Invitation to IIM-A

Graduates
Commodity Markets-
Business8Potential and Strategy
th March 2004

1 17th July, 2004

 Indian Financial Markets and
Regulators

Ministry of Finance Ministry of Consumer

Affairs

National Insurance Regulatory Company

Development Authority FMC
Housing Bank Law Board
(IRDA)

Commodity
Housing Finance Pension
Insurance Corporates Markets
Companies Funds

SIDBI RBI SEBI NABARD

State Financial Banking / Capital Co-operative Banks &

Institutions NBFCs Markets Regional Rural Banks

2
 The Indian Definition: FCRA (1952)
z Goods
z “Every kind of movable property other than
actionable claims, money and securities.”
z Securities
z “Shares, scrips, stocks, bonds, debentures,
debentures –stocks or other marketable securities
of a like nature in or any incorporated company or
any other body corporate and also government
securities.”

Inclusive definitions-Gaps exist

3
 Objectives of Commodity trading

z Leads to price discovery

z Provides hedging option
z A smart investment choice
z Integrates players and markets
z Improves cropping pattern

….a win-win, or Pareto optimal, state

4
 What are the risks in commodities?
Commodity enterprises face three classes of risk:

z Price risk – risk relating to movements in the

world price, the exchange rate and the basis
between local and world prices)

z Yield/Output risk (eg from weather)

z Political risk

Exchange to facilitate hedgers to mitigate price risk

Insurance and exchange traded derivatives to be
made available for mitigating yield risk
5
 Forwards
z A bilateral agreement in which the buyer and
seller agree upon the delivery of a specified
quantity and quality of an asset at a specified
date and agreed price
z Traded on an OTC between two FIs or one FI and
a client
z Price of contract is called a delivery price: usually
is equal to spot price plus cost of carry
z Contracts are custom designed
z Actual delivery has to take place
z No margin systems exist here
z No exchange guarantee

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 Futures
z Are exchange traded versions of forward
contracts
z Time, place and delivery price fixed between buyer
and seller
z Buyer is taking a long position
z Seller takes a short position
z Contracts have standard specifications
z Brings in hedgers, speculators and those who
want to discover prices
z Margin system reduces risk, provides liquidity and
reduces volatility

7
 Margin Requirements

z Initial margin at time of contract

z Maintenance margin which is lower than

initial margin

z Additional margin in volatile times

z Mark-to-market margin on a daily basis

8
 Exchange Vs bilateral trading
Exchange Bilateral trading
Common platform for all Restricted access
traders
Price transparency Traded prices unknown to
other players
Low transaction costs High cost and time consuming
negotiations
Absence of counter party credit Counter party credit risk
risk
Market prices available to wider Difficulty in price dissemination
world
Standardized contract size Customized contracts

Exchange - a common meeting ground for all industry

participants
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 Types of trading
Open-outcry
Participants congregate in a
“ring” to discover prices
Physical presence in exchange
premises required
Price quotations / traded prices
not transparent
Cannot facilitate on-line real time
price dissemination
Monitoring of member’s
positions and risk management
practices cumbersome
Other functions such as margining and mark-to-market are
similar
10
Online trading
Participants put orders on-line
to discover prices
Orders routed through
electronic networks
Quotations and traded prices
available on-line
Real time price dissemination
possible
On-line monitoring of member
positions
 Capital Market vs. Commodities
Capital Market Commodities
Prices movements based on Price movements are purely
the expectation of future based on the supply and
performance demand
Seasonality
Price changes can also be due Price changes are due to
to corporate actions changes policy changes
zDividend announcements zChange in tariffs / duties etc
zBonus shares / stock splits
Predictability of futures Predictability of future prices
performance is reasonably are not in the control
high zFailure of Monsoon
zHistory of management zFormation of El-ninos at
performance to support pacific

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 Options
z Gives holder the right but not the obligation to
buy or sell an asset at a known fixed price for a
premium
z Call option gives the buyer (of option) the right to
buy an asset by a certain date
z The seller has the obligation to sell the asset
z Put option gives the buyer the right to sell the
underlying asset
z Seller has the obligation to buy the asset
z Could be American option where right can be
exercised before expiry date or an European
option where it is exercised at the end of life of
contract

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 Market Structure…

13
 Commodity markets in India
z Spot trading mostly in regional mandis & unorganized
markets
z Markets fragmented and isolated
z Reduced Government procurement activity
z Mostly restricted to cereals as of date
z MSP distorting markets in favour of food grains
z Restrictions on inter-state movement and
warehousing of commodities
z Futures trading largely regionalized & based on pit
trading

