DYNAMICS OF COMMODITY MARKET IMPACT ON INDIAN INVESTMENT SECTORS

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1 DYNAMICS OF MARKET IMPACT ON INDIAN INVESTMENT SECTORS Prasad R.A Research Scholar, Department of Studies and Research in Commerce, Tumkur Abstract: This paper finds that concurrent with the rapid growing world financial market has witnessed a spectacular change in the field of Commodity market in the past one decade. India also could not become aloof from the world trend and mainly after the liberalization has set in motion. India introduced the different types is phased manner. A Commodity Market has gained momentum since, its introduction in India and has played a major role in Indian financial markets. Similarly, on the equity market, many retail investors who are uncomfortable about the equity market would enter if they were given the alternative of buying insurance, which controls their downside risk. This would enhance the action of the savings of the country, which are routed through the equity market. More importantly, Commodity Market is one of the important tools of hedging risk. Therefore, the study of current scenario of Commodity Market in India is very importance. Beside the investor are not well aware about the commodity market India, and the investor are showing reluctance in invest on commodity market. The people have not fully accepted the investment on commodity market, even though it provides much advantage to the investor to hedging their risk. Keywords: Commodity Market, Indian Investment Sector, and Dynamics of Commodity Market in India Introduction: Derivatives as a tool for managing risk first originated in the Commodities markets. They were then found useful as a hedging tool in financial markets as well. The basic concept of a derivative contract remains the same whether the underlying happens to be a commodity or a financial asset. However there are some features, which are very peculiar to commodity derivative markets. In the case of financial derivatives, most of these contracts are cash settled. Even in the case of physical settlement, financial assets are not bulky and do not need special facility for storage. Due to the bulky nature of the underlying assets, physical settlement in commodity derivatives creates the need for warehousing. Similarly, the concept of varying quality of asset does not really exist as far as financial underlying are concerned. However in the case of commodities, the quality of the asset underlying a contract can vary largely. This becomes an important issue to be managed. A Commodity market broadly is an Agriculture market whose payoff structure is determined by the value of underlying commodities, exchange rate, oil price, and the like. So a Commodity market comprises of trade instruments which derive their value from some underlying variable assets like food grains such as wheat, rice pulses etc. All commodity markets are based on some cash products. The underlying asset of a commodity market instrument may be 78

2 any product of the following types they are Precious metals (Gold, Silver, and Copper) Agriculture Products (grain, coffee, beans, orange juice etc.), Other Metals, and Energy. Commodity markets came into the spotlight along with the rise in uncertainty of post 1848; when in U.S. there was a problem in trade between the farmers & merchants. At that time CBOT was established to bring the farmers and merchants together under a common trading umbrella. 2. Objectives of the Study To study the current scenario of Commodity Market in India. To analyse the factors mainly affect on success of Commodity Market in India. 3. Research Methodology Sources of data: The required and relevant data are collected from secondary sources like, books, journals and website 4. Research design The study is in exploratory in nature, intends to explore the information on importance of Commodity Market in the investment area. Secondary sources predominantly used in the study to collect information on different variables collected data was analyzed and presented and for proper understanding 5. Literature Review Raj Narayana Guptha (April-June 2011) his study entitled as The Commodity Derivative Market In India: The Past, Present and Future his study says that after a long period of suspension of commodity derivative market was re-introduced in India in early 2000s. Since its resumption, however, the market has been growing at a very high pace. The growth is evident in the spread of market network as well as in volume of trade. Narender. L. Ahaja (2006) his study entitled as Commodity Derivatives Market in India: Development, Regulation and Future Prospectus his study says that India is one of the top producer of a large numbers of commodities, and also has a long history of trading in Commodity and related derivatives allowed to play their role. The management price risks is going to assume even greater importance in future with the promotion of free trade and removal of barriers in the world. Janathan Hill, Ian Jack (March 2007) his study entitled as Growth In Commodity Investment: Risk and Challenging For Commodity his study says that commodities influence a significant portion of the world economy and can be viewed as the largest nonfinancial market in the world. In recent history these have significant bull markets in Commodities every 20-30years. When the prices are low producers cannot hedge their future. 6. Types of Derivatives The most commonly used derivatives contracts are forwards, futures and options. Here we take a brief look at various derivatives contracts that have come to be used. 79

