CONTEMPORARY CONCERNS STUDY
COMPARATIVE STUDY OF OPTION PRICING MODELS
FOR COMMODITIES
SUBMITTED
TO
PROF. DAMODARAN A
ON
AUGUST 29TH, 2006
BY
SANDEEP M THARIAN(0511255)
VIJAY JACOB (0511268)
PGP 2005 - 07
INDIAN INSTITUTE OF MANAGEMENT, BANGALORE
Acknowledgements
We, Sandeep Tharian and Vijay Jacob wish to extend our gratitude to Professor Damodaran for
giving us an opportunity to undertake a Contemporary Concerns Study on Comparative Study of
Option Pricing Models for Commodities and providing constant support throughout.
We also wish to thank Mr. RadhaKrishnan, Head of Research at the Indian Coffee Board,
Bangalore for giving us an insight into the option markets in coffee and providing us with
sufficient data to support our study
We would be failing in our duty if we did not extend our gratitude to Dr. Prashob of ICFAI
Business School, Bangalore for helping us with the outline of the study and providing us useful
information about the econometric analysis.
2
TABLE OF CONTENTS
ACKNOWLEDGEMNETS
ABSTRACT
INTRODUCTION TO DERIVATIVES MARKET .................................................................................. 5
COMMODITY MARKETS IN INDIA – A BRIEF ................................................................................... 7
THE NEED FOR A COMMODITY MARKET IN INDIA ........................................................................ 8
PROBLEMS FACED BY THE INDIAN COMMODITY MARKET ........................................................ 9
COFFEE AND PLATINUM – AN OUTLINE ....................................................................................... 12
FUNDAMENTALS OF COFFEE HISTORY .......................................................................................... 12
FACTORS AFFECTING THE PRICING OF COFFEE........................................................................... 12
FUNDAMENTALS OF PLATINUM HISTORY ..................................................................................... 14
COFFEE AND PLATINUM – THE DERIVATIVES MARKET .......................................................... 17
PROBLEMS FACED BY THE COFFEE AND PLATINUM COMMODITY DERIVATIVE MARKETS IN
INDIA ...................................................................................................................................................... 18
PRICE SUPPORT POLICY IN INDIA – A STUDY AND REFORMS ................................................... 21
FMC – CAN IT BE CARRIED OUT?....................................................................................................... 24
COFFEE AND PLATINUM – ARE THEY EFFICIENT MARKETS? ................................................ 26
ECONOMETRIC THEORY............................................................................................................................ 26
Stationary Series.................................................................................................................................. 26
The Augmented Dickey-Fuller (ADF) Test .......................................................................................... 27
Cointegration Testing .......................................................................................................................... 27
METHODOLOGY........................................................................................................................................ 28
FINDINGS .................................................................................................................................................. 29
COFFEE AND PLATINUM – A DICHOTOMY OF OPTIONS.......................................................... 31
COMPARISON OF COFFEE AND PLATINUM ................................................................................... 32
APPENDIX .................................................................................................................................................. 32
3
Abstract
This paper essentially deals with the study of the developing commodity markets in India. We
have aimed to give the reader a useful insight through the development of the commodity markets
and compare two commodities namely coffee and platinum. The reasons we chose coffee and
platinum are (1) Coffee, a high value life-cycle product could well be compared with platinum, a
high-value life-cycle independent product with respect to derivatives (2) Coffee and platinum
markets are well developed world over
The first section of the paper deals with an introduction to the derivative instruments. It is
followed by a section on the history of the Indian commodity market where in the need for a
commodity market in India is discussed along with the problems faced by the Indian market
currently. The history and trading practices, such as price factors of both platinum and coffee are
discussed thereafter. The derivatives market in coffee and platinum are discussed. In this section,
the factors that make an efficient derivative market is elaborated and contrasted with the Indian
market. This section also deals with the price support policy and the problems with the regulatory
authority, FMC.
The econometric analysis of the coffee and platinum data is explained in the next section which
also explains the theory behind the analysis. The ADF test and cointegration testing mechanism
are utilized for the data analysis and the findings are reported thereafter. The last section compiles
all the findings and forms the conclusion. The coffee market is highly volatile due to its
dependency on its life-cycle and the relaxation of the regulatory authority alone wouldn’t deliver
an efficient market. On the other hand, platinum markets are less volatile and can be exactly
modeled maybe. The regulatory body has to be first concerned about these issues rather than the
high premiums charged on the option. Also, government support is essential for the initial
deployment of the options market.
4
CHAPTER 1
INTRODUCTION TO DERIVATIVES MARKET
A derivative is a generic term for specific types of investments from which payoffs over time are
derived from the performance of assets (such as commodities, shares or bonds), interest rates,
exchange rates, or indices (such as a stock market index, consumer price index (CPI) or an index
of weather conditions). Both the amount and the timing of the payoffs can be determined by this
performance. The diverse range of potential underlying assets and payoff alternatives leads to a
huge range of derivatives contracts available to be traded in the market. The main types of
derivatives are futures, forwards, options and swaps1.
Futures: In finance, a futures contract is a standardized contract, traded on a futures exchange, to
buy or sell a certain underlying instrument at a certain date in the future, at a pre-set price. The
future date is called the delivery date or final settlement date. The pre-set price is called the futures
price. The price of the underlying asset on the delivery date is called the settlement price. The
futures price, normally, converges towards the settlement price on the delivery date. A futures
contract gives the holder the right and the obligation to buy or sell, which differs from an options
contract, which gives the buyer the right, but not the obligation, and the option writer (seller) the
obligation, but not the right. In other words, the owner of an options contract can exercise (to buy
or sell) on or prior to the pre-determined settlement/expiration date. Both parties of a "futures
contract" must exercise the contract (buy or sell) on the settlement date. To exit the commitment,
the holder of a futures position has to sell his long position or buy back his short position,
effectively closing out the futures position and its contract obligations. Futures contracts, or
simply futures, are exchange traded derivatives. The exchange acts as counterparty on all contracts,
sets margin requirements, etc.
Forwards: A forward contract is an agreement between two parties to buy or sell an asset (which
can be of any kind) at a pre-agreed future point in time. Therefore, the trade date and delivery date
are separated. It is used to control and hedge risk, for example currency exposure risk (e.g.
forward contracts on USD or EUR) or commodity prices (e.g. forward contracts on oil). Allaz and
1
http://en.wikipedia.org/wiki/....
5
Vila (1993) suggest that there is also a strategic reason (in an imperfect competitive environment)
for the existence of forward trading, that is, forward trading can be used even in a world without
uncertainty. This is due to firms having Stackelberg incentives to anticipate its production through
forward contracts. One party agrees to buy, the other to sell, for a forward price agreed in
advance. In a forward transaction, no actual cash changes hands. If the transaction is collaterised,
exchange of margin will take place according to a pre-agreed rule or schedule. Otherwise no asset
of any kind actually changes hands, until the maturity of the contract. The forward price of such a
contract is commonly contrasted with the spot price, which is the price at which the asset changes
hands (on the spot date, usually next business day). The difference between the spot and the
forward price is the forward premium or forward discount. A standardized forward contract that
is traded on an exchange is called a futures contract.
Options: In finance, an option is a contract whereby one party (the holder or buyer) has the right
but not the obligation to exercise a feature of the contract (the option) on or before a future date
(the exercise date or expiry). The other party (the writer or seller) has the obligation to honor the
specified feature of the contract. Since the option gives the buyer a right and the seller an
obligation, the buyer has received something of value. The amount the buyer pays the seller for
the option is called the option premium. Most often the term "option" refers to a type of
derivative which gives the holder of the option the right but not the obligation to purchase (a "call
