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TERM PAPER

ON

COMMODITY MARKET & ITs

FUTURE PROSPECT

(The Authors are students of ICFAI Business School, Kolkata and this paper are in

part fulfillment of their curriculum. The views expressed in this paper do not

represent the views of the institute in any way.)

Submitted to

Prof Tamal Dutta Choudhary

Prepared by:

Nisha Kumari

(06bs2056) Nitin

Parasar (06bs2099)


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Pratik N Manek (06bs2152)

Executive summary

After the dot-com bubble burst in 2000, commodities prices and the level of

investment in commodities rose significantly. Commodities could provide the yield

investors were looking for but, more important, investors began taking greater

advantage of the negative price correlation to bonds and equities to diversify their

portfolios. While the FSA monitors the commodity markets through a combination

of exchange and firm supervision, commodities have historically been a small and

specialized market predominantly used by producers and consumers to hedge their

price risk. Organized commodity derivatives in India started as early as 1875, barely

about adecade after they started in Chicago. However, many feared that derivatives

fuelledunnecessary speculation and were detrimental to the healthy functioning of

the markets for the underlying commodities. As a result, after independence,

commodity options tradingand 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 defaulton forward contracts (and even caused

some suicides), forward trading was banned in many commodities considered

primary or essential. Consequently, the commoditiesderivative markets dismantled

and remained dormant for about four decades until the newmillennium when the

Government, in a complete change in policy, started actively encouraging the

commodity derivatives market. Since 2002, the commodities futuresmarket 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

2008. However, there are several impediments to be overcome and issues to be

decided for sustainable development of the market.: So this Report will focus on


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how did India pull it off in such a short time since 2002? Is this progress sustainable

and what are the obstacles that need urgent attention if the market is to realize its

full potential? Why are commodity derivatives important and what could other

emerging economies learn from the Indian mistakes and experience?

As the markets have grown, new investors have been attracted to commodities, with

increased interest from pension funds, high net worth individuals and even some

retail investors. Most commentators expect investment from pension funds to

continue growing and most of that money to flow into index funds. Unlike previous

cyclical bouts of investment we expect much of this money to stay. As a result, a

wealth of new products has been developed both on and off exchange to meet

investors needs. These range from new futures contracts in coal and ethanol to

exchange traded funds and similar products which may make it easier for retail

investors to gain exposure.

Challenges and risks arising from the changes in the market.

For exchanges the increase in volumes primarily brings systems and controls

challenges that is, can their trading platforms and monitoring capabilities cope

with the huge increase in trading? It is vital that systems are designed and

thoroughly tested to ensure they remain robust. For firms there are several

challenges. Recruiting and retaining staff with the appropriate level of expertise and

experience is a challenge for all. As more firms have entered the market or expanded

their operations the limited pool of experienced staff in the market has become

stretched. Firms themselves acknowledge the problem and it is imperative that they

manage this risk. Staffing issues apply equally to commodities exchanges which

must ensure compliance functions are adequately resourced. Secondly, firms are

facing increased volatility in some markets which raises the cost of trading and the

risk of financial failure. It is essential that firms have appropriate and robust risk


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management systems and procedures in place. This includes thorough testing and

modeling for algorithmic trading systems.

Thirdly, in some cases firms are investing in commodities through the acquisition

of physical assets such as power stations. This significantly alters their portfolio of

risk. Again, risk management systems must be appropriate and senior management

must fully appreciate the risks they are assuming. A further issue affecting firms and

exchanges arises from the increasing number of users not previously participating in

commodities markets. Aggressive and high volume

trading and ever more ambitious investment funds pose fresh challenges for more

traditional users of the markets and for the infrastructure providers who must now

operate in a significantly changed environment. Given the growth of investment and

the range of new participants we will be increasing our monitoring of commodities

markets. While these markets are no more susceptible to improper practices than any

other, firms should ensure they have adequate controls in place. Consumers risk

being exposed to unsuitable investments that they do not fully understand. A

growing number of products allow retail exposure to commodities, while indirect

exposure through pension funds is also increasing.

In conclusion, there has been a significant expansion in commodities investment in

recent years, bringing with it a range of new participants. These developments raise

various risks and challenges for those involved. It is essential that all parties

fully appreciate and address these risks.


