Commodities Derivative hedging: Portfolio and Effectiveness

By Mr. Kumar Dasgupta and Dr. Chiragra Chakrabarty

Commodities have been the bedrock of civilization. Ever since we arrived, our existence has been defined by a quest for control over geological resources call it oil, gold, copper or even exotics like uranium. Man has undertaken treacherous expeditions and fought battles to discover and conquer commodities. Civilisations rise and fall, and economies prosper based on their ability to harness energy, mine metals, and cultivate agricultural produce. Interesting to note: the progress of mankind has been marked through the ages with different commodities Stone Age, Bronze Age, Iron Age, and now Nuclear Age. The enigma, called commodities, has determined the fate and wealth of nations for eons and would continue to do so in future
1. Introduction to Commodity Derivatives Markets vehicles for accumulation of significant wealth for individuals. Some of the most enduring fortunes have been built with commodities. Among the stars in the galaxy, Mayer Rothschild singlehandedly built the banking empire by providing vault facilities for storing bullion during World War II. John D. Rockefeller created the first true corporate, Standard Oil Co., by exploring crude oil. Andrew Carnegie conglomerated the steel industry in the United States to form US Steel. Abdel-Aziz-Al-Saud, the founding father of Saudi Arabia, created one of the most influential nations on energy products. Jim Rogers, the Ambanis, the Tatas and Laxmi Mittal have all become legends because they had the foresight to invest in commodities. 1.3. With a growing population of over one billion (2001 census), India would remain one of the largest markets for traders in global commodities, with metals and energy playing a crucial role in the growth and development of the industrial sector of the Indian economy and agricultural products. At this juncture, institutional development of commodity markets will: (a) create a near-perfect market situation, (b) enable wider participation by different segments of the economy, (c) create a global hub for trading in commodities due to its strategic geographical location, and (d) make India a potential price setter for many commodities.
| 53

1.1. Commodities derivatives markets are deep and broad, presenting both challenges and opportunities in their wakes. It has been the experience of participants that they have been besieged by the vastness of the market and the types of underlying assets available. Despite millennia of commerce in commodities, we are still perplexed by questions such as: what should we trade in?, how much do we buy or sell?, how do we give or take delivery of commodities?, when is the ideal time to enter and exit the market, and so on. These asymptomatic behaviours of intermediaries and investors have given naissance to the major commodity markets, as we know them today. From the mandis in Asia and Africa to the sophisticated electronic platforms in the Western world, commodities trading has come a long way. The mode of exchange of the value of commodities has also seen a transformation over the ages from the rudimentary barter system, trade was revolutionised by the introduction of money, and yet again with the advancement in electronic transfer of credits called dematerialisation. 1.2. While it is true that commodities have dictated the economic passions of sovereign and nonsovereign nations, they have also acted as the

EXPERTS VIEWS

1.4. The paper has been divided into five sections. While section 2 draws a comparison of Indian markets with international markets, the use of commodity derivatives in portfolio management is explained in section 3. Section 4 depicts the methodology and issues related to the measurement of hedge effectiveness. Section 5 is devoted to conclusion. 2. Indian Markets vs. International Markets Where We Stand

Rs.33,162.07 billion in 2008-09. The growth charted by the Indian commodity exchanges can be summarised in Table 1.1. Table 1.1: Turnover of the Indian Commodity Derivative Exchanges
Year 2002-03 2003-04 2004-05 2005-06 2006-07 2007 -08 2008-09 (Nov. 2008)
Source: MCX, NCDEX, NMCE & NBOT

Turnover (in Rs. Billion) 665.30 1,293.64 5,717.59 21,551.22 36,769.27 40,659.89 33,162.07

2.1. If we look at our history, Indian market participants have had the experience of trading in commodity derivatives for ages. Even during the long period of ban, there were reports of parallel markets in commodity derivatives. It is interesting to note that, in 2002, just after the ban was lifted and the Government approved the launch of national-level trading platforms, the Indian commodity market took a quantum jump. Industry observers were left wondering as to how India could pull off a coup dtat in such a short time. The question which was, and perhaps still lingers (even after five years of operation) is: Is such a progress sustainable and what are the obstacles that need attention if the market has to realise its full potential? 2.2. Since 2002 there has been a revival of commodity derivatives markets in India, both in terms of commodities allowed for futures trading and volumes of the trade. Let us consider some statistics. While in 2001-02 futures trading was allowed only in eight commodities, the count jumped to 109 in 2008-09. The value of trading in Rupee-denominated terms saw a quantum jump from about Rs.350 billion in 2001-02 to

