Commodity bourses get set for index futures

The move could impart greater liquidity and attract more participation

If you are a trader in the Indian stock markets, you would be spending more time trading the Bank Nifty and Nifty futures and options, than the time spent trading single-stock futures and options. Since index derivatives have higher volume, are less volatile with lower impact costs and are harder to manipulate, it is common to see many investors and traders turn to index derivatives.

The commodity market regulator, the Securities and Exchange Board of India’s decision to introduce trading based on commodity indices is therefore likely to change the trading pattern in commodity exchanges, imparting greater liquidity and attracting more participation.

The rules

The market regulator, SEBI, has laid down certain rules on the manner in which the constituents of the index futures shall be selected.

The indices on which derivatives are offered shall be made of single-commodity futures already traded on the exchanges. The SEBI guidelines require that the futures contracts that form part of the index futures be in existence on the respective exchange for at least the previous 12 months, the previous calendar year or the previous financial year. The contracts should be liquid with good trading volume and should have been traded for at least 90 per cent of trading days over the past year. The average daily turnover of the constituent futures contracts during the previous year should have been ₹75 crore for agricultural and agri-processed commodities and ₹500 crore for all other commodities.

The index constituents and their weightage need to be rebalanced semi-annually or annually. Reselection of constituents shall be done in case of any extraordinary event such as banning of trading in any contract. Maximum weightage for any index constituent in a composite index should be a maximum of 20 per cent and a minimum of 1 per cent.

Prospective index futures

SEBI has recommended that futures on commodity indices be launched first. Index options will probably follow after a year or so. So, what can investors expect? Which index futures are likely to be launched first?

Currently, NCDEX has one index — NKrishi (earlier known as DHAANYA). This is a reference index, which is not an investable/ tradable index.

But NCDEX is getting ready to launch commodity index futures. “The exchange has designed this futures on commodity index, a value-weighted index, computed on real time using the prices of the 10 commodity futures traded on the NCDEX platform,” says Kapil Dev, EVP-Business, NCDEX. A set of general eligibility criteria for inclusion of commodities in the index is based on the liquidity in the commodity futures contracts.

The Multi Commodity Exchange of India (MCX) currently has three indices — iCOMDEX Composite Index, iCOMDEX Base Metals Index and iCOMDEX Bullion Index. The exchange is likely to launch futures on all the three after a little bit of tweaking to meet SEBI deadlines.

The iCOMDEX Composite Index is made up of 11 commodities — crude oil, natural gas, aluminium, copper, lead, nickel, zinc, gold, silver, crude palm oil and cotton. Each commodity is selected primarily based on its liquidity and physical market size in India. This index has been in a structural downtrend since 2013, when global economy began slowing and crude and base metal prices began shrinking. While the one-year annualised performance of the index is -5.29 per cent, the three- and five-year returns are 1.22 and -7.97 per cent, respectively.

The iCOMDEX Base Metal Index includes five base metals futures listed on MCX — aluminium, copper, lead, nickel and zinc. This index can therefore serve as an indicator of the performance of the Indian industrial sector. This index has been rallying since the 2015 low, though there has been some decline since the beginning of 2019. This is reflected in its three-year annualised return of 7.08 per cent though the returns over one year is -6.93 per cent.

The iCOMDEX Bullion Index includes gold and silver commodities listed on MCX. Each precious metal is weighted two-thirds by its liquidity and one-third by its physical market size in India, determined by local production and imports; 67.5 per cent weight is given to gold and the rest to silver. The performance of this index has been lacklustre across time-frames, with a negative return of 3 per cent over one, five and five years.

Benefits

This move is expected to impart greater liquidity to exchanges. Arbitrage trades between the index and its constituents are also likely to help improve market liquidity overall. Hedgers who want to insure against price risk in a basket of commodities will now have an avenue to do so. Those who wish to place bets on a group of commodities, instead of single commodities that are prone to higher risk, are also likely to be happier once these instruments see the light of the day.

Institutional traders such as mutual funds and insurance companies are more likely to take exposure to commodity indices, where the risk is more dispersed, compared with single commodities, where the risk is concentrated and therefore higher. These indices can pave the way to commodity exchange-traded funds, that can be of greater use to retail investors and others.

“Futures and options contracts on the index can be used for hedging purposes by taking appropriate opposite positions in these contracts. Market participants will have an option that will allow them to mitigate their exposure to an adverse movement in their commodity portfolios,” Dev adds.

Published on August 04, 2019
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