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Futures and Options Essay

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Futures and Options in the Commodities Market.

The agreement to buy and sell such commodities is made through contracts to bring in legality in trading as it involves cash payments margins, delivery of goods and scope for profit maximisation. The emergence of contract systems eventually led to trading in contracts whereby a middlemen stands in between buyers and sellers. The active trading in such contracts brought standardisation which in turn led to the development of futures contracts.

A future contract is a standardised, binding agreement to make or take delivery of a specified quantity and grade of a commodity at an established point in future at an agreed upon price. The organization of merchants involved in the trading these commodities evolved into an organisation that standardised the contracts and trading practises and came to be known as – The Futures Exchange such as the New York Board of Trade (NYBOT) and the London International Financial & Futures Exchange. One essential objective of the exchange is to provide the dealers with all necessary information with regard to price volatility i.e. the magnitude of price movement in either direction. Note that it measures price risk and volatility but does not remove or eliminate risks. The exchange provides the benchmark for the determination of price by making price margins mandatory for effective fair trading.

Future transactions do not require full advance payments for the commodity (just the margin), the buyer of a futures contract which increases in value (or the seller of futures contract which decreases in value) can realize a profit which can be substantial in relation to the commitment of capital.

Brazil today is the world largest producer of coffee. Considering this figures, it is not surprising to note that it has attracted considerable amount of speculation and ever increasing susceptibility to price volatility.

Coffee production has direct linkage with weather besides many other factors such as world coffee prices. A coffee drink manufacturer will buy coffee beans from a coffee producer at an agreed price if he/she expects to have drastic climatic changes which will result in coffee being expensive at a future date. A sudden drop in the production in future will cut supply and make it more expensive. \the buyer can, therefore, avoid unnecessary risk by buying a futures contract that will guarantee him delivery of coffee at a future date at a price fixed now. However, it must also be noted that he/she will suffer loss if the future current/spot price of coffee beans were to fall drastically due to improved production and competitions.

Take an example of Brazil – The Brazilian Crop was initially expected to produce about 50 million bags of coffee. Seasonal disturbances such as rain, harvest delays and quality problem caused production to fall to 33.5 million bags. Due to severe drought in Viet Nam coffee production dropped by almost 1 million bags. These shortages of coffee output distort the supply level which leads to a global rise in prices.

So what roles does the future markets play in the production and selling of coffee? Taking these points into account the next chapter looks at the Indian and world coffee markets and the role future market plays in its pricing. In the analysis, I have made use of some articles from the Times of India newspaper and other websites.

It is logical to state that at times of shortage prices tend to go up due to higher demand and which in turn puts pressure on sellers to sell their product at a lower price. We know from our analysis before that a buyer will resort to futures contract if he expects the prices to go up in future. However considering that the production too has been low the chances of producing the required amount to meet the demand is less which adds to speculation in the market.

The report also suggests one source as saying that it is better to pay penalty and cancel a contract rather than to loose significant amount of money by fulfilling it. Note that sometimes the whole idea of futures contract is not meet the obligation in terms of delivering the commodity but to profit from the speculation that these uncertainties give rise to.

The world coffee production in 2003/2004 was estimated to be around 105.3 million 60 kilogram bags down nearly 2 percent from forecast made in June and down 15 percent from the 2002/03 season. Factors such as lower production contribute to great extent the price determination. For the year 2004/2005 it was widely believed that Brazilian coffee production to be around 33-35 million bags but due to substandard weather and low level of investment the production is likely to be below 30 million bags. This drop in production is likely to cut the supply level and Brazil being the world largest producers, any drop in its output will affect the world supply and thereby raise the price.

These uncertainties lead to prices going up in the futures markets. It has long been felt that some traders hold stocks to push the prices up and then sell it to make supernatural profits.

Let’s look at the graphical representation of prices of Robusta class of coffee as determined at the International Coffee Organisation (ICO) to assess the trends in the market. The graph below shows that since November 2004 Robusta coffee prices have increased at a slow and steady pace. However, a report that appeared on the Economic Times suggests that volatility in the world prices over the last few days have affected trading in coffee in the markets. The ICO in its Coffee Market Report seems to suggest that the downturn in mid-April caused a slight fall of 3.19 percent in the monthly average of the ICO Composite Indicator Price which dropped from 101.44 cents/lb in March to98.20 cents/lb in April. It also suggests that this has been due to high level of activity from various investment funds.

