Commodity futures market convergence is the process where prices in the spot and futures markets come together or converge at futures market expiration.
Convergence occurs at the expiry date of every futures contract because of arbitrage. If spot prices remain below futures prices, a market participant could buy in the spot market and sell in the futures market and make a risk-free profit.
Similarly, if the spot price is above the futures price, a market participant can buy in the futures market, take delivery and sell in the spot market and earn a risk free-profit.
Spot prices may be at a discount to futures prices during a delivery, when there is a lack of warehouse space and the spot price discount to futures is tied to the cost of putting the commodity into storage.
When a warehouse is full with a certain allotment for commodity storage, the cost to store an additional quantity of commodity can increase significantly due to the lost opportunity of using that space for other commodities.
To address this issue, if the cost to store a commodity changes, one needs to examine how to also change the returns from storage to keep the costs and benefits in alignment. The benefits from storage are discovered in the price spreads between different expiration months in the futures market.
However, this has got restricted in India on account of exchange pre-determined storage rates which are not market-driven.
Variable rates This creates a fundamental market flaw as the exchanges, in order to keep the transaction cost low, keep the real storage cost artificially lower than the market for exchange delivered commodities and thus affecting the convergence of the prices.
CME has already introduced variable storage rates (VSR) to promote convergence from July 2010. The results of this implementation have had a positive impact on convergence during expiration.
In case of CME contracts, if the market expects storage rates to increase following the current contract expiration, the spread between current to further month contract can widen. Now, storage rates can change under VSR mechanism.
It is rather interesting to observe that in India, participants on futures platform are given a fixed rate of storage while market driven rates are offered to the spot market user which is ever changing, market determined and dynamic in nature.
We need not ignore a situation where sustained non-convergence would make hedging less effective, send confusing signals to the market, threaten the viability of a contract and ultimately lead to a misallocation of agricultural resources.
The writer is the Chief Business Officer of NCML. Views are personal.