The Hindu Business Line : Spelling stability and growth

Having looked into how `price discovery' happens how price risks can be managed with the help of commodity futures trading, let us see how the system benefits the economy, and society at large.

Broadly, the stakeholders in the commodity eco-system are primary producers (growers), processors or industrial users, consumers, traders, exporters, importers and, of course, the government. Input suppliers, trade intermediaries and service providers (logistics, finance) too benefit from the price signals generated by futures trading.

Stabilising influence

Futures trading helps stabilise prices, as information on spot and futures prices of commodities is available to almost everyone. Large-scale participation of hedgers (those with genuine underlying exposure to commodities) and speculators (those with no commercial interest) helps to moderate price fluctuation.

Because the futures market is transparent and has national reach, prices nationwide are largely integrated. Supply gaps are quickly identified and remedial action taken. Price signals help identify glut or shortage situations. This helps balance demand and supply, over time.

Importantly, futures trading fosters healthy competition. There are numerous participants and the sheer numbers prevent an individual or group from dominating or unduly influencing prices.

Futures prices are often seen as a barometer for farmers and traders. They expand the farmers' choice of raising crops and marketing; which crop to grow, when to market. For instance, based on futures prices, growers can decide to switch from one crop to another, subject to agro-climatic conditions, input availability, and so on.

Growers can also decide on the most appropriate or profitable time to sell the produce. This leads to better price realisation and improved farm profitability.

Wide application

An industrial consumer or processor can hedge his raw material and/or finished goods price risk by buying raw material in futures as well as selling his finished products in the futures market. Exporters and importers can strike overseas trade contracts for deliveries in forward months and insure themselves against adverse price movement.

There are crops or commodities whose production is seasonal but consumption is year-round. Also, there are commodities whose production is region-specific but consumption nationwide. Traders and stockists invariably carry risk of price changes in such commodities. Futures trading help smoothen the prices of seasonal commodities throughout the year.

For policymakers, the futures market provides valuable input for action, if any, by providing advance price signals about various commodities.

Since these price signals often reflect the combined expectation and mood of market participants, policymakers can initiate appropriate responses to emerging market conditions.

The futures market has players who can broadly be categorised as `hedgers' and `speculators'.

Hedgers are those with underlying interest in ready delivery or specific delivery forward contracts, and use futures trading to insure themselves against adverse price movement. In other words, hedgers are those who buy/sell physical goods, and hedge the price risk that arises in the process of dealing in physical goods.

Examples of hedgers: A sugar mill that produces and sells sugar; a chocolate manufacturer who buys sugar as raw material; an edible oil mill that buys oilseeds for crushing and sells the resultant oil; an edible oil refinery that buys raw oil for producing refined oil; a textile mill that buys cotton as raw material; a jeweller who buys gold to make and sell gold ornaments. When these entities go to a futures exchange to manage price risk, they are termed hedgers.

Speculators may not have an interest in ready contract, that is in taking or giving physical delivery of goods, but see an opportunity of price movement favourable to them.

They are usually players with in-depth knowledge of the market dynamics and are willing to bet on price movement. They provide a useful economic function by improving the liquidity and depth of the market.

Besides hedgers and speculators, there is a third category — `arbitrageurs'. The market provides various arbitrage possibilities. Cash-and-carry arbitrage; arbitrage between spot and futures; arbitrage in same commodity between two exchanges; and so on.

Please send suggestions and queries to younginvestor@thehindu.co.in, or The Research Bureau, The Hindu Business Line, 859-860, Anna Salai, Chennai-600002.