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Introduction

Two of the statutory regulatory objectives are to maintain confidence in the

financial system and to secure the appropriate degree of protection for consumers.

Against these objectives commodities have traditionally been a specialised market,

dominated by professional participants, so they have received less regulatory

attention than the larger and more high-profile equity and bond markets. However, a

significant bull run has been underway in commodities in recent years. Bull markets

are nothing new but this time the number of participants and the amount of assets

invested has grown significantly. Many are investing in commodities for the first

time. The Indian economy is witnessing a mini revolution in commodity derivatives

and risk management. Commodity options trading and cash settlement ofcommodity futures had been banned since 1952 and until 2002 commodity

derivatives market was virtually non-existent, except some negligible activity onan

OTC basis. Now in September 2005, the country has 3 national level electronic

exchanges and 21regional exchanges for trading commodity derivatives. As many

as eighty (80) commodities have beenallowed for derivatives trading. The value of

trading has been booming and is likely to cross the $ 1Trillion mark in 2008 and, if

all goes well, seems to be set to touch $5 Trillion in a few years.


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History

The history of organized commodity derivatives in India goes back to thenineteenth century when the Cotton Trade Association started futures trading in

1875, barely about a decade after the commodity derivatives started in Chicago.

Over time the derivatives market developed in several other commodities in India.

Following cotton, derivatives trading started in oilseeds in Bombay (1900), raw jute

and jute goods in Calcutta (1912), wheat in Hapur (1913) and in Bullion in Bombay

(1920). However, many feared that derivatives fuelled unnecessary speculation in

essential commodities, and were detrimental to the healthy functioning of the

markets for the underlying commodities, and hence to the farmers. With a view to

restricting speculative activity in cotton market, the Government of Bombay

prohibited options business in cotton in 1939. Later in 1943, forward trading was

prohibited in oilseeds and some other commodities including food-grains, spices,

vegetable oils, sugar and cloth. After Independence, the Parliament passed Forward

Contracts (Regulation) Act, 1952 which regulated forward contracts in commodities

all over India. The Act applies to goods, which are defined as any movable property

other than security, currency and actionable claims. The Act prohibited options

trading in goods along with cash settlements of forward trades, rendering a crushing

blow to the commodity derivatives market. Under the Act, only those

associations/exchanges, which are granted recognition by the Government, are


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allowed to organize forward trading in regulated commodities. The Act envisages

three-tier regulation: (i) The Exchange which organizes forward trading in

commodities can regulate trading on a day-to-day basis; (ii) the Forward Markets

Commission provides regulatory oversight under the powers delegated to it by the

central Government, and (iii) the Central Government - Department of Consumer

Affairs, Ministry of Consumer Affairs, Food and Public Distribution - is the ultimate

regulatory authority. The already shaken commodity derivatives market got a

crushing blow when in 1960s, following several years of severe draughts that forced

many farmers to default on forward contracts (and even caused some suicides),

forward trading was banned in many commodities considered primary or essential.

As a result, commodities derivative markets dismantled and went underground

where to some extent they continued as OTC contracts at negligible volumes. Much

later, in 1970s and 1980s the Government relaxed forward trading rules for some

commodities, but the market could never regain the lost volumes.

Change in Government Policy

After the Indian economy embarked upon the process of liberalization andglobalization in 1990, the Government set up a Committee in 1993 to examine the

role of futures trading. The Committee (headed by Prof. K.N. Kabra) recommended

allowing futures trading in 17 commodity groups. It also recommended

strengthening of the Forward Markets Commission, and certain amendments to

Forward Contracts (Regulation) Act 1952, particularly allowing options trading in

goods and registration of brokers with Forward Markets Commission. The

Government accepted most of these recommendations and futures trading was

permitted in all recommended commodities. Commodity futures trading in India

remained in a state of hibernation for nearly four decades, mainly due to doubts

about the benefits of derivatives. Finally a realization that derivatives do perform a

role in risk management led the government to change its stance. The policy


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changes favouring commodity derivatives were also facilitated by the enhanced role

assigned to free market forces under the new liberalization policy of the

Government. Indeed, it was a timely decision too, since internationally the

commodity cycle is on the upswing and the next decade is being touted as the

decade of commodities.

Why are Commodity Derivatives Required?

India is among the top-5 producers of most of the 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 this indicates 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


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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.

