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Make commodity hedging your Infinity Stone

Rajalakshmi Nirmal | Updated on May 05, 2019 Published on May 05, 2019

The Avengers were lucky to have a time machine that helped them go back in time. While investors may not be so fortunate, hedging commodity price risk eliminates the need to time-travel and re-write the past

Commodity prices are so volatile today that businesses can go belly-up overnight. In aluminium, for instance, the annualised volatility is 25 per cent (as captured by the MCX aluminium futures contract), in zinc, it is 24 per cent and in crude oil, 33 per cent.

Investors can lock in the price of a commodity by hedging. Say, you run an airline, you can lock the price of aviation fuel when it is the lowest, while an oil producer can lock the crude price when it hits the highest.

Commexes in India and abroad provide commodity derivative contracts that can be used to hedge against adverse price movements in commodities. While Indian commodity exchanges still lag their global counterparts in market depth and liquidity, they still are a good choice for those who do business in the domestic market, for two reasons. One, there is no hassle of doing paper-work for regulatory approval and, two, you do not have to hedge the forex risk separately.

There are three national-level commodity exchanges in India, where you can hedge your price risk through derivative contracts — the Multi Commodity Exchange of India (MCX), the National Commodity and Derivatives Exchange (NCDEX) and the Indian Commodity Exchange (ICEX). Recently, equity exchanges BSE and NSE have also started offering commodity derivative contracts.

For anyone who wants to learn how to hedge commodity risks, we clear some common doubts and explain the steps to hedging.

Exchanges stronger than before

Over the last six years, after taking over the reins from the Forwards Markets Commission, SEBI, as the regulator for commodity derivatives, has done a lot to strengthen the ecosystem. A key move was its order to increase the minimum net worth required for commodity derivative exchanges to ₹100 crore, and the directive to commodity exchanges to transfer clearing and settlement operations to a separate Clearing Corporation (CC). The watchdog also ensures that the Clearing Corporations maintain the requisite amount in the settlement guarantee fund (SGF).

It is the SGF which ensures that an exchange is able to fulfil its counter-party guarantee. When a member (broker) defaults, the SGF is used to settling the obligations of that member without affecting the normal settlement process. The corpus of the SGF is decided by the Clearing Corporation based on the methodology recommended by SEBI. The fund gets contributions from the Clearing Corporation (to the extent of at least 50 per cent), the exchange and the clearing members. It also receives penalties levied by the Clearing Corporation on members and earns interest from its own core funds. The sufficiency of the SGF is periodically tested by way of stress tests. These are also carried out to assess credit risk and liquidity risk in commodity derivatives. The core SGF at MCX Clearing Corporation was ₹329.8 crore towards the beginning of this fiscal year. For the NCDEX, it was ₹140.29 crore.

Safeguards against default

The next question is, what if there is default at the client (investor) level? Will the counter-party be protected then too?

In case of a futures contract, every member (broker) is mandated to collect margins from a client, and this is monitored by SEBI. The margin money collected from clients are of many types, and one of them is the mark-to-market (MTM) margin. This is nothing but the difference between the trade price and the current day’s settlement price.

Members (brokers) are mandated to collect the MTM from respective clients as soon as the margin calls are made by the exchanges at the end of each day. So, if you square-off a contract in profit at the end of the contract expiry, you can be sure that the Clearing Corporation will settle the profit amount – as this would have been collected from the counter-party through margins on a piecemeal basis, starting from the trade date.

Note that if a party to a trade doesn’t pay the margin money, the broker will square the open position. If a broker has, however, extended leverage to his/her clients and has not regularly collected applicable margins against trades, SEBI will come to know of it as there is a monitoring mechanism in place. So, this ensures that there is no systemic risk from a client default.

In case of options too, the counter-party risk is guaranteed by the Clearing Corporation of the exchanges with the help of the margin money provided by the brokers. Brokers collect margin amounts from writers of call and put options, depending on market price movements.

Grievance redressal mechanisms at the exchanges are also strong. If there is problem with the broker, the client can approach the IGRC – Investor Grievance Redressal Committee, of the exchange (information on which is provided on website of all the exchanges). If the issue is still not resolved, it can be escalated to arbitration. If the member does not honour the award favouring the client, the exchange adjusts such amount from the member’s deposit. If the member’s deposit falls short, the exchange initiates legal proceedings against the defaulter, and clients get paid from the IPF (investor protection fund) corpus.

Options take off

To hedge on the exchange platform, there are two ways — futures contracts and options.

SEBI waved the green flag to options in the commodity derivative market in June 2017. Options are derivatives instruments that give the buyer the right, but not the obligation, to buy or sell an asset at a specified price on a future date. For example, if you wish to buy 10 gm of gold after three months and worry that prices may go up from ₹3,000 a gm to ₹3,200/3,500 in the interim period, you may want to lock in at the current price. This can be done by entering into an ‘option’ agreement with the seller, by paying a fee (referred as premium) that gives you the right to buy gold at ₹3,000 a gm after three months.

Now, two scenarios can emerge. One, gold prices may go up at the end of three months, say to ₹3,300. Since you have locked into the price earlier and paid a ‘premium’ to validate the contract, you need to pay the seller only ₹3,000 a gm. Alternatively, if gold prices drop in those three months, say, to ₹2,700 a gm, you can let the contract expire. Since market prices are now much cheaper, you can buy gold from the market. Your loss is only the premium you paid.

Options are of two types – call and put. In a call option, the buyer has the right to buy; in a put option, the buyer has the right to sell.

