Commodity Exchanges –

Prospects and emerging opportunities in India

–- Madan Sabnavis, Chief Economist

July 2, 2005
2
 Agenda

 Overview
 Arbitrage Opportunities
 Hedging Opportunities
 Investment Opportunities
 Institutional Participation
 NCDEX

3
 Role of an Exchange
 Anonymous auction for price discovery
 Neutrality - conflict of interest avoided
 Transparent real time price dissemination
 Benchmark reference price
 Liquidity to participants
 Risk Management in a volatile market
 Robust Clearing & Settlement systems - counter
party credit risk mitigated
 Fair, safe, orderly market - rigorous financial
standards and surveillance procedures

4
 Benefits of trade on Futures Market

 Risk transfer platform from actual users to

traders / speculators
 Helps hedgers concentrate on core activity
 Long term price signals help
 Farmers to decide cropping pattern
 Corporate managers to take investment / capital
expenditure decisions
 Cover sales and raw materials risk
 Cost of Capital reduced
 A good investment option
 Arbitrage opportunities

5
 Myths about commodity exchanges
 Commodity exchanges are speculative markets
not meant for actual users
 Speculators infuse liquidity to enable hedgers to
transfer their price risk
 If commodity exchanges do not enable physical
delivery, they are then only for speculators
 Exchanges are meant for price discovery and
physical delivery is only incidental

As Exchanges gain liquidity actual users will separate

hedging from physical delivery
6
 Myths about commodity exchanges
 How can trading volume be greater than actual
production in that commodity?
 Open Interest is the only true indicator of the
depth of the market
 E.g.: Trading volume in Infosys / Reliance in
the Capital markets is a multiple of the
outstanding shares
 Can an Exchange have a price view?
 Exchange is a platform for price discovery– It
is only the thermometer of the price
movements and is not responsible for the
price movements

NCDEX rigorously monitors & controls level of and composition of Open

interest in any commodity
7
 Evolution of Commodity markets in India

 Ban in forward trading in mid-sixties

 Emergence of national level online multi-
commodity exchanges
 3 National level and 21 regional
 Trade in 60 commodities compared with just
8 in 2000
 Volumes of Rs 571,000 crores in 2004-05
 Volume first two months of 2005-06
reached 1,90,000 crores (800 % growth
over 25,000 crores in 2004-05)
Traded volume in 2004-05 around 20% of India’s GDP

8
 The Indian Definition: FCRA (1952)

 Goods
 “Every kind of movable property other than
actionable claims, money and securities.”
 Securities
 “Shares, scrips, stocks, bonds, debentures,
debentures –stocks or other marketable
securities of a like nature in or any incorporated
company or any other body corporate and also
government securities.”

Inclusive definitions-Gaps exist

9
 Regulatory Structure in India
Ministry of Finance Ministry of Consumer
Affairs

National Pension Funds Regulatory Company

Insurance Regulatory
FMC
Housing Bank Development AuthorityLaw Board
Development Authority
(IRDA) (PFRDA)

Commodity
Housing Finance Pension
Insurance Corporates Exchanges
Companies Funds

SIDBI RBI SEBI NABARD

State Financial Banking / Capital Co-operative Banks &

Institutions NBFCs Markets Regional Rural Banks

10
 Structure of Indian Commodity Futures
Exchanges
FMC

Commodity Exchanges

National Regional
exchanges exchanges

NCDEX NMCE MCX NBOT 20 Other Regional

Exchanges

11
 Growth in volumes of Indian Commodity
Exchanges

Rs Crores
6 0 0 ,0 0 0

5 0 0 ,0 0 0 5 7 1 ,0 0 0

4 0 0 ,0 0 0

3 0 0 ,0 0 0

2 0 0 ,0 0 0
1 2 9 ,4 0 0
1 0 0 ,0 0 0 6 6 ,5 0 0
4 ,5 0 0
0
20 01-02 20 02 -03 2 003 -04 2 00 4-0 5

