How to Manage Risk and Price?

Risk Management and Price Discovery in Agribusinesses (incl. Food and Feed Industry)

 By:

 Vijay Sardana

Since ages we have conventional approached to price discover and risk management like spot price, auction, etc. In the emerging market and in new economic environment we have other financial instruments and mechanisms to discover the prices by market participants under a well-governed system of Futures Market.

Futures market is expected to help the market participants through two vital economic functions, viz., Price Discovery and Price Risk Management. At the macro level, the liquid and vibrant futures market having nationwide participation also assists in sobering down inter-seasonal and intra-seasonal price fluctuations. This not only helps in bringing about reasonable stability in the prices of commodities, but also supports farmers to get remunerative prices without adversely affecting interests of consumers. Such a market also provides a market-based alternative to government involvement like procurement at Minimum Support Price and Public Distribution System.

Price discovery made in spot markets – sometimes also called as cash markets - which are mostly fragmented over-the-counter markets, is inefficient because price discovery in spot market is affected by geographical dispersion, differential needs of the buyers and sellers in terms of quality, quantity, place of delivery and difficulties associated with handling physical delivery, absence of option to settle the contract by payment of price-difference. In any case, the spot market does not meet the need for price-forecast felt by participants in the physical markets.

With convergence of bids and offers emanating from a large number of buyers and sellers from different parts of the country – and possibly from abroad - futures trading is a very efficient means of forecasting the price for a commodity. Convergence of bids and offers in a single order book at electronic futures exchange is facilitated by the computer software.

In Futures Market, Price Risk Management is very closely related to Hedging, which means transfer of some or all of that risk to those who are willing to accept it, which are in turn called Speculators. Price risk is managed by taking opposite positions on the two legs of the market e.g. spot and futures. The futures prices are linked to the spot prices through carrying cost, which comprises cost of storage, interest, wastage, shrinkage etc. Therefore, the two prices tend to move in parity. Taking opposite positions in the two legs of the market therefore tends to offsets loss in any market on account of adverse price fluctuation. All the participants in the physical markets, like, producers, processors, manufacturers, importers, exporters and bulk consumers can focus on their core activities by covering their price-risk in futures market. Their operations become more competitive since the price-risk involved in procurements, supply is transferred to the futures market.

Trading Mechanism in Futures Market

Benefits of futures market, viz., price discovery and price risk management flow more easily from an Order-driven system rather than Quote-driven system. Commodity Futures Exchange follows the former system. Commodity Futures Exchange does not support any market maker. Traders submit orders and the incoming orders are matched against the existing orders in the order book. Transactions are cleared and settled through Commodity Futures Exchange in-house clearing and Settlement House, which is connected to all its Members and the Clearing Banks. Delivery of the underlying commodities is permitted only through an authorized Warehouse receipt, which meets predefined contemporary national or international quality standards. Anonymity of trading participants and effective risk management system strengthens the trust of the participants in the trading system, which is a precondition for enhancing breadth and depth of the market. 

Terminologies used in Commodity Futures Exchange Transactions

Trading hierarchy:

Trading rights on the Exchange can be acquired by Individuals, Registered Firms, Corporate bodies and Companies (as defined in the Companies Act 1956) by complying with the admission norms. Membership of the Exchange follows a hierarchy, and each level is characterized by a definitive role and incumbent privileges and obligations.

Trading Cum Clearing Member (TCM) is one who has the right to execute transactions in addition to a right to clear its transactions in contracts executed at Commodity Futures Exchange either on his own behalf or on behalf of other Trading Members

Trading Member/Broker (TM) is one who has the right to execute transactions in the trading system of the exchange and the right to have contracts in his own name. The TM can also deal on behalf of clients (Registered Non Members) or enlist Sub Brokers who may in turn have their own set of clients. TM must settle all his transactions (and those of Sub Brokers and Registered Non Member) through Clearing Members (Trading cum Clearing Members or Institutional Clearing Members).

Institutional Clearing Members (ICMs): are professional entities providing clearing services to their institutional clients (viz. Trading Members and their Sub Brokers & Registered Non Members). They however do not have the right to trade on their own account.

New ignore the Transaction Cost in any business decision.

In fact, participants trade in any market to make money. If transactions costs are high, there will be less incentive to trade. Notwithstanding the distinctive advantages Commodity Futures Exchange offers to its customers, they provide trading, clearing and settlement facilities at lowest possible cost.

Clearing & Settlement Mechanism and Risk Management

For efficient clearing & settlement of trades, Commodity Futures Exchanges have has an automated clearing and settlement system with Banks as their Clearing Banks.

The software automatically calculates Initial Margins using VAR (Value At Risk) and MTM (Mark to Market) margins on a daily basis. In the same way, members’ positions are also computed on a daily basis. The information regarding pay-ins and pay-outs arising in calculations of positions of members is transferred at the end of trading hours electronically, using flat files for the clearing banks and members.

