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I. Project Details
Commodity prices in the coming years will be influenced by two the forces of
deflation and inflation. If deflationary forces dominate, commodity prices will
tend to decrease; if inflationary forces dominate, commodity prices will tend
to increase
The inflation is worrying and the government has stepped in to take all
measures to control inflation even at the cost of foregoing growth. The
government is taking both monetary and fiscal policies to bring down the
prices.
To study that futures trading has a direct impact on inflation. This is brought
about by the presence of basis (the difference between spot and future
prices)the futures prices are higher than spot prices. In usual cases, The
cause of this phenomenon is the presence of speculation and positive
expectations. However, in certain commodities where speculation is
negative, futures prices are lower than the spot prices. This difference in
spot and futures prices is capable of causing a shit in the demand-supply
mechanisms in favour of a particular time period to the prejudice of the
other. For instance, when futures prices are higher than spot prices for an
agricultural commodity, the farmers would like to sell the commodity in
future, bringing down the supply levels at present. However, the lower prices
at present compared to future prices prompts a high demand for the
commodity at present. This mechanism causes excess demand in the
present time period and pushes up the price of the commodity in question,
thereby causing higher levels of inflation. Given that the futures prices were
almost always higher than the spot prices as far as agricultural commodities
are concerned,
Introduction:
(i) its effectiveness in attaining the stated goal of curbing inflation and
(iii)In brief the concept of forward trading and risk hedging, need for
regulation in a futures market and the legal and institutional framework
governing futures markets in India with focus on commodity derivatives.
An option is the right, not obligation, to buy or sell a specified amount (and
quality) of a commodity, currency, index or financial instrument, or to buy or
sell a specified number of underlying futures contracts, at a specified price,
on or before a specified a given date in the future. An option confers upon its
holder a right but not obligation to buy/sell the underlying commodity/
contract/ index/ instrument/ currency at a pre-specified price on or before
the said date. An option that gives its holder a right to buy is called a call
option while one that confers upon its holder a right to sell is called a put
option. Options, like futures, can be traded in an exchange so as to alter or
reverse positions. An option appears to the general rule that an offer can be
revoked any time before it is accepted. In an option the option writer (the
one who grants the option) is not free to revoke the offer before the
specified date though the option holder has not accepted the offer by the
exercise of the offer. There appears to be an ancillary agreement between
the parties by which the offeror undertakes to keep the offer open till the
specified date. It appears to the researcher that where there is a payment of
an advance or earnest money between the parties, it acts as consideration
for the ancillary agreement and makes it a contract. Where there is no such
payment, the obligation of the option writer to keep the offer open arises
from the doctrine of promissory estoppel.
Similarly, parties entering into futures contracts fix the quantity, quality,
price and other particulars at a prior date. This helps the parties to avoid
(hedge) the risks of price fluctuations and also to plan out future activities.
While hedgers are those risk-aversive agents who try to shift the price risks
associated with volatile nature of prices in a deal by opting for a fixed price
decided in the present by the means of futures, speculators are those who
are willing to take risks and intend to reap benefits out of the speculated
changes in price of the derivative itself. While hedgers are concerned about
securing a fixed price for the commodity underlying the derivative
speculators are concerned about possible fluctuations in the price of the
derivative itself and the profits that can be reaped from them. Most of the
times it is noticed in a real world market that though the same agent may
act as a hedger at one instance and a speculator at another, the general rule
is that hedgers form the two extreme ends of a chain of transactions (the
persons who really intend to buy or sell the commodity as such and not
merely the derivative, that is mostly the producers and the final demanders
of the commodity) the intermittent roles are filled by a number of
speculators who may further be divided into a number of categories like
arbitragers, day-traders, etc. So, in a way, a futures market is a forum for
trade offs in risk between the risk aversive hedgers and the risk taking
speculators. Both speculators and hedgers have their own demand and
supply schedules and it is an interaction between these market forces that
fix prices in a future market, if they are given a free hand.
Though Speculators and hedgers account for the demand and supply
equations in a futures market, they are not the only entities that matter.
Clearance houses and brokers are the people who really appear in the pit.
Clearance firms ensure that the contracts are complied with. In every deal
between two parties, clearance houses stand between the parties, taking the
stand opposite to what each party has taken. That is, the person taking short
position sells the commodity to the clearance house and the person taking
the long position buys the contract from the clearance house. Clearance
houses require the parties to deposit a margin, proportional to the worth of
the deal so that performance can be assured. Brokers are hired by parties to
trade on their behalf in the market, in accordance to a range of orders that
are exercised by the party from time to time.
The difference between future and spot prices is known as Basis. (Basis = Pt
- P0 where Pt is future price and P0 is spot price). In a normal market Basis is
positive while in an inverted market Basis is negative. The difference in
prices tends to decrease and the prices tend to converge bringing down
Basis to zero as the month of delivery approaches. The convergence of price
occurs because any non-zero Basis at a period close to the month of delivery
will provide the traders ample opportunities of arbitrage and as they reap
these opportunities the Basis will come closer and closer to zero.