option") or sell (a "put option") a specified amount of a security within a specified time span.
(Specific features of options on securities differ by the type of the underlying instrument
involved.)
Swaps: In finance, a swap is a derivative, where two counterparties exchange one stream of cash
flows against another stream. These streams are called the legs of the swap. The cash flows are
calculated over a notional principal amount. Swaps are often used to hedge certain risks, for
instance interest rate risk. Another use is speculation.
6
CHAPTER 2
COMMODITY MARKETS IN INDIA – A BRIEF2
Commodity derivatives in India have had a highly chequered history. Though the fact remains that
the derivative markets have survived the prohibition inflicted from time to time, thanks largely to
the gray markets, the participants have not yet been able to shrug off the scare of the markets
being banned any time in future. Owing to the above, these markets have not developed as much
as the markets in developed countries or even the securities market in our own country. Emerging
from such a suffocating environment, these Exchanges are in a constant battle to breathe in a free
and liberal regulatory and policy environment.
Commodity Derivative markets had its first stint in India in Cotton in 1875 and in oilseeds in 1900
at Bombay. This was followed by forward trading in raw jute and jute goods at Calcutta in 1912.
Meanwhile forward Markets in Wheat had been functioning at Hapur in 1913 and in Bullion at
Bombay since 1920. In 1919, Bombay Contract Control (War Provision) Act was passed by the
Government of Bombay and the Cotton Contracts Board was set up. The Government of
Bombay issued an Ordinance in September 1939 with a view to restricting speculative activity in
cotton market by prohibiting option business. Bombay Options in Cotton Prohibition Act, 1939,
later replaced the Ordinance. For the purpose of prohibiting forward trading in some commodities
and regulating similar trading on an all India basis, in 1943, the Defence of India Act was utilized
on large scale. This was followed by the prohibition order on oilseeds forward contract. Similarly
forward trading was banned by order in food-grains, spices, vegetable oils, sugar and cloth. These
orders were retained with necessary modifications in the Essential Supplies Temporary Powers
Act 1946, after the lapse of the Defence of India Act. It was feared that derivatives would spur
unnecessary speculation and prove detrimental to the healthy functioning of the markets for the
underlying commodities. As a result, after independence, commodity options trading and cash
settlement of commodity futures were banned in 1952. A further blow came in 1960s when,
following several years of severe draughts that forced many farmers to default on forward
2
http://www.nmce.com/publication/dsk.jsp
7
contracts (and even caused some suicides), forward trading was banned in many commodities
considered primary or essential. 3
Consequently, the commodities derivative markets was dismantled and remained dormant for
about four decades until the new millennium when the Government, in a complete change in
policy, started actively encouraging the commodity derivatives market. Since 2002, the
commodities futures market in India has experienced an unprecedented boom in terms of the
number of modern exchanges, number of commodities allowed for derivatives trading as well as
the value of futures trading in commodities, which might cross the $ 1 Trillion mark in 2006.
However, there are several impediments to be overcome and issues to be decided for sustainable
development of the market.
THE NEED FOR A COMMODITY MARKET IN INDIA
India is among the top-5 producers of most commodities, in addition to being a major consumer
of bullion and energy products. Agriculture contributes about 22% to the GDP of the Indian
economy. It employees around 57% of the labor force on a total of 163 million hectares of land.
Agriculture sector is an important factor in achieving a GDP growth of 8-10%. All these are
indicative of the fact that India can be promoted as a major center for trading of commodity
derivatives. It is unfortunate that the policies of FMC during the most of 1950s to 1980s
suppressed the very markets it was supposed to encourage and nurture to grow with times. It was
a mistake other emerging economies of the world would want to avoid. However, it is not in India
alone that derivatives were suspected of creating too much speculation that would be to the
detriment of the healthy growth of the markets and the farmers. Such suspicions might normally
arise due to a misunderstanding of the characteristics and role of derivative product.
It is important to understand why commodity derivatives are required and the role they can play in
risk management. It is common knowledge that prices of commodities, metals, shares and
currencies fluctuate over time. The possibility of adverse price changes in future creates risk for
businesses. Derivatives are used to reduce or eliminate price risk arising from unforeseen price
changes. A derivative is a financial contract whose price depends on, or is derived from, the price
of another asset.
3
http://www.eurojournals.com/IRJFE%202%2011%20Ahuja.pdf
8
Two important derivatives are futures and options.
(i) Commodity Futures Contracts: A futures contract is an agreement for buying or selling a
commodity for a predetermined delivery price at a specific future time. Futures are standardized
contracts that are traded on organized futures exchanges that ensure performance of the contracts
and thus remove the default risk. The commodity futures have existed since the Chicago Board of
Trade (CBOT, www.cbot.com) was established in 1848 to bring farmers and merchants together.
The major function of futures markets is to transfer price risk from hedgers to speculators. For
example, suppose a farmer is expecting his crop of wheat to be ready in two months time, but is
worried that the price of wheat may decline in this period. In order to minimize his risk, he can
enter into a futures contract to sell his crop in two months’ time at a price determined now. This
way he is able to hedge his risk arising from a possible adverse change in the price of his
commodity.
(ii) Commodity Options contracts: Like futures, options are also financial instruments used for
hedging and speculation. The commodity option holder has the right, but not the obligation, to
buy (or sell) a specific quantity of a commodity at a specified price on or before a specified date.
Option contracts involve two parties – the seller of the option writes the option in favour of the
buyer (holder) who pays a certain premium to the seller as a price for the option. There are two
types of commodity options: a ‘call’ option gives the holder a right to buy a commodity at an
agreed price, while a ‘put’ option gives the holder a right to sell a commodity at an agreed price on
or before a specified date (called expiry date).
PROBLEMS FACED BY THE INDIAN COMMODITY MARKET
Even though the commodity derivatives market has made good progress in the last few years, the
real issues facing the future of the market have not been resolved. Agreed, the number of
commodities allowed for derivative trading have increased, the volume and the value of business
has zoomed, but the objectives of setting up commodity derivative exchanges may not be achieved
and the growth rates witnessed may not be sustainable unless these real issues are sorted out as
soon as possible. Some of the main unresolved issues are discussed below.
a. Commodity Options: Trading in commodity options contracts has been banned since 1952.
The market for commodity derivatives cannot be called complete without the presence of this
9
important derivative. Both futures and options are necessary for the healthy growth of the market.
While futures contracts help a participant (say a farmer) to hedge against downside price
movements, it does not allow him to reap the benefits of an increase in prices. No doubt there is
an immediate need to bring about the necessary legal and regulatory changes to introduce
commodity options trading in the country. The matter is said to be under the active consideration
of the Government and the options trading may be introduced in the near future.
b. The Warehousing and Standardization: For commodity derivatives market to work
efficiently, it is necessary to have a sophisticated, cost-effective, reliable and convenient
warehousing system in the country. Further, independent labs or quality testing centers should be
set up in each region to certify the quality, grade and quantity of commodities so that they are
appropriately standardized and there are no shocks waiting for the ultimate buyer who takes the
physical delivery. Warehouses also need to be conveniently located. Central Warehousing
Corporation of India (CWC: www.fieo.com) is operating 500 Warehouses across the country with
a storage capacity of 10.4 million tonnes. This is obviously not adequate for a vast country. To
resolve the problem, a Gramin Bhandaran Yojana (Rural Warehousing Plan) has been introduced
to construct new and expand the existing rural godowns. Large scale privatization of state
warehouses is also being examined.
c. Cash Versus Physical Settlement: It is probably due to the inefficiencies in the present
warehousing system that only about 1% to 5% of the total commodity derivatives trade in the
country are settled in physical delivery. Therefore the warehousing problem obviously has to be
handled on a war footing, as a good delivery system is the backbone of any commodity trade. A
particularly difficult problem in cash settlement of commodity derivative contracts is that at
present, under the Forward Contracts (Regulation) Act 1952, cash settlement of outstanding
contracts at maturity is not allowed. In other words, all outstanding contracts at maturity should
be settled in physical delivery. To avoid this, participants square off their positions before
maturity. So, in practice, most contracts are settled in cash but before maturity. There is a need to
