How about ‘synthetic’ commodity prices?

Future contracts can be considered to derive underlying prices

Developed commodity markets across geographies, including India, are characterised by the existence of closely intertwined spot and derivatives market.

To the curious mind, this begs a natural question: do prices in the futures market take cues from the spot market, or is it the other way round?

Academic research suggests that both support each other in terms of information flow that is critical to the formation of prices.

Accordingly, it is possible to calculate spot prices using the prices of the futures contracts. Of course, actual spot transactions may not take place at these ‘calculated’ prices, making them ‘synthetic’ or ‘theoretical’.

Statistical/financial tools provide the capability for conversion of the (future) prices in the futures market to (spot) synthetic prices, taking into account the cost of holding the commodity in the interim period, the length of holding, discounting the expectations and considering other market variables.

Obviously, this synthetic price varies from the actual spot market price. In practice, the spot price displayed by exchanges is often an average of market prices polled from select physical market participants, which is used as an anchor by futures market participants to form expectations about future prices.

Creating synthetic prices

What, then, is the advantage of creating synthetic spot prices? It is two-fold: first, since the (largely electronic) futures market is much more accessible, participative and prevalent across a much wider spectrum of people across geographies, the prices discovered in the futures market tend to be more robust, reflecting all expectations, discounting all available fundamental information relevant to the commodity.

Consequently, the derived spot price would tend to be robust and more appropriate.

Second, in Indian physical markets, marked by inefficiencies on multiple counts, the actual spot prices may be inefficient or, worse, unavailable on some days. Synthetic spot prices could come to the rescue of market participants looking for price cues in such cases.

An important hurdle in creating synthetic prices arises from the assumptions about its determinants. Apart from the holding cost and days to maturity of the underlying futures contract, there are several real world conditions that play significant, and often uncertain, roles in price formation. Take policy uncertainty, for instance.

A commodity market participant could find the uncertainty in policy measures, and therefore, his expectations, leading to uncertainty in anchoring the futures price.

This could, in turn, inhibit the creation of robust synthetic prices, demonstrated by the notable difference between the synthetic prices and actual spot prices.

It goes short of saying that such uncertainty could distort the process of ‘efficient price discovery’ in the futures markets.

Nevertheless, the success of the Tokyo Commodity Exchange’s rolling spot futures contracts in gold throws interesting light on the practical use of synthetic prices to help the participants assess such uncertainties and hedge their exposure.

The TOCOM rolling contract

In May 2015, the Tokyo Commodity Exchange (TOCOM) launched a Gold Rolling Spot futures contract, which is a yen-denominated cash-settled contract with a lot size of 100 gram.

The contract witnessed a daily volume of about 29,000 contracts within six months of its launch and the highest open Interest of 100,399 contracts on June 2, 2016, till end of June this year.

Significantly, the contract is settled on a synthetic spot price, which is calculated from the settlement price of the first contract month using a ‘forward rate’ and the number of days remaining until expiry.

The ‘forward rate’ is nothing but the difference between the price of the first contract month and sixth-contract month of the Gold Standard contract traded on TOCOM.

This provides opportunities for such innovation in Indian markets, too, to help market participants protect themselves against any such uncertainties in a dynamic manner.

Differences between synthetic spot prices and a rolling spot futures contract ( a la TOCOM) on the same underlying commodity could help arbitragers reap market opportunities.

In addition, it will strengthen the price discovery in the spot markets to make it a widely accepted benchmark.

The existence of rolling spot futures contract will make up for the non-existence of transparent and electronically traded spot markets.

For commodities like gold, synthetic gold spot prices could help India walk the path of being a ‘price signaller’ to the global markets supported by its strong fundamentals.

The authors are with MCX. The views are personal

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