3 Figure.1 Showing Types of Commodity Derivatives DERIVATIVE MARKET DERIVATIVE MARKET FINANCIAL DERIVATIVE MARKET FUTURES FORWARDS OPTIONS SWAPS WARRANTS OTHER Source: Secondary Data Forward contract: Forward contact is a customized contract between two entities, where settlement takes place on a specific date in the future at today s pre-agreed price. Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts. Options: Options are of two types - calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date. Warrants : Options generally have lives of up to one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longerdated options are called warrants and are generally traded over-the-counter. Leaps: The acronym LEAPS means Long- Securities. Term Equity Anticipation These are options having a maturity of up to three years. Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average or a basket of assets. Equity index options are a form of basket options. Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are: Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency. Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction 80

4 being in a different currency than those in the opposite direct Table 1 Showing Total Turnover of Commodity Market in India Exchanges Year Multi Commodity Exchange in India (MCX) National Commodity and derivatives exchange Ltd (NCDEX) National Multi Commodity exchange of India Ltd (NMCE) ,25,663 27,30,415 42,84,653 59,56,656 78,95,404 12,43,327 7,73,965 6,28,074 8,05,720 9,73,217 1,11,462 25,056 37,272 1,95,907 1,80,738 Other 1,04,033 1,24,051 83,885 1,36,173 4,45,366 Total 34,84,485 36,53,487 50,33,884 70,94,456 94,94,725 Source: Analytic April-June 2012 Turnover in the Indian commodity futures market has increased many times over. The total value of trade in the Commodity Futures Market has risen substantially in the last few years (Table 1). MCX recorded the highest turnover in terms of value of trade from 2006 to 2010 followed by NCDEX and NMCE. The above table clearly shows that investors showing interest to invest their money on commodity market. Underlying Asset in a Derivatives Contract As defined above, the value of a derivative instrument depends upon the underlying asset. The 81

5 Underlying asset may assume many forms: i. Commodities including grain, coffee beans, orange juice; ii. Precious metals like gold and silver; iii. Foreign exchange rates or currencies; iv. Bonds of different types, including medium to long term negotiable debt securities issued by governments, companies, etc. v. Shares and share warrants of companies traded on recognized stock exchanges and Stock Index vi. Short term securities such as T-bills; and vii. Over- the Counter (OTC) money market products such as loans or deposits. 7. Functions of Commodity Market The primary objectives of any futures exchange are authentic price discovery and an efficient price risk management. The beneficiaries include those who trade in the commodities being offered in the exchange as well as those who have nothing to do with futures trading. It is because of price discovery and risk management through the existence of futures exchanges that a lot of businesses and services are able to function smoothly. Price Discovery Based on inputs regarding specific market information, the demand and supply equilibrium, weather forecasts, expert views and comments, inflation rates, Government policies, market dynamics, hopes and fears, buyers and sellers conduct trading at futures exchanges. This transforms in to continuous price discovery mechanism. The execution of trade between buyers and sellers leads to assessment of fair value of a particular commodity that is immediately disseminated on the trading terminal. Price Risk Management Hedging is the most common method of price risk management. It is strategy of offering price risk that is inherent in spot market by taking an equal but opposite position in the futures market. Futures markets are used as a mode by hedgers to protect their business from adverse price change. This could dent the profitability of their business. Hedging benefits who are involved in trading of commodities like farmers, processors, merchandisers, manufacturers, exporters, importers etc. Import- Export competitiveness The exporters can hedge their price risk and improve their competitiveness by making use of futures market. A majority of traders which are involved in physical trade internationally intend to buy forwards. The purchases made from the physical market might expose them to the risk of price risk resulting to losses. The existence of futures market would allow the exporters to hedge their proposed purchase by temporarily substituting for actual purchase till the time is ripe to buy in physical market. In the absence of futures market it will be meticulous, time consuming and costly physical transactions. Predictable Pricing 82