2.3. The Group on Forward and Futures Markets, 2001, has estimated that the contribution of commodity derivatives exchanges would be as high as 10% of Gross Domestic Product (GDP) by the year 2007 compared with a nominal of 1.2% of GDP in 1999. Compared by volumes (the number of contracts traded), nine of the worlds top 22 major commodity derivatives exchanges are in developing countries. And interestingly, three of them are based in India (MCX1, NCDEX2 and NMCE3). Further, one of these exchanges (MCX) features in the worlds top 10, overtaking longestablished and mature institutions such as the Tokyo Commodity Exchange and New York Board of Trade. A figurative assessment is given in Table 1.2. The figures include the volumes in terms of contracts traded in the first half of 2009. The volumes in terms of USD or INR are not considered within the scope of this study.

Table 1.2: Turnover of Global Commodity Derivatives Exchanges

Rank 1 2 3 4 5 6 7 8 9 10 Exchange New York Mercantile Exchange (NYMEX) Dalian Commodity Exchange (DCE) Shanghai & Hong Kong Futures Exchange (SHFE) Zhengzhou Commodity Exchange (ZCE) Chicago Board of Trade (CBoT) ICE Futures, Europe Multi Commodity Exchange of India (MCX) London Metal Exchange (LME) ICE Futures U. S. (erstwhile New York Board of Trade) Tokyo Commodity Exchange (TOCOM) Country USA China China China USA Belgium. India UK USA Japan Turnover (number of contracts traded) 206,010,205 170,869,127 151,544,472 93,213,149 83,233,736 78,372,945 77,742,706 55,185,086 25,271,245 14,643,397

Source: Industry Analysis

1 2 3

Multi Commodity Exchange of India Limited, Mumbai (www.mcxindia.com) National Commodity and Derivatives Exchange Limited, Mumbai (www.ncdex.com) National Multi Commodity Ex change of India Limited, Ahmedabad (www.nmce.com)

54 | A PUBLICATION BY MCX AND PRICEWATERHOUSECOOPERS

2.4. In retrospect, MCX Comdex fell by 24% during 2008 somewhat lower compared with the decline in international commodity futures indices of Dow Jones AIG Commodity Index Cash Index (DJAIG) at 36.6% and Reuters/Jefferies Commodity Research Bureau (RJCRB) at 36%. For a comparative analysis of MCX Comdex with the other global indices, we have recalibrated the base period of all the indices to 100 from June 2005. Levels are calculated as in January 2009, tabulated in Table 1.3. Table 1.3: Comparison of MCX Comdex with major global commodities indices
Indices RJCRB DJAIG Comdex
Source: Industry Analysis

Table 1.4: Global Sector-wise Futures & Options Volume

Sector Sector Equity Index Individual Equity Interest Rates Agriculture Energy Foreign Currency Precious Metals Non Precious Metals Other TOTAL Contracts Traded in Millions 6,488.62 5,511.19 3,204.84 888.83 580.40 577.16 180.37 175.79 45.50 17,652.70

Levels in June 2005 100 100 100

Levels in January 2009 128.7134 102.7972 128.5218

Note: Prices of commodities and indices are taken from January 2006 to June 2009.

2.5. Even if we undertake a comparison of the share of equity market investors wealth in GDP with that of the commodity futures markets, we find that India ranks quite high among all countries. The ratio of Indias market capitalisation to GDP touched a historical high of 165% in early 2008. While this is a substantially sharp rise, India is still in the fifth position, behind Hong Kong, Singapore, Switzerland and Taiwan, some of which have ratios in excess of 200%. The value of investors wealth in Rupee-denominated spot market turnover terms is approximately Rs.30,860.75 billion in 2008-09 (excluding assets under management of fund management houses). The derivatives segment of the historically more mature Indian equity markets ranks seventh (S&P CNX Nifty Futures) and tenth (S&P CNX Nifty Options), respectively, in terms of turnover ratio when compared to the top 20 derivatives exchanges globally. The Indian commodity derivatives exchanges, on the other hand, are among the top 10 in terms of volumes generated. 2.6. A snapshot of the global volumes of futures and options contracts traded across the asset classes will ingrain an impression of what we are looking at. Table 1.4 shows the sectoral break-up of volumes in terms of million contracts traded and/or cleared on 69 exchanges worldwide for the year ended March 2008.

