Price discovery has often been defined as the process of arriving at a transaction price for a quality and quantity of a commodity at a particular time and place.

On the other hand, to protect margins one has to look at price drivers such as storage cost, transportation cost and natural quality deterioration. Even the usage of old or new gunny bags for packing commodities affects transactional margins.

These dynamic elements have significant impact on the margins of trade transactions.

Arbitrage rates

Some of the commodity futures contracts introduced during the last decade have “dream arbitrage” where storage rates are fixed and quality deterioration has been considered to be the responsibility of custodian of the physical goods.

On the practical side, the price of storing a physical commodity from one month to the next is freely set in the storage market. No doubt, price occurs at the intersection of supply and demand for storage services, which changes over time. As the demand for storage services rises, the price of physical storage also rises, all else remaining equal.

In contrast, the storage fees for deliverable commodities are set by futures exchanges.

Naturally, a section of the ecosystem participants take advantage of the lacuna and make profit out of this surreal situation.

Frequent tweaking of contract terms on the exchange have also resulted in participation and volumetric inconsistency from year to year.

For some of the deliverable futures contracts, prices no longer represent the expected cash market price.

Instead, it represents the price of the delivered commodities which has higher value than physical commodities because it incurs artificial storage fees without any natural shrinkage and topped with predetermined premium fixed by the exchanges.

Naturally, the market does not converge at the expiry.

Delivery structure

Non-convergence leads to welfare losses among less informed market participants, so futures exchanges and stakeholders have an interest in preventing such future episodes.

During most period of 2005-10, the price of expiring US corn, soyabeans and wheat futures contracts settled much higher than corresponding delivery market cash prices and are most likely to be repeated elsewhere if unintended results of the market delivery structures of traditional market are ignored.

We must appreciate the fact that in India (unlike CBOT/CME) we do not deal with deliverable instruments and shipping certificates. We first need to strengthen the delivery issue based on our own ecosystem.

The sooner some of these “dream arbitrages” are controlled and a move is made towards “normal arbitrage” contracts aligned to the reality of physical market, the faster agricultural futures markets will grow. This will also result in wider participation and deeper penetration.

The writer is a commodity commentator

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