by- Jayant Manglik, President of Retail Distribution at Religare Securities Limited
Commodity prices change due to fundamentals. Supply and demand is affected by gradual changes in demographics and weather patterns. Sometimes this is accentuated by local or instant events and man-made taxes. Essentially being used either for consumption or as raw material, changing commodity prices affect companies, industries, economies and people directly. This necessitates the need for price discovery, hedging and risk management.
Any commodity producer, a wheat farmer for instance, will want to hedge his losses due to a potential fall in prices. Likewise, physicals’ traders too use available tools to hedge the risk of price changes in the commodities they are holding in stock. On the other hand, be it a bread making factory buying wheat or an airline buying jet fuel, end-users need raw material at a predictable price so as to price their end product consistently and competitively. Finally people in the financial chain, like banks and others of their ilk, provide capital to facilitate business between the buyer and seller and they need financial tools to reduce risk and lend at lower rates, thus enabling lower end-product prices.
This is the reason why commodity markets first inspired the use of derivatives, originating the concept of risk management. In our commodity markets, the passing of the FCRA bill can foster much needed market changes quickly. Indeed, regulation can drive the change rather than respond to it. While commodity futures are the base of derivatives trading, there are a varied group of financial instruments now available which have general and specific relevance to our markets. Using established electronic national commodity exchanges to trade most of these makes sense for India as a technologically superior platform is already in use. Farmers can already hedge on futures exchanges but forwards can make for customized trades for non-standard quality produce. Conversely, futures contracts have a specified delivery location, quality grade, quantity and product definition as listed on the exchange they are traded on. So the first product required is exchange settled forwards and will help reduce price risk in agricultural markets. Trading on the exchange provides better regulatory protection as well as significant transparency. This product does not require any regulatory changes and can be allowed right away.
While commodity futures are already being successfully traded, tertiary products like options are the need of the hour. This needs change in regulation as the current laws which were conceived sixty years ago do not allow it. In a price volatile agri economy susceptible to significant price and output swings, options are singularly suited for us. Likewise trading indices makes sense as it will help make for more efficient hedging. Exchange traded commodities or Commodity ETFs are a good way to introduce the product because they trade like ETFs and can be listed on commodity as well as equity exchanges. This will help investors invest in commodities as an asset class. All of this will tie in well with the reintroduction of interest rate futures and complete the economic model. Trading on weather indices will make it easy for farmers to have an effective hedge against bad crops, unlike the largely ineffective crop insurance system we currently have. Likewise freight derivative contracts are an important part of the cost component of commodities and should be traded to allow for hedging of freight rate fluctuations.
In practice, futures are good for price discovery but not overly effective as a hedging tool because it can involve significant cash flow if the futures position moves against you. Buying options is a solution used worldwide. It is also noteworthy that options will give full upside gains to farmers who use them, with losses capped due to limited cash exposure in the form of options premium. Such a platform also allows for purchasing in tranches rather than buying in bulk and storing to avoid cost fluctuations. Adding multiple derivative products will also help in bank finance as risks are reduced and the biggest beneficiary here would be the agricultural sector. All this will not only help farmers be financially wiser but also help them in deciding their cropping patterns as they will then sow what is easily marketable in the future, and they can lock in the selling price today.
At one level, none of this is new and is being successfully used the world over. So, for a combination of practical use as well as to truly integrate well with the developed world, speedy introduction of different derivative products in our commodity markets is recommended.
All this is more relevant today than ever before, more so in India. As demand increases and with limited resources at hand, there is a clear need for multiple types of derivative products in Indian commodity markets. The government, policy influencers, market groups, producers and consumer forums should work towards meeting these challenges using financial risk mitigation tools as part of a larger plan concerning production, transportation, storage and delivery to combat price volatility. All medium and long term price trends are a function of global demand and supply and largely beyond our control. Towards this end, providing the best financial tools available to hedge and mitigate risk is virtually obligatory today.
Jayant Manglik, President, Religare Securities Ltd.