Risk Management

The objective of Commodity Futures Exchange is to organize trading in such a way that possibility of defaults is almost eliminated. To achieve this, Commodity Futures Exchange adopts various means. They are as follows: -

Exposure Limits:

Exchange provides facility in the system enabling the Trading Cum Clearing Members (TCMs) to select the commodities in which the Trading Member/Broker (TM) can trade and also fix the trading limits for each TM. TCM can also monitor the position of TMs online.

Initial Margin:

The initial margin (IM) is levied on all open positions (Buy or sell positions) of the members and their clients. The IM percentage on each commodity varies depending upon its market volatility. The margin so calculated is reduced from the total margin of the member available with the exchange and accordingly further exposure is given on the balance amount.  As the IM increases, the exposure shall decrease.

Mark to Market (MTM) Margins:

MTM is a mechanism devised by the exchanges to prevent the possibility of the potential loss accumulating to the level where the participants might willingly or unwillingly commit default. All trades done on the exchange during the day and all open positions for the day are marked to closing price for the respective delivery/contract and notional gain or loss is worked out. Such loss/gain is debited/credited to respective member’s account at the end of each day. The outstanding position of the members is then carried forward the next day at the closing price.

Special Margins have primarily been introduced not as a risk management tool, but to act as a speed-breaker for sharply rising or falling price. It is applied when price reaches a particular level above/below the previous day’s closing price.

Delivery Margins are applicable to the contracting parties (both, buyer and seller) from the specified day of the contract maturity month.

Price Bands either Daily Cap or Life Time Cap: have been imposed on all commodities to prevent extreme volatility and unhealthy practices of cornering the market.

Final Settlement: On the expiry of the futures contracts, the settlement is by the way of delivery.  The delivery is at seller’s option between certain dates of the delivery month.  The pay-in/pay-out for delivery is by way of debit to the buyer and credit to the seller to the relevant Clearing Member’s clearing bank account on T+3 day (T=date of allocation of delivery). On specified date, if seller fails to tender delivery or fails to square-off his position then the highest price of the contract during its currency is taken for cash settlement in marking all undelivered outstanding position to final settlement price.  Resulting profit/loss settled in cash.  Final settlement loss/profit amount is debited/credited to the relevant Clearing Member’s clearing bank account on T+1 day. (T=expiry day).

On-Line Surveillance at Exchange includes the monitoring of prices, volume & volatility in various series and its analysis using various methods like real time graphs, queries, alerts etc.

Off-Line surveillance includes margining requirements, procedures in respect of exception handling, position monitoring, exposure limits, investigation techniques & disciplinary action procedures

Delivery Mechanism: One of the methods of settling the contracts is by taking or making delivery. Delivery period at every exchange is fixed for the delivery month. During this period Members of the exchange are not permitted to create any fresh position in the expiring contracts. They can either square up their position or take/give delivery to settle their outstanding contracts. Various steps required to be followed by the participants having outstanding position on settlement date of delivery month are as follows

Settlement Mechanism in Commodity Futures Exchange:

Steps to follow

1)    Sellers and buyers have to convey intention on or before settlement date of the delivery month

2)    The intentions are then matched and assigned by the Exchange with the corresponding buyers. As is the case universally, seller has freedom to tender delivery during the delivery period at any approved delivery centers. In other words, buyer cannot demand delivery at delivery center of his choice. When the seller gives intimation, a call is made to the corresponding buyer to whom the delivery is assigned by the Exchange. Delivery margin is collected from both the buyer and seller

3)    After matching the open positions of relevant buyer and seller, the same is transferred from the system and settled at the closing price of the preceding day, so that mark to market (MTM) is not levied or paid to the member

4)    Within three days from the position transfer, the buyer has to maintain the required funds in their clearing & settlement account while the seller has to tender the warehouse receipts to the exchange along with the computation of warehouse charges. On the 3rd day, the exchange makes pay-in & payout simultaneously after retaining the warehouse charges margin and sales tax margin from the buyer and seller respectively

5)    After the completion of pay-in and payout, duly endorsed warehouse receipts are sent to the buyer immediately

6)    Settlement of warehouse charges, margins and sales tax margins take place soon after receipt of relevant documents (copies of sales bill, sales tax form) from the member.

7)    Computer records all transactions and documentary evidence is always available for the clients to ensure transparency in transactions.

Caution:

Commodity Exchanges work on very well established rules and regulations. It is important for every participant to understand the rules and regulation about the futures exchanges. Any action without proper understanding of the commodity market and commodity Futures Exchanges may lead to losses. Many people blame the exchanges for the losses but the fact is it is their own ignorance or greed that was responsible for losses. My sincere advice to all the readers is please talk to the experts; understand the futures market before you participate. You can also write to author to know more about the Commodity Futures Exchanges and how you can take the benefit of future exchanges in management of your supply chain.

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