“An analysis of volatility in commodity market in

India”

By
Triveni R.I (09SJCCM035)

Submitted to
Dr. Nagaraj

An Assignment Submitted in Partial Fulfillment of

the Requirement for the Degree of
M.com.

Department of Commerce
St. Joseph’s College of Commerce (Autonomous)
Bangalore -560 025

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I. INTRODUCTION

India, a agriculture based economy where two-third of its population depends on

agricultural commodities, surprisingly has an under developed commodity market.
Unlike the physical market, futures markets trades in commodity are largely used
as risk management (hedging) mechanism on either physical commodity itself or
open positions in commodity stock.

Meaning of commodity

A commodity may be defined as an article, a product or material that is bought

and sold. It can be classified as every kind of movable property, except Actionable
Claims, Money & Securities. Commodities actually offer immense potential to
become a separate asset class for market-savvy investors, arbitrageurs and
speculators. Retail investors, who claim to understand the equity markets, may
find commodities an unfathomable market. But commodities are easy to
understand as far as fundamentals of demand and supply are concerned. Retail
investors should understand the risks and advantages of trading in commodities
futures before taking a leap.

Bombay Cotton Trade Association Ltd., set up in 1875, was the first organized
futures market. Bombay Cotton Exchange Ltd. was established in 1893 following
the widespread discontent amongst leading cotton mill owners and merchants over
functioning of Bombay Cotton Trade Association. The Futures trading in oilseeds
started in 1900 with the establishment of the Gujarati Vyapari Mandali, which
carried on futures trading in groundnut, castor seed and cotton. Futures' trading in
wheat was existent at several places in Punjab and Uttar Pradesh. But the most
notable futures exchange for wheat was chamber of commerce at Hapur set up in
1913. Futures trading in bullion began in Mumbai in 1920. Calcutta Hessian
Exchange Ltd. was established in 1919 for futures trading in raw jute and jute

2
goods. But organized futures trading in raw jute began only in 1927 with the
establishment of East Indian Jute Association Ltd. These two associations
amalgamated in 1945 to form the East India Jute & Hessian Ltd. to conduct
organized trading in both Raw Jute and Jute goods. Forward Contracts
(Regulation) Act was enacted in 1952 and the Forwards Markets Commission
(FMC) was established in 1953 under the Ministry of Consumer Affairs and
Public Distribution. In due course, several other exchanges were created in the
country to trade in diverse commodities.

Structure of Commodity Market

Different types of commodities traded

World-over one will find that a market exits for almost all the commodities known
to us. These commodities can be broadly classified into the following:

Precious Metals: Gold, Silver, Platinum etc

Other Metals: Nickel, Aluminum, Copper etc
Agro-Based Commodities: Wheat, Corn, Cotton, Oils, Oilseeds.
Soft Commodities: Coffee, Cocoa, Sugar etc

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 Live-Stock: Live Cattle, Pork Bellies etc
Energy: Crude Oil, Natural Gas, Gasoline etc

Different segments in Commodities market

The commodities market exits in two distinct forms namely the Over the
Counter (OTC) market and the Exchange based market. Also, as in equities,
there exists the spot and the derivatives segment. The spot markets are essentially
over the counter markets and the participation is restricted to people who are
involved with that commodity say the farmer, processor, wholesaler etc.
Derivative trading takes place through exchange-based markets with standardized
contracts, settlements etc.

Leading commodity markets of world

Some of the leading exchanges of the world are New York Mercantile Exchange
(NYMEX), the London Metal Exchange (LME) and the Chicago Board of Trade
(CBOT).

Leading commodity markets of India

The government has now allowed national commodity exchanges, similar to the
BSE & NSE, to come up and let them deal in commodity derivatives in an
electronic trading environment. These exchanges are expected to offer a nation-
wide anonymous, order driven, screen based trading system for trading. The
Forward Markets Commission (FMC) will regulate these exchanges.

Consequently four commodity exchanges have been approved to commence

business in this regard. They are:

Multi Commodity Exchange (MCX) located at Mumbai.

National Commodity and Derivatives Exchange Ltd (NCDEX) located at Mumbai.
National Board of Trade (NBOT) located at Indore.
National Multi Commodity Exchange (NMCE) located at Ahmedabad.

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 • What is market volatility?

It is the measure of how unstable the trade and commerce industry is, and how
big a chance a certain investment has for becoming a failed venture.

II. STATEMENT OF THE PROBLEM

Volatile markets are characterized by wide spread fluctuations and heavy trading
undertaken in short span of time. Volatility estimation is important for several reasons
and for different people in the market. Pricing of underlying commodity is supposed to be
dependent on volatility of commodity market. Thus, investors always find various ways
to protect themselves from the volatility on the commodity price inflation.
• The volatility in the commodity market has a direct impact on the direct physical
market trading and pricing.
• If there is a change in the volatility of the commodity market can it be attributed
to commodity trading or some other factor.