2.7. Clocking an impressive growth within five years, this transformation has expanded the breadth and intensity of potential impacts that a commodity derivatives exchange can make on underlying commodity sectors as well as the economy. In a comparison of the Indian commodity derivatives market with the international markets, we find that there is a need for elevating the products base of the exchanges in India. Limited commodities are limiting industry participation. In the new economy paradigm, banks are engaging in warehouse receipt financing and collateral management. Now, with the participation of banks, this industry is bound to flourish. 2.8. There is a need for strengthening the regulatory framework of the market. The government's approval to the amendment of Forward Contracts (Regulation) Act, through an ordinance, paves the way for introduction of long-awaited options trading in commodity derivatives. The move will certainly deepen commodity markets, make them more mature and spur wider participation in derivatives trading on the domestic commodity exchanges. If the move is symptomatic of the government's softening stance towards commodity exchanges and commodity futures, it must be hailed as one of the most pragmatic pieces of economic legislation. Moreover, the existing national-level exchanges support a strong and advanced technology-driven platform.

EXPERTS VIEWS

| 55

3.

W h y Yo u r Po r t f o l i o S h o u l d I n c l u d e Commodities Derivatives

3.1. In our country, direct commodity investment has not been a major part of the investors pool. In recent times, however, commodity-linked assets have increased the number of available commodity-based products. Empirical studies have shown that investment in commodities results in significant diversification benefits. These benefits are traced to the unique exposure of commodity investment to macroeconomic variables, as well as the potential to capture a positive roll return. But the principal thought lingers: why should the investor think about diversifying the portfolio through investments in commodity-linked instruments? The answer lies in the fact that direct or indirect investments in the commodities market actually increase the Sharpe ratio of the portfolio and significantly reduce the annualized volatility. A few studies have been cited. 3.2. The diversification benefits of commodities have been studied in length and breadth, and across the continents. Studies have found that the inclusion of portfolios of long commodity futures contracts (CRB and GSCI) improves the risk and return performance of stock and bond portfolios for the period 1970 through 1990. It was observed that the improvement is more pronounced for the 1970s than the 1980s due to the high inflation of the 1970s with commodities acting as a natural inflation hedge. Futures prices were also found to have little value in predicting inflation. Tests were performed on the theory of storage and present empirical evidence that in periods of increasing volatility and risk, convenience yields increase for a wide variety of metals prices. 3.3. Academicians have identified business cycle component in the variation of spot and futures prices of industrial metals. The theory of storage splits the difference between the futures price and the spot price into the forgone interest from purchasing and storing the commodity, storage costs and the convenience yield on the inventory. The question of whether commodities represent a separate asset class has been extensively debated.

3.4. Furthermore, on examining the correlations of oil-based futures contracts with energy-related and non-energy-related stock, bond, real estate and commodity markets, and CPI, results confirm that, except in periods of extreme energy price movement, many traditional forms of indirect energy investments such as natural resource mutual funds and energy-based common stocks are not correlated with energy price movements. This is as expected. Given the risk management and firm diversification abilities of most corporations, unless the price change in the underlying commodity is structural and long lasting, short-term changes in commodity prices may have little impact on a firm's equity performance. 3.5. It was also confirmed that in addition to energybased passive long-only commodity indices offering returns not available in traditional equity investments, active long/short energy traders offer returns (positive returns in markets with declining energy prices) not available in longonly commodity indices or traditional commodity-based equity investments. 3.6. The principal argument for investing in commodities is that investing in assets that rise in price with inflation provides a natural hedge against losses in equity and debt holdings that typically lose value during periods of unexpected inflation. The studies have spanned across years of high inflation such as 1978, 1983, 1998 and 2000. In continuation with the evidences presented, we present our case by demonstrating that during a same period analysis, equities show a n e g at i ve co r re l at i o n w i t h i n f l at i o n . Commodities indices have shown a greater independence from inflation. This contradicts the popular belief that commodity derivatives put inflationary pressures on the economy. We have compared MCX Comdex with the BSE Sensitive Index and inflation respectively for a period spanning June 2005 to January 2009, the findings of which are tabulated in Table 1.5 Table 1.5: Comparative Analysis of BSE Sensex, MCX Comdex and Inflation
BSE Sensex 1.000 0.210 (-)0.01 MCX Comdex 1.000 (-)0.08 Inflation 1.000