There is an overwhelming need to develop

commodity futures markets as a stabilizing influence
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 Mandi trading in India
z Over 7000 Mandis
z Trading in 140 crops
z Farmers, Licensed Traders, Brokers & Wholesale
Dealers
z Mandi Inspectors issue type & quantity certificate
z Mandi fees : Transaction fee, Taxes; total varies
between 4% and 12%
z Trading, Clearing and Settlement
z Governance : State Agricultural Marketing Boards
(SAMB), Mandi Board (Farmers, Traders, State)
z Secretary, Clerks and Inspector

Issues in price dissemination, standards,

15 certification and warehousing
 Commodity futures

Precious Other
Metals Metals

Agriculture Energy

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 Potential trade in commodities (Rs. in Billion)
Current 5 times Delivery
physical trade multiple Base (5% of
volumes Market)

Bullion 400 2,000 100

Metals 600 3,000 150

Agriculture 5,000 25,000 1,250

Energy 5,000 25,000 1,250
Total 11,000 55,000 2,750

Internationally the multiple for physical versus

derivatives is much higher (In TOCOM Gold contract,
the multiple is 70 times upwards)

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 Volumes as on March 2003
Commodity Exchange Products Approx Annual Vol.
(Rs bn)
NBoT, Indore Soya, Mustard 800
NMCE, Ahmedabad Multiple 400
Ahmedabad Commodity Exch. Castor, Cotton 35
seed
Rajdhani Oil & OilSeeds Mustard 35
Vijai Beopar Ch., Gur 25
Muzzaffarnagar
Rajkot Seeds Oil & Bullion Castor, Groundnut 25
IPSTA, Cochin Pepper 25
Chamber of Commerce, Hapur Gur, Mustard 25
Bhatinda Om and Oil & Gur 15
Oilseeds
Others (mostly inactive) 15
TOTAL 1400
* Current
- annualized
futures volumes are miniscule compared to underlying spot
18 market volumes and the potential
 Indian Commodity Futures
Exchanges
FMC

Commodity Exchanges

National Regional
exchanges exchanges

NCDEX NMCE MCX NBOT 20 Other Regional

Exchanges

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 Functions of an Exchange
z Product Conceptualization and Design
z Price Discovery & Dissemination
z Robust Trading & Settlement systems
z Management of Counter party Credit Risk
z Self Regulation to ensure
z Overview of Trading and Surveillance
z Audit and review of Members
z Enforcement of Exchange rules

An Exchange provides a a common meeting ground for

all industry participants
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 National Level versus Regional Exchanges

z Multi commodities
z Transparency
z Screen based trading
z Professionally run
z Best practices pursued
z Innovative products
z Large expanding volumes

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 Current Mindsets
z Commodity exchanges are speculative markets
not meant for actual users
z If commodity exchanges do not enable physical
delivery, they are then only for speculators
z Awareness lacking amongst actual users
z Interest rate, exchange rate risk actively managed,
but not commodity risk
z Main impediments centred around safety,
transparency and taxation issues

22
 Benefits to actual users
z Farmers: Price hedging
z Contract farmers: Price hedging
z Metal manufacturers: Forward sale of production
z Metals consumers/farm produce consumers:
Forward purchase of inputs
z Gold users: Hedging price for future

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 Price variations (Average annual %)

Cotton Zinc Steel Rubber Copper

FY00 1.5 10.5 6.1 3.3 5.6

FY01 6.6 -0.03 -8.6 -1.9 8.0

FY02 -6.0 -24.8 31.2 5.9 -15.4

FY03 -2.3 -6.4 9.5 21.8 3.9

FY04 11.5 15.7 36.0 42.2 29.0

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 Industry Perspective
Industry Raw materials PBT (FY03) Impact of 5%
to COS % Rs cr rise in raw
mat prices (Rs
Textiles 62% -2265 cr) - 1429

Steel 54% +200 -1667

Edible oils 88% 148 -566

Gems and 86% 76 -216

jewellery

Source: CMIE

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 Do actual users use Exchange platforms
for physical delivery?

z They can, but do not..

z View taking
z Stocking sub-optimal
z Reasons
z Grades
z Logistics costs
z Sales tax/octroi
z Set off not permitted
z Most actual users use exchanges for hedging
z For commodity needs, bilateral arrangements
preferred

26
 Investors’ story..

27
 Investors
z Portfolio diversifiers
z Lower margins
z Lower risk
z Better risk-adjusted returns
z Mutual funds on the anvil
z PDs have sought enlargement of roles

28
 Volumes in Commodity Derivatives
Worldwide

z Derivatives volumes of non-US exchanges in the

last decade has been increasing
Source : World Federation of Exchanges, various websites
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 Comparison of Commodities & Equities

zAverage 20 day historical volatility (1/91 till 8/02)