III. SAMPLING AND METHODOLOGY

IV. OBJECTIVES OF THE RESEARCH

• The basic objective of this study is to analyze the impact of volatility in
commodity market on the physical market.
• To understand the impact of volatility in the commodity market on the
inflationary prices of different commodities.
• To study and understand is there any pattern for the commodity market
volatility.

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 • IV. RESEARCH DESIGN AND METHODOLOGY
• Research design for the study is exploratory
• Sources of Information - Primary and Secondary Data

IV. SCOPE OF STUDY

The scope of the study is restricted to an in depth analysis of volatility in commodity
market and to understand its impact on physical market of the commodity traded.

VI. LIMITATIONS OF THE STUDY

• Since most of the data used will be secondary the reliability of data is also
questionable.
• Speculation in commodity market may lead to wrong interpretation.
• Lack experience in research also can be another limitation of this study.

Nowadays, with the word “recession” hanging over everybody, people are becoming
more aware and conscious about their economic and financial situations. Many are
seeking to become more educated on financial matters, and this action is in fact a good
idea; it will be easier to beat a situation if you know as much about it as you can.

Perhaps one of the issues that you’d like to get to know more of is about how does the
government and other industries use risk models to forecast market volatility. First of all,
it’s important to define some terms:

• What are risk models? In general terms, they are the use of various financial
techniques or methods to measure the risk or uncertainty of investing in certain
business enterprises, stocks or financial portfolio.

To find out how to use risk models to forecast market volatility, it may help to look at the
different risk models and to know volatility modeling and see how they work:

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1. Market Risk models. These show the possibility of the decrease of a value of an
asset due to multi-factor trends such as fluctuating interest rates, stock and
commodity prices, and foreign exchange rates. Some market risk factors include
equity risk (or the chance that interest rates will decrease), currency risk (pertains
to foreign exchange), equity risk (pertains to stock prices), commodity risk (refers
to a change in commodity prices) and operational risk (based on business
functions of the specific company). To use a market risk model for forecasting
volatility, these elements must be adequately factored in on the equation.
Sufficient preparation must also be done to counter volatility, such as credit risk
management and insurance to cover for losses.
2. C. Methodology
3. The autoregressive conditional heteroskedasticity (ARCH) models introduced by
Engle (1982) and its
4. extension, the GARCH models (Bollerslev, 1986) have been the most commonly
employed class of
5. time series models in the recent finance literature for studying volatility. The
appeal of the models is
6. that it captures both volatility clustering and unconditional return distributions
with heavy tails.
7. The estimation of GARCH model involves the joint estimation of a mean and a
conditional
8. variance equation. The GARCH (1,1) model which is stated as follows:
9. Yt = xt’θ + εt
10. Where the above is the conditional mean equation with xt being the vector of
exogenous
11. variables. The conditional variance, σ2
12. t, can be stated as follows:
13. σ2
14. t = ω + αε2
15. t-1 + βσ2
16. t-1
17. where ω is a constant term, αε2
18. t-1 is the ARCH term and βσ2
19. t-1 is the GARCH term.
20. The SPSE being the only sourse in Fiji is the data source for the stock market
return. The daily
21. stock market return data has been collected on the time series basis for the period
between 2001-2005.
22. For the interest rate information, the Reserve Bank of Fiji was the source.

23. Commodity and Commodity Market in India

24.
By
Ankur Rajoria
Student (Batch-2006-SEM-III)
ICFAI Business School

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 ICFAI House, Nr. GNFC Tower, S.G. Highway, Bodakdev, Ahmedabad-380 054
E-mail: ankurrajoria04@yahoo.co.in / ankur.rajoria@gmail.com
Mobile: 9898097790

1. Commodity and Commodities market

25. 1.1 INTRODUCTION

26. India, a commodity based economy where two-third of the one billion
population depends on agricultural commodities, surprisingly has an under
developed commodity market. Unlike the physical market, futures markets
trades in commodity are largely used as risk management (hedging)
mechanism on either physical commodity itself or open positions in
commodity stock.

27. For instance, a jeweler can hedge his inventory against perceived short-term
downturn in gold prices by going short in the future markets.

28. The article aims at know how of the commodities market and how the
commodities traded on the exchange. The idea is to understand the
importance of commodity derivatives and learn about the market from Indian
point of view. In fact it was one of the most vibrant markets till early 70s. Its
development and growth was shunted due to numerous restrictions earlier.
Now, with most of these restrictions being removed, there is tremendous
potential for growth of this market in the country.

29.

30. 1.2 COMMODITY

31. A commodity may be defined as an article, a product or material that is

bought and sold. It can be classified as every kind of movable property,
except Actionable Claims, Money & Securities.

