Name of the student: Sanjeet Chahal

Enrollment No. : 09BS0002067

Mobile No. : 9818591806

E-mail Id : Sanjeetchahal@gmail.com

Management research Prject

Project Interim Report

I. Project Details

Title of the Project : Status of Commodity Trading in

India and its Influence on Inflation (Focusing On Agriculture Commodities)

II. Description of the project in Brief

Agricultural commodities are the fundamentals of life: water, wheat, sugar,

soybeans, livestock, hogs, timber, cotton. Agricultural commodity are a
hedge against inflation because food prices often head higher first .Indian
markets have recently thrown open a new avenue for retail investors and
traders to participate: commodity derivatives. For those who want to
diversify their portfolios beyond shares, bonds and real estate, commodities
is the best option.

Commodity prices in the coming years will be influenced by two the forces of
deflation and inflation. If deflationary forces dominate, commodity prices will
tend to decrease; if inflationary forces dominate, commodity prices will tend
to increase

The inflation is worrying and the government has stepped in to take all
measures to control inflation even at the cost of foregoing growth. The
government is taking both monetary and fiscal policies to bring down the
prices.

III. Objective Of the Project

To study that futures trading has a direct impact on inflation. This is brought
about by the presence of basis (the difference between spot and future
prices)the futures prices are higher than spot prices. In usual cases, The
cause of this phenomenon is the presence of speculation and positive
expectations. However, in certain commodities where speculation is
negative, futures prices are lower than the spot prices. This difference in
spot and futures prices is capable of causing a shit in the demand-supply
mechanisms in favour of a particular time period to the prejudice of the
other. For instance, when futures prices are higher than spot prices for an
agricultural commodity, the farmers would like to sell the commodity in
future, bringing down the supply levels at present. However, the lower prices
at present compared to future prices prompts a high demand for the
commodity at present. This mechanism causes excess demand in the
present time period and pushes up the price of the commodity in question,
thereby causing higher levels of inflation. Given that the futures prices were
almost always higher than the spot prices as far as agricultural commodities
are concerned,

Futures trading has been advocated as a tool to solve the market

uncertainties by promising the farmers a fixed price for their future output.
Given the market situation and volatility of prices of agricultural products in
India, such an assurance is of extreme importance. Thus, futures trading, in
theory, has the potential to solve a number of problems in the agricultural
sector. But, in the present scenario, a forward markets are beyond the reach
of a vast majority of Indian farmers. A huge chunk of Indian farmers fall
within the category of marginal farmers. It is these farmers who are the most
affected the most by the market fluctuations and the monsoon failures.
Hence, it is these farmers who really need to hedge risks through futures
trading. But the present regulations in the Indian commodity exchanges
appear to exclude small farmers from the picture completely. A comparison
between the average product per farmer and the minimum lot size to be
traded in the commodity exchange throws some light on the situation.
comparison of minimum lot size that can be traded in commodity exchanges
in India with the production data for small and marginal farmers reveals that
the minimum lot size in a commodity market is much larger than the total
annual production of a small or marginal farmer. This keeps future markets
outside the reach of marginal and small farmers.
The direct gains of futures trading in India were always cornered by
speculators and large farmers who were able to meet the huge lot size
requirements of the Indian commodity markets. Thus what the average
Indian farmer stands to lose from the ban is the higher price lever arrived at
as a spillover effect of forward trading and not any direct gain.
IV. Methodology

A thorough analysis of the available Indian data both in terms of behaviour

of agricultural commodity prices pre and post futures trading and the
direction of causality between futures and spot prices to reveal any
unambiguous direction of impact

-Study the Spot price indices of select commodities

-Volume & Value of Trading in Major Agri-commodities

-Annualized Trend Growth Rate and Volatility of WPI of Selectedagricultural
Commodities in which Futures are traded

Introduction:

The notification of the Forward Market Commission imposing a ban on

futures trading in a number of agricultural futures has struck up discussions
regarding its probable impact on farmers and its effectiveness as a policy
measure to curb inflation. Against this background, this report intents to
examine the ban in terms of

(i) its effectiveness in attaining the stated goal of curbing inflation and

(ii) its likely impact on farmers.