Impressive growth of 341 % between 2003-04 to 2004-05

12
 Volumes of Indian Commodity Exchanges

Rs Crores
M a rke t T ra d e V a lu e
M CX,
157246, 28%

O th e r s ,
87418, 15% NCDEX,
NBOT, 266460, 46%
50875, 9% N M C E , 9 0 0 1 ,
2%

N C D E XN M C EN B O TO th e r sM C X

13
 Agenda

 Overview
 Arbitrage Opportunities
 Hedging Opportunities
 Investment Opportunities
 Institutional Participation
 NCDEX

14
 Arbitrage opportunities

 Law of One Price – “a commodity cannot

command two different prices in two different
markets ”

 Arbitrage opportunities emerge out of pricing

inefficiencies
 Between the cash & derivatives market
 Between two futures contracts with different
expiry dates
 Between two or more exchanges

15
 Arbitrage Opportunities
Annualized Returns on Contract
over Spot (in %)
June July August
Grade A 88 12 2.5
parboiled Rice
Gram 84 57 46
Urad 28 19 9
Sugar 13 3 5
Raw Jute 85 68 48
Guar Seed 25 15 13
Gold N.A. 5.8 8.3
Silver 8.5 7.3 5.9
Copper N.A. 29.5 18.3

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 Agenda

 Overview
 Arbitrage Opportunities
 Hedging Opportunities
 Investment Opportunities
 Institutional Participation
 NCDEX

17
 Raw material intensive industry
Industry Ratio of Raw
materials/Net
sales
Soyabean products 92.2
Vanaspati 89.6
Vegetable oils 88.0
Refinery products 86.2
Petroleum products 85.8
Steel wires 85.5
Gems and jewellery 84.9
Textile products 76.7
Bakery and milling 73.7
Aluminium products 73.8
Polymers 70.0
Automobiles 68.3 Source: CMIE

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 Steel: Need for hedging mechanism
 Characterized by high volatility during the last 2
years
 Steel market expected to remain volatile
 Participants need a mechanism to reduce price
risk
 Steel futures can help mitigate price risk
 Steel futures will give an indication of future
trend in steel prices

19
 Seller’s hedge - assumptions

 Price of saleable steel falls by 10% in FY02

 Steel hedged at FY01 prices
 Decrease in PBDIT solely due to fall in price of
saleable steel

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 Seller’s Hedge
FY00 FY01 FY02 FY03 FY04

Saleable Steel 16500 18500 16600 20300 24500

Prices (Rs/Ton) (10%)
Quantity Sold 2668 2446 2731 3448 3473
(‘000 tonnes)

PBDIT 1291 1507 1179 2208 3548

(Rs Crore) (22%)

(* Saleable steel constitutes approx. 72% of sales)

If hedged completely, could have made incremental profits of

Rs 518 crores, 44% higher

21
 Buyer’s Hedge - assumptions

 Prices increase by 17% in FY04

 Prices hedged at FY03 prices
 Decrease in PBDIT is solely because of
increase in raw material component

22
 Case Study-Buyers Hedge

FY00 FY01 FY02 FY03 FY04

HR Coils 13728 15736 13115 16776 19626

Prices (Rs/Ton) (17%)

Quantity 299927 261118 265973 350807 340996

purchased
PBDIT 183.39 240.23 160.15 637.74 635.56
(1%)

The company could have saved the loss of around Rs 97 crores by hedging,
i.e. 15% higher profits

23
 Effect of Price shock
Rs crores

R a tio o f R M In c r e a s e o f 5 %
N e t S Ra Ml e sCt oo sN t e t S aP lBe Tsi n r a w m a t e r i a l s
S o y B e a n p r 6o 1d 0u 3c . t15s 6 0 0 92 98 -2 8 0
S ugar 9 6 2 0 .7 1 4 3 74 66 -3 5 7
G e m s & J e w 8l l 4e 6r y2 . (7G1 o5 l0d ) 8 4 99 -3 5 8
S te e l 7 3 0 7 34 9 8 3 0 54 6134 -1 9 9 1
Source: CMIE