32. Commodities actually offer immense potential to become a separate asset

class for market-savvy investors, arbitrageurs and speculators. Retail
investors, who claim to understand the equity markets, may find commodities
an unfathomable market. But commodities are easy to understand as far as
fundamentals of demand and supply are concerned. Retail investors should
understand the risks and advantages of trading in commodities futures before
taking a leap. Historically, pricing in commodities futures has been less
volatile compared with equity and bonds, thus providing an efficient portfolio
diversification option.

33. In fact, the size of the commodities markets in India is also quite significant.
Of the country's GDP of Rs 13, 20,730 crore (Rs 13,207.3 billion),
commodities related (and dependent) industries constitute about 58 per cent.

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 34. Currently, the various commodities across the country clock an annual
turnover of Rs 1, 40,000 crore (Rs 1,400 billion). With the introduction of
futures trading, the size of the commodities market grows many folds here
on.

35. 1.3 COMMODITY MARKET

36. Commodity market is an important constituent of the financial markets of any

country. It is the market where a wide range of products, viz., precious
metals, base metals, crude oil, energy and soft commodities like palm oil,
coffee etc. are traded. It is important to develop a vibrant, active and liquid
commodity market. This would help investors hedge their commodity risk,
take speculative positions in commodities and exploit arbitrage opportunities
in the market.

Table: 1

Turnover in Financial Markets and Commodity Market

(Rs in Crores)

S No. Market segments 2002-03 2003-04 2004-05 (E)

1 Government Securities Market 1,544,376 (63) 2,518,322 (91.2) 2,827,872 (91)

2 Forex Market 658,035 (27) 2,318,531 (84) 3,867,936 (124.4)

3 Total Stock Market Turnover (I+ II) 1,374,405 (56) 3,745,507 (136) 4,160,702 (133.8)

I National Stock Exchange (a+b) 1,057,854 (43) 3,230,002 (117) 3,641,672 (117.1)

a)Cash 617,989 1,099,534 1,147,027

b)Derivatives 439,865 2,130,468 2,494,645

II Bombay Stock Exchange (a+b) 316,551 (13) 515,505 (18.7) 519,030 (16.7)

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 a)Cash 314,073 503,053 499,503

b)Derivatives 2,478 12,452 19,527

4 Commodities Market NA 130,215 (4.7) 500,000 (16.1)

Note: Fig. in bracket represents percentage to GDP at market prices

Source: Sebi bulletin

37.
1.4 Its EVOLUTION IN INDIA

38. Bombay Cotton Trade Association Ltd., set up in 1875, was the first organized
futures market. Bombay Cotton Exchange Ltd. was established in 1893
following the widespread discontent amongst leading cotton mill owners and
merchants over functioning of Bombay Cotton Trade Association. The Futures
trading in oilseeds started in 1900 with the establishment of the Gujarati
Vyapari Mandali, which carried on futures trading in groundnut, castor seed
and cotton. Futures' trading in wheat was existent at several places in Punjab
and Uttar Pradesh. But the most notable futures exchange for wheat was
chamber of commerce at Hapur set up in 1913. Futures trading in bullion
began in Mumbai in 1920. Calcutta Hessian Exchange Ltd. was established in
1919 for futures trading in raw jute and jute goods. But organized futures
trading in raw jute began only in 1927 with the establishment of East Indian
Jute Association Ltd. These two associations amalgamated in 1945 to form the
East India Jute & Hessian Ltd. to conduct organized trading in both Raw Jute
and Jute goods. Forward Contracts (Regulation) Act was enacted in 1952 and
the Forwards Markets Commission (FMC) was established in 1953 under the
Ministry of Consumer Affairs and Public Distribution. In due course, several
other exchanges were created in the country to trade in diverse commodities.

39. 1.5 Structure of Commodity Market

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40.
1.6 Different types of commodities traded

41. World-over one will find that a market exits for almost all the commodities
known to us. These commodities can be broadly classified into the following:

42. Precious Metals: Gold, Silver, Platinum etc

Other Metals: Nickel, Aluminum, Copper etc
Agro-Based Commodities: Wheat, Corn, Cotton, Oils, Oilseeds.
Soft Commodities: Coffee, Cocoa, Sugar etc
Live-Stock: Live Cattle, Pork Bellies etc
Energy: Crude Oil, Natural Gas, Gasoline etc

43.1.7 Different segments in Commodities market

44. The commodities market exits in two distinct forms namely the Over the
Counter (OTC) market and the Exchange based market. Also, as in
equities, there exists the spot and the derivatives segment. The spot markets
are essentially over the counter markets and the participation is restricted to
people who are involved with that commodity say the farmer, processor,
wholesaler etc. Derivative trading takes place through exchange-based
markets with standardized contracts, settlements etc.

