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Risk management through introduction of futures contracts in tea An attempt at solving the heterogeneity problem.

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Presentation on theme: "Risk management through introduction of futures contracts in tea An attempt at solving the heterogeneity problem."— Presentation transcript:

1 Risk management through introduction of futures contracts in tea An attempt at solving the heterogeneity problem

2 What is a futures contract? Commodities are often contracted for delivery in the future at a fixed price. When this is done informally, the word forward contract is used to describe the transaction. However, when the transaction is organized and regulated by a recognized exchange, in a standard size and delivery period, with an implicit performance guarantee through the institution of a clearing house, the same is called a futures contract in the underlying asset.

3 Why the need for such transactions? The reason why such transactions are made is that the seller is a hedger and the buyer is a speculator, or, vice versa

4 Futures on intangible assets Observation of this fact resulted in the invention of index futures, and futures on other non deliverable assets, where actual delivery is not an option (pun intended!). Examples are S&P index futures where the stock index is the underlying asset, crude oil basket futures, where a specified basket of oil prices is the underlying asset etc.

5 What kind of assets lend themselves to futures trading? Since a futures contract is an insurance related transaction, it stands to reason that futures contracts on assets with zero or very low variability might neither be popular (high trading volume), nor effective ( a successful hedge). Conversely, futures contracts on highly variable underlying assets should be both popular and effective.

6 The different kinds of variability There are different kinds of variability in asset prices. This could be random non cyclical, random cyclical, intra year pattern cyclical, inter year pattern cyclical, or monotone trend.

7 Futures as a hedge vs futures as an instrument for speculation Agricultural commodity futures have been the means by which a limited number of traders stabilized future prices and enabled farmers to finance investments in future crop production. However, speculative purchases of index futures that have no purpose other than to make money for the speculator, who hold their contracts to drive up spot prices with the intention not of selling the commodities in the real market, but of unloading their holdings onto an artificially inflated market, at the expense of the ultimate consumer, may have a profoundly destabilizing effect on the spot market..

8 Examples of speculation in futures If speculation is the major cause rather than supply/demand factors for transactions in any commodity market, spot prices may shoot upin the short term, but would be expected to fall dramatically when the market corrects itself. As an example, assets allocated to commodity index trading strategies in the USA increased from $13 billion to $300 billion between 2003 and 2008 and the prices of the 25 underlying commodities increased 200% over the same period.

9 An idea of the size of speculation

10 The challenge of devising futures for tea The tea industry unlike commodities like coffee, cocoa, and rubber, or food crops like wheat or corn has no precedent anywhere in the world to drawn upon and hence the complexity of developing the framework for a tea futures exchange. In both the following suggested scenarios, due approval from the Forward Markets Commission of the respective country will have to be obtained.

11 Why tea futures would be useful Tea prices show both random and cyclical variability. Theoretically, trading futures in tea would be a useful hedging instrument available to producers to insure themselves against price risk. However, informal systems of entering into forward contracts with reputed buyers of bulk tea already exist in the Indian market and for futures contracts to be used popularly as a hedge, they would have to offer superior cover compared to the existing forward booking. For speculators, who would take the long position in these contracts, the depth and liquidity of the market would be a crucial determinant of their popularity.

12 The magnitude of the problem Since tea is heterogeneous both over season and region, and even intra region depending on the stock from which harvest was made and the periodicity of the harvest, it would be impossible to define a quality for delivery or even for squaring ones position. The key to establishing a set of successful futures contracts is to have standardized lots of a given quality that are easily available for delivery. Tea may not conform to this criterion and contracts may have to be tailor made for individual gardens. The multiplicity of contracts will confound the market and prevent secondary trading.

13 Option 1: A classic commodity futures initiative: Damodaran (March 2000), in a report to Tea Board India, had suggested a framework for developing commodity based futures contracts in tea, and had worked on segregating more than 50 grades on which such contracts could be traded. He came to the conclusion that such an initiative was indeed feasible since the spot market had sufficient volume, turnover and liquidity, was adequately regulated, operated under a few centralized umbrellas, and also had inbuilt quality regulation mechanisms in the shape of brokers being the unspoken referees.

14 Our suggestions if we go this route The aim of establishing the contract should not be to ensure a supply of a specific grade of tea on a certain date to the buyer of the contract, but rather to reduce his risk by providing a mechanism to offset his short position. To ensure liquidity, a limited number of well defined contracts should be offered on grades or baskets of grades which are sufficiently distinct from each other. The delivery months should be spread through the year but should skip those months where pronounced upward or down ward price variance for the particular basket/grade is known to occur.

15 Further suggestions and some reservations on option 1 The contract should be closed out either by actual delivery or by cash settlement. The goods supplied under the actual delivery option should be certified by an agency operating under the aegis of the futures market organizer, who could be the broker presently licensed by the auction organizer, who would have a dual role as the futures exchange. The clearing house could be the present auction settlement bank. The issues of variability of quality if actual delivery is taken, or the price of the category of tea if cash closing out is taken will remain as real hurdles to the smooth functioning of the system.

16 Option 2: Develop a financial future on tea: The other way would be to have an index based futures contract where the index could be an auction average price for a defined category of tea. The great advantage of this would be a total transparency of the asset price at closing, and absence of any disputes regarding quality issues.

17 Index selection The success of this futures market will depend critically on the selection of the correct index. We have a range of possible indices which are presently available and the desired qualities we require in our final choice of index are basically as follows: –Index has sufficient market depth, in other words, spot transaction volume –Index has sufficient random and non seasonal variability. Overall auction averages generally show lower variance, and may not be directly suitable –Perhaps, a medium Assam index could be devised from the auction prices of a defined set of estates

18 Index selection continued.. Intra year weekly average prices vary more for some categories of tea compared with others. To elaborate, higher priced teas have higher variance in weekly averages than the common teas. It also makes sense to have at least two index futures contracts on offer, since price behavior of South Indian teas differ from that of the North.

19 Characteristics of an ideal index More research is needed to determine which widely traded category has the maximum random variability. Our index can be then based upon this specific category of tea, and its weekly auction average at one of major North Indian auction centers could serve as the index for the proposed tea futures contract. This financial derivative, if not misused, would be a useful instrument for both hedgers with positions in the physical stock of tea as well as speculators with views that are contrary to those of the hedger.

20 Who would manage the futures market? In this scenario, the auction centers and associations may not be the ideal organizers of the futures exchange, having no experience in managing financial derivatives. In India, an established stock exchange like National Stock Exchange may be more suitable.

21 The risk While index futures designed as suggested would eliminate structural problems in devising a tea futures contract resulting from the heterogeneity of tea, there is some evidence that such commodity futures may act as a magnet for large speculative investment, which might result in medium term abnormal inflationary pressure on the spot commodity price, followed by a severe correction, in cases where the real demand for the concerned commodity is weak. Prompt continuous corrective action by the designated watchdog should take care of this aspect.

22 Recommendation A decision to permit trading in futures contracts based on a suitable transparent tea price index at an existing stock exchange may be taken by the concerned authorities. The selected exchange could be authorized to take all downstream decisions regarding the details of this contract. The popularity of the contract could guide the future course of action.

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