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Wednesday, January 03, 2007

Noticed an interesting paper on commodity futures trading in India

Underdeveloped Spot Markets and Futures Trading: The Soya Oil Exchange in India by Bharat Ramaswami with Jatinder Bir Singh. [pdf] They ask the question about whether the soya oil futures market in India is effective for hedging. They find that this works out well, despite all the problems of liquidity and transparency of the underlying spot market. The paper is well written and gives you insight. The econometrics is well focused - flowing directly from the questions and obtaining robust answers. It is not a mechanical exercise in crunching numbers; it is rooted in good domain knowledge about real world aspects of soya oil.


  1. 1. Commodity exchanges volumes are not related to the physical stocks, which are just a proxy, and whats is traded on exchange is a multiplier, for instance in Tokyo, the physical stock to exchange trading volume ratio is 40 times. This does not imply that there is large speculative activity only.
    a. Exchanges are meant to facilitate
    i. Risk mitigation
    ii. Price discovery
    b. The benchmark for market reading of exchange is:
    i. Open Interest: which basically shows the overall positions
    1. longs and shorts together and shows that number of contracts which are open till the maturity date
    2. unless specified, there is no way one can deduce that the larger OI, leads to more speculative interest. CFTC reports very specifically the positions of the various market constituents, but none of the Indian exchanges do this, therefore, it cannot be said that since OI has increased , speculators are very active.
    ii. Volume: represents the number of contracts traded, extremely important parameter
    iii. Price : which moves depending upon the sentiment
    c. Certain standard principals used by the market to interpret these are:
    i. If volume is relatively high while the market is going up and remains relatively low during corrections, the inference is that the market is in a strong uptrend, which should continue.
    ii. If volume is high while the market is going down and relatively light during upward retracements, then the market is weak with a continuing downward trend likely.
    iii. If both open interest and prices are increasing, then new buyers are being brought into the market with a strong technical picture unfolding. Expect the uptrend to continue.
    iv. If on the other hand, open interest is increasing while prices decline, short sellers have the upper hand in a technically weak market. As open interest is growing while prices decline, buyers are obviously the more aggressive party.
    v. In the event of open interest declining while prices are also slipping, liquidation by long positions is the implication, therefore suggesting a technically strong market overall. In other words, the market is strong as open interest declining suggests no new aggressive shorts, as this would entail an increase in open interest.
    vi. When open interest is declining and prices are increasing, short covering is the most likely cause suggesting that overall the market is weak - i.e. attracting new buyers would be required for a technically strong market and consequently open interest would rise

    2. Spot markets are extremely important, the basis of futures prices is depend dent upon this hence true value of the spot is very essential, which is a huge gap given our existing setup of Mandis etc.

    3. The difference between the spot and future price is known as – contango & backwardation , basis is technically referred to the difference between the same contract across the other markets , quality etc.
    a. Contango:
    i. when the cash price is lower than the futures price, a typical scenario seen in all agri & base metal markets,
    ii. since the stock is available much easily in the present market
    iii. however the same will become as we move further, as consumption increases.

    b. Backwardation:
    i. Spot is higher than the near month future prices
    1. prevalent in the Oil markets, since the gestation period is longer for bringing oil above ground and Dd higher in the near term, it becomes expensive to buy oil today.
    2. This was experience across the base metal in the current bull run, where in Nickle etc were having a deep backwardation of Usd 5000/ tn ie, cash was expensive than the near month .
    3. Infact this is something which was seen even in Wheat , Urad, Chilli in India as well ( something not experience in the global markets)

    4. It has been said that , when the cash price of Soya is high the import generally lowers the cash price and subsequently brings down the futures as well:
    a. This cannot always be true, in case the global price itself are higher and there is large demand domestically ( as happened in case of wheat) then this logic does not work, it will infact push the futures further up.
    5. Most exchanges globally have sellers options ie, seller can decide to give delivery on the xchange instead of cash settlement.:
    a. Cash settlement has been allowed at NBOT more because no body wanted take delivery as this would require larger infrastructure as well.
    b. Cash settlement has got nothing to do with Warehouse Receipts and its tradability.
    c. In case of delivery based mechanism, the underlying stock has be of delivery grade etc on the exchange and requires warehousing facility along with assaying etc.
    d. WR is not a tradable instrument , as its not negotiable
    6. On any exchange there are different set up players each with a different risk profile:
    a. Hedger: would lock in his cost
    b. Arbirtager: would lock in his spreads ( cash and near month or month on months , wherever there is risk free return he would lock in)
    c. Specualtors: who have strong views and trade on that, they would greatly look at the convenience yield, the roll over cost etc.
    d. Scalpers: Day traders who trade on technical etc.

    In my opinion , the article over looks a lot of market practices and market norms , and bases conclusion on superficial understanding. The very fact that the basics of futures trading has been not talked about, specially the role of Backwardation and Contango & relevance of various market participants, etc makes this article very superficial.

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