45.1.8 Leading commodity markets of world

46. Some of the leading exchanges of the world are New York Mercantile
Exchange (NYMEX), the London Metal Exchange (LME) and the Chicago Board
of Trade (CBOT).

47.1.9 Leading commodity markets of India

48. The government has now allowed national commodity exchanges, similar to
the BSE & NSE, to come up and let them deal in commodity derivatives in an
electronic trading environment. These exchanges are expected to offer a

11
 nation-wide anonymous, order driven, screen based trading system for
trading. The Forward Markets Commission (FMC) will regulate these
exchanges.

49. Consequently four commodity exchanges have been approved to commence

business in this regard. They are:

50. Multi Commodity Exchange (MCX) located at Mumbai.

National Commodity and Derivatives Exchange Ltd (NCDEX) located at
Mumbai.
National Board of Trade (NBOT) located at Indore.
National Multi Commodity Exchange (NMCE) located at Ahmedabad.

Turnover on Commodity Futures Markets

(Rs. In Crores)

Exchange 2003-04 2004-05 FIRST Half

NCDEX 1490 54011

NBOT 53014 51038

MCX 2456 30695

NMCE 23842 7943

ALL EXCHANGES 129364 170720

51.
1.10 Volumes in Commodity Derivatives Worldwide

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52.

2. Commodity Futures Trading in India

53. 2.1 INTRODUCTION

54. 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 underlyings 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.

55. 2.2 Benefits to Industry from Futures trading.

56. * Hedging the price risk associated with futures contractual commitments.
* Spaced out purchases possible rather than large cash purchases and its
storage.
* Efficient price discovery prevents seasonal price volatility.
* Greater flexibility, certainty and transparency in procuring commodities
would aid bank lending.
* Facilitate informed lending.
* Hedged positions of producers and processors would reduce the risk of
default faced by banks. * Lending for agricultural sector would go up with
greater transparency in pricing and storage.
* Commodity Exchanges to act as distribution network to retail agri-finance
from Banks to rural households.
* Provide trading limit finance to Traders in commodities Exchanges.

2.3 Benefits to Exchange Member

57. * Access to a huge potential market much greater than the securities and
cash market in commodities.
* Robust, scalable, state-of-art technology deployment.
* Member can trade in multiple commodities from a single point, on real time
basis.
* Traders would be trained to be Rural Advisors and Commodity Specialists
and through them multiple rural needs would be met, like bank credit,
information dissemination, etc.

58. 2.4 Why Commodity Futures?

59. One answer that is heard in the financial sector is "we need commodity
futures markets so that we will have volumes, brokerage fees, and something

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 to trade''. I think that is missing the point. We have to look at futures market
in a bigger perspective -- what is the role for commodity futures in India's
economy?

60. In India agriculture has traditionally been an area with heavy government
intervention. Government intervenes by trying to maintain buffer stocks, they
try to fix prices, and they have import-export restrictions and a host of other
interventions. Many economists think that we could have major benefits from
liberalization of the agricultural sector.

61. In this case, the question arises about who will maintain the buffer stock, how
will we smoothen the price fluctuations, how will farmers not be vulnerable
that tomorrow the price will crash when the crop comes out, how will farmers
get signals that in the future there will be a great need for wheat or rice. In all
these aspects the futures market has a very big role to play.

62. If you think there will be a shortage of wheat tomorrow, the futures prices
will go up today, and it will carry signals back to the farmer making sowing
decisions today. In this fashion, a system of futures markets will improve
cropping patterns.

63. Next, if I am growing wheat and am worried that by the time the harvest
comes out prices will go down, then I can sell my wheat on the futures
market. I can sell my wheat at a price, which is fixed today, which eliminates
my risk from price fluctuations. These days, agriculture requires investments
-- farmers spend money on fertilizers, high yielding varieties, etc. They are
worried when making these investments that by the time the crop comes out
prices might have dropped, resulting in losses. Thus a farmer would like to
lock in his future price and not be exposed to fluctuations in prices.

64. The third is the role about storage. Today we have the Food Corporation of
India, which is doing a huge job of storage, and it is a system, which -- in my
opinion -- does not work. Futures market will produce their own kind of
smoothing between the present and the future. If the future price is high and
the present price is low, an arbitrager will buy today and sell in the future.
The converse is also true, thus if the future price is low the arbitrageur will
buy in the futures market. These activities produce their own "optimal" buffer
stocks, smooth prices. They also work very effectively when there is trade in
agricultural commodities; arbitrageurs on the futures market will use imports
and exports to smooth Indian prices using foreign spot markets.

65. In totality , commodity futures markets are a part and parcel of a program
for agricultural liberalization. Many agriculture economists understand the
need of liberalization in the sector. Futures markets are an instrument for
achieving that liberalization.

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