modify the law to bring it closer to the widespread practice and save the participants from
unnecessary hassles.
d. The Regulator: As the market activity pick-up and the volumes rise, the market will definitely
need a strong and independent regulator, similar to the Securities and Exchange Board of India
(SEBI) that regulates the securities markets. Unlike SEBI which is an independent body, the
10
Forwards Markets Commission (FMC) is under the Department of Consumer Affairs (Ministry of
Consumer Affairs, Food and Public Distribution) and depends on it for funds. It is imperative that
the Government should grant more powers to the FMC to ensure an orderly development of the
commodity markets. The SEBI and FMC also need to work closely with each other due to the
inter-relationship between the two markets.
e. Lack of Economy of Scale: There are too many (3 national level and 21 regional) commodity
exchanges. Though over 80 commodities are allowed for derivatives trading, in practice derivatives
are popular for only a few commodities. Again, most of the trade takes place only on a few
exchanges. All this splits volumes and makes some exchanges unviable. This problem can possibly
be addressed by consolidating some exchanges. Also, the question of convergence of securities
and commodities derivatives markets has been debated for a long time now. The Government of
India has announced its intention to integrate the two markets. It is felt that convergence of these
derivative markets would bring in economies of scale and scope without having to duplicate the
efforts, thereby giving a boost to the growth of commodity derivatives market. It would also help
in resolving some of the issues concerning regulation of the derivative markets. However, this
would necessitate complete coordination among various regulating authorities such as Reserve
Bank of India, Forward Markets commission, the Securities and Exchange Board of India, and the
Department of Company affairs etc.
f. Tax and Legal bottlenecks: There are at present restrictions on the movement of certain
goods from one state to another. These need to be removed so that a truly national market could
develop for commodities and derivatives. Also, regulatory changes are required to bring about
uniformity in octroi and sales taxes etc. VAT has been introduced in the country in 2005, but has
not yet been uniformly implemented by all states.
11
CHAPTER 3
COFFEE AND PLATINUM – AN OUTLINE
FUNDAMENTALS OF COFFEE HISTORY4
“Although coffee, like cotton, has many grades, growths and specific growth qualities, it is
primarily classified into two types – arabica and – robusta. Arabica coffee beans, which grow
mainly in the tropical highlands of the Western Hemisphere, make up the bulk of world
production. Robusta coffee beans, less mild than arabica, are produced largely in the low, hot areas
of Africa and Asia.
Arabica coffee (the coffee represented by the Coffee “C” futures contracts traded at NYBOT) is
the preferred, higher quality coffee. It is higher in price due to several factors. Growing conditions
for arabica are affected more often by weather events (drought, freeze). The picking of arabica
coffee cherries is also labor intensive. In most countries, quality arabicas must be harvested by
hand selectively.
In most countries there is one main harvest a year. In Colombia, the source of a large amount of
fine quality arabica coffee, there is a main and a secondary crop. The labor-intensive nature of
arabica coffee production is reflected by the large number of small family-owned farms engaged in
the production of coffee.”
FACTORS AFFECTING THE PRICING OF COFFEE
When a commodity assumes a prominent position in the global economy, it also invites
speculative excess and ever-increasing vulnerability to major price shocks. The coffee trade – with
its long sea-route, supply lines and weather variables – suffered from wild price swings.
After uncontrolled cash market speculation brought about a calamitous market collapse in 1880, a
group of coffee merchants mobilized to bring some order to the chaos. As result of this effort, on
March 7, 1882, 112 dealers and importers gathered in lower Manhattan to buy and sell coffee
futures. The first transaction on the New York Coffee Exchange of 250 bags of coffee helped to
4
Coffee, Futures and Options published by NYBOT
12
establish an organized marketplace that served several key functions: set standards for different
grades of coffee; provided a market where growers, merchants, roasters and wholesalers could
hedge against losses in the cash market; established an arbitration system to settle disputes;
recorded and disseminated current market information to members.
At any time along the marketing chain for coffee from the tree to the cup, coffee prices can move
quickly and often in response to key supply and demand factors such as weather, political policies,
labor contracts, crop predictions, etc. Given the growth cycle/characteristics of the coffee
bush/tree (three to five years from planting before bearing marketable beans), the processing
capabilities necessary for higher grade and quality washed arabica coffee and the shipping/storage
demands, the physical market cannot respond quickly to reflect changing supply/demand
conditions. In the absence of a major increase in consumption, adjustments on the supply side are
difficult to implement in a short time frame and involve painful choices for producers that cannot
be easily undone.
Futures markets, however, can respond quickly through their price discovery process that reflects
changing cash market conditions. Futures markets react immediately to any fundamental change in
the marketplace and the price discovery process reflects this shift. The coffee futures and options
markets at NYBOT provide the perfect tools for risk managers throughout the coffee marketing
chain to help protect the bottom line.
Coffee offers a good illustration of the vital risk management function of futures and options.
Coffee production's sensitivity to weather shocks and its limitations of climate and geography are a
constant source of price volatility. The historical volatility for coffee has been significantly greater
than for other commodities (like cocoa or sugar).
13
Coffee futures and options markets do not increase volatility. The volatility and risk originate in
the cash market. The cash price of coffee, while benchmarked to the Coffee “C” futures price, is
determined primarily by cash market conditions. Coffee futures and options markets cannot
remove volatility and risk arising from a change in cash market conditions; they do allow coffee
industry participants to transfer and manage risk.
The same coffee price volatility that makes coffee futures and options markets necessary to risk
managers creates opportunities for investors. Since volatility measures the frequency and size of
price movements in both directions, it affects all levels of the marketing chain and brings in
market users with opposing price goals. As the levels of volatility and risk management activity in
the futures market increase, the speculative opportunities on both the buy and sell side of the
market often expand as well. The speculative activity in the coffee market provides a critical mass
of liquidity and pricing opportunity. Increasing the numbers of bids and offers in the trading ring
throughout the day increases the pricing efficiency of the market.
Basis is a major factor in coffee pricing and hedging. Basis refers to the difference between the
New York spot futures price (nearby futures contract) and the cash price at the local delivery point
(wherever the cash market transaction takes place). Carrying charges and delivery location all affect
coffee basis pricing. Coffee delivered at the Port of New Orleans or the Port of Hamburg, for
example, trades at a discount of 1.25 cents/lb. to the coffee delivered in New York.
FUNDAMENTALS OF PLATINUM HISTORY5
“Platinum is an extremely rare metal and that makes it even more precious than gold or silver. The
percentage of platinum under the earth’s crust is just a mere 5 parts per billion. It possesses all the
characteristics that make it a very useful industrial metal and the fact that this is a very costly metal
becomes irrelevant when approximately 50% of the platinum produced annually is used for
industrial purposes. Platinum is so heavier and denser than other metals that it is said that only
one cubic foot of this metal weighs as much as over half a ton! Platinum is the chief metal of a
group of metals that include palladium, rhodium, rhodium, osmium and iridium. Economies of
5
http://www.crnindia.com/commodity/platinum.html
14
many developed and developing nations are dependent on this metal and hence it can be
considered a very fruitful form of investment.
Basically, platinum deposits in its true form are concentrated only in two areas on earth, South
Africa and Russia. At other places of the world it is produced as a by-product in the production of
other metals. The world production of platinum is over 6 million troy ounces, which is around 7%
of the world production of gold and just 1% of the world production of silver. This depicts the
level of scarcity of this metal. South Africa is leader in the mine production of platinum. This
multi purpose metal is vastly used throughout the globe in various industries. The demand for the
metal in 2004 figured around 6.58 million ounces.
Due to a very small quantity present on the earth and also due to the ever-increasing demand of
the metal, the prices of platinum are highly volatile. Even a small mismatch in the demand and
supply scenario can bring about a huge fall or rise in the prices of platinum. That’s why it is
considered to be a very sensitive mode of investment. This fact attracts the investors towards it.
However, the London physical market provides the world with the basic reference price i.e.
London fix for platinum and is considered as an international benchmark. The factors that govern
the prices of platinum are

