PROJECT REPORT ON

“A STUDY ON COMMODITY MARKET”

SUBMITTED BY:
HARSH CHHADWA
T.Y.BMS (SEM-V)

USHA PRAVIN GANDHI COLLEGE OF MANAGEMENT

VILE PARLE (WEST)
MUMBAI-400056.

SUBMITED TO

UNIVERSITY OF MUMBAI

ACADEMIC YEAR
2007-2008

UNDER THE GUIDANCE OF

MR.AMIT CHHEDA

1
 PROJECT REPORT ON

“A STUDY ON COMMODITY MARKET”

SUBMITTED BY:
HARSH CHHADWA
T.Y.BMS (SEM-V)

USHA PRAVIN GANDHI COLLEGE OF MANAGEMENT

VILE PARLE (WEST)
MUMBAI-400056.

SUBMITED TO

UNIVERSITY OF MUMBAI

ACADEMIC YEAR
2007-2008

UNDER THE GUIDANCE OF

MR.AMIT CHHEDA

DATE OF SUBMISSION
OCTOBER 15TH, 2007.

2
 INDEX

PAGE
SR NO. TOPICS
NO.
EXECUTIVE SUMMARY 1
1
2 COMMMODITY MARKET INTRODUCTION 3
3 BREIF HISTORY 4
4 MARKET DEVELOPMENT 5
5 INDIA CONNECTION 7
6 COMMODITY MARKET IN INDIA 8
COMMODITY MARKET
7 11
CHARACTERISTICS
8 HEDGERS AND SPECULATORS 20
9 HOW MARKET WORKS 23
10 HOW TO TRADE? 26
ECONOMIC IMPORTANCE OF FUTURE
11 28
MARKET
12 PRICING AND LIMITS 29
OVER- THE-COUNTER AND HAVALA
13 31
MARKET
14 ELEMENTS OF COMMODITY MARKET 32
15 STRATEGIES FOR TRADING IN FUTURES 35
16 LIST OF VARIOUS MARKETS 39
PARTICIPATION OF FII's AND MUTUAL
17 45
FUND's IN COMMODITY MARKET
TAXATION ISSUES IN COMMODITY
18 47
MARKET
19 ISSUES FACED IN INDIA 50
20 INTERNATIONAL TREND 51
21 REGULATORY ISSUES 53
22 REGULATORY PERSPECTIVE 55
23 MAIN TOPIC: CONCLUSION 60
24 CASE STUDY - COFFEE CRISIS 62
25 GENERAL QUESTIONS AND ANSWERS 83
26 BIBLIOGRAPHY 91

3
 Executive Summary

This project is about the study of the commodities market which will help you to
understand the basic structure of the market and also the practicalities of this market. It is an
overview, a brief study, and the situation of this market in India.

Commodity market is a place where trading in commodities takes place. It is similar to

an Equity market, but instead of buying or selling shares one buys or sells commodities.
The commodities markets are one of the oldest prevailing markets in the human
history. In fact derivatives trading started off in commodities with the earliest records being
traced back to the 17th century when Rice futures were traded in Japan.

Main Topics:

This report shows different types of trading strategies used while trading in a
commodity market. A brief description of how the market works and how one can trade in this
market can also be understood.

Several measures taken by the FMC in regard to the commodity exchanges in India
such as - Limit on open position of an individual operator to prevent over-trading, Limit on
price fluctuation to prevent abrupt upswing or downswing in prices - Special Margin deposits
to be collected on outstanding purchases or sales etc.

‘Futures’ and ‘options’ are two commodity traded types of derivatives. An ‘options’
contract gives the owner the right to buy or sell an asset at a set price on or before a given
date. On the other hand, the owner of a ‘futures’ contract is obligated to buy or sell the asset.
Unlike the physical markets, futures markets trade in futures contracts which are primarily
used for risk management (hedging) on commodity stocks or forward physical market)
purchases and sales The two major economic functions of a commodity futures market are
price risk management and price discovery. Futures contracts ensure their liquidity by being
highly standardized

Economic importance of the future market is stated as the commodity market is both
highly active and central to the global marketplace; it's a good source for vital market
information and sentiment indicators. There are various factors like price discovery and risk
reductions help the economy a great deal.