Equity
Commodity

z Commodities have less volatility compared to equity

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 Volatility comparison - Summary
Average annual volatility
z Sensex or Nifty - 25-30%
z Govt Sec Index - 5-10%
z Gold - 12-18%
z Silver - 15-25%
z Cotton - 10-12%
z Oil seeds - 15-20%

z Commodities are less volatile compared to equity

market, but more volatile as compared to G-Sec’s

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 Correlation: 1997-03

Correlation coefficients in Indian m arkets

Gold Silver Stocks Bonds
Gold 1 0.089 0.206 0.741
Silver 1 -0.099 0.146
Stocks 1 0.112
Bonds 1
Data: LBMA bullion prices, NSE Nifty, NSE G-Sec Index

Benefit of diversification can be seen from the

Risk Adjusted Returns
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 Risk-Adjusted Returns:1997-03
Ab s Cum ulative Risk of Risk Adjusted
Portfolio structure Returns portfolio Return
100% Stock Portfolio 73.70% 24.43% 3.017
Stocks (50% ) & Gold 47.80% 3.326
(50% ) Portfolio 14.37%
Stocks (50% ) & Silver 48.30% 3.634
(50% ) Portfolio 13.29%
100% Gold Portfolio 21.80% 2.001
100% Silver Portfolio 22.90% 1.742
100% Bonds Portfolio 25.20% 7.92% 3.182
Bonds (50% ) & Gold 23.50% 8.79% 2.673
(50% ) Portfolio
Bonds (50% ) & Silver 24.00% 6.58% 3.647
(50% ) Portfolio

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 NCDEX Value Proposition…

34
 Why NCDEX
z Create a player without trading interest
z Foster professionalism and transparency
z Inculcate international best practices
z Demutualisation
z Technology platforms
z Information dissemination without noise
z Low cost solutions
z Nation-wide reach and consistent offering
z Bring together names the market can trust

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 NCDEX – Current shareholders

17% 17% 10% 14%

17% 17% 7%

Canara Bank to take additional stake

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 Consortium brings ….
z Institution building expertise
z Commitment to the agri sector
z Nation-wide reach
z Ability to bring in capital
z Technology and Risk Management skills

37
 Governance
z Independent Board
z Professionally managed organization
z Executive Committee
z Other Committees
z Membership
z Product
z Risk Management
z Arbitration

38
 Commodities selected in Phase I

zGold
Bullion
zSilver

zSoya bean
zSoya oil
zRapeseed/Mustard Seed
Agri-Commodities zRapeseed / Mustard Seed Oil
zCrude Palm oil
zRBD Palmolein
zCotton

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 Commodities introduced in Phase II
z Rubber
z Jute
z Pepper
z Chana (Gram)
z Guar
z Wheat

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 Commodities in Phase III
z Rice, wheat
z Turmeric, chillies
z Base metals
z Aluminium, Copper, Zinc and Nickel
z Coffee
z Tea
z Other edible oil products
z Groundnut, Sunflower, Castor
Seed, oil & cakes
z
z Energy products
z Commodity Indices and weather derivatives
z Agri-commodity index, Metal Commodity index

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 NCDEX Landmarks….

42
 Spot Prices: The only real-time
source
z NCDEX initiatives – Price discovery
z Spot price polling from traders, exporters, mandis
etc with multiple polling centers
z Partners: CMIE and CRISIL market wire

z Bootstrapping to eliminate manipulation effect

z Price collection from trade associations

The challenge ahead is price dissemination

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 Special mention by Economic Survey
z Innovative spot prices polling process introduced
by NCDEX
z Robustness of systems
z Convergence/closeness of the traded futures
prices and the final settlement prices
z “Has given a new level of near real-time access to
reliable prices from agricultural markets in the
country. This marks a milestone for the statistical
system in agriculture, and sets the stage for
modern development of commodity derivatives
markets despite the presence of a fragmented
OTC spot market”

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 Price Dissemination: Implemented
z Real-time price dissemination
z Extranet
z Website (www.ncdex.com)
z Tie-up with Reuters, Telerate
z Corporate tie-ups for rural kiosks
z ITC E-choupals
z Newspapers, Agri journals
z AgmarkNet
z Kissan call centres

Basic idea is to encourage farmers to choose cropping

pattern based on future and not past prices
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 Price Dissemination: In process
z Proposed vehicles of price dissemination
z APMC boards at mandis
z Agri extension service providers
z Mahindra Shubhlabh, Rallis etc
z Govt. office outlets
z Post offices
z Bank branches
z FMCG dealer points