Policies in South Africa and Russia

Size of Russian stockpile

Economic situation in the consuming g countries like Japan, USA and European Union

Fluctuations in the prices of other precious metals
The major trading centers where platinum is traded are

New York Mercantile Exchange (NYMEX)

Tokyo Commodity Exchange (TOCOM)

Mid America Commodity Exchange (MIDAM)
The main physical market indulging in the trade of platinum is the London Platinum and
Palladium market. This is market, which provides the world with the ‘London fix’ price that is
considered as a benchmark in detecting world platinum prices The London Platinum and
Palladium Market (LPPM) oversees dealings in platinum and palladium. Twice each day, four
members of the LPPM fix the bid prices. The bid price is the price at which LPPM members agree
15
they will buy “good delivery” metal. The bid prices are benchmarks for the market and hence for
the industry. Bid prices in turn affect the offer prices that customers are asked to pay for metal.
The market values of platinum and palladium, as is the case for all commodities, ultimately affect
manufacturing costs.”
Agriculture and Metals Future Commodity Trading6
6
Businessworld.com
16
CHAPTER 4
COFFEE AND PLATINUM – THE DERIVATIVES MARKET
Before looking into the need and developments of a derivatives market for the above said
commodities in India, one needs to understand the requirements for an efficient derivatives
market. The absence or rather an improper development of these factors might be one of the
major hampers to a well rounded derivatives market in India

Size: The increase in the size of the market translates into more number of players
which in turn adds liquidity and diversity. Currently in India, only very few players exist
in the commodity markets. Most of the high net-worth players engage in the stock and
equity markets. Requiring a good amount of financial muscle, the entry barrier to the
market limits size and thus liquidity. For a flourishing market, FIIs, mutual funds and
banks need to enter

Liquidity: A highly liquid market attracts investors and helps in an efficient
functioning. It mainly aids in the efficient use of arbitrage options. One of the simplest
liquidity indicators are volumes

Volatility: A higher volatile market arbitrage and speculative options.

Regulatory Framework.: A regulatory framework is necessary for the handling of
settlement risks and aiding in the mitigation of default risks through Clearing funds,
margins, etc. The regulatory authority should allow independence in the market besides
keeping a check on the market conditions

Accountability and handling of market misconduct

Investor confidence: Boosting of investor confidence by reducing systemic risk;
providing client fund protection, capital adequacy of dealers, secure clearing and
settlement procedures.

