Hedging is described as business activity which allows a person to mitigate or reduce the risk of physical commodities by taking an opposite position in the derivatives market. A commodity exchange provides a platform whereby all commodity participants are able to hedge their underlying positions through a regulated and transparent mechanism. For the first time in over four decades, commodity exchanges NCDEX and MCX, set up in 2004, provided Indian entities to hedge in the domestic commodities market. Till then, only a few commodity participants used the RBI policy to hedge in international markets.

In the last 10 years, exchanges and regulators have tried their best to increase the hedging participation on the exchanges. However, restrictions on the position limit were one of the biggest problems faced by the market participants who wished to hedge their underlying positions. In certain commodities such as soyabean,where India’s production is over 10 million tonnes, the client-wise position limit was capped at 30,000 tonnes. Hence, traders, including the Government’s own agencies such as FCI, Nafed, PEC, etc were not able to participate in the local exchanges thereby reducing the volumes and open interest.

To cope with this situation, NCDEX launched its hedging policy in 2005 whereby a genuine hedger was able to create positions in excess of the client wise limit provided he/she was able to satisfy the following two criteria:

* Short hedge (or short side position in the futures market) required stocks in the warehouse.

* Long hedge (or long side position in the futures market) required export contracts where the price was fixed.

However, this definition excludes a lot of traders due to the complex nature of commodities. Hence, the new NCDEX risk policy is a bold and pragmatic step to increase market participation and address the long pending issues of the hedgers.

Differentiation factor

The main differentiation factor is the criteria for eligibility of a hedging participant. The new basis for granting of a hedge limit is as under: export obligation/anticipated sales; import obligation/anticipated purchases; domestic obligation; stocks held/anticipated; Past track record of production/processing capacity; past track record of purchase/sales; any other documentation that would establish validity for seeking hedge limits.

For the first time, an exchange in India has allowed hedging limits on the basis of the past performance. This is a new approach to commodities – albeit in use in FX markets for many years. Every agricultural commodity has a crop cycle/marketing cycle (for e.g. sugar marketing cycle is from October to September). At the start of the crop cycle (harvesting) it is not possible for a processor to accumulate enough physical material but he wants to lock prices in the futures market to insulate from further price rise for the remaining part of the year. Commodity futures contracts are up to 3-6 months and hence he can lock his/her purchase price right up to six months forward for an anticipated sale during that period of time. Alternatively, a producer can benefit from going short in the forward market on the basis of the anticipated cash purchases/stock that he will build over a period of time.

Cross commodity hedge

Another interesting factor in the new hedge policy is where the exchange provides and hence approve of different types of hedging requirement such as Cross Commodity Hedge whereby a soyameal exporter is able to get hedge limit using soyabean futures since soyameal is not actively traded in India. Realisation of soyameal from bean is approximately 80 per cent and hence to hedge an exposure of 32,000 tonnes of soyameal, the processor can actually take a hedge limit of 40,000 tonnes of soyabean.

In certain instances, the consumer of a commodity is exposed to another quality/form of the listed commodity but based on the correlation between these commodities is able to use the exchange platform for hedging. Hence different qualities of wheat or maize can be correlated with the exchange-listed commodities and adequate hedge limits can be obtained.

Upstream and downstream hedging of commodities is also permitted. Hence in most of the agricultural commodities, many participants in the commodities value chain who prepare value-added products can also avail of the hedging policy.

The guidelines regarding the process flow for obtaining and adhering to the hedge limit is well-documented and will be easier for companies to follow. The onus is still on the company to disclose proof and present valid documents to the broker and the exchange. However, the exchange has imposed strict action in case of false details or documents being presented to avail of the hedge limits. In any case, hedge limits are not applicable in the near month and thus will ease the concerns on concentration of positions.

If the experience of the currency markets is anything to go by, areas such as hedging limit based on past performance allows market participant to be more flexible in their pricing. Cash flows can be better managed and there is a genuine amount of risk reduction due to surety of pricing and no counter party defaults. However, like FX markets whereby large companies report their FX loss/gain as a separate balance sheet item, SEBI and FMC should also push commodity based companies to disclose their hedging programme and make the exercise more mainstream.

The writer is Head- Institutional Business, Geojit Comtrade Ltd. Views are personal.

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