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


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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).The option holder will

exercise the option only if it is beneficial to him; otherwise he will let the option

lapse. For example, suppose a farmer buys a put option to sell 100 Quintals of wheat

at a price of $25 per quintal and pays a premium of $0.5 per quintal (or a total of

$50). If the price of wheat declines to say $20 before expiry, the farmer will exercise

his option and sell his wheat at the agreed price of $25 per quintal. However, if the

market price of wheat increases to say $30 per quintal, it would be advantageous for

the farmer to sell it directly in the open market at the spot price, rather than exercise

his option to sell at $25 per quintal.

Futures and options trading therefore helps in hedging the price risk and also

provide investment opportunity to speculators who are willing to assume risk for a

possible return. Further, futures trading and the ensuing discovery of price can help

farmers in deciding which crops to grow. They can also help in building a

competitive edge and enable businesses to smoothen their earnings because non

hedging of the risk would increase the volatility of their quarterly earnings. Thus

futures and options markets perform important functions that can not be ignored in

modern business environment. At the same time, it is true that too much speculative

activity in essential commodities would destabilize the markets and therefore, these

markets are normally regulated as per the laws of the country.


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Modern Commodity Exchanges

To make up for the loss of growth and development during the four decades of

restrictive government policies, FMC and the Government encouraged setting up of

the commodity exchanges using the most modern systems and practices in the

world. Some of the main regulatory measures imposed by the FMC include daily

mark to market system of margins, creation of trade guarantee fund, back-office

computerization for the existing single commodity Exchanges, online trading for the

new Exchanges, demutualization for the new Exchanges, and one-third

representation of independent Directors on the Boards of existing Exchanges etc.

Responding positively to the favorable policy changes, several Nation-wide Multi-

Commodity Exchanges (NMCE) have been set up since 2002, using modern

practices such as electronic trading and clearing. Selected Information about the two

most important commodity exchanges in India [Multi-Commodity Exchange of

India Limited (MCX), and National Multi-Commodity & Derivatives Exchange of

India Limited (NCDEX)] .

What risks and challenges arise from these recent developments in

commodities markets?

To answer this we spoke to several exchanges, hedge funds, pension funds and other

firms active in the market. We identified the most recent developments in the market

and saw how developing markets are changing the way firms conduct business (and

vice versa). There are some areas of uncertainty between commentators, especially

when attempting to determine the exact amount invested in commodities so our

research is bound by these constraints. Where these uncertainties exist we have set


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out the range of estimates we were given. It is vital that firms, individuals and the

FSA understand the full range of risks facing them. The purpose of this paper is to

illustrate the changing nature of investors, the expanding range of products and to

estimate the current level of investment in commodities markets. Most important,

we identify and investigate issues facing the market and highlight potential risks and

challenges.

Why invest in commodities?

Studies have shown that commodity price movements have traditionally been

negatively correlated to price movements of other financial instruments (such as

equities or bonds), so a natural resource investment can provide important portfolio

diversification. Equities, bonds and other financial instruments have shown that they

tend to follow the same trend in times of economic crisis. In addition, equities are

also bound by country-specific economic pressures. In contrast, commodities such

as zinc and wheat or orange juice will rarely rise and fall in parallel, regardless of

economic fundamentals, and they reflect the global economy. By being able to

efficiently diversify a portfolio, a fund manager reduces the risk that the total value

of their fund will decline given particular economic fundamentals. Even so,investors should be cautious. Recent price drops have led to media comment quoting

commodities professionals who say that the bull run may be over and that it would

be a bad time for investors to enter this asset class. They say that with some markets

now in contango (i.e. the spot price is lower than the forward price) in the nearby,

the roll on indices has become a negative yield.

Further, and as we cite above, some commentators point to the number of leading

equity indices made up by companies whose share prices are positively correlated

with commodity prices, e.g. BP and oil prices, Rio Tinto and the price of copper.

This means an investment manager must be very careful when seeking to have a

truly diversified portfolio.


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Retail investors and institutional funds (if allowed) would be wary of trading incommodity derivatives due to fear of ending up in delivery and lack of an efficient

portfolio that would keep up the growth momentum in their value of investment in

commodities. Hence an approach has been made here to compare one of the Indian

commodity indices (MCX Comdex) and its global counterparts to find if there is a

steady bull run in the Indian commodities compared with the global markets.

