Valuable Commodities: DNA, 2nd May 2008

Inflation now appears to be an annual phenomenon, with February through April being quite critical. This is when rabi crops are harvested and prices tend to move northwards everytime there is some bad news.
Futures trading have been in operation for the last four years, and in the last two years kicked up dust. Critics have drawn the conclusion that since futures trading is vibrant and prices are moving up, the former is responsible for higher inflation.
The assumptions here are incorrect because if futures trading were the sole guiding factor, then they should have been commended when inflation was low! Quite clearly, there is an issue here with the understanding of the purpose and functioning of the futures market.
The commodity futures market is one where one can buy and sell a derivative instrument called a ‘future’ at a predetermined price. Therefore, a chana June future contract refers to the price in June for chana as determined by the market.
Futures trade at a multiple of the physical underlying as all members of the value chain would have an interest in trading in the same quantity of the product. Each player enters the market anonymously with an expectation of the price, based on fundamentals. If I think that there is going to be a shortage, then I will bid a high price, and if all think so, then the final price will be higher. The future price is normally defined as the spot price plus cost of carry, which in rudimentary language is the interest cost.
To gauge if the market is working well or not, three questions need to posed. The first is whether the market is being driven by some players in a particular direction. Here, the exchanges have rules laid down to ensure that the positions taken by any member or client does not exceed the limit, which is fixed in relation to the overall availability of the product in the country.
Also the exchanges ensure that the overall open interest, which is the quantity that can be potentially delivered on the exchange, does not exceed 1 to 3 per cent of total availability, so one can be sure there is no manipulation. This also ensures that there are is no subversive hoarding being carried out on the futures platforms.
Secondly, the price monitoring division checks to see if the price movement is in consonance with fundamentals. Shortages, sudden import/export orders, inclement weather conditions are also tracked assiduously. Lastly, price convergence is tested wherein the cost of carry should typically fall as one approaches the settlement date where finally the spot price must equal the futures price.
Intuitively it may be seen that the futures price is a very useful barometer of expected demand-supply positions. By looking at the futures price, one can guess that there will be a shortfall, something which has been predicted in chana and mustard today.
These signals can be used for policy action. In 2006, the rising futures price of wheat indicated a crop shortfall. If the signal was taken by the government, it could have reckoned its imports in the month of December itself.
Today, inflation in food products has been caused by supply shortages. Prices of edible oils are rising because of high international prices which get imputed into domestic prices as we import 45 per cent of our requirements.
When prices are volatile, there is inducement to trade in the futures market, and traded volumes increase. The error here is in linking these traded volumes with price increases and drawing a causal relationship. Curiously, price increases have been even more pronounced in commodities that are not traded such as vanaspati, rice, coarse grains, pulses such as arhar and masoor.
Futures trading are not a new concept in India — the first cotton exchange in Mumbai started in 1875. Globally, commodity exchanges register higher volumes than securities markets.
Futures trading were popular until the ’60s when on account of shortages due to wars and near-drought situations in some states, the government banned it with the belief that it encouraged hoarding and contributed to inflation. Almost four decades later, the markets were revived, but it appears that they are not yet well understood.
The government banned four important commodities last year, but it did not really help as prices of rice, wheat and tur continued to rise because of supply bottlenecks or global factors.
The same conundrum has been poised again, but hopefully, the response will be better. One must not forget that futures trading reflect the image that is to be seen in future. There is no use in shattering the image as it will not change.