(iii)In brief the concept of forward trading and risk hedging, need for
regulation in a futures market and the legal and institutional framework
governing futures markets in India with focus on commodity derivatives.

Part –I (Functional knowledge)

Derivatives, Forward Contracts, Futures And Options: Some Basic

Concepts In Derivative Trading:

Forward and future contracts are both contracts to meet a certain

obligation, (usually, to deliver a specified quality and quantity of a
commodity or a specified number of a financial instrument for a specified
pricein specified manner on a specified date in the future. Both the parties
are required to perform their obligations in a future date known as the
maturity date of the contract. The essential distinction between a future
contract and forward contract is that while forward contract is one to one
covenant between the parties thereto, futures contract is a much more
standardized agreement between the parties, which can be bought or sold to
a third party (or between the parties) at any point of time, so as to alter or
even reverse the rights and obligations arising under the original contract.
This capability to altering positions, makes a futures contract an instrument
with a higher level of liquidity than the forward contract. Moreover, in a
forward, as the parties are the only persons involved in the transactions,
there is a high level of counter-party risks, that is, the risk of non-
performance from one of the parties. But this counter party risk is eliminated
in a futures contract by the presence of clearance houses who take opposing
positions in every alternate transaction and ensure the equality of long and
short positions.

An option is the right, not obligation, to buy or sell a specified amount (and
quality) of a commodity, currency, index or financial instrument, or to buy or
sell a specified number of underlying futures contracts, at a specified price,
on or before a specified a given date in the future. An option confers upon its
holder a right but not obligation to buy/sell the underlying commodity/
contract/ index/ instrument/ currency at a pre-specified price on or before
the said date. An option that gives its holder a right to buy is called a call
option while one that confers upon its holder a right to sell is called a put
option. Options, like futures, can be traded in an exchange so as to alter or
reverse positions. An option appears to the general rule that an offer can be
revoked any time before it is accepted. In an option the option writer (the
one who grants the option) is not free to revoke the offer before the
specified date though the option holder has not accepted the offer by the
exercise of the offer. There appears to be an ancillary agreement between
the parties by which the offeror undertakes to keep the offer open till the
specified date. It appears to the researcher that where there is a payment of
an advance or earnest money between the parties, it acts as consideration
for the ancillary agreement and makes it a contract. Where there is no such
payment, the obligation of the option writer to keep the offer open arises
from the doctrine of promissory estoppel.

Futures and options guarantee certain economic advantages to the parties

thereto in terms of risk hedging, speculative benefits and arbitrage
opportunities. As futures and options ensure a high level of liquidity, parties
can alter their obligations and rights arising from the contract by buying or
selling contracts in the exchange. Thus a party can reduce losses or earn
profits by transferring the rights and obligations under the contract by a deal
in the exchange, when performance on his part would mean lesser profits or
greater losses. Similarly, even if one party is in a situation where
performance on his part is either impossible or detrimental to his interest,
the other party does not have to bear the counter party risks as the party
not interested in performance can alter his position by trading in the
exchange. Whatever counter-party risks remain are taken over by the
clearance houses. Thus options and futures serve the purpose of reducing
counter-party risks, which has been stated above as a vital function of the
contract.

Similarly, parties entering into futures contracts fix the quantity, quality,
price and other particulars at a prior date. This helps the parties to avoid
(hedge) the risks of price fluctuations and also to plan out future activities.