Even an increase of 5 % in cost of raw materials could wipe

out the profits of a raw material intensive commodity

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 Agenda

 Overview
 Arbitrage Opportunities
 Hedging Opportunities
 Investment Opportunities
 Institutional Participation
 NCDEX

25
 Conducive drivers

 Beginning of the Bull phase after 20 years of

Bear market
 Escalating commodities demand from Asia,
especially China
 Depreciating dollar – shift to hard currencies like
Gold
 Inflationary pressures build-up
 Surging energy prices – leading to energy crisis
 Rise in commodity demand with economic
recovery

26
 NCDEX Agri vs. NSE-Nifty
1350.00 2500

1300.00
2000

1250.00

1500
1200.00

1150.00
1000

1100.00

500
1050.00

1000.00 0
16-Dec-02 05-May-03 22-Sep-03 09-Feb-04 28-Jun-04 15-Nov-04 04-Apr-05

NCDEX Index NSENIfty

Correlation coefficient is 0.02

27
 Correlation: 1997-05
Correlation Coefficients in Indian markets
Gold Silver Stocks Bonds
Gold 1 0.55 -0.09 -0.076
Silver 1 -0.06 -0.015
Stocks 1 0.112
Bonds 1

Data: LBMA bullion prices, NSE Nifty, NSE G-Sec Index

Benefit of diversification can be seen from the

Risk Adjusted Returns

28
 Volatility comparison – 1997-05
Average annual volatility
 Sensex or Nifty - 25-30%
 Govt Sec Index - 5-10%
 Gold - 12-18%
 Silver - 15-20%
 Cotton - 10-12%
 Oil seeds - 15-20%

 Commodities are less volatile compared to equity

market, but more volatile as compared to G-Sec’s

29
 Portfolio diversification & value investing

 Low co-relation between stocks/bonds and the

commodities market
 Better diversification of portfolio
 Commodity markets are less risky compared
with stock market.
 Reduces risks in a diversified portfolio

30
 Risk-Adjusted Returns:1997-05
A bs Cumulative Risk of Risk A djusted
Portfolio structure Returns portfolio Return
100% Stock Portfolio 73.70% 24.43% 3.017
Stocks (50% ) & Gold 47.80% 3.326
(50% ) Portfolio 14.37%
Stocks (50% ) & Silver 48.30% 3.634
(50% ) Portfolio 13.29%
100% Gold Portfolio 21.80% 2.001
100% Silver Portfolio 22.90% 1.742
100% Bonds Portfolio 25.20% 7.92% 3.182
Bonds (50% ) & Gold 23.50% 8.79% 2.673
(50% ) Portfolio
Bonds (50% ) & Silver 24.00% 6.58% 3.647
(50% ) Portfolio

31
 Agenda

 Overview
 Arbitrage Opportunities
 Hedging Opportunities
 Investment Opportunities
 Institutional Participation
 NCDEX

32
 Regulatory Facilitation

Institutional Participation Pool the retail money to the

Banks,MFs, PFs, FIIs market, boost liquidity & volume

Exchange Traded Benefit of ‘upside’ for

Options value-investing

Trading on
Benchmarking the market
Commodity Indices

33
 Banks - Present Scenario
 Not allowed to trade on commodity exchange
 Not allowed to do margin financing against
commodities
 Bank lending to commodities remained very low
 Commodity a ‘sensitive sector’
 Not under priority sector lending
 Credibility of Warehouse receipts
 Reliability of the warehouse
 Hedging not possible

Bank lending against commodities was only Rs 9,952 cr out of Rs 8,64,143 cr

i.e. 1.1% as on March’04

34
 Involvement of Banks
 Banks as aggregators
 Institutions with good rural presence and sufficient
financial expertise and infrastructure
 Banks can hedge their agri and corporate loans
 Banks as market makers for price stabilization
 Role similar to the role of RBI for stabilization of
dollar prices
 Banks as dealers in commodity markets

