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Options and the Commodity Market

Kushankur Dey (kushankur@ximb.ac.in) teaches at the Xavier School of Rural Management, Xavier University, Bhubaneswa r. Debasish Maitra (debasishm@iimidr.ac.in) teaches at the Indian Institute of Management Indore.

The necessity of options in commodity markets in India has been discussed for a long time. It aids in improving market liquidity, information transmission, and acts as a risk transfer mechanism. However, given the nature of farm and non-farm commodity markets, fi nancial investors may be attracted more towards non-farm commodity options. This would eventually lead to illiquidity in farm commodities. The regulator and exchanges should therefore work in unison to launch options in a prudent manner, especially in farm commodities, to benefi t the concerned stakeholders, including producer groups and processors.

The authors have benefi ted from the working paper “Options: A Critical Missing Link in India’s Commodity Market,” Multi Commodity Exchange of India, 2014.

The Ministry of Finance allowed options trading in commodities in 2015–16. The Securities and Exchange Board of India (SEBI), the new regulator of commodity derivative markets, has recently approved, in principle, options trading in commodities. The approval came after a few rounds of discussion between the Commodity Derivatives Advisory Committee (CDAC) and the regulator (Sahgal 2016). Now, with this risk management instrument, will the breadth and depth of commodity derivative market increase and would this factor in the efficiency of price risk transfer mechanism?

To address this, serious work in product development and market regulation with reference to amendments to the relevant by-laws and rules needs to be accomplished in a stipulated period. How the regulator, SEBI, and exchanges would go about this can generate considerable attention and debate in academic and policy circles. The regulator has released the framework related to settlement and delivery in June 2017. Drawing a critical perspective from the mechanics of options market, we aim to discuss some of them in this article.

Rationale

The need for options has been felt on some occasions (Sen 2005). Options trading impacts information transmission and aids in improving market liquidity and complementing existing product such as futures (Camerer 1982; Chan and Lien 2002; Dey 2015).

It is noteworthy to mention that China followed a “rectification” approach by “right-sizing” the number of commodity exchanges in the early 2000s (three from more than 40 exchanges that existed in the 1990s), and allowed options trading in commodities in 2012. This happened when Dalian Commodity Exchange introduced a mock trading of options in agricultural futures that signalled the introduction of options trading. In India, a similar intent was expressed by the Parliamentary Standing Committee of the Ministry of Consumer Affairs, Food and Public Distribution in late 2011 (MCX 2014).

A few developing countries like Brazil, Argentina, and South Africa experienced the functioning of options market in commodities after the United States (US) first introduced options contract on the Chicago Board of Trade in agricultural products in 1982. In Brazil, BM&FBOVESPA launched gold options trading in 1986 followed by options in coffee and live cattle in the early 1990s. Argentina through Mercado a Término de Buenos Aires and Rosario Futures Exchange introduced options in wheat and corn in the 1990s, while South Africa allowed options in a phased manner, for example, floated in wheat in 1997, followed by yellow maize in 1998, sunflower seeds in 1999, and so on (MCX 2014). However, the “tulip mania” that occurred in the Netherlands in the 17th century had put a stigma on options trading.

Options Microstructure

An option gives a right to the buyer (option holder), while the seller (option writer) has an obligation to exercise the contract on or before the time of expiry or maturity of the contract. An option, unlike a futures contract, delimits the risks but provides unlimited gain or loss to the buyer or options holder. For an options seller or writer, maximum profit is limited to the premium the seller receives from the buyer; potential losses are also limited. In the case of long call option (a right to buy), there is a possibility of unlimited gain to the option holder, and in the case of short call option, unlimited losses to the writer. In the case of put option (a right to sell), the potential gain or loss can be delimited with the strike price movement. The option pays a premium while the seller receives that premium by writing the contract. In contrast, a futures contract can expose the buyer or seller to unlimited gain and unlimited loss but in a linear fashion. Options give more flexibility than other derivative products in terms of position closing—offsetting, exercising, expiration, and the nature of product. Pure insurance product is associated with a secondary market and free from any counter-party risk.

Options can outweigh a futures contract from the tax imposition viewpoint as well. For example, a commodity transaction tax (CTT) at 0.01% is levied on the futures contracts of non-agricultural com­modities. After its imposition in 2013–14, the trading volume has declined by 45% due to an increase of 300% trading costs for the proprietary traders or exchange members (Chopra 2015). However, the outlay due to the imposition of CTT on options can be negligible that may not factor in as a liquidity barrier.

