DH Deciphers | What do we know about commodity derivatives market?

Securities and Exchange Board of India's (SEBI) Executive Director G P Garg on Monday said that there was an urgent need to increase awareness about the commodity derivatives market among investors because the level of financial inclusion in the segment was very low. The Indian public's indifference to the commodity derivatives market sits at odds with the fact that the National Stock Exchange (NSE) is the world's largest derivatives bourse by volume. What explains this paradox?

What did the SEBI chief say?

Speaking at an event during the World Investor Week 2021, Garg said that only 4% of the Indian adult population was aware of or had made investments in the commodities market. This was discovered in a survey conducted by SEBI and the National Centre for Financial Education. Therefore, he said, there is an urgent need to educate individuals about the market, and this needs coordinated efforts of the exchanges, the market regulator and other stakeholders.

What are commodity derivatives?

Commodity derivatives are financial instruments that do not have their own independent value, i.e., their value is entirely "derived" from the value of an underlying asset (hence the term derivatives). The underlying asset can be agricultural products, oil, metals, bullion, currency, livestock or anything else. The contract is of a pre-determined fixed duration, linked for the purpose of contract fulfilment to the value of a specified real or financial asset.

What is the difference between derivatives and equities?

While commodity derivatives are essentially used for speculation, hedging, risk management or price discovery purposes, equity is a form of ownership primarily used for investment and trading purposes. The former's worth lies in the value of the underlying asset while the latter's is affected by considerations such as performance of the company, market conditions, investor mood, volume of buying/selling, etc.

Another major difference is the timeframe for holding them. While the nature of derivatives itself gives them an expiry date (though the underlying asset may or may not be perishable), equities can be held for a single day or indefinitely.

Can commodity derivatives be explained through an example?

Suppose Rahul runs a tea shop and purchases tea for, say, Rs 1,000 per kg. He expects the price to go up to Rs 1,300 per kg in the near future. Rahman has a tea plantation and produces it at Rs 900 per kg and fears that the price will sink below Rs 800 per kg and doesn't want to sell at a loss. In this case, both parties fear a price risk. To reduce the risk, both enter into a contract to buy/sell at a predetermined price (say Rs 1,100) next year. This way, both buyers and sellers can hedge their price risk.

In short, commodity derivatives reduce uncertainty for someone who is more susceptible to risk.

Why is the penetration of commodity derivatives so low in India?

Roughly 4% or about 5 crore Indians either know or are exposed to the derivatives market. As per the SEBI Annual Report 2021, the total turnover of the commodity derivatives market (all the exchanges taken together) is about Rs 92 lakh crore, and with awareness programmes, the numbers can be pushed higher, argues Garg.

In January, India's NSE surpassed the USA's CME Group Inc to become the world’s largest derivatives bourse by volume. NSE, citing data from the Futures Industry Association, said that it grew 58% to about 6 billion derivative contracts in 2019, surpassing CME’s 4.83 billion contracts.

Experts say trading in derivatives requires greater than common knowledge of finance. The wide variety of traders have not yet understood the full implications of buying and selling derivatives.

What are the risks involved?

Derivatives are generally riskier assets comparatively as they are more sensitive to the supply and demand dynamics and geopolitical happenings. Counterparty risk (the other party not fulfilling its part of the deal) and trade defaults are other elements that impact commodity derivatives.

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