BSE Sensex MCX Comdex Inflation

Source: Industry Analysis

56 | A PUBLICATION BY MCX AND PRICEWATERHOUSECOOPERS

3.7. Adding commodities to an equity portfolio can minimise the damage during economic crises or downturns. As commodities have the ability to react favourably to economic downturns or macroeconomic conditions unfavourable to equities, they are a perfect contender for reducing downside risks. The ability to protect the value of investment in chaotic markets is the key to any diversification. 3.8. Perhaps the major advantage of diversifying an equity portfolio using commodities is the mitigation of management risk. In any portfolio management, risk seeps in from the style incorporated by the fund manager. Even though, in a given period, a fund manager investing in equities may give higher returns, the impression of the company management may have its effects on the financial statements during the same period. The return from the equity is subject to company policies, valuations, industry-wide conditions and management styles. These are systemic risks associated with the equity market. In the commodity market, however, the prices are dependent purely on demand and supply conditions. The macroeconomic variables determine the prices and the behaviour of commodities. In a nutshell, investing in commodities automatically mitigates the abovementioned risks. 3.9. However, it is also emphasised that price risk management may not always be the most important benefit. Commodity derivative exchanges can yield other critical impacts: b ro a d e n a cce s s to m a r k e t s ; e m p owe r participants to take better decisions; reduce information asymmetries that have previously advantaged more powerful market actors; upgrade procurement, storage, grading and technology infrastructure; and expand access to cheaper sources of finance. Last but not the least, these exchanges enable entities to create a hedge against their exposures to the vagaries of commodity price movements. 3.10. But the moot question is: how effective is the hedge created by commodity derivatives? The next section tries to answer this question.

4.

How Effective is Highly Effective An Accounting Perspective

4.1. Normally there are three common methodologies for testing and analysing hedge effectiveness the dollar-offset method, the variability-reduction method, and the regression method. 4.2. The above methods to an extent have also been enshrined in the new accounting norms dealing with such types of instruments. The new accounting norms for derivative instruments and hedging activities were issued because the effects of the increasing quantity and variety of derivatives used by companies were not always transparent in their financial statements. These standardise the accounting treatment for derivative instruments by requiring all entities to report derivatives as assets and liabilities on the balance sheet at their fair value. 4.3. However, the new accounting norms also recognise hedges that are put in place by entities and try to reflect the economics of such hedges in the financial statements. It basically allows for three accounting models for hedges a fair value hedge model, a cash flow hedge model and a net investment hedge model with the first two being most commonly used. A fair value hedge offsets the price risk of a recognised asset or liability or an unrecognised firm commitment. A cash flow hedge offsets the variability of the cash flows of a balance sheet item or a forecasted transaction. If a derivative qualifies for hedge accounting and the hedge is deemed to be highly effective, the standard permits entities to match the timing of the gains and losses on the hedged item and with the gains and losses on the derivative positions in their profit or loss account. Or, in other words, the accounting captures the economics of the hedge whereby an entity has mitigated its exposure to commodity price risks through commodity derivative instruments. 4.4. In principle, a hedge is highly effective if the changes in the fair value or the cash flow of the hedged item and the hedging derivative offset each other. To qualify a derivative position for hedge accounting, the hedging entity must specify the hedged item, identify the hedging strategy and the derivative, and document by statistical or other means the basis for expecting the hedge to be highly effective in offsetting the designated risk exposure. This documentation step is called prospective testing, and it must be done to justify continuing hedge accounting. The hedger must also regularly perform retrospective testing to determine how effective the hedging relationship has actually been.
EXPERTS VIEWS