Here in this report it has been tried to show a basic understanding of the commodity
market, its characteristics like Margins, Derivatives, Leverage, etc which are very important to
understand for studying or entering in to the Commodity Market.

Participation of FII and Mutual Funds in Commodity Markets is shown, before these
entities where not allowed in the commodity market but now the Government is considering
the proposal to allow these entities to trade in commodity future markets.

Various issues like; India does not have a large nation-wide commodity market, but
isolated regional commodity markets. In parallel with the underlying cash markets, Indian

4
commodity futures markets too are dispersed and fragmented, with separate trading
communities in different regions and with little contact with one another.

Some recommendation showing what Forward Markets Commission should focus on;
Regulators should move away from a concern about preventing volatility towards protecting
market integrity. The regulators must set the regulatory template under which each of the
exchanges is permitted to operate and is expected to run its business.

The case study is on ‘Falling commodity prices and industry responses: some lessons from the
international coffee crisis.’ It is a case study on the commodity coffee. It show the
international crisis, various analysis and the reason behind the falling price of coffee.

In the end there are some general questions and answers about this market which
would help you understand a little more about this market.

5
 Commodities Market Introduction

Overview:

Ever since the dawn of civilization commodities trading have become an integral part
in the lives of mankind. The very reason for this lies in the fact that commodities represent the
fundamental elements of utility for human beings. The term commodity refers to any material,
which can be bought and sold. Commodities in a market's context refer to any movable
property other than actionable claims, money and securities. Over the years commodities
markets have been experiencing tremendous progress, which is evident from the fact that the
trade in this segment is standing as the boon for the global economy today. The promising
nature of these markets has made them an attractive investment avenue for investors.

In the early days people followed a mechanism for trading called Barter System, which
involves exchange of goods for goods. This was the first form of trade between individuals.
The absence of commonly accepted medium of exchange has initiated the need for Barter
System. People used to buy those commodities which they lack and sell those commodities
which are in excess with them. The commodities trade is believed to have its genesis in
Samaria. The early commodity contracts were carried out using clay tokens as medium of
exchange. Animals are believed to be the first commodities, which were traded, between
individuals. The internationalization of commodities trade can be better understood by
observing the commodity market integration occurred after the European Voyages of
Discovery. The development of international commodities trade is characterized by the
increase in volumes of trade across the nations and the convergence and price related to the
identical commodities at different markets. The major thrust for the commodities trade was
provided by the changes in demand patterns, scarcity and the supply potential both within and
across the nations.

6
Brief History:

Before the North American futures market originated some 150 years ago, farmers
would grow their crops and then bring them to market in the hope of selling their commodity
of inventory. But without any indication of demand, supply often exceeded what was needed,
and unpurchased crops were left to rot in the streets. Conversely, when a given commodity
such as Soybeans were out of season, the goods made from it became very expensive because
the crop was no longer available, lack of supply.

In the mid-19th century, grain markets were established and a central marketplace was
created for farmers to bring their commodities and sell them either for immediate delivery
(spot trading) or for forward delivery. The latter contracts, forwards contracts, were the fore-
runners to today's futures contracts. In fact, this concept saved many farmers from the loss of
crops and helped stabilize supply and prices in the off-season.

Today's commodity market is a global marketplace not only for agricultural products,
but also currencies and financial instruments such as Treasury bonds and securities securities
futures. It's a diverse marketplace of farmers, exporters, importers, manufacturers and
speculators. Modern technology has transformed commodities into a global marketplace
where a Kansas farmer can match a bid from a buyer in Europe.

7
 Market Development

In the context of the development of commodities markets, integration plays a pivotal

role in surmounting the barriers of trade. The development of trading mechanisms in the
commodities market segment largely helped the integration of commodities markets. The
major thrust for the integration of commodities trading was given by the European discoveries
and the march of the world trade towards globalization. The commodities trade among
different countries was originated much before the voyages of Columbus and Da Gama.
During the first half of the second millennium India and China had trading arrangements with
Southeast Asia, Eastern Europe, the Islamic countries and the Mediterranean. The
advancements in shipping and other transport technologies had facilitated the growth of the
trade in this segment. The unification of the Eurasian continent by the Mongols led to a wide
transmission of people, ideas and goods. Later, the Black Death of 1340s, the killer plague that
reduced the population of Europe and Middle East by one-third, has resulted in more per
capita income for individuals and thus increased the demand for Eastern luxuries like precious
stones, spices, ceramics and silks. This has augmented the supply of precious metals to the
East. This entire scenario resulted in the increased reliance on Indian Ocean trade routes and
stimulated the discovery of sea route to Asia.