Forward contracts have often been confused with wagering agreements as

fluctuations in the price of the subject of the contract, which is an uncertain
event, will determine payoffs for the parties to the contract. the parties had
entered into a contract for sale goods, delivery to be made in three months?
time, and the price to be market price at the date of delivery. It was argued
that this transaction was a wagering agreement as the parties stood to gain
or lose from an uncertain event, that is, the fluctuation in prices. But this
element of chance was held to be merely an incident in the larger
transaction of a contract of sale of goods on certain terms; it did not convert
that transaction into a wagering contract. If however both the parties use
this means to gamble on future price differences and for no other purpose, it
being in effect agreed between them that neither party should be entitled to
call for performance, then the contract will be held to be a wager

In India, the Courts have held that mere presence of speculation in a

contract does not make it a wager and that intention of the parties to wager
is crucial. Every forward contract is speculative to some extend, but that
does not reduce them to wagering agreements .If the parties intent merely
to speculate in prices and in no circumstances perform the obligations under
the contract, only then a futures contract becomes a wagering agreement.
The mere fact that the parties have an option of paying the price difference
and not actually performing the contract does not make it a wagering
agreement unless it be the intention of both the contracting parties, at the
time of entering into contracts under no circumstances to call for, or give
delivery, from or to each other. There is no presumption that a forward
contract with an option of cash settlement is a wager. On the contrary, the
presumption is that such a contract is not a wager and it is the onus of the
party alleging it to be a wager to prove his allegation. An accepted test to
prove the real intention of the parties is a comparison between the value of
the transaction and the financial condition of the party alleging wager

As futures exchanges allow market players to trade in futures with the

deposition of a very small margin compared to the total worth of the
transaction, option of cash settlement (settlement by payment of the
difference in prices) would give ample opportunities for speculators to enter
into contracts of which the total worth is beyond the capacity of the parties
and speculate on the fluctuations in prices and settle the transaction through
payment of difference in prices. This test acts as an effective mechanism to
check such wagering to some extent. But it is to be noted that wagering is
done not only by parties with low capacity to pay.

Futures Market: The Agents And The Mechanism:

(Having defined the key concepts like derivatives, futures and hedging, an
analysis of the working of a futures market can be undertaken. This section
discusses who the agents in a commodities futures market are, what their
strategies are, how an interaction of these strategies fix the price of futures
and need or regulation.)

It appears that the participants in a commodities futures market can be

divided broadly into hedgers and speculators depending on their attitude
towards

While hedgers are those risk-aversive agents who try to shift the price risks
associated with volatile nature of prices in a deal by opting for a fixed price
decided in the present by the means of futures, speculators are those who
are willing to take risks and intend to reap benefits out of the speculated
changes in price of the derivative itself. While hedgers are concerned about
securing a fixed price for the commodity underlying the derivative
speculators are concerned about possible fluctuations in the price of the
derivative itself and the profits that can be reaped from them. Most of the
times it is noticed in a real world market that though the same agent may
act as a hedger at one instance and a speculator at another, the general rule
is that hedgers form the two extreme ends of a chain of transactions (the
persons who really intend to buy or sell the commodity as such and not
merely the derivative, that is mostly the producers and the final demanders
of the commodity) the intermittent roles are filled by a number of
speculators who may further be divided into a number of categories like
arbitragers, day-traders, etc. So, in a way, a futures market is a forum for
trade offs in risk between the risk aversive hedgers and the risk taking
speculators. Both speculators and hedgers have their own demand and
supply schedules and it is an interaction between these market forces that
fix prices in a future market, if they are given a free hand.

Though Speculators and hedgers account for the demand and supply
equations in a futures market, they are not the only entities that matter.
Clearance houses and brokers are the people who really appear in the pit.
Clearance firms ensure that the contracts are complied with. In every deal
between two parties, clearance houses stand between the parties, taking the
stand opposite to what each party has taken. That is, the person taking short
position sells the commodity to the clearance house and the person taking
the long position buys the contract from the clearance house. Clearance
houses require the parties to deposit a margin, proportional to the worth of
the deal so that performance can be assured. Brokers are hired by parties to
trade on their behalf in the market, in accordance to a range of orders that
are exercised by the party from time to time.

An issue of theoretical and academic interest and of regulatory concern is

the gap between future and spot prices. This is a concern or the policy
makers because a huge gap between spot and future prices may create a tilt
in favour of either future or spot market at the expense of the other thereby
affecting the demand and supply equations in the macroeconomic picture
and causing consequent fluctuations in the related macroeconomic
variables.