Investing in commodity indices that are efficiently designed for such purposes

would serve the dual purpose of removal of the fear of physical deliveries and would

yield them better returns with a moderate risk. Such commodity indices not only

provide an investment opportunity, but also provide with an alternative risk

mitigation mechanism for investors with intention to spread their eggs across

different commodity baskets. This would also help mitigate risks for those with


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exposure to more commodity related industries such as Refineries, Copper wire

manufacturers, edible oil crushers/refiners. As such, investing in indices is not a new

phenomenon to the investors in India, as indices designed based on spot and futures

securities market are commonly traded in the Indian stock exchanges. However,

globally commodity derivative indices are different from their financial derivative

counterparts in that their underlying physical/futures markets in commodities ranges

from paper pulp to gold, pork bellies to live cattle and crude oil. Globally, there are

about half a dozen popular indices that reflect the futures prices of commodities

from different underlying markets. The list includes indices such as Goldman Sachs

Commodity index (GSCI), Dow Jones-AIG Commodity Index (DJ-AIGCI), Reuters

CRB Commodity Index (RCRBCI), S&P Commodity Index (S&PCI), Rogers

International Commodity Index (RICI), and Deutsche Bank Liquid Commodity

Index (DBLCI). An interesting feature in these commodity indices is that, unlike

stock indices, all are based on futures contract prices due to the non-availability of

reliable spot prices of commodities at short regular intervals.

According to Goldman Sachs, about $80 billion have been invested globally in the

commodity derivatives of which 60 percent (about $48 billion) has been invested in

passive index-tracking instruments. Of these, a bulk has been invested in


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instruments linked to the Goldman Sachs Commodity Index (GSCI), DJAIGCI, and

RCRBCI that are traded on global benchmark exchanges CME, CBOT and

NYBOT respectively. Apart from futures and options, huge investments have been

done on these commodity indices through over-the-counter instruments such as

swaps and structured notes. Trading houses and derivatives dealers are the principal

players involved in trading and designing of these instruments. Apart from this,

smaller funds such as Pimcos Commodity Real Return Strategy Fund,

Oppenheimers Real Asset Fund, and Rogers International Raw Materials Funds are

available to retail investors interested in accessing global commodity markets

through index funds. These funds either invest in futures markets directly or Over-

The-Counter instruments or both for their commodities exposure. Recently,

Scudders Commodity Securities Fund, a path-breaking and an innovative fund

based on commodity derivatives associated with GSCI benchmark (50 percent) and

the shares of companies involved in commodity-based industries, (50 percent) was

launched. However, the current RBI regulations do not allow individuals and

entities from India to participate in trading in these global indices or global funds

tracking these indices.

How are Commodity Indices different from Stock Indices?

The cash prices of the exchange-traded stocks are available on a regular and

continuous basis; hence construction of index based on this data is simple and

continuous. Contrarily, cash prices of commodities are not readily available on a

continuous basis. To have an index that is indicative of the fundamentals and

actively tradable, it would be better to construct an index using futures prices rather

than cash prices in the absence of effective spot exchanges for commodities in the

country, commodity futures traded on an organized platform provides the best

platform to base the indices. However, futures contract expires on the date of their

maturity. In order to have continuous futures prices, commodity indices are

constructed in such a way that futures prices of given maturities (preferably near

(front) months) are considered and all are replaced with (rollover to) the subsequent


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months contracts during a definite rollover period. The popularity of the

commodity futures indices would have wide implications on the futures industry as

well. Investment in indices is normally a long-term strategy that could help increase

open up interests in futures contracts for various commodities as investor gain better

grip of the fundamentals. A significant spurt in trading activity could be witnessed

during the rollover days, when traders rolled over their positions into new contracts.

As the indices undertakes the movements in the nearest deferred months, funds

would like to hold positions in those underlying contracts. And, in the process this

would increase the trading activity in nearest deferred month contracts as well

during the roll-over period. Another interesting proposition could be that the trading

and investment community would get new trading opportunities whereby they can

take the strategic positions in both the indices and the underlying commodities to

profit out of the mismatched pricing between the two instruments ranging from

crude oil to live stock to precious metals. GSCI is highly volatile, as it gives nearly

75% of its index weight to commodities in energy sector. The futures on GSCI are

listed on Chicago Mercantile exchange.