To make the options market liquid and effective to hedging, microstructure plays an important role. In other words, a liquid microstructure aids in reliable price discovery, broad-based price dissemination and effective hedging against price (basis) risks. Microstructure refers to a process by which an investor’s desire and expectation gets translated into financial transaction. To create a robust microstructure, certain issues related to option mechanics need to be addressed.

First, options pricing relating to the (call and put) premium estimation in commodities comes to the fore. What methodology is to be used to derive this? Will it follow the standard Black–Scholes–Merton model that has been heavily adopted in financial asset pricing? Would this be appropriate for options pricing in commodities?

Second, position limit, margining system, and trading cycle should call for serious engagement through arithmetic exercises and decisions within the purview of the regulation that may not be like that of futures or over-the-counter derivative products. Mark-to-market rela­ted to daily settlement, however, may not be pertinent to options trading unlike that of futures contract. Regulator and exchanges need to work out how the exercise or strike price will be determined and in what manner the spot prices will be polled. Is the newly promoted electronic National Agriculture Market ready to facilitate spot price pooling? What criteria commodity bourses follow to fix the opening strike price for options contract? Which commodity classes are to be chosen for different options styles: European, American, and Bermudan?

It is interesting to note that CDAC in June 2016 expressed that the European style would be approved for options contract culminating in physical delivery. The former style options can be exercised upon the maturity or settled in cash at the time of expiry that is followed in the index-stock options traded in India, for example, in National Stock Exchange of India (NSE). American-style options can be exercised on or before the maturity that is followed in the single-stock options. These are in vogue in developed markets, for example, in Chicago Mercantile Exchange, US.

Bermudan options, a synthetic option having the characteristics of American and European, can be exercised on or before the expiry. CDAC has opined that commodity options will be based on futures contract as unlike in the equity market that lacks a cash segment (Sahgal 2016). There is a high possibility that the final settlement of options contract would follow the final settlement price of the futures contract that is mostly based on either the simple average of pooled spot price at the delivery centre called due date rate. In the case of daily settlement, weighted average futures price is taken as closing futures price. The regulator has resolved the issues of settlement through amendments to the Securities Contracts (Regulation) (Stock Exchanges and Clearing Corporations) Regulations, 2012 and Securities Contracts (Regulation) Act, 1956.

CDAC and market experts are in favour of the pilot-like launch of options permitting in one or two each in the agricultural (for example, mustard seed, refined soy oil, guar) and the non-agricultural (for example, gold, silver, zinc, copper, and crude oil) segment. For the non-farm segment, the average daily turnover should be around ₹1,000 crore whereas in farm segment, the turnover is to be pegged at ₹200 crore (Sahgal 2016). Top five commodities in daily turnover in the concerned exchange are subject to the inclusion for options trading. It is understood that all the commodities suggested meet the criteria for inclusion in options trading. Multi Commodity Exchange of India (MCX) and National Commodity and Derivatives Exchange (NCDEX) would facilitate options trading in non-farm and farm segments, respectively.

We need to bear in mind that commodity exchanges are yet to experience a liquid- and broad-based futures market, while stock exchanges have illustrious capacity and acquired expertise in the new product development. A critical view is important while suggesting the eligibility criteria (product and participants) for introducing options in commodities. For instance, India has no crude oil spot market, and often, crude contracts are cash-settled that vitiates the mechanism for efficient spot and futures price discovery and adequate risk management. Similarly, a handful of commodities are actively traded on the national commodity exchanges, especially in the farm segment, and speculators appear to have played “spoilsport” in the agricultural futures market (Sahadevan 2014). Further, commercial users/producer groups who might prefer to devise a protective strategy to ward off their anticipated price risks should be cautious before they make a sizeable ­position (call/put) in option trade.

The estimation of sensitivity of options price to the spot price, storage costs, interest rates (lending and borrowing), and spot price movement, among others, entails an underlying robust option market microstructure. Unlike stocks, commodities, especially, agricultural are not available in “paper” form. These are not standardised and their spot markets are yet to be organised and efficient in price discovery. Furthermore, storage costs are variable, subject to agents’ incentive to holding the commodities in a period of scarcity; charges are not uniform, and service providers or assayers are diverse in character and service profile.