Technology of the market: This could be achieved by leveraging on the strong software
background that the country has. By utilizing Indian software professionals to develop
specific software packages, the issue can well be addressed.
17
PROBLEMS FACED BY THE COFFEE AND PLATINUM COMMODITY
DERIVATIVE MARKETS IN INDIA7
“One of the main factors hindering the deployment of a commodity derivative market in India (in
regards to options) is the Regulatory Issues. Commodity futures markets in the country are
regulated through Forward Contracts (Regulation) Act, 1952.
The Forward Markets
Commission (FMC) performs the functions of advisory, monitoring, supervision and regulation in
futures and forward trading.
Forward/futures trading is done in exchanges owned by the
associations registered under the Act.
These exchanges operate independently under the
guidelines issued by the FMC and of their byelaws.
As per the existing provisions of the Forward Contract (Regulation) Act, 1952 commodities are
broadly divided into 3 categories for purpose of forward/futures trading. In 81 commodities
specified in the Prohibited List, covered under section 17 of the Act, futures trading is not
allowed. Platinum is currently in this ‘prohibited’ list. In the Regulated List, 40 commodities
permitted for futures trading from time to time under Section 15 of the Act, notifications are
issued both for the commodity and for specific Exchanges approved for futures trading in them.
The 'residual commodities' (i.e. not figuring in either the prohibited list or in the regulated list) are
called "free" commodities in respect of which the Forward Markets Commission could give a
certificate of registration to any applicant Association/Exchange for commencing futures trading
under section 14 of the FC(R)A.
After a commodity is approved for futures trading, whether under section 15 or section 14,
contract-wise approvals are given by the FMC to the concerned Exchange(s).
Normally
permission for a maximum of two contracts is given at any point of time; though in exceptional
cases contracts for a full year may be given approval in advance. Furthermore, two types of
derivative transactions are being allowed currently in commodities (i) forward contracts [with two
sub-categories Non-Transferable Specific Delivery Contracts (NTSD) and Transferable Specific
Delivery Contracts (TSD)] and (ii) hedge (futures) contracts. In 79 Commodities covered under
section 18 of the Act even NTSD contracts are prohibited, for which permission has to be sought
under section 15 of the Act. These approvals are also specifically laid down for any particularly
commodity-exchange-configuration. That means the exchanges specifically allowed for NTSD
7
agmarknet.nic.in/amrscheme/taskrepmarketing.htm
18
forward contracts are not allowed to undertake trading in other form of derivative contracts or an
exchange which is allowed for hedge contracts cannot undertake NTSD/TSD contracts etc.,
unless it is specifically permitted. Other forms of commodity derivatives such as options, as well as
commodity exchanges trading in financial derivatives (equity or index options and futures, interest
rate derivatives, foreign exchange derivatives etc.) are not permitted.
Thus, the degree of
compartmentalization is absolute between commodity exchanges and financial derivative exchanges
and substantial within Commodity Exchanges for different types of Commodity derivatives
themselves.
The resulting commodity composition of futures trading is such that major voluminous
commodities (such as grain, pulses, metals etc.) are out of the purview of futures trading; minor
agricultural products are the ones generally permitted (exception being oil complex and sugar, just
recently approved). Many of these 'prohibited' commodities are under such controls and policies
such as MSP that commencing futures trading has no meaning, as there is virtually no price risk to
manage. Such a 'defensive approach' might have had its logic at the time of scarcity it requires a
change in the approach in the liberalized system gearing up for international competition in the
post-WTO era. Only if the markets are allowed to function under proper regulatory environment,
the agricultural economy - one of the largest in the world - can fully exploit the benefits of markets
in the country and abroad.
Amendments to some of the provisions of the Forward Contract (Regulation) Act, 1952 are
currently with the Parliamentary Standing Committee. These amendments include defining futures
trading, removal of ban on options trading, provision of registration of brokers, strengthening of
FMC by including professionals as part-time Members, enhancing the penalty provisions, etc.
These amendments have to be carried out expeditiously.
Commodity futures trading in the country also suffers from a number of other limitations as
detailed below:
a)
Limited and closed nature of membership in the Exchanges;
b)
Absence of many hedgers who have substantial underlying positions;
c)
Absence of transparency;
19
d)
Limitations of prudential regulation; and
e)
Absence of a legal framework for warehouse receipt system with full negotiability and
transferability.
Concerted efforts, therefore, need to be made to expand the scope of futures trading, along with
general economic reforms. Efforts have to be made for increasing the number of commodities
permitted for futures trading. The objective has to be to move towards a situation where all
‘candidate commodities’ would be automatically allowed for futures trading under the overall
regulation of the commodity market regulator. The objective of expansion of futures trading
should be with a view to increase futures trading from the current level of 1.26% of the GDP in
the year 2000-01 to that of at least 10% of the GDP by the end of the X Plan (2006-07). The
negative list under Section 17 of the FC(R) Act needs to be given a fresh look so as to drastically
prone it. Prohibition of NTSD contracts under the Act may be discontinued. The design of
contracts and type of contracts should left to the Exchanges to be decided. Only the appropriate
regulatory mechanism and enabling provision should be finalized with the approval of the market
regulator.
Important institutional reforms required in this area are as follows:
a)
Regulatory framework has to be strengthened, making FMC an autonomous
organization
on the lines of SEBI;
b)
Exchanges have to be exposed to the best practices from across the world;
c)
Institutional interface between various related agencies such as warehousing corporations,
banks and financial institutions, clearing and settlement corporations, system of brokages and
institutions for risk containments, have to be strengthened;
d)
Enabling provisions for commencing options trading etc. have to be incorporated by means of
an amendment to the Act;
e)
Initiatives such as modern national level commodity exchanges and warehousing receipt
system have to be actively pursued;
f)
The Exchanges and other stake-holders are too sensitized to the challenges facing
commodity futures trading and to ‘upgrade’ their responses;
20
g)
The policy direction should aim towards convergence of futures markets i.e. trading in
derivatives products by all the interested exchanges by removing the compartmentalization of
commodity exchanges trading on in commodity derivatives products;
h)
The level of general awareness, particularly that of farmers and cooperatives, on futures
trading and related issues needs to be raised for increasing their participation in the futures
markets.
As already recommended, the system of warehouse receipts needs to be universalized in futures
trading for enhancing trade volumes and in minimizing transaction costs. Warehousing Receipts
should act as good evidence of the receipt for goods and the terms of the contract and storage,
proof for their quality and condition, or “apparent order and condition”. Warehousing receipts
(WHR) would go a long way in achieving these objectives apart from covering quality risk, which
is an important risk component of commodity futures trading. If quality risk is not covered price
risk management by means of futures contracts have limited meaning and could have only
qualified success. Legal framework for making warehouse receipts transferable and negotiable has
to be strengthened in making negotiable warehouse system the demat of commodity futures
trading.”
PRICE SUPPORT POLICY IN INDIA – A STUDY AND REFORMS8
“The Minimum Price Support Policy (MSP) linked to procurement has served the country well in
the past three decades. However, in recent years it has started encountering problems mainly
because of surpluses of several agricultural commodities and excessive built up of stocks with FCI.
Even deficit states like Bihar, Assam, Eastern U.P. have started generating surpluses of certain
cereals. Also, as a result of operation of the pricing Policy, private trade has not been able to play
its role particularly in respect of two major cereals, namely wheat and rice that account for over 70
percent of total food grain production in the country. Under the MSP scheme prices of major
agricultural commodities are not only exogenously determined but these prices are defended
through nodal procurement agencies like FCI. The adverse effects lay hidden as long as the
country operated in a situation of shortages in a relatively closed economy. Bringing equilibrium in
the market, a function that is normally performed by private trade, was successfully performed by
8
agmarknet.nic.in/amrscheme/taskrepmarketing.htm
21
the public sector nodal procurement agencies. In the process the private trade has been
marginalized. In the changing environment it is essential to think of an alternative policy,
particularly if the private trade is to be restored its rightful role in the market place.
There is a need to work out an alternative to the existing MSP linked procurement scheme. Till the
policies are developed and implemented which assign rightful role to private trade in the
marketing of agricultural commodities, the existing nodal agencies need to be strengthened and
States need to be encouraged to undertake decentralised procurement.
The Fair Average Quality (FAQ) norms fixed for different agricultural commodities should not be
relaxed frequently, because such relaxation breeds inefficiency and discourages quality. At present,
there is no reliable and transparent system existing at the field level and the grading is done more
or less on discretionary basis. This system of subjective assessment needs to be replaced by a
system of objective criteria by providing moisture measuring equipments and other equipments,
which can help in measuring Fair Average Quality. FAQ norms have to be strictly enforced and
the quality upgraded by educating the farmers.
There is a need to give wide publicity among the farmers to the FAQ norms fixed by the
Government through different means of media. Due to ignorance of FAQ norms of the farmers,
unscrupulous elements enter the market and purchase agricultural commodities at much lower
price than the MSPs fixed by the Government. In this way, the farmers are exploited. Cases of
farmers being turned back on the ground of non-conformity with the FAQ norms are also
frequent, leading to hardship and resentment amongst the farmers.
The number and location of purchase centers should be decided sufficiently in advance and given
wide publicity. The nodal agencies should decide, in consultation with the State Governments, the
location and number of purchase centers to be set up much in advance of the marketing season.
The information regarding number and location of purchase centers should be given wide
publicity through media, radio, television, leaflets, etc.
As long as the services of nodal agencies are being used for market intervention and procurement,
etc., they must be given full support so as to enable them to operate efficiently. Necessary
budgetary provisions need to be made by the Government in this regard so that their operations
could be carried out smoothly. Likewise, the role of banks in financing the public and cooperative
procuring agencies need to be made more active and participative.
22
The Market Intervention Scheme (MIS) suffers from limited operations, since it is implemented
