Risk diversification is as important as risk management to several stakeholders such as producers, manufacturers, traders, importers and exporters.
It is also critical to financial institutions as they are often involved in managing an array of risks: market risk, credit risk and operational risk.
Prima facie, risk is of two types: systematic and unsystematic. Systematic risk is embedded in asset class, while unsystematic is manageable through diversifying portfolios with at least two assets being negatively correlated. Hence, asset pricing related to the value-at-risk (VaR) draws the attention of scholars and practitioners.
Commodity, a distinct asset class, is subject to production, distribution and processing risks. Managing risks in commodities is thus essential across the value chain. Risk estimation and monitoring is a real-time challenge to commodity merchants and other stakeholders.
Investment in commodity derivative index can offer benefits as risk aggregation and can help derive gains through a robust index. However, it has not been offered in India as in the US, UK and European countries.
For instance, the Chicago Mercantile Group (CME) offers an opportunity to invest in a group of indices across metals, energy, and agricultural products.
Domestic exchanges have been facing inherent challenges to promote index investment. While it is quite popular in stock futures/option index, say Nifty futures and S&P 500 from risk diversification point of view, fragmented spot markets and fragile price polling appears to be a stumbling block for the development of futures index in commodities, such as Dhaanya of NCDEX and Comdex of MCX.
Construction approach Indian commodity exchanges need to adopt a comprehensive index construction approach considering some benchmark indices, viz. GSCI, MSCI and CRB, among others.
The constituent of the index takes account of the commodity’s weight and average of near-month futures price based on a rebalancing rule.
Unlike stock, index construction methodology in commodity futures and spot markets is more nuanced. Liquidity of the contract, computation of total returns from futures contracts in major exchanges, maturity month or date are a few factors adopted for the index construction.
Global indices contribute maximum to energy and metals in terms of their capitalisation weights. On the other hand, agricultural futures index provides relatively lower return.
In most cases, these are nominal or provide an indication of liquidity in the market, for instance, ‘Dhaanya’ launched in 2007 has remained illiquid with a mean return of less than one per cent between 2007 and 2014.
MCX Comdex was launched in 2005 and had been rebalanced in three years consecutively during 2007-2009. It is a weighted average of three group indices – MCX Metal, MCX Energy and MCX Agri – having different weights (40, 40 & 20 per cent).
Returns calculation The computation of return in futures market is complex. The exchange needs to consider the spot return, risk-free return/ yield such as T-bills and roll yield that is realised through a rolling mechanism.
In every futures contract specification, contract expiry or delivery month is known. So, after a particular period, the contract has to be rolled over to the latest contract in order to achieve continuity or what is known as “rolling mechanism”. The return linked with rollover period is known rollover return, which is different from the spot return.
Managing risks Index construction and return computation follows a step-wise process that is crucial in implementation. Liquidity is a critical parameter for making the index operational. Liquidity Enhancement Scheme (LES) could be positive on the implementation front.
The Forward Markets Commission has laid down operational guidelines of LES, which may be replicated in index operation with a great caution. Commodity traders and corporations such as ITC, Ruchi Soya, Cargill, Marico, among others, can hedge their portfolio risks, investing in the index.
Risk quantification, on one hand, would be easier by tracking the index. Risk mitigation may also be possible through error minimisation between actual and expected outcomes by comparing risk-return metrics of created portfolios and the index.
Comexes thus need to design an operational framework and contract specifications for initiating index investment in commodity derivatives. Further, allowance of option instrument may accommodate more participants in the exchange-traded indices.
Investing in futures index might, therefore, act as a speed breaker to any unwarranted move in commodity prices. This would also create an improvised yet leveraged platform to offload unsystematic risk.
The writer is a Post-Doctoral Fellow of CMA, Indian Institute of Management-Ahmedabad. Views are personal.