35
 FII presence

 Benefits  Issues involved

 More liquidity  Concentration and
 Broaden and control over prices
deepen markets of crucial
commodities
 Help in the
 Physical delivery
utilization of capital
 Withdrawal from the
 Global experiences
country
 Research
 Best practices

36
 Involvement of Mutual Funds

 Mutual Funds can bring liquidity and

professional skill in the commodity market
 Mutual Funds can mobilize small savings and
invest in commodities and commodity
derivatives
 Easiest route for retail investment

37
 Options and indices
 Options
 Provides benefit of upside
 Substitute MSP of government
 Not allowed under FCRA
 Need for changes in the Act
 Indices
 Weather indices
 Regulatory changes needed

38
 Agenda

 Overview
 Arbitrage Opportunities
 Hedging Opportunities
 Investment Opportunities
 Institutional Participation
 NCDEX

39
 NCDEX – Current shareholders

NABARD NSE IFFCO CRISIL

15% 15% 12% 12%

ICICI Bank LIC Canara Bank PNB

15% 15% 8% 8%

-Only institutions are our shareholders

-NCDEX fully compliant with shareholding guidelines

40
 Independent Board of Directors
Name Organisation Expertise in

Shri U. S. Awasthi MD, IFFCO Agriculture

Shri R.N. Bharadwaj Chairman, LIC Insurance

Shri B.V. Bhargava Chairman, CRISIL Credit rating/finance

Shri S.H. Bhojani Partner, Amarchand Mangaldas & Co. Legal

Shri Dileep Choksi Sr. Partner, C.C Choksi & Co. Accounting

Shri D. S. Kolamkar Director, FMC Market Regulation

Smt Ranjana Kumar Chairperson, NABARD Rural finance/Banking

Shri Ravi Narain MD & CEO, NSE Exchange operation

Shri Lamon Rutten Chief - Finance & Energy, UNCTAD Finance & Energy

Shri Ravi Mohan MD, CRISIL Credit rating

Dr. Ajay Shah Consultant, Ministry of Finance Economics & Finance

Shri H.N. Sinor CEO & Secretary, IBA Banking & Finance

Shri P. H. Ravikumar MD, NCDEX Banking & Finance

41
 Product Calendar
Apr-Dec Jan – May
Dec 2003 2004 2005 In pipeline

Gold,
Gold, Guar
Guar Gur,
Gur, Rice,
Rice, Other
Other
Silver,
Silver, seed,
seed, Jute
Jute Maize,
Maize, base
base
Crude
Crude sacking,
sacking, Raw
Raw silk,
silk, Metals,
Metals,
Palm
Palm oil,
oil, Chana,
Chana, Cocoon,
Cocoon, Energy
Energy
RBD
RBD Rubber,
Rubber, Jeera,
Jeera, Products,
Products,
Palmolein
Palmolein Pepper,
Pepper, Chilli,
Chilli, More
More
,, Cotton,
Cotton, Wheat,
Wheat, Steel,
Steel, Agricultur
Agricultur
Mustard
Mustard Castor
Castor Cashew,
Cashew, al
al
seed,
seed, seed,
seed, Cottonsee
Cottonsee products
products
Mustard
Mustard Guar
Guar dd oilcake,
oilcake,
oil
oil gum,
gum, Raw
Raw Sesame
Sesame
Soybean,
Soybean, jute,
jute, seed,
seed, Tur,
Tur,
Refined
Refined Urad,
Urad, Arabica
Arabica & &
soy
soy oil
oil Yellow
Yellow Robusta
Robusta
peas,
peas, Coffee,
Coffee,
Sugar,
Sugar, Copper
Copper
Turmeric,
Turmeric, Cathode
Cathode
Each product isSoymeal
Soymeal
selected after an
in-depth research & market
feedback
42
 Average daily volumes
Rs cr
2500
2231
2095
2015
2000 Peak Volume for a single day
Rs. 4271 cr on Mar 30 ‘05
1619