Capital and Commodity Markets a comparison

I. Capital market

Progress on developing Indias capital market, which is already more competitive,

deep and developed by international markets standards, continued. Business in the

countrys oldest stock exchange, namely the Bombay Stock Exchange (BSE) dating

back to 1875, which is also one of the oldest stock exchanges in the world,

continued to thrive. The National Stock Exchange (NSE), which emerged in the

mid-1990s and catalyzed improvements in trading systems to provide the necessary

depth and choice to investors, made sustained progress. With the BSE and NSE

emerging as the two apex institutions of the countrys capital market, restructuring

of other stock exchanges went apace. Overseen by Securities and Exchange Board

of India (SEBI), an independent statutory regulatory authority, the countrys capital


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market dealt in scrips of a large number of listed companies with a wide

geographical outreach, providing a world class trading and settlement system, a

wide range of product availability with a fast growing derivatives market, and well

laid down corporate governance and investor protection measures. As a part of the

on-going financial and regulatory reforms of the primary and secondary market

segments of the capital market, a number of initiatives were taken in 2005-06 and

the current year so far. These measures, together with accelerated economic growth

and macroeconomic stability, sustained the confidence of investors (both domestic

and foreign) in the countrys capital market. The stock market scaled new peaks

year after year since 2003, with the BSE and NSE indices crossing the 14,000 and

4,000 marks, respectively, in January 2007.

Primary market

The primary capital market has remained upbeat during 2006-07 so far. The

aggregate resource mobilization in the market, especially through Initial Public

Offerings (IPOs) and private placements, was much higher in calendar year 2006

than during the previous year (Table 4.1).


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Out of Rs. 161,769 crore mobilized in the primary capital market, Rs. 117,407 crore,

or 72.5 per cent of the total resources mobilized, was raised through private

placement. Seventy five IPOs raised Rs. 24,779 crore, which accounted for 76 per

cent of resources raised through equity. The number of IPOs showed a steady rise to75 during 2006; on an average, there were around 6 IPOs per month.Net

mobilization of resources by mutual funds increased by more than four-fold to Rs.

104,950 crore in 2006 from Rs. 25,454 crore in 2005. The sharp rise in mobilization

by mutual funds was due to buoyant inflows under both income/debt oriented

schemes and growth/equity oriented schemes. After suffering negative inflows in

2003 and 2004, inflows turned positive for public sector mutual funds in 2005 and

accelerated in 2006. The share of UTI and other public sector mutual funds in the

total amount mobilized was around 22.5 per cent in 2005 and 17.8 per cent in 2006

(Table 4.2).


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Secondary market

In the secondary market, the up trends continued in 2006-07 with BSE Sensex and

NSE Nifty indices closing above 14,000 (14,015) and 4,000 marks (4,024) for the

first time, respectively on January 3, 2007. After a somewhat dull first half,

conditions on the bourses turned buoyant during the later part of the year with large

inflows from Foreign Institutional Investors (FIIs) and larger participation ofdomestic investors. During 2006, on a point-to-point basis, Sensex and Nifty Indices

rose by 46.7 and 39.8 per cent, respectively. The pick up in the stock indices could

be attributed to impressive growth in the profitability of Indian corporate, overall

higher growth in the economy, and other global factors such as continuation of

relatively soft interest rates and fall in crude oil prices in international markets.

Amongst the NSE indices, both Nifty and Nifty Junior delivered strong positive

returns, appreciating by 39.8 per cent and 28.2 per cent, respectively during the

calendar year 2006. While Nifty gave compounded returns of 28.3 per cent, Nifty

Junior recorded compounded returns of 27.8 per cent per year between 2004 and

2006 . The NSE indices (Nifty and Nifty Junior), on a climb since November 2005,


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dipped in May and June 2006 owing to bearish sentiments and selling by FIIs. But

there was a rapid recovery thereafter and an uptrend in the indices. Similarly, BSE

Sensex (top 30 stocks) which was 9,398 at end-December 2005 and 10,399 at end-

May 2006, after dropping to 8,929 on June 14, 2006, recovered soon thereafter to

rise steadily to 13,787 by end-December 2006 .