on the request of the State Government(s) willing to bear 50% of the losses, incurred if any, in its
implementation. The implementation of the scheme needs to be made more flexible and easy.
The provision of sharing of losses by the State Government(s) needs re-examination.
There are two ways in which support can be extended to farmers for protection of their incomes.
One way could be to de-link MSP from procurement. Under this model, while MSP could
continue to be fixed as at present prices may be determined by market forces. The farmers could
be reimbursed the difference between the market prices and MSP on the marketed produce. The
other method could be to guarantee the income level of farmers through an insurance programme
where guaranteed income will be determined on the basis of MSP and historical yield of the
farmer and the difference between guaranteed income and actual income (actual production and
market price) will be made good under the insurance programme. Positive implications of such an
Income Insurance Scheme (IIS) are as follows: a)
Private trade will play a major role in the
market and the pricing mechanism would reflect the market fundamentals of demand and supply.
Therefore, any excess production or supply will cause the prices to decline. The decline in prices
will help in creating increased demand, particularly from the poorer sections or BPL segment of
population. Besides, if prices fall below international levels, the commodity can also be exported
competitively. There would thus be a possibility of sustained exports of coffee from the country.
On the other hand, in case of decline in production, the prices will increase, either obviating the
need for income support payments to farmers and thus reduce the liability under the Insurance
program. The requirements of the weaker sections of the society, however, would continue to be
met through PDS from buffer stocks maintained by public sector organisations like FCI and SFCs
and through States.
b)
The existing system of MSP-procurement is essentially functional in the States of Punjab,
Haryana, Uttar Pradesh and Andhra Pradesh. Even here only a small segment of farmers is
covered. Thus the benefit of the present policy, which is being implemented at such a huge cost is
available only to a very small number of farmers in a few States in the country. The alternative
Scheme will have a much wider reach and potentially a larger number of farmers who opt for the
insurance cover in all the States will be benefited.
23
c)
The Scheme offers comprehensive coverage of income rather than yield risks alone.
Farmers will be benefited from such a comprehensive risk coverage consistent with the objective
of the National Agricultural Policy – 2000.
d)
The alternative Scheme provides incentive to the farmers for improving quality. In the
MSP regime, quality is confined to FAQ, which also is subject to flexibility. The farmers’ real
income in market will be rewarded for quality grade while his income protection is covered by the
Insurance. This will also help the country to compete in the world market”.
FMC – CAN IT BE CARRIED OUT?9
Rampant manipulation of commodity markets is exactly what led to a 40-year ban on futures
trading. But the government forgot the past when it allowed three national, automated, multicommodity stock exchanges to start operations without putting in place a powerful regulatory
structure or deciding the future of 20 odd regional commodity exchanges. To be fair, the
Congress-led government has inherited this confusion from the trader-dominated BJP
government. It was also lulled by Agriculture Minister Sharad Pawar’s willingness to transfer
commodity futures regulation to the finance ministry. The Cabinet had also cleared the move to
converge capital market and commodity market regulation under the Securities and Exchange
Board of India (Sebi). Their solution is to update the FMC Act and beef up the staff to take care
of the problem. But FMC’s staff cannot deal with complex financial derivates traded on automated
exchanges. While they begin their learning process, trading turnover at these exchanges is already
highly speculative and in excess of Rs 3,000 crore per day. But that doesn’t worry traders, who
argue that Sebi does not have ‘domain knowledge’ about commodity cycles, crop trends or
linkages with farmers, traders and other institutions that currently supervise physical trading. At
the same time they want the introduction of even more esoteric derivatives products such as
weather, insurance and freight futures.
Trading turnover at India’s commodity bourses is bound to grow rapidly and speculators who will
spot bigger profit opportunities in badly regulated commodities are bound to switch over from the
capital markets. In effect, what we have in the commodity markets today is the exact replica of the
capital markets situation in the late 1980s and early 1990s. Former Prime Minister Rajiv Gandhi
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24
had announced the creation of Sebi, but broker lobbies prevented it from getting its statutory
teeth until a massive securities scam blew up in its face in April 1992.
Things may be a little different in the commodities market. A bull market in stocks spreads
happiness all around, but a bull market in commodities hurts ordinary people and raises raw
material prices for manufacturers. So the alarm bells ring much earlier. Moreover, rising prices are
political cannon fodder and elections have even been lost because of high onion prices.
Commodities markets are potentially too large and important to be handed over to Sebi, although
there are strong arguments in favour of such a move. On the plus side, the market regulator has a
lot of learning in place over the last 15 years. It has evolved market safety mechanisms, put in
place stringent disclosure norms and margining rules that have withstood severe volatility tests.
On the other hand, market supervision remains a serious weakness. Over the last few years, Sebi
has passed confused and inconsistent orders that have been set aside by the appellate body or have
also destroyed any scope of action against insider trading and price manipulation. Insider trading
and price manipulation precedes every major corporate announcement (it happened again before
Gujarat Ambuja’s announcement about the sale of a stake in ACC) and the market reacts to Sebi’s
threat to investigate with derisive sniggers.
The commodity markets and their potential for future growth are too huge to be left to the mercy
of Sebi’s weak supervision. Although the government is reluctant to set up yet another
independent regulator, that is exactly what the commodity markets need. An independent
regulator, which is not handicapped by bad precedents and many supervisory failures of Sebi is
what is required. The regulator must come under the finance ministry, be based in Mumbai, the
FMC should be merged with it and the board of this new regulator should have representation
from the Consumer Affairs Ministry, the Agriculture Ministry as well as the rubber, spices and
other commodity boards. Only then can India prepare for a large and vibrant commodities futures
market, without waiting for a scam to push the government into action.”
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CHAPTER 5
COFFEE AND PLATINUM – ARE THEY EFFICIENT MARKETS?
In order to study the possibility of a derivative market in a commodity, it becomes necessary to
first study the nature of the commodity. We proceed to do this for the case of both platinum and
coffee derivatives studying the nature of the international market. We perform an analysis to check
the efficiency of the market and infer from that the nature of platinum and coffee. On this basis, it
can be attempted to compare the nature of these two commodities. We, first look at the theory
underlying the tests that we perform for market efficiency. Key to the idea behind the test is the
idea of a stationary series.
Econometric Theory
Stationary Series
A series is said to be (weakly or covariance) stationary if the mean and autocovariances of the
series do not depend on time. Any series that is not stationary is said to be nonstationary. A
common example of a nonstationary series is the random walk:
yt= yt-1 + et
where et is a stationary random disturbance term. The series has a constant forecast value,
conditional on, and the variance is increasing over time. The random walk is a difference
stationary series since the first difference of the above equation is stationary:
yt - yt-1= et
A difference stationary series is said to be integrated and is denoted as I(n) where n is the order of
integration. The order of integration is the number of unit roots contained in the series, or the
number of differencing operations it takes to make the series stationary. For the random walk
above, there is one unit root, so it is an I(1) series. Similarly, a stationary series is I(0). Having
understood what a stationary series is, we realize that if the movement of market prices, as
regressed against previous historic prices , gives a stationary process this would imply inefficiency
26
within the market. The Augmented Dickey Fuller Test tests for the presence of this stationary
process.
The Augmented Dickey-Fuller (ADF) Test
Let us consider an autoregresseive, pth order process:
yt = a0+ a1yt-1 + a2yt-2 + … + apyt-p + et
This can be rewritten in the following form:
∆ yt = a0 + Γyt-1 + Σbi∆yt-i+1 + et ; for i ranging from 2 to p
Where Γ = - (1- Σai); for i ranging from 1 to p
And bi = - Σaj; where j ranges from i to p
The coefficient that is to be observed in the above equation is Γ. If Γ = 0, the equation has a unit
root. This comes from the theory of difference equations. As if the coefficients of a difference
equation sum to 1 (In this case Σai) , at least one of the characteristic roots is unity. We thus test
the hypothesis of a unit root at standard critical values and a failure to reject the hypothesis would
imply a non-stationary process.
One must keep a number of issues in mind while performing the ADF test. Firstly, it assumes that
the error terms are independent and have a constant variance. The value of Γ cannot be estimated
accurately unless all the autoregressive terms are included in the estimating equation. The practical
implication of this is the problem of choosing the lag length. Seasonality in the roots and structural
breaks require specific handling. Once the series has passed the unit root test performed, namely
the ADF test, we check the correlation between the spot and the future market. This is done
through cointegration testing.
Cointegration Testing
The basis behind cointegration testing is the possibility that a linear combination of two or more
non-stationary series may be stationary. We say that a non-stationary series is cointegrated if there
exists such a linear combination of series. The latter combination is known as a cointegrating
27
equation and indicates long run equilibrium between the variables. Cointegration testing checks if
a group of non-stationary series are cointegrated or not.
Mathematically, if yt and xt are I(1) variables, then the two are cointegrated if there exists b such
that yt-bxt is I(0). This is represented by CI(1,1). Thus the regression equation obtained between yt
and xt; namely yt = bxt + ut makes sense only if yt and xt are cointegrated. If this is not the case,
then the regression equation is spurious as yt and xt would drift apart over time. This equation is
called the cointegrating regression and b is called the cointegrated vector.
We can test whether yt and xt are cointegrated by checking if the error in the cointegrating
regression is I(1). The hypothesis that ut has a unit root, if proved, indicates that there is not
cointegration. There are a number of procedures that estimate cointegration; however Johansen
procedure is the most common. The procedure leads to two test statistics for cointegration namely
the trace test and the maximum eigenvalue test. The former test the hypothesis that the number of
cointegrating vectors is less than or equal to some value r. The latter tests the hypothesis of there
being r+1 cointegrating vectors versus the hypothesis that there are cointegrating vectors.
Methodology
The methodology followed for the data analysis is as given below.

