Commodity derivatives: Features and impact on underlying

Abstract

The farmers who produce agricultural products like rice and wheat face a risk in production volumes as well as price at the time of harvest. The risk is attributed to the high variability of price and production volumes within a year. The price risk for agricultural commodities may arise from various factors like drought, damage to crops due to heavy rains or frost, pest infestation, increase in demand, decrease in production etc. Commodity futures provide a means to manage this risk effectively. The commodity futures market facilitates farmers to hedge their risks to manage price risk and even minimize losses in case of unfavorable movement in prices. This is accomplished by transfer of risk between the producers and the speculators in the market. In contrast to the hedgers, who try to minimize their losses by managing risk, the speculators look for opportunities to make profits by out-guessing the market. Future contracts distribute the total risk between hedgers and speculators. The functions of futures markets in general can be summarized as below: a) Indicate future demand of the commodity and help in balancing production with the demand forecasts. For example, If the market participants believe that the future demand would be high and envisage a shortage in production volumes, the future contract prices will go up accordingly, It acts as an indicator to the farmers to increase production of the particular commodity, b) Provide hedging for farmers against the price volatility risk. Farmers cultivating crops are vulnerable to several risks in the future and may be concerned over the price that the crop may fetch in the future. In order to eliminate this price risk, the farmers can buy future contracts on their produce and hence reduce exposure to price fluctuations. c) Facilitate price discovery: Traders and market participants of the futures markets trade by arbitraging, forecasting demand and market prices, and holding stocks. They analyze available data and information and influence the way prices move. Farmers, who are less privileged in estimating prices may benefit from the trading and price discovery d) Optimize buffer stock holdings and smooth prices between present and future, if the future prices are much higher than the spot prices, an arbitrager buys the commodity and holds it to sell in the future and vice versa. It helps in optimizing the holding of buffer stocks and smoothing price movements. This kind of arbitrage trading works better in international markets. Still commodity futures are a relatively unknown asset class as they are strikingly different from stocks, bonds and other assets. Among these differences are (1) commodity futures are derivative securities; they are not claims on long-lived corporations; (2) they are short maturity claims on real assets; (3) unlike financial assets, many commodities have pronounced seasonality in price levels and volatilities. There has also been considerable criticism of the commodity futures markets. There have been arguments globally that commodity exchanges promote speculation, which impacts the spot prices adversely. This issue gained too much momentum each time the price of a particular commodity rises very high. In the recent past, when oil prices were reaching around 150$/barrel one of the causes of the price rise was mentioned to be the presence of the commodity market and that excessive speculation was leading to price rise in the spot markets as well. The lack of physical delivery is also considered to be equivalent to gambling. In spite of the criticism, the commodity futures continue to play important role in the Agriculture sector, and more and more exchanges are being setup to facilitate trading in the commodity futures. Further, commodities are perceived as a distinct asset class because of their counter cyclic nature. Commodities bring a very strong diversification effect to the portfolio because they have negative correlation with other asset classes. Hence besides hedging they act as an important asset class for investment as well.