Comparing the results put forward by the ICO to the recent reports in the Economic Times newspaper (24/05/2005) the volatility in the world prices have triggered a bullish trend in the Indian markets which explains why trading in the coffee auctions markets have suffered. Estimates shows that there was a 40 percent drop in the overall quantum sold when compared to the previous ICTA auction.

– The beginning of the year showed a significant climb in the moving averages between January and mid-March and then a significant drop till the mid of April. One of the least complex ways to use a moving average is to simply look at the slope – a rising slope indicates that the market is in an uptrend and falling slope indicates a downward trend in the market. Moving Averages is a statistical technique for smoothing price movement in order to identify the trends more easily. It is equally important to understand that moving averages are sensitive to the number of days used to calculate the average i.e. the more days that are used; the less sensitive is the average.

Some experts are of the view that MA can be a critical factor in decision making. For e.g. traders can make use of one or more MA to determine buy or sell decisions i.e.to use a slow MA together with a fast MA. A slow moving average can be calculated by taking more days opening or closing prices and fast moving average by taking fewer days prices. In a more elaborate way, what it means is that you must buy when the faster MA goes above the slower one and sell when the faster MA goes below the slower one [or] buy when prices are above both fast and slow MA and sell when prices are below both MA.

The chart below is a graphical example of how a Moving Average looks like as of 05/27/2005. The Red Line (price line) is above the moving average so the trend is up indicating that the market is bullish and also the fast moving average (dark blue) is above the slow moving average (light blue).

Volume of7078.00 suggests the measure of trading activity during the selected period of time. It refers to the number of futures contract that are either bought or sold during that period. Open Interests, on the other hand, measures the number of futures contract that remains open at a particular point in time, usually at the closing of trade.

In the next chapter, I have looked at India as a producer of Coffee. India is relatively new into the coffee future markets and has performed exceedingly well. However, due to the speculative nature of the futures market and also bureaucratic hurdles have led to decrease in contract sales and increased price and non-competitiveness in the global coffee market.

The two principal species of coffee grown in India are Robusta and Arabica. Trading in coffee futures was introduced only recently and prices are extensively depended on the coffee trading in the New York and London futures markets as it has considerable influence on the world coffee prices. These prices are notoriously volatile and varies considerably due to factors such as weather forecast, size of the coffee stock worldwide and speculations in the futures markets

The Indian coffee production and physical trade is worth over $ 430 million annually. The production of Indian coffee is greatly influenced by world prices particularly since it is the second largest actively traded commodity in the world market. The Coffee Futures Exchange India Limited was formed under the supervision of Forwards Markets Commission to look into all trading practices affecting coffee prices. The main objectives are –

  • To provide hedging opportunity against coffee price risk.
  • To ensure guaranteed delivery of coffee.
  • To provide a price discovery mechanism for future period up to 18 months at any given point of time.

Besides these it is important to look at the mechanism COFEI uses to ensure that market participants follows the rules in ensure financial integrity. Factors such as margins, Price limits for trading, daily marking-to-market of all trades and sufficient capital including guarantee funds ensures that proper procedures are followed when a contract is bought and sold. In India, coffee has been categorized into 4 different types with each having different margins for smooth and efficient trading. The table next page gives a snapshot view of how coffee in India is traded and in particular the different class of coffee whether raw or clean.

The coffee industry, in general, has seen surge in prices by almost 40 percent. Exports in recent times have been hit quiet badly. Reports on the Financial Express newspaper suggest that export have suffered especially due to the price non-competitiveness in the world markets. India exported nearly 225,000 tonnes of coffee last year with majority (50 %) of it going to Europe. India’s coffee production and exports for the year 2005-06 (October-September) are forecast to increase by 5% and 29%, respectively. The anticipated rise in coffee export is against the backdrop of almost 26% decline in the current year (2004-05/Oct-Sep).

Coffee exports are expected to fall to an eight-year low of 169,980 tonne, or 2.83 million 60-kilogram bags, in the current year ending Sept 30, from 229,320 tonne, or 3.82 million bags, a year earlier. India, the world’s fifth-biggest coffee exporter is set to witness decline as farmers and traders are withholding beans on expectations of higher prices.

One of the biggest problems facing the traders in the Indian coffee industry is the time difference between India and the New York and London trading centres. Indian traders were now finding it difficult to hedge their risk. The local exchange functioned only till 5pm when the LIFFE and NYBOT and other European markets functioned till over 11.30 pm IST.

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