The coffee and platinum data have been obtained from the websites of the New York
Board of Trade and the London Platinum and Palladium Markets respectively. The data
spans from the year 1994 to the year 2002.

As a preliminary step, all structural breaks and data suspected of being inaccurate or
considered inconsistent were removed.

The trends in data for both were observed and the volatility over a running 30 day period
calculated. In the case of coffee, we were able to obtain the implied volatilities running
across a 30 day period. We noted that while in most cases the two volatilities were
comparable, the two diverged every now and then by a considerable amount.

The software used for performing both the unit root and the cointegration tests was
Eviews 5.
28

For the unit root test performed, i.e – the Augmented Dickey-Fuller Test we used the
standard Schwarz Info Criterion option of EViews to determine the appropriate lag length.

Our modeling included as an exogenous variable, a constant term and ignored a linear
trend.

The cointegration test performed was the Johansen Test, which is one of the most
common VAR tests used.

The assumption for exogenous variables is that there is no trend in the cointegrating
equations, only an intercept and thus choose the trend specification while running the test.
Findings
The results of the data analysis are enclosed in Appendix 1 to 4 of this report. Our findings in a
nutshell are as follows.
Coffee
We look at this from two periods from 1994 to end 2001 and from 2002 to the current period.
During the first period, coffee prices underwent a period of intense volatility showing very high
bullish trends due to considerable speculative activity. The only inevitable correction caused prices
to plummet only to witness this cycle repeat.
The subsequent period is characterized by relative stability and an almost lack of volatility.
However, the last year or so has seen a sudden climb in coffee prices indicating a period of
upcoming volatility. The data series for these periods passed the unit root test indicating they were
non-stationary processes.
A cointegration test between the spot and futures rates indicate the presence of a cointegrating
equation between the two. The test probability is low for the initial 1994 to 2001 end period but
the significance improves for the subsequent period.
29
Platinum
Once again, we split the data into two periods from 1994 to the end of 2001 and from 2002 to the
current date. Both periods show a lack of significant volatility especially as compared to coffee.
The prices of the first period are a bit more volatile than the prices in the second. The data series
of spot prices for the platinum pass the unit root test indicating that they are non-stationary series
and thus do not violate the random walk hypothesis.
30
CHAPTER 6
COFFEE AND PLATINUM – A DICHOTOMY OF OPTIONS
After having interacted with Dr. Radhakrishnan, Head of Research at the Indian Coffee Board,
Bangalore, the following observations were made regarding the Indian Coffee market.