Executing Options Trade

Many interactive sessions need to be conducted with the market participants to get a comprehensive view of commo­dity derivative markets. These would include trading volume, liquidity, share of different class of commodities in the trade, the magnitude of partici­pation in futures contracts and feasibi­lity of the new product launch or possibility of coexistence of the new and existing product.

As the stock market is not akin to commodity market, one need not be biased when designing options contract specifications and surveillance measures. Nonetheless, illustrations on this can be extracted from the national stock exchanges that have experienced the promise and pitfalls of options trading on the bourses.

Participants, including commercial users (processors, exporters, importers, growers), can be empowered to share their views on the feasibility of options in commodities. Users or farmer organisations hold that cooperative and farmer companies’ participation can make the options trading more nuanced and enhance the scope for options on futures with multiple delivery grades (Lien and Wong 2002). However, as farmer participation in futures remains a utopian proposition so far, without adequate institutional support, their participation even in options would remain infeasible. In other words, whether options in farm segment would be a “game changer” for farmers remains a questionable claim.

In contrast, options can benefit small and medium enterprises, and the national government. For example, Malawi government utilised options contract for mitigating the country’s food crisis. The government, in 2005, entered a contract with the Standard Bank of South Africa through erstwhile South African Futures Exchange to procure about 60,000 tonnes of white maize at a cost of around $18 million (UNCTAD 2009). Similarly, the coffee cooperative, FEDECOOP in Costa Rica, helped plantation growers hedge their risks through millers by entering put options to manage producers’ downside risks (Varangis et al 2002). Many oil exporting countries such as Mexico, Angola, Oman, and Nigeria use options to mitigate the skewed price movement in international oil markets (for details, see MCX 2014).

Food Corporation of India (FCI) and state procurement agencies can use call options to hedge their risks against price uncertainty of procured stocks from farmers under the price support scheme. FCI can also utilise call options to guard against price fluctuations of agro-commodities such as wheat and maize. Farmer organisations can use put options in delimiting their potential loss by paying options premium. If the market price goes below the minimum support price (MSP), they can sell their commodities to public procurement agencies at the MSP. In that case, loss from options trading will be equivalent to the option premium paid alone.

Trading firms are actively engaged in commodity buying and selling. In this activity, they take a stock of their exposure or aim to mitigate downside risks. Options contract can thus appeal to them as there is flexibility embedded in exercising options and insurance against abnormal losses. However, they should not corner off the market to meet up their risk appetite. Similarly, domestic institutions like mutual funds participation in options may be allowed in the non-farm segment.

Exchange views can be put on priority as they facilitate trading in association with associated market infrastructure institutions engaged in settlement and delivery. The regulator can draw some operational guidelines and adopt best practices from transnational exchanges that are successfully running the exchange operation in options segment, and have demonstrated the potential benefit of options in price risk management (Dana et al 2006). Some of them include the Chicago Mercantile Exchange Group in the US (energy and agriculture), London Metal Exchange in United Kingdom (metals), Chicago Board of Trade in the US (agriculture), South African Futures Exchange in South Africa (agriculture), Taiwan Futures Exchange in Taiwan, and Tokyo Commodity Exchange in Japan (metals), among others.

Optimism with Caution

In 2011–12, commodity exchanges witnessed a boom, trading volume reached about ₹181 lakh crore with an annualised growth rate of 54%. However, following this splendid performance in the trade, the trading volume has decreased sharply and exchange-traded derivative market might have lost its sheen. The reasons for this can be many, but the imposition of CTT in non-agricultural segment, spot exchange crisis, and management issues of the national-level exchange are seen to have downgraded the market sentiment in general (Lingareddy 2015).

In 2014–15, the traded volume of futures contracts further declined to ₹61.7 lakh crore and in 2015–16, this improved marginally and stood at ₹67 lakh crore. Agricultural commodity product-wise share has also declined significantly, for example, castor seed and chana futures have been suspended over the past year “due to rampant speculation and cornering of stocks by speculators to boost prices artificially” (Iyengar 2016). The aggregate turnover of agricultural commodities across the three exchanges—National Multi Commodity Exchange, NCDEX and MCX—stood at ₹77,696 crore while that of non-agricultural commodities was ₹5.73 lakh crore as reported in June 2016 (Laskar 2016).