The difference between future and spot prices is known as Basis. (Basis = Pt
- P0 where Pt is future price and P0 is spot price). In a normal market Basis is
positive while in an inverted market Basis is negative. The difference in
prices tends to decrease and the prices tend to converge bringing down
Basis to zero as the month of delivery approaches. The convergence of price
occurs because any non-zero Basis at a period close to the month of delivery
will provide the traders ample opportunities of arbitrage and as they reap
these opportunities the Basis will come closer and closer to zero.

Another feature of futures markets that calls for regulation is that traders in
futures markets need merely a small proportion of the money that the trade
is worth to be deposited as margins. This enables traders to enter into deals
which are worth many times more than the money they have at their
disposal. Such transactions are indeed undertaken by speculators who act as
retail investors or day traders with the plans of reversing the trade position
before the maturity of the future. But if such a reversal becomes impossible
owing to huge fluctuations, a number of traders may face bankruptcy and
even the presence of clearance houses may not be able to eliminate
counter-party risks. (Risk of non performance by the other party to the
contract)

Part II (Analyzing)

: An Assessment Of The Current Ban On Futures Trading In Certain

Agricultural Commodities:

I. Effectiveness of the Ban on curbing inflation

It is quite undisputed that futures trading has a direct impact on inflation.

This is brought about by the presence of basis (the difference between spot
and future prices). In usual cases, the futures prices are higher than spot
prices (In support of this proposition, see market data for different
commodities and different dates available at www.ncdex.org). The cause of
this phenomenon is the presence of speculation and positive expectations.
However, in certain commodities where speculation is negative, futures
prices are lower than the spot prices. This difference in spot and futures
prices is capable of causing a shit in the demand-supply mechanisms in
favour of a particular time period to the prejudice of the other. For instance,
when futures prices are higher than spot prices for an agricultural
commodity, the farmers would like to sell the commodity in future, bringing
down the supply levels at present. However, the lower prices at present
compared to future prices prompts a high demand for the commodity at
present. This mechanism causes excess demand in the present time period
and pushes up the price of the commodity in question, thereby causing
higher levels of inflation. Given that the futures prices were almost always
higher than the spot prices as far as agricultural commodities are concerned,
the ban is likely to bring down the prices of food grains.

However, whether the ban will help in curtailing overall inflation or merely
act as a stopgap measure bringing down prices of agricultural commodities
alone, leaving the farmers faced with lower incomes and higher price levels
for nonagricultural commodities is a question that can be answered only by
an examination of real causes of the current inflation phenomenon. Between
2004-05 and 2005-06 there has been an acceleration in growth of broad
money (M3) from 12.3% to 17%.. This rapid growth cannot be attributed
merely to the presence of future traders. There are and fiscal factors like
increased credit availability which are at the root of the phenomenon.
Banning futures trading without attending to these real causes will merely
bring down price of agricultural products without causing a corresponding
deflation for non-agricultural products. This will lead to a highly inequitable
result, leaving the farmers at a worsened position.

II. Impact of the Ban on Farmers

It has been pointed out in the previous section how ban on futures trading in
agricultural commodities, without initiating steps to attend to the real causes
of inflation will leave the farmers in a worsened situation. However, it is to be
noted here that the gains that the typical Indian farmer used to reap from
futures trading are those that arise as a spill-over effect of futures trading
(through the mechanism mentioned in the previous section) and not from
the participation of farmers in forward markets.

Futures trading has been advocated as a tool to solve the market

uncertainties by promising the farmers a fixed price for their future output.
Given the market situation and volatility of prices of agricultural products in
India, such an assurance is of extreme importance. Thus, futures trading, in
theory, has the potential to solve a number of problems in the agricultural
sector. But, in the present scenario, a forward markets are beyond the reach
of a vast majority of Indian farmers. A huge chunk of Indian farmers fall
within the category of marginal farmers. It is these farmers who are the most
affected the most by the market fluctuations and the monsoon failures.
Hence, it is these farmers who really need to hedge risks through futures
trading. But the present regulations in the Indian commodity exchanges
appear to exclude small farmers from the picture completely. A comparison
between the average product per farmer and the minimum lot size to be
traded in the commodity exchange throws some light on the situation.
comparison of minimum lot size that can be traded in commodity exchanges
in India with the production data for small and marginal farmers reveals that
the minimum lot size in a commodity market is much larger than the total
annual production of a small or marginal farmer. This keeps future markets
outside the reach of marginal and small farmers.