| 57

4.5. Defining and testing a measure of hedge effectiveness represents an important and potentially challenging aspect of hedge accounting. Failure to meet the challenges hedge accounting presents may introduce substantial volatility into reported earnings. 4.6. Highly effective hedge substantially offsets the change in the fair value (or the cash flow) of the hedged item. That is, if the hedged item in a fair value hedge appreciates by $100,000, then there is some range of decline in values of the hedge that can be defined as substantially offsetting this change. Defining this range is a matter of subjective judgment. A highly effective hedge has been defined in literature as one that offsets at least 80% of this change and no more than 125%. Then the acceptable range of the change in value for the derivative will be between ()USD.80,000.00 and ()USD.125,000.00. However, even when a hedge is determined to be highly effective, there could be an impact on current earnings when there is not an exact offset of the hedged risk. If, for example, the change in value of the derivative were ()USD.110,000.00, then the hedge would be highly effective, because this change in value falls within the specified range and hedge accounting would report an effect on income of USD.(+100,000110,000) = ()USD.10,000.00. This idea of offsetting has found its way into the hedge effectiveness testing literature in the form of the dollar-offset method of testing. 4.7. The dollar-offset method compares the changes in the fair value or the cash flow of the hedged item and the derivative. The dollar-offset method can be applied either period by period or cumulatively. For a perfect hedge, the change in the value of the derivative exactly offsets the change in the value of the hedged item. Therefore, the ratio of the cumulative sum of the periodic changes in the value of the derivative and the cumulative sum of the periodic changes in the value of the hedged item will equal one in a perfect hedge (after multiplying the ratio by negative one to adjust for the two sums having opposite signs in a hedging relationship). 4.8. Anyone choosing this test should be aware that researchers question its reliability because of its excessive sensitivity to small changes in the value of the hedged item or the derivative. Canabarro (1999) showed that under reasonable assumptions about the distribution of changes in prices, the 80/125 standard rejects as ineffective 36% of all hedges when the coefficient of determination (correlation squared) R2 is 0.98.

4.9. The other two methods of assessing hedge effectiveness i.e. the variability-reduction method and regression analysis are closely related. The difference is that the variabilityreduction method assumes that the riskminimising derivative position is equal and opposite to the hedged item in a one-to-one hedge. 4.10. If a one-to-one hedge performs perfectly, the change in the value of the derivative exactly offsets the change in the value of the hedged item. The variability-reduction method compares the variability of the fair value or the cash flows of the hedged (combined) position to the variability of the fair value or the cash flows of the hedged item alone. This method places greater weight on larger deviations than on smaller ones by using the squared changes in value to measure ineffectiveness. The preferred test statistic for this method is the proportion of the hedged items mean-squared deviation from zero that the hedge eliminates. To calculate the test statistic, subtract from one the ratio of the sum of the squared periodic changes in the hedge and the hedged item to the sum of the squared changes in the hedged item. 4.11. The measure of hedging effectiveness using regression analysis is based on the regression line in which the change in the value of the hedged item is the dependent variable and the change in the value of the derivative is the independent variable or vice versa. Given the definitions of X and Y, the slope of this regression equation should be negative and close to ()1.0. However, for the hedge to be considered effective it should lie between -0.8 and -1.25. The interpretation of the intercept term is also important. It is the amount per (data measurement) period, on an average, by which the change in value of the hedged item differs from the change in value of the derivative. 4.12. Ederington (1979) showed that the estimated slope coefficient is the variance-minimising hedge ratio. Consequently, the accounting literature explicitly allows for a hedge ratio that differs from 1.0.

58 | A PUBLICATION BY MCX AND PRICEWATERHOUSECOOPERS

5.

Concluding Remarks 5.2. As the recent global experience has exhibited, growth in derivative products without corresponding development in regulation both from a macroeconomic perspective and a risk management perspective is neither desirable nor advantageous from the viewpoint of long-term stability. In this arena, the new literature on the accounting for such instruments is a welcome addition. What is also required is more detailed guidance from a risk management perspective by the Reserve Bank of India on the use of such products. It is only a combined approach that will lead to the establishment of stable and deep markets for commodities in India, which is essential for the long-term growth of our economy.

5.1. The need for commodity derivatives is multifarious in a growing economy like India. Be it for risk management, investment, portfolio diversification or to provide access to our producers to the most efficient markets in commodities, it is difficult to argue for other than an expansion of the availability of such products in the arena of exchange-traded instruments. However, as the above article demonstrates, there has been unprecedented growth in this area over the last few years.

Mr. Kumar Dasgupta is Partner and Dr. Chiragra Chakrabarty is Associate Director, Price Waterhouse. Views expressed are personal.

EXPERTS VIEWS

| 59