A future where inflation is hedged: Mint: 5th August 2010

We need to protect against price rise. How about a futures contract on the Wholesale Price Index?

Inflation remains a major concern today; it’s certainly preoccupying members of India’s Parliament these days. While prices of some commodities can come down at some point of time, the problem is they can get volatile any time. For that, we need a hedge against inflation. There is at present no such hedge available; whether, say, stock indices or interest rates can act as effective hedges has not yet been established. So is there a more direct way to protect against inflation?
The answer is yes. We have the Wholesale Price Index (WPI), which is reported partly every week for some components, while there is a monthly number for the entire index. So we can quite easily have futures on the WPI. A future is a contract to buy something at a preset price, specified today, in the future.
There are two issues here. The first is how these contracts would be structured. The second is the regulatory part which is, admittedly, a tricky subject.
Just as we have Nifty futures traded on the National Stock Exchange—a contract where the seller pays the buyer if the Nifty hits or crosses some level, allowing the buyer to hedge his underlying stock bets—we can have futures trading on the WPI and its components. Unlike the Nifty, which changes every moment and constantly influences bids on the Nifty futures, the WPI will change every week or month. A call on the WPI futures would be based on a subjective conjecture on where the index will be during the settlement date. Hence, in August, someone can take a call on the WPI October futures contract.
We can have a contract size of 500 WPI indices, which will be valued at around Rs125,000 (500 multiplied by the WPI level, currently around 250). Based on the historic volatility of the WPI, the margin would be 5-10% depending on the index (or sub-index) chosen. Hence, an individual with an initial margin of, say, Rs12,500 (10%) can buy one WPI futures contract. For every 1 percentage point increase in the index in the futures market, the trader going long—betting on the index to rise—would be hedged with a gain of Rs1,250 on a single contract.
The contract will be non-deliverable, like Nifty futures, and would hence have no other obligation (unlike the commodity futures market, where there is physical delivery of the underlying commodity). The settlement price would be the actual WPI level for the contract—the seller will pay the new WPI level times the number of indices in the contract to the buyer— and would be free of controversy, since the government announces it. Those trading can monitor the movement of prices in, say, the commodities market on a daily basis to conjecture how WPI futures would be moving and take a call on whether to buy or sell. The commodity market provides robust prices that can be monitored on a real-time basis.
Who will be the players? A WPI futures market will be of use to financial institutions and individuals, the latter having a direct trading interest in combating inflation. In fact, trading in options instead of futures would be preferable for most individuals: One is freed of the obligation of going through with the contract in case the WPI comes down, for instance. They would just have to approach their brokers or use online trading portals to put in their orders. WPI futures will also provide a comprehensive cover for companies who track specific product prices.
Banks, in particular, would be very keen on this index: They monitor the WPI closely, as it affects their holding of government securities (the price and yield of which can move with inflation). Then there would be the ubiquitous speculators and arbitrageurs who would add liquidity by taking opposing positions: There are always those who gain from higher inflation, just as others might lose.
The fact that the WPI is based on unbiased collection of prices by the government ensures that it cannot be influenced by anyone. So contracts could be weekly or monthly, depending on the index or sub-index. For instance, there could be six-month contracts running for the WPI, which allows participants to take a medium-term view on prices. More importantly, the bouquet can be spread to cover consumer price indices, or CPI, too.
The interesting debate here is on the regulatory turf for such an index, especially since regulators have been at war to decide who should oversee what. Ideally a WPI index should be within the purview of the commodity market regulator, the Forward Markets Commission (FMC). However, in the last six years, the Forward Contracts (Regulation) Act has not been amended to permit index trading, which has prevented exchanges from launching such products. The ball can then be tossed into the securities arena that can deal with such indices—which means the Securities and Exchange Board of India—especially since futures are always exchange-traded.
Because the contracts are non-deliverable, there would be no exchange of physical commodities and hence could be interpreted as being outside the commodity market. This can avoid debate such as the one over electricity futures, where both the electricity regulator and FMC claimed turf; the two regulators are now discussing a way out to integrate the regulatory structure for the physical commodity with futures trading. Also, banks and other financial institutions are outside the purview of commodity markets; their presence is necessary to add depth, which will be possible, under the present circumstances, only on a securities platform.
With inflation becoming a major problem in the way of economic growth, it is essential to have a financial product that offers a hedging option. We can hope that just as retail interest has been engendered in stock markets, a similar trend would develop in WPI futures trading over time.