Thus a major part of the gains that critics of the ban accuse the ban of
snatching from the farmers, were in fact never enjoyed by the majority of
agrarian community in India. The direct gains of futures trading in India were
always cornered by speculators and large farmers who were able to meet
the huge lot size requirements of the Indian commodity markets. Thus what
the average Indian farmer stands to lose from the ban is the higher price
lever arrived at as a spillover effect of forward trading and not any direct
gain.

Part-III (Findings and observation)

TEST: of commodity futures trading impacting inflation

Using the Granger causality tests to study whether prices in one market
impact prices in the other, RBI has concluded that “commodity prices in
India seem to be influenced more by other drivers of price changes,
particularly demand-supply gap in specific commodities, the degree of
dependence on imports and international movements in these
commodities.”

The RBI has carried out tests on six farm commodities — sugar, urad, tur,
wheat, chana and potatoes — to find out whether futures trading impacted
spot prices and vice-versa. The tests relate to monthly data on these
commodities for the period of 2004-2009. For commodities such as urad and
tur on which bans were imposed, data for the 2004-2007 period were used.

The causality tests show that futures prices have causal impact on spot
prices in the case of sugar and urad and that spot prices impact futures
prices in case of urad, chana, wheat and sugar.

“The emprical analysis, thus, does not provide any conclusive evidence in
support of the relationship between spot and futures prices,” noted RBI in its
annual report for FY10.

“The RBI diagnosis reinforces what has been held all along by the futures
market that futures prices do not cause spot price inflation and, hence,
cannot be held responsible for food inflation in essential commodities
The government banned futures trading in tur, urad, wheat and rice in 2007.
It relisted wheat in May 2009 but delisted sugar in the same month because
of price volatility. The sugar ban comes up for review by the government on
September 30.

Conclusion:

TRADING OF ESSENTIAL COMMODITIES NOT RESPONSIBLE FOR

PRICE RISE

Facts show that futures trading in essential commodities has not been
responsible for the price rise in recent period. There is no future trading in
Urad and Tur since January 2007 when it was suspended. But the prices of
these commodities are showing sharp increase during 2008-09 and 2009-10.
The year-on-year price increase (in terms of Wholesale Price Index) at the
end of financial year 2008-09 (29.3.2009) was 14.7% for Urad and 17.1% for
Tur. During the year 2009-10 (as on 28.11.09). Year-on-Year increase was
59.46% and 72.25% for Urad and Tur respectively. As against this there is
futures trading in Gram. Year on Year change of prices of Gram was negative
at –6.8% in 2008-09 and 4.32% during 2009-10 (as on 28.11.09)
respectively. Therefore, the increase in prices of commodities need not
necessarily be attributed to future trading. In fact an Expert Committee
appointed by the Government under the Chairmanship of Planning
Commission’s Member Prof. Abhijit Sen to examine whether futures markets
was responsible for rise in the prices of essential commodities in its report
submitted in April 2008 did not find futures market responsible for the
increase of the prices of essential commodities.
In the light of the above analysis, it can be safely concluded that the current
ban on futures trading in certain agricultural commodities is a mere stopgap
measure to curb inflation. It certainly will affect the farmers adversely by
lowering the price level of agricultural commodities unaccompanied by a
corresponding lowering in prices of non-agricultural products. However this
does not mean forward trading, as it stood before the ban was helpful to the
farmers. It is specially emphasized that the market regulations regarding lot
size and other standards prevailing in the Indian commodity exchanges are
not suited for the socio-economic realities of the Indian farming community.

Refrences

-http://www.mainstreamweekly.net/article858.html

-www.ncdex.org.

-http//www.fmc.gov.in

- The Economics Times

Faculty Guide Name: Prof. Kapil Gupta

Sutdent’s Signature