It is interesting to note that options trade accounts for 75% of NSE’s total derivative turnover of ₹404 lakh crore in 2016–17. Average daily turnover of equity derivatives on the NSE has been ₹3.31 lakh crore against just ₹25,000 crore–₹30,000 crore for the three national exchanges in commodities considered. While institutional investors have been allowed in the financial derivative market, commodity derivative market has not witnessed that sort of participation so far. SEBI may allow domestic institutions like mutual funds in commodity options to push up the market liquidity (Sahgal 2016). Thus, the scope of institutional participation may remain limited to the non-agricultural segment. In other words, options in the selected agricultural commodities need to attract agro-based firms and farmer companies if the market turns out to be liquid.

Futures traded volume on the commodity exchanges indicates that the non-farm segment outperforms the farm segment in terms of lot or contract size that results in enhanced liquidity in the former segment (SEBI 2016). The provision of cash settlement and more diverse nature of participation in non-agricultural segment have led to the volume unlike that of in the agricultural segment (Lingareddy 2015). Therefore, options in non-agro products may be attractive to the financial investor, while agro products may not generate that much of interest to either the exchange member or client.

So, is this an opportune time to launch options in both non-agro and agro commodities? Are market participants, especially members and investors, ready to support this move? Have the regulator, demutualised exchanges, and clearing houses enough bandwidth, knowledge, and capacity to oversee this new product development? If not, mature stock exchanges may facilitate options trading in selective commodities. They have been illustrious in facilitating the trade as evident from the above discussion. However, any wrong move or counter-productive decision on the type of product and options style being permitted can have serious repercussions on the commodity market in general: if actual users are sidelined or not encouraged to hedge their risks, options market may be left to the whims and fancies of speculators who, through sophisticated trading modalities, could make the market more volatile and less useful to the ones who need it. The regulator’s purpose may not be achieved then. Whether options in commodities would make the market more nuanced needs a clinical diagnosis of the commodity market rather than a populist move to bring about any reform in the commodity market.

References

Camerer, C (1982): “The Pricing and Social Value of Commodity Options,” Financial Analysts Journal, Vol 38, No 1, pp 62–66.

Chan, L H and D Lien (2002): “Are Options Redundant? Further Evidence from Currency Futures Markets,” International Review of Financial Analysis, Vol 15, No 2, pp 179–88.

Chopra A (2015): “MCX 2.0: Renewed,” https://www.mcxindia.com/docs/default-source/investor-relations/analyst-coverage/mcx_initiating_coverage_mosl.pdf?sfvrsn=2.

Dana, J, C L Gilbert and E Shim (2006): “Hedging Grain Price Risk in the SADC: Case Studies of Malawi and Zambia,” Food Policy, Vol 31, No 4, pp 357–71.

Dey, K (2015): “Can Options Trading Gain Ground in Commodities,” Business Line, 23 February.

Iyengar, S P (2016): “Where SEBI Needs to Tread Cautiously,” Business Line, 28 September.

Laskar, A (2016): “SEBI Allows Options Trading in Commodities,” Mint, 29 September.

Lien, D and K P Wong (2002): “Delivery Risks and Hedging Role of Options,” Journal of Futures Markets, Vol 22, No 4, pp 339–54.

Lingareddy, T (2015): “Commodity Futures Trading at the Crossroads,” Economic & Political Weekly, Vol 50, No 24, pp 113–16.

MCX (2014): “Options: A Critical Missing Link in India’s Commodity Market,” Occasional paper 5/2014, Multi Commodity Exchange of India.

Sahadevan, K G (2014): “Economic Benefits of Futures: Do Speculators Play Spoilsport in Agricultural Commodity Markets,” Economic & Political Weekly, Vol 49, No 52, pp 45–53.

Sahgal, R (2016): “SEBI May Allow Trade in Commodity Options Soon,” Economic Times, 23 June.

— (2017): “What Is Options Trading in Commodity Futures,” Economic Times, 31 July.

SEBI (2016): “Commodity Derivatives Market,” Annual Report (2015–16), Securities and Exchange Board of India.

Sen, S (2005): “The Exchange-traded Options and the Minimum Support Price,” Financing Agriculture, Vol 37, No 4.

UNCTAD (2009): “Development Impacts of Commodity Exchanges in Emerging Markets,” United Nations Conference on Trade and Development.

Varangis, P, D Larson and J Anderson (2002): “Agricultural Markets and Risks: Management of the Latter, Not the Former,” Policy Research Working Paper No 2793, World Bank.

Updated On : 12th Oct, 2017

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