Another feature of futures markets that calls for regulation is that traders in
futures markets need merely a small proportion of the money that the trade
is worth to be deposited as margins. This enables traders to enter into deals
which are worth many times more than the money they have at their
disposal. Such transactions are indeed undertaken by speculators who act as
retail investors or day traders with the plans of reversing the trade position
before the maturity of the future. But if such a reversal becomes impossible
owing to huge fluctuations, a number of traders may face bankruptcy and
even the presence of clearance houses may not be able to eliminate
counter-party risks. (Risk of non performance by the other party to the
contract)
Part II (Analyzing)
However, whether the ban will help in curtailing overall inflation or merely
act as a stopgap measure bringing down prices of agricultural commodities
alone, leaving the farmers faced with lower incomes and higher price levels
for nonagricultural commodities is a question that can be answered only by
an examination of real causes of the current inflation phenomenon. Between
2004-05 and 2005-06 there has been an acceleration in growth of broad
money (M3) from 12.3% to 17%.. This rapid growth cannot be attributed
merely to the presence of future traders. There are and fiscal factors like
increased credit availability which are at the root of the phenomenon.
Banning futures trading without attending to these real causes will merely
bring down price of agricultural products without causing a corresponding
deflation for non-agricultural products. This will lead to a highly inequitable
result, leaving the farmers at a worsened position.
It has been pointed out in the previous section how ban on futures trading in
agricultural commodities, without initiating steps to attend to the real causes
of inflation will leave the farmers in a worsened situation. However, it is to be
noted here that the gains that the typical Indian farmer used to reap from
futures trading are those that arise as a spill-over effect of futures trading
(through the mechanism mentioned in the previous section) and not from
the participation of farmers in forward markets.
Thus a major part of the gains that critics of the ban accuse the ban of
snatching from the farmers, were in fact never enjoyed by the majority of
agrarian community in India. The direct gains of futures trading in India were
always cornered by speculators and large farmers who were able to meet
the huge lot size requirements of the Indian commodity markets. Thus what
the average Indian farmer stands to lose from the ban is the higher price
lever arrived at as a spillover effect of forward trading and not any direct
gain.
Using the Granger causality tests to study whether prices in one market
impact prices in the other, RBI has concluded that “commodity prices in
India seem to be influenced more by other drivers of price changes,
particularly demand-supply gap in specific commodities, the degree of
dependence on imports and international movements in these
commodities.”
The RBI has carried out tests on six farm commodities — sugar, urad, tur,
wheat, chana and potatoes — to find out whether futures trading impacted
spot prices and vice-versa. The tests relate to monthly data on these
commodities for the period of 2004-2009. For commodities such as urad and
tur on which bans were imposed, data for the 2004-2007 period were used.
The causality tests show that futures prices have causal impact on spot
prices in the case of sugar and urad and that spot prices impact futures
prices in case of urad, chana, wheat and sugar.
“The emprical analysis, thus, does not provide any conclusive evidence in
support of the relationship between spot and futures prices,” noted RBI in its
annual report for FY10.
“The RBI diagnosis reinforces what has been held all along by the futures
market that futures prices do not cause spot price inflation and, hence,
cannot be held responsible for food inflation in essential commodities
The government banned futures trading in tur, urad, wheat and rice in 2007.
It relisted wheat in May 2009 but delisted sugar in the same month because
of price volatility. The sugar ban comes up for review by the government on
September 30.
Conclusion:
Facts show that futures trading in essential commodities has not been
responsible for the price rise in recent period. There is no future trading in
Urad and Tur since January 2007 when it was suspended. But the prices of
these commodities are showing sharp increase during 2008-09 and 2009-10.
The year-on-year price increase (in terms of Wholesale Price Index) at the
end of financial year 2008-09 (29.3.2009) was 14.7% for Urad and 17.1% for
Tur. During the year 2009-10 (as on 28.11.09). Year-on-Year increase was
59.46% and 72.25% for Urad and Tur respectively. As against this there is
futures trading in Gram. Year on Year change of prices of Gram was negative
at –6.8% in 2008-09 and 4.32% during 2009-10 (as on 28.11.09)
respectively. Therefore, the increase in prices of commodities need not
necessarily be attributed to future trading. In fact an Expert Committee
appointed by the Government under the Chairmanship of Planning
Commission’s Member Prof. Abhijit Sen to examine whether futures markets
was responsible for rise in the prices of essential commodities in its report
submitted in April 2008 did not find futures market responsible for the
increase of the prices of essential commodities.
In the light of the above analysis, it can be safely concluded that the current
ban on futures trading in certain agricultural commodities is a mere stopgap
measure to curb inflation. It certainly will affect the farmers adversely by
lowering the price level of agricultural commodities unaccompanied by a
corresponding lowering in prices of non-agricultural products. However this
does not mean forward trading, as it stood before the ban was helpful to the
farmers. It is specially emphasized that the market regulations regarding lot
size and other standards prevailing in the Indian commodity exchanges are
not suited for the socio-economic realities of the Indian farming community.
Refrences
-http://www.mainstreamweekly.net/article858.html
-www.ncdex.org.
-http//www.fmc.gov.in
Sutdent’s Signature