NCDEX spot price can be used for valuation of

collateral for commodity- based funding by financial
46 agencies
 NCDEX Approach to Warehousing

z Accreditation of Warehouses: parameters based

z Promoting Collateral Management
z The McDonald Approach
z Robust grading by international agencies like
Geochem, Dr. Amin etc. to assure quality
z Developing a scientific grading process for
cotton
z Project in co-ordination with CIRCOT
z Dematerialisation of Warehouse receipts
z Reduction in physical/repayment risk to lead to
lower lending rates

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 Pilots in Futures
z NCDEX project with GujCot
z Hedging mechanism for farmers on NCDEX
platform
z GujCot covers price risk
z Facilitates price dissemination at grass roots level
z Two more cotton projects in Hyderabad and
Warrangal

Options for farmers can be a substitute for MSP

48
 Some facts
z 1st to carry out delivery through dematerialized
warehouse receipt for Feb’04 Gold contract
z In June, 21 kgs of gold and 10 tons of pepper
delivered
z Warehouse accreditation
z Spot price data base built for last 10 years
z Presence in over 135 centers
z Over 1800 trading terminals
z 300 members enabled for trading as against
target of 125
z Evening session of trading introduced on Feb 23,
2004- up to 11.30 p.m.
z Saturday trading also introduced
Working towards round-the-clock trading…
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 Activity on NCDEX
z Recoded peak traded volume of Rs 283 cr on July
7
z Turnover of Rs 566 cr
z 60% share of bullion and agricultural commodities
z Has highest open interest ratio to volume traded
in gold and silver
z Average daily number of trades is around 6,500
z Highest was above 17,000
z Average daily number of orders is around 10,000
z Highest was around 37,000
z Average daily client participation of around 650

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 Looking ahead…We are

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 Educating corporates
Industry (data of 1500 % of Raw Material cost to
companies) Aggr. Turnover
Agro/ FMCG/ Edible Oils 70%
Auto/Auto Ancil. 90%
Chemicals 65%
Construction 40%
Consumer Goods 50%
Engineering/Industrial G. 50%
Fertilizer/Pesticides 45%
Livestock/Leather 65%
Metals/Mining/Steel 70%
Packaging 60%
Oil/Petro/Refineries 85%
Sugar 65%
Textiles 90%
Transport 40%

Source of data – ICICI Bank Corporate Infobank

Industry in India runs the raw material price risk, going Forward
52 they can hedge this risk
 Spreading awareness
z Awareness Program during January – June 2004
z Over 75 programs
z 5000 Participants
z Expect to conduct 200 programs during FY05
z To cover over 20,000 participants
z Certification Exam already being conducted by
NCFM

53
 Seeking changes in Banking Regulation

z Aggregators
z Banking Regulation Act to be modified
z Accreditation of warehouses and quality of
products
z Furthers bank lending against commodities
z Change in Priority sector norms
z Lending against commodities to be considered
priority sector lending
z Banks to lend against bullion
z Need for hallmarking

54
 Working towards Extension of
players
z Mutual funds
z Commodities as an investment diversifier
z FIIs
z Either directly or through Indian arm
z PDs
z Insurance firms
z Pension funds

55
 Changing the face of Warehousing
z Electronic warehouse receipt (EWR) to be legally
recognized
z EWR to be a negotiable instrument
z Depositories Act to be amended to cover
commodities
z SEBI to notify that FMC is regulatory body for
demat commodities

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 Inducing Policy changes
z Introduction of options
z Will ably substitute the MSP programme of
government
z Permit weather derivatives
z Redefining commodities
z Goods not covered under ’securities’
z Products not covered under SCRA
z Physical delivery not to be mandatory

57
 Budget proposals relating to Commodities

z Integration of commodity market with securities

market
z Service tax on forward contracts to affect
commodity brokers
z Significant omissions in light of other
announcements
z Weather derivatives
z Bank investment in commodities

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 Thank you

59
 Polling centres
Commodities Priority Center Non-Priority Center
Mustard Seed / Rapeseed Jaipur Alwar, Sriganganagar
Expeller Mustard /Rapeseed Jaipur Sriganganagar, Alwar
Oil
Soyabean Indore Nagpur, Mumbai, Dhar,
Dewas
Refined Soya Oil Indore Mumbai, Nagpur, Dewas

Crude Palm Oil Kandla Kolkatta

RBD Palmolein Kakinada Mumbai, Chennai
Medium Staple Cotton Bhatinda Abhor, Sirsa
Long Staple Cotton Ahmedabad Surendranagar, Kadi (Guj)

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 Polling Centre (Contd.)
Commodities Center

Chana Delhi, Indore

Guar Jodhpur, Bikaner

Jute Kolkata

Pepper Kochi, Allepey, Angamaly

Wheat Delhi, Khanna, Karnal, Bareilley, Kanpur,

Shahjahanpur
Rubber Kottayam, Kochi, Ernakulam, Palakkad

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