The BSE Sensex has continued its movement upwards in 2007 so far. It closed at14,652 on February 8, 2007. The journey from 13,000 to 14,000 mark, achieved in

just 26 trading sessions, was one of the fastestever climbs. The Sensex gained 4,389

points and appreciated by 46.7 per cent during 2006. It recorded compounded

returns of 33.2 per cent per year between 2004 and 2006. BSE 500 recorded a gain

of 38.9 per cent during 2006 to close at 5,271. The compounded returns of BSE 500

between 2004 and 2006 were 30.6 per cent per year.

According to the number of transactions, NSE continued to occupy the third

position among the worlds biggest exchanges in 2006, as in the previous three

years. BSE occupied the sixth position in 2006, slipping one position from 2005

(Table 4.5). In terms of listed companies, the BSE ranks first in the world.


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With the stock indices soaring, capitalisation also increased significantly by over 45

per cent during 2006. The year under review saw increased daily volatility (as

measured by standard deviation of returns) in the Indian markets partly due to a

sharp sell off in the market during the month of May in line with global markets in

reaction to the trend in global interest rates. The market soon recovered thereafter to

touch new highs reflecting the underlying strength of the fundamentals of the Indian

economy. The price-to-earnings (P/E) ratio, which partly reflects investors

expectations of corporate income growth in future, was higher at a little over 20 by

end-December 2006 as compared to 17-18 at end-December 2005 . investors

wealth as reflected in market


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In terms of volatility of weekly returns, uncertainties as reflected by the Indian

indices were higher than that depicted by indices outside India such as S&P 500 of

United States of America and Kospi of South Korea. The Indian indices recorded

higher volatility on weekly returns during the two-year period January 2005 to

December 2006 as compared to January 2004 to December 2005


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The market valuation of Indian stocks at the end of December 2006, with the Sensex

trading at a P/E multiple of 22.76 and S&P CNX Nifty at 21.26, was higher than

those in most emerging markets of Asia, e.g. South Korea, Thailand, Malaysia and

Taiwan; and was the second highest among emerging markets. The better valuation

could be on account of the good fundamentals and expected future growth in

earnings of Indian corporates (Table 4.8)

Market capitalisation in terms of GDP indicates the relative size of the capital

market, besides investor confidence and discounted future earnings of the corporate


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sector. As on January 12, 2007, market capitalisation (NSE) at US$834 billion was

91.5 per cent of GDP. Indias market capitalisation compares well with other

emerging economies and shows signs of catching up with some of the mature

economies (Table 4.9).

Liquidity, which serves as a fuel for the price discovery process, is one of the main

criteria sought by the investor while investing in the stock market. Market forces of

demand and supply determine the price of any security at any point of time. Impact

cost quantifies the impact of a small change in such forces on prices. Higher the

liquidity, lower the impact cost. The impact cost for purchase or sale of Rs.50 lakh

of the Nifty portfolio and that of Rs. 25 lakh of Nifty Junior portfolio remained

constant at 0.08 per cent and 0.16 per cent, respectively, over 2005 and 2006 (Table

4.10).


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The turnover in the spot and derivatives market, both on the NSE and BSE, has

shown steady growth in the recent years. NSE and BSE spot market turnover more

than doubled between 2003 and 2006. In respect of derivatives, the turnover on NSE

nearly doubled in a single year between 2005 and 2006 (Table 4.11).

NSE and BSE spot market turnovers adding up to Rs. 2,877,880 crore and NSE

and BSE derivatives turnover adding up to Rs. 7,050,677 crore in 2006 showed


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significant growth over the previous year. At the end of 2006, as a proportion of

GDP (advance estimate for 2006-07), the turnover in the spot market was 70.2 per

cent, while that in the derivatives market was 171.9 per cent.In terms of the

composition of market participants, the stock market continued to be dominated by

retail investors. The average transaction size of the spot market indicated its

continued accessibility to small investors (Table 4.12).


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The daily average volume of trade in the commodity exchanges in December 2006

was Rs. 12,000 crore. In the fortnight ending on December 31, 2006, gold, silver

and copper recorded the highest volumes of trade in MCX, while in NMCEX,


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pepper, rubber and raw jute, and in NCDEX, guar seed, chana and soy oil had the

highest volumes of trade. MCX emerged as the largest commodity

futures exchange during 2006-07 both in terms of turnover and number of contracts.