It has been found that the most demanded option by Indian farmers is the put option.
Although not high, preference is given to both 6 month and 10 month forwards as well.
This would be to secure a form of insurance when the commodity prices go significantly
below the level these farmers expect.

The current Indian regulations prevent players from writing either call or put options or
even from the purchase of call options. This is based partly on the downside risk that these
options expose you to and also on its effect on foreign exchange flows.

The absence of a commodity derivative market in India implies a requirement to trade at
International markets, significantly New York and London for meeting India’s hedging
needs. These traders and markets, quite unaware of the Indian seasonality cannot do
complete justice to the execution of the trade. The translation of prices from the Indian to
the International scenario could result in some amount of price distortions and inhibit
efficient trading.

While the coffee board can buy put options in bulk and thus provide a means of risk
management, there are several problems with this in practice. One of the major problems
is that most markets are not sufficiently liquid enough. The two liquid markets London
and New York command significantly high premiums. The intention of the coffee board,
to support the coffee growers (similar to a price support system) could not perform as
expected since this required heavy government intervention. Market Research among
Indian farmers has revealed that they would be willing to pay a premium of less than 3%
on the derivative. However most premiums currently hover above the 10% mark. To make
up for the gap, the Indian government needs to provide heavy subsidies which it is not yet
ready to do. The main reason for high premium seems to be in the predominantly
31
speculative nature of these markets. Around 60% of the NY market is composed of
speculators.

Overall, due to the above mentioned factors, there is an inability to utilize even
international markets for hedging. The lack of a properly developed market has resulted in
the failing of the option model (as a price support system) which the coffee board had
launched.

One of the possible solutions could be the loosening of the regulations on derivative
trading in India. The first step should be taken by the government by offering protection
to the coffee growers. This is particularly important as even the so called “free market”
developed countries give huge subsidies to their farmers who are thus able to reduce prices
considerably to undercut their competition. Thus India cannot exactly survive a so called
“free market” without supporting its farmers.
COMPARISON OF COFFEE AND PLATINUM
It was decided to examine coffee and platinum as the commodity products since the desire was to
compare and contrast the market behavior of a high value, life-cycle independent commodity like
platinum with another high value agricultural product susceptible to life cycle changes. Before
going any further with this discussion it becomes necessary to understand the impact made by the
life cycle vagaries that coffee is subjected to.
A major factor affecting only the coffee market is the Commodity Cycle. Commodity cycles in
tree crops, characterized by alternating phases of high prices, low prices and price recovery, are
engendered partly by the fundamental features of the industry and partly by a special constellation
of demand and supply price elasticities, coffee being an outstanding case. It is a tree crop which
requires a fairly long gestation period: coffee trees begin to bear within three to five years after
planting and come into full bearing only about 7-10 years after planting. The short-run response of
supply to an increase in price is weak: high prices lead to some increase in current yields, by more
expenditure on pruning, weeding, spraying and fertilizer.
Their main effect, however, is on new investment in coffee production (purchase and preparation
of land, planting, buildings), i.e. the major thrust is on long-run supply. Investment responds
sharply to high and rising prices. However, once a substantial number of young trees begin to
32
come into production, the process reverses itself. The stream of new supplies come to the market
and causes a very heavy pressure on prices, as demand responds very weekly to price changes; and
the short-run response of supply is also low since variable costs (wages) are relatively low, while
shifts into alternatives require cash outflow for new investment. Prices have to fall to a very low
level to affect current output. However, depressed prices do affect investment activity in coffee
production. New investment ceases, while old trees go out of production.
There is a painful readjustment which may last almost two decades, until consumption catches
again with output, leads to a new shortage and a new cycle. And intertwined with this multi-year
cycles are purely short-term fluctuations which compound the problem of volatility within the
market.
This study quickly revealed that a trend cannot be established in coffee prices by merely looking at
the coffee data over the last several years (’94 to ’06). The reasons could be as follows:

Analysis of the coffee data is highly sensitive to the horizon period within which it is
observed especially during the tests for market efficiency. Analysis of coffee markets
makes much more sense when we look at data pre 2001 and date post 2001 as market
context and the very nature of price movements in this commodity seems to be
significantly different in these two periods. This gives justification for making an
independent study of these two periods.

The period pre-2002 has been characterized by an enormous amount of volatility within
the market. Prices of coffee to fluctuate from highly bullish when the price of coffee more
than doubled on several occasions to intensely bearish when the market underwent its
inevitable correction with respect to the over inflated coffee price causing the bottom to
fall out of the market. A large amount of this fluctuation was due to predominantly
speculative activity proceed during this period.

The period post 2002 is one of astonishing stability by comparison to the previous period.
For practical purposes, there has been an almost absence in volatility with the market still
unable to move over the correction in prices with saw coffee trading at new lows.
However, the last year has seen a massive increase in coffee prices indicating a strong
bullish trend, the duration and intensity of which becomes difficult to predict.
33

Also, as discussed above, the cyclicality of the product itself requires that the data studied
span over a period of about twenty years. However, it is unjustified to use data prior to
1994 as the market conditions/regulations which came into place following the
liberalization process of the Indian economy would not be present. Such an analysis of
international data makes no sense especially when it is not applicable to the closed
economy constraints prevalent at that time. Thus this study may give considerably greater
insights when done in the future after sill more data is available.
Platinum, by contrast, is considerably more stable not being affected by life cycle fluctuations but
by the factors listed out in previous chapters.
As of now, the FMC is highly reluctant to introduce options in India. This currently is
independent of the suitability of options to the Indian context but more because of
macroeconomic constraints of capital account convertibility and the government restriction on
CAPAC flows. However, in the light of this study, irrespective of CAPAC controls, we still believe
that options are not applicable to India under the current context. Coffee due to its intense
volatility and hence the proportionately higher downside risk that the market players are exposed
to is still not ready for options trading. Also due to the higher margins implied by higher
volatilities and the nature of the Indian coffee segment where players while large in number do not
have the financial muscle to pay for these increased premiums or even to compete on the
international market. The international market also has a disproportionate number of speculators
as compared to hedgers, both of whom are required in sufficient quantity for efficient and fair
price discovery.
With platinum the absence of significant volatility does not give either hedgers or speculators
sufficient motivation for entering the options market. While players in platinum have enough
financial muscle to take advantage if possible if an options market exists, there is barely a market
in platinum commodities in India. This is so even with the spot market let alone the derivative
market, once again giving regulators no reason why they should even consider the introduction of
a platinum options market.
34