0.0610 0.4780

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Figure 9: Efficient Frontier for the Sensex and MCX Energy Portfolios

Table 8: Analysis of the Sensex and MCX Agri Portfolios


Portfolio Weights Return Risk Sharpe Ratio
Sensex MCX Agri
0.4326 0.5674 0.0194 0.0327 0.4423
0.4596 0.5404 0.0201 0.0332 0.4568
0.4866 0.5134 0.0208 0.0338 0.4690
0.5136 0.4864 0.0215 0.0345 0.4790
0.5407 0.4593 0.0222 0.0354 0.4870
0.5677 0.4323 0.0229 0.0364 0.4932
0.5947 0.4053 0.0236 0.0375 0.4977
0.6217 0.3783 0.0243 0.0386 0.5008
0.6487 0.3513 0.0250 0.0399 0.5026
0.6758 0.3242 0.0257 0.0412 0.5034
0.7028 0.2972 0.0264 0.0426 0.5034
0.7298 0.2702 0.0271 0.0441 0.5026
0.7568 0.2432 0.0278 0.0456 0.5013
0.7838 0.2162 0.0285 0.0471 0.4995
0.8109 0.1891 0.0292 0.0487 0.4974
0.8379 0.1621 0.0299 0.0504 0.4950
0.8649 0.1351 0.0306 0.0521 0.4924
0.8919 0.1081 0.0313 0.0538 0.4896

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Table 8: Analysis of the Sensex and MCX Agri Portfolios
Portfolio Weights Return Risk Sharpe Ratio
Sensex MCX Agri
0.9189 0.0811 0.0320 0.0556 0.4868
0.9460 0.0540 0.0327 0.0573 0.4838
0.9730 0.0270 0.0334 0.0591 0.4809
1.0000 0.0000 0.0341 0.0610 0.4780
0.9460 0.0540 0.0327 0.0573 0.4838
0.9730 0.0270 0.0334 0.0591 0.4809
1.0000 0.0000 0.0341 0.0610 0.4780

Figure 10: Efficient Frontier for the Sensex and MCX Agri Portfolios

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Figure 11: Combined Efficient Frontier

Commodity Futures as a Defensive Investment


Though diversification benefits may be achieved by adding to an equity portfolio an asset that has less-than-perfect
correlation with the equity portfolio, one of the major concerns is to minimise the damage during economic crises or
downturn. As commodities have the ability to react favourably during such economic downturns or during macro-
economic conditions unfavourable to equities, they are the perfect candidates for reducing downside risks. The ability
to protect the value of investment in turbulent markets is the key to any macroeconomic diversification.
To demonstrate downside risk protection, we begin with the return distribution of a 100-percent equity portfolio as
demonstrated in Figure 12.

Figure 12: Frequency Distribution – 100% Equities (Sensex)

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Our concern is the portion of the distribution that shows negative returns. The average monthly downside return
(negative returns) of a 100-percent equity portfolio is -6.9 percent. The investor would want to reduce these negative
returns by diversification.
In Figure 13, we changed our portfolio by reallocating 83.7 percent to equities and 16.3 percent to MCX COMDEX
futures. The average monthly downside return of this portfolio reduced to -4.9 percent. This is an improvement over
the return distribution demonstrated in Figure 12, i.e., adding 16.3 percent commodity futures to the portfolio of
equities have enhanced the downside return by 29 percent.
Similar results are obtained in the case of MCX Metal and MCX Agriculture futures. The average downside return of
a portfolio with 86 percent equities and 14 percent MCX Metal futures is -6.02 percent, an improvement of around 13
percent. The average downside return of a portfolio with 67.5 percent equities and 32.5 percent MCX Agriculture
futures is -4.17 percent, an improvement of 40 percent. The return distributions of these portfolios are provided in
figures 14 and 15 respectively. The results discussed above are summarised in Table 9.