The growth of MCX during 2006-07 is comparable with some of the international

commodity futures exchanges like Goldman Sachs Commodity Index (GSCI), Dow

Jones AIG Commodity Index Cash Index (DJAIG) and Reuters/Jefferies

Commodity ResearchBureau (RJCRB) (Figure 4.2).

segment. The recent policy initiatives to address the systemic issues in the primary

capital market may increase the reliance on public issues as a major source of funds

for Indian corporates besides helping to broaden the investor base. With increased

globalisation, behaviour of stock prices in the near-term will be largely influenced

by a host of domestic as well as international factors. Global economy, after four

consecutive years of strong growth, is expected to post an equally impressive

growth in 2007. Favourable international economic conditions enhance the growth

prospects of developing countries which in turn facilitates sustained flow of cross-

border portfolio investment to emerging economies. On the domestic front, there are


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expectations of higher corporate investment and earnings, GDP growth of over 8 per

cent for the fourth year in a row with macroeconomic stability, and Governments

commitment to carry forward the economic reforms. These are expected to sustain

the interest of not only the domestic investors but also scale-up FII interest in Indian

equity and debt papers and to retain India as one of the preferred destinations for

portfolio investment. Improved investor awareness and expanding equity-cult

among the small savers appear to augur well for buoyant stock markets. Recent

trend of increased investors preference to participate in equity markets through

mutual fund conduit would enhance institutional investment in equity markets. The

institutional and regulatory architecture should facilitate this further as this would

counterbalance and cushion the impact of the swings in the stock prices.

While Government securities market is expected to attain further width and breadth

as a result of the latest policy initiatives such as introduction of intra-day short sale

and when issued market, measures need to be taken to revive the corporate debt

market to remove its sluggishness and encourage individual investment as well as

institutional investment including those by FIIs.

The commodity exchanges, which have seen consistent increase in turnovers for the

last few years, may remain vibrant in 2007- 08 witnessing larger volume and value

of commodities traded. Gold and crude oil account for the major part of the total

transactions in futures market at present. But, other commodities, particularly

agricultural commodities, are expected to gain importance helping their price

discovery process and thereby providing an opportunity for farmers, traders and

consumers to obtain a reasonable price. The proposed amendments to the Forward

Contracts (Regulation Act), 1952 are expected to strengthen the regulatory aspects

and ensure orderly conditions in the commodity futures market.

Different index and relationship between factors

There are some nationalized index which are predicting and tracking the commodity

market movement .the commodity index are consist of certain factors and its


30/32

showing the movement of commodity market pattern as per scenario goes. In our

project we try to show the relationship between different indices.

relationship between rain fall index and future

index

0

500

1000

1500

2000

2500

3000

28-10

-2007

17-10-20

07

06-10-20

07

25-09-20

07

14-09-20

07

03-09-20

07

23-08-20

07

12-08-20

07

01-08-20

07

21-07-

2007

10-07-

2007

29-06-20

07

date

indexv

alue

rain fall index

commodity futureindex

Rainfall Vs spot commodity index

0

500

1000

1500

2000

2500

3000

28-

10-

2007

06-

10-

2007

14-

09-

2007

23-

08-

2007

01-

08-

2007

10-

07-

2007

18-

06-

2007

date

va

lue

Index Value

Actual Cummulative

Rainfall(mm) since

06/01/2007


31/32

relationship between rainfall index and

spot commodity index

0

500

1000

1500

20002500

3000

28-10-2007

17-10-2007

06-10-2007

25-09-2007

14-09-2007

03-09-2007

23-08-2007

12-08-2007

01-08-2007

21-07-2007

10-07-2007

29-06-2007

date

indexv

alue

rain fall index

spot commodity

index


32/32

References:

www.mcxindia.com

www.indiabullion.com

www.indiainfoline.com

www.ssrn.com
http://www.mcxindia.com/http://www.mcxindia.com/http://www.mcxindia.com/http://www.mcxindia.com/http://www.indiabullion.com/http://www.indiainfoline.com/http://www.ssrn.com/http://www.mcxindia.com/http://www.indiabullion.com/http://www.indiainfoline.com/http://www.ssrn.com/

Documents

Final Report Frm