6 The demand for certain commodities is highly price elastic. The manufacturers have to ensure that the prices should be stable in order to protect their market share with the free entry of imports. Futures contracts will enable predictability in domestic prices. The manufacturers can, as a result, smooth out the influence of changes in their input prices very easily. With no futures market, the manufacturer can be caught between severe short-term price movements of oils and necessity to maintain price stability, which could only be possible through sufficient financial reserves that could otherwise be utilized for making other profitable investments. Credit accessibility The absence of proper risk management tools would attract the marketing and processing of commodities to high-risk exposure making it risky business activity to fund. Even a small movement in prices can eat up a huge proportion of capital owned by traders, at times making it virtually impossible to pay back the loan. There is a high degree of reluctance among banks to fund commodity traders, especially those who do not manage price risks. If in case they do, the interest rate is likely to be high and terms and conditions very stringent. This posses a huge obstacle in the smooth functioning and competition of commodities market. 8. Benefits of Commodity Market in India As the constituents of the commodity market ecosystem get benefited, the Indian economy is also benefited. Growth in the organized commodity markets and their constituents implies that there would be tremendous advantages and benefits accrued to the Indian economy in terms of business generation and growth in employment opportunities. As India imports bulk of raw material (especially in base metals and energy), there is scope for minimizing price risk for international commodities. With the consumption of commodities increasing rapidly, especially in developing countries such as China and India, the prices of commodities are volatile, emphasizing the need for organized commodity derivatives exchanges. 1. Benefits for Farmers/Agriculturalists 2. Commodities as an asset class for diversification of portfolio risk 3. Commodity derivatives markets are extremely transparent 4. An option for high net worth Investors 5. Useful to the Producer 6. Useful for the consumer 7. Benefits to corporate entity 8. Useful to Exporters 9. Improved product quality 10. Liquidity Other Benefits of Futures trading are Price stabilization-in times of violent price fluctuations - this mechanism dampens the peaks and lifts 83

7 Helps balance in supply and demand position throughout the year. Encourages competition and acts as a price barometer to farmers and other trade functionaries Advantage of Future Market Trading explained with one example In Future Market, one needs to keep prescribed margin at MCX through your broker. It s not necessary to keep full amount in account E.g. Consider Mr. Yashwanth Rao purchased 5 Kg Silver in Physical market and Mr. Prasaad Arya purchased it in Future Market. As Mr. Yashwanth Rao have purchased in physical market he have to pay Rs.60, 000 x 5 = 3Lakh to the jeweler.also now he have a headache of safekeeping of the same. Mr. Prasaad Arya have purchased 5 Kg of silver in future Market.. MCX will ask to keep a margin of around 6% in your account.i.e MCX want you to keep balance of Rs. 18,000 at a time. Here there is no tension for keeping the jewellery. Conclusion Many people have become rich in the Commodity Markets, It is one of a few investment areas where individuals with limited capital can make extra-ordinary profits in a relatively short period of time and most of the people lose money, Commodity Market has a bad reputation as being too risky for the average individuals. The truth is that Commodity trading is only as you want to make it. Investors are consider the Commodity derivative market as only a risk hedging instrument, and also it is only a optional for investment escape from capital market losses, by this reason Commodity derivative market are not developed as compare to Capital market. Investor point of view it is alternative for minimizing the losses instead buy the insurance scheme. Investors are not understood about Commodity market, it is also one of the obstacles for development of Commodity Derivative market in India Bibliography Bose, S. (2008): Commodity Futures Market in India: A Study of Trends in the Notional Multi- Commodity Indices, Money & Finance, Vol.3, No. 3, pp Kabra, K. N. (2007): Commodity Futures in India, Economic & Political Weekly, Vol. 42, No. 13, pp Bhattacharya, H. (2007): Commodity Derivatives in India, Economic & Political Weekly, Vol. 2, No. 3, pp Srivastava, P. (2004), Financial and legal aspect of derivative trading in. India, available at: Nath, G. C and T. Lingareddy (2008): Impact of Futures Trading on Commodity Prices, Economic & Political Weekly, Vol. 43, No. 3, pp