1500 1444

1231 1229

1000

691

500

21 55
0
Q1- Q2- Q 3 - O c t - N oD ve c - '0 J4 a n '0 5F e b '0 5M a r '0 5A p r '0 5M a y '0 5
Impressive growth of NCDEX with 85% volume contribution from
2004 2004 2004 04

agriculture
43
 Robust Deliveries - 2005
T O T A L D E L I V E R I E S (in m e t r ic t o n n e s )

50000
44904
40000

30000 3 6 3 5 2 .3 5
28301
22904
20000
15624
10000
4686
0
J a n - 0 5F e b - 0 5M a r - 0 5A p r - 0 5M a y - 0 5J u n - 0 5

T O T A L D E L IV E R IE S

Deliveries of over 1,10,000 MT in first quarter 2005-06

44
 Deliveries to Open Interest – June 2005

  COMMODITY June deliverables Open Interest Deliveries to

in Metric tonnes Open
Interest

1JEERA 2697 2721 99%

2URAD 7990 8160 98%
3CASTOR SEED 1270 1450 88%
4GUARGUM 940 1085 87%
5SUGAR S 110 130 85%
6SUGAR M 12810 15260 84%
7PEPPER 756 910 83%
  Others 9779   
Total quantity for delivery 36352   

Deliveries in over 18 commodities

45
 Architecture for Price Discovery
610 Spot Price
members 70,000
6600 polling
daily
terminals trades

490
155,0000
centres
daily
orders

37
80% agri
commodities
volume

250 Monthly
100 delivery
Awareness Deliveries of
centres
Programmes 40-45000 tt

46
 Price dissemination: Choose your crop

Radio
TV Channels E-chaupals
N-logue

News agencies
PCOs

Newspapers &
Kisan call
journals
centres

IFFCO, HAFED
AGMARKNET Bank branches
Warehouses

47
 NCDEX’s integrated financial solution for
farmers

48
 Pre-harvest
Price
hedging
NCDEX

Aggregator Farmers Insurance

Bank
Finance

Buffering yourself from nature’s vicissitudes

49
 Post Harvest Scenario
Farmer sees NCDEX spot and futures prices

Sells futures On NCDEX

Approaches mandi of choice

Lodges goods
in NCDEX/NCMSL warehouse

90
WAREHOUSES Goods assayed
by approved assayers
Working with
all leading Warehouse Receipt
assayers
in electronic form
NCMSL
arranges Bank finance against WR
credit
50
 Grading and Standards: Improve your
prospects

IARI
Quality
Grading in rice, wheat
standards
maize

CIRCOT
Grading in cotton

51
 Impact of NCDEX on Prices
Guar Seed Price (Rs/qtl) Raw Jute Price (Rs qtl)
  FY 02 FY 03 FY 04 FY 05   FY 02 FY 03 FY 04 FY 05

1st Qtr 823 840 1217 1082 1st Qtr 1146 1008 842 1056

2nd Qtr 821 1575 847 1625 2nd Qtr 1042 857 823 1405

3rd Qtr 698 1434 978  1669 3rd Qtr 1042 827 784 1557

Castor Seed price (Rs/20

4thkgs)
Qtr 1167 804 794 1303
4th Qtr 758 1439 958  1534
  FY 02 FY 03 FY 04 FY 05

1st Qtr 197 247 375 304

2nd Qtr 224 263 287 357

3rd Qtr 211 297 292 348

4th Qtr 211 363 300 305
Prices are those received by the farmers after adjusting for the taxes and other incidentals. The
Prices are from the following mandis: Bikaner, Calcutta and Ahmedabad. Numbers marked in
red pertain to Prices after trading was enabled on NCDEX.

52
 Thank You

53