For buyers of option contracts, while the loss is limited to the premium paid, the profit is unlimited. The seller (or writer) of the call/put option contract is the one who faces a higher risk — his profit is limited to the premium amount that he receives from the buyer, but the loss is unlimited.

Those wanting to write an option contract have to meet the margin requirements — that is determined based on volatility in the underlying. In commodity option contracts in India, the underlying are the respective commodity’s futures contracts traded on the same exchange.

Continuing with the example above, on the day of option expiry, the contract will convert to an equivalent futures position (long call will convert into long futures) at a price of ₹3,000 (commodity options expire a few days before the tender date of the futures contract). Now, it is left to you to either square off the position or pay the margin money on the contract and hold on.

Undeniably, options are good hedging tools, but at present there are only a few options contracts available on Indian exchanges (in NCDEX, there are guar seed, guar gum, chana, refined soya oil and soya bean; and in MCX we have gold, silver, zinc, copper and crude oil).

Options versus futures

A producer or user of, say, aluminium or lead or other metals, can consider taking futures contracts on the metals at MCX for hedging price risk exposure.

In a futures contract, there is an agreement between two parties to buy or sell an asset at a future date for a price agreed upon at the time of entering into the contract.

The key difference between a futures and an option contract is that in an options contract, there is no obligation to buy. If price is unfavourable, you can leave the contract to expire and your loss will be limited to the premium you paid. But in case of a futures contract, you will have to honour the contract, irrespective of the price movement. And the loss, in case of unfavourable price movement, is unlimited. That said, as a hedger with physical stock on hand, you will only end up in a no-loss/no-profit situation.

Following the SEBI order, commexes are now converting all their cash-settled metal contracts into compulsorily deliverable ones. So, if you are a hedger in a metal, you can also give/take delivery on the exchange platform.

Hedging key risks

Commodity exchanges in the country offer a transparent hedging platform. Most metal contracts have a 98-99 per cent correlation with their respective global benchmarks and serve as good hedging tools for users/producers of metals in the domestic market. Two kinds of hedging are common — hedging to save the business from risk of rising input prices, and hedging against inventory price fluctuation.

Higher input prices

M/s ABC is a copper dealer who buys stocks and sells refined copper. The price at which the company sells to its customers is pre-fixed, but it doesn’t get to buy copper from its supplier at a fixed price. The company lifts copper from the supplier’s warehouse every week at the then prevailing price. This impacts the company’s cash flow and profit margins; so, it wants to lock in the input price. This can be achieved by hedging in the futures market.

Let us assume that M/s ABC’s agreement with the supplier is to buy 10 tonnes of copper every Monday during January 20XX, at the prevailing price. The total procurement comes to 40 tonnes.

To hedge the price risk, all that the company needs to do is to take a ‘long’ position (buy) on 40 lots of MCX Copper futures contract at the time it enters into the agreement with the supplier (lot size of one MCX Copper futures contract is one tonne). As the company lifts each lot from the warehouse, it has to close positions in an equal number of lots in the futures market — that is, sell 10 lots of futures every time it lifts 10 lots from the supplier’s warehouse. The company’s purchase price will, thus, remain closer to the level (of ₹450/kg) it began with (see Table).

 

 

Inventory price fluctuation

 

Now, let us assume M/s ABC Fans holds an inventory of 50 tonnes of aluminium in April 20XX, and it expects to process and sell all the inventory by April end. To hedge against the risk of a fall in inventory price, the company has to take a ‘sell’ position in MCX aluminium futures contract. The lot size of one MCX aluminium futures contract is five tonnes. So, it has to go ‘short’ on 10 lots.

Later, as the company makes its final sale in the physical market, it can close its position by squaring up the contract. If prices fall, as anticipated, the company will make a profit on the futures contract, and this would make good the loss in the physical market. If, however, prices rise, loss in the futures market will be offset by the profit in the physical market.

Cost, not a worry

As derivatives don’t attract capital gains, one can rest easy on the tax front too

Hedging reduces risks, but it comes with a cost. The costs can be direct or indirect. Direct costs include CTT (commodity transaction tax), exchange transaction fees, brokerage charges on trading, GST (18 per cent of brokerages and exchange charges), stamp duty and regulatory fee (of SEBI). All this, put together, will be about 0.05-0.06 per cent.

What may pinch hedgers is the indirect cost — that includes the opportunity cost of holding margin capital and the lost upside.

For every position you take in a futures contract, you are required pay a margin amount. This is fixed by the exchange and collected from you by the broker.

While the initial margin may be only 5-10 per cent, depending on volatility in the commodity, additional margins may be collected from you.

So, if you are hedging in bulk quantities, then you have to price in the opportunity cost of the money that you are provisioning for to be given away as margin when there is a requirement — this money, otherwise in your bank, would have earned an interest.

However note that when you close your futures position, the initial and additional margins collected are refunded.

As for the lost upside in price, even if the price moves favourably and you make a profit in the physical market, you may still be glum, as you would have made a loss on your position in the futures market. Remember, hedging is not about profiting, it’s only about covering risk.

On the tax front, you need not stress out with respect to your positions in the derivatives market.

There is no capital gains concept in the derivatives market.

Further, in the 2013 Budget, the Centre amended the definition of ‘speculative transactions’ under the Income-Tax Act to exclude commodity derivative transactions in recognised exchanges.

Thus, the loss on derivative positions in the commodities market is allowed as a set-off against business income, helping reduce tax outgo for businesses.

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