Figure 13: Frequency Distribution – 83.7% Equities, 16.3% MCX COMDEX Futures

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Figure 14: Frequency Distribution – 86% Equities, 14% MCX Metal Futures

Figure 15: Frequency Distribution – 67.5% Equities, 32.5% MCX Agri Futures

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Table 9: Summary of Downside Risk Benefits
Sensex Portfolio Portfolio Portfolio
MCX MCX
Sensex COMDEX Sensex Metal Sensex Agri
Weights 100.00% 83.70% 16.30% 86.03% 13.97% 67.58% 32.42%
Average Downside Return -6.91% -4.90% -6.02% -4.17%
Downside Protection N/A 29% 13% 40%
Sharpe Ratio 0.478 0.4817 0.4826 0.5034
Skewness -0.9557 -0.8325 -0.8573 -0.5745
Kurtosis 4.2497 4.0042 4.0579 3.4403

Deciding on the diversification benefit of commodities without considering the third and fourth moments i.e. skewness
and kurtosis of the resulting portfolio will lead to misleading conclusions in this non-normal world. The analysis shown
in Table 9 indicates that adding commodity futures to equity portfolio increases skewness and decreases kurtosis,
thus, obtains the result much desired by an investor.
The less-than-perfect or negative correlation of commodities with equities makes them an excellent candidate for
diversification. This diversification benefit was demonstrated in two ways. First, it was observed that by adding
commodity futures to a portfolio of equities enhance the risk-adjusted return of a portfolio. Second, it was observed
that adding commodity futures to equity portfolios provides a significant downside protection and enhances skewness
and kurtosis of the return distribution. It was discovered that MCX Energy futures do not add any diversification
benefit to equity portfolios. Thus, the study concludes that commodity futures are indeed valuable diversifying tools.

Concluding Remarks
Commodity derivatives play a pivotal role in the price-risk management process especially in any agricultural surplus
country. As unique hedging instruments derivatives such as forwards, futures, swaps, options and exotic derivative
products are extensively used in the global market. However, Indian market is limited to commodity futures only. The
present study is an investigation into the present status, growth constraints and developmental policy alternatives for
commodity futures markets in India. The study has surveyed the various publicly available websites of recognized
commodity exchanges and their organizational and the regulatory set up for futures trading. In the light of this the
study identified there are twenty three commodity exchanges are operating in Indian territory and out of these three
exchanges such as MCX, MCDEX, NCME are considered as national level of exchanges. There are around 146
commodities are traded in the current scenario. The study also identified that the major bottlenecks faced by the
exchanges are common such as warehousing finance, ware housing receipts and the integration of regional and
national level of exchanges etc. In terms of the market size, India is considered as the one of the fifty biggest
economies in the World in 2005 and one of the world’s leading producer in sugar, tea, textiles and pharmaceuticals.
Therefore, a review of the nature of institutional and policy level constraints facing by this segments attracts for more
focused and pragmatic approach from government, the regulator and the exchanges for making the commodity
futures markets a vibrant segment of risk management like equity and bond markets, which can play an important
role especially in Indian economy. The present study is also attempted to examine empirically whether commodity
future can be considered as a unique diversifying agents to the equity portfolio. The study considered monthly
closing values of Sensex as the proxy for equity portfolio and MCX COMDEX, MCX Metal, MCX Energy, MCX
Agriculture representing the commodity future markets, which is spanning from June 2005 to November 2007. The
empirical finding of the study in the context of commodity future as a diversifying agent to the equity portfolio is two
fold. First, it was observed that by adding commodity futures to a portfolio of equities enhance the risk adjusted return
of a portfolio. Second, it was observed that adding commodity futures to equity portfolio provides a significant
downside risk protection and enhances skewness and kurtosis of return distribution. The study also found that MCX
Energy futures do not add any diversification benefit to the portfolio of equities whereas MCX Agri futures are found
to be the best diversifying agents. While conducting this study, we were severely limited by the data availability,
especially data in the commodity futures market. The commodity futures data is available only from June 2005
onwards and therefore, the conclusions drawn on the basis of limited historical data may not be generalised and may
be biased. Further, the conclusions may hold true in future only if the macro- and micro-economic conditions and
drivers that influenced the historical data available continue to exist. Therefore, we request readers to make
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conclusions with caution. We have taken the BSE Sensex as a proxy for equities. The Sensex may not truly reflect a
well-diversified equity portfolio.

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About Evalueserve
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Disclaimer
The information contained in this article has been obtained from sources believed to be reliable, but the author
disclaims all warranties as to the accuracy, completeness or adequacy of such information, and the author shall have
no liability for errors, omissions or inadequacies in the information contained herein or for interpretations thereof.

Dr. Alok Kumar Mishra


Manager EVS Contact
EVS Media Relations
Investment Research Tel: +91 124 4154000
Evalueserve.com Pvt. Ltd pr@evalueserve.com

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