The second half of the second millennium is characterized by the connectivity of the
markets related to the Old and the New worlds. In the year 1571, the city of Manila was found,
which linked the trade between America, Asia, Africa ad Europe. During the initial stages,
because of the high transportation costs, preference of trade was given to those commodities,
which had high value to weight ratio. In the aftermath of the discoveries huge volumes of
silver was pumped into world trade. With the discovery of the Cape route, the Venetian and
Egyptian dominance of spice exports was diluted. The introduction of New world crops into
China has lead to the increased demand for silver and a growth in exports of tea and silk.
Subsequently, Asia has become the prime trader of spices and silk and Americas became the
prominent exporter of silver.

Earlier investors invested in those companies, which specialized in the production of

commodities. This accounted for the indirect investments in commodity assets. But with the
establishment of commodity exchanges, a shift in the investment patterns of individuals has

8
occurred as investors started recognizing commodity investments as an alternative investment
avenue. The establishment of these exchanges has benefited both the producers and traders in
terms of reaping high profits and rationalizing transaction costs. Commodity exchanges play a
vital role in ensuring transparency in transactions and disseminating prices. The commodity
exchanges ensured the standard of trading by maintaining settlement guarantee funds and
implementing stringent capital adequacy norms for brokers. In the light of these
developments, various commodity based investment products were created to facilitate trading
and risk management. The commodity based products offer a huge array of benefits that
include offering risk-return trade-offs to investors, providing information on market trends and
assisting in framing asset allocation strategies. Commodity investments are always considered
as defensive because during the times of inflation, which adversely affects the performance of
stocks and bonds, commodities provide a defense to investors, maintaining the performance of
their portfolios.

The commodities trade in the 18th and 19th centuries was largely influenced by the
shifts in macro economic patterns, the changes in government regulations, the advancement in
technology, and other social and political transformations around the world. The 19th century
has seen the establishment of various commodities exchanges, which paved the way for
effective transportation, financing and warehousing facilities in this arena. In a new era of
trading environment, commodities exchanges offer innumerable economic benefits by
facilitating efficient price discovery mechanisms and competent risk transfer systems.

9
 India Connection

Coming to the Indian scenario, despite a long history of commodity markets,

commodity markets in India are still in their initial stages of development. The essential
contributors of this scenario include stringent regulatory restrictions, intermediate ban on
commodity trading and policy interventions by the government. Commodity markets have a
huge potential in the Indian context particularly because of the agro-based economy. With the
government's initiative for agricultural liberalization, commodities' trading in India has gained
increased momentum in activities. To increase the efficiency of the markets the Forward
Markets Commission (FMC), the governing body of commodities trading in India has taken
several initiatives for the establishment of national level multi-commodity exchanges in India.
These exchanges serve as platforms for facilitating transparent trading, trading in multiple
commodities, electronic delivery systems and efficient regulatory mechanisms, creating a
world class environment for Indian traders. In order to sustain the increasing volumes in
commodities trade, the need for proper clearing and settlement systems, warehousing facilities
and efficient pricing mechanisms has been identified. With the recent boom in commodities
markets, Indian participants are gearing up for exploiting the potential opportunities in the
future.

Commodity markets are of great help not only for their participants but also the
economy as a whole. The twenty year bear market for commodities has drastically reduced the
prices of many commodities to their lowest levels. The present shift in trend in commodity
trading complimented by the global increase in demand will certainly hold a promising future
for the investments in this segment.

10
 Commodities Market in India

Government of India, in 2002-03, has demonstrated its commitment to revive the Indian
agriculture sector and commodity futures markets. Prime Minister’s Independence Day
address to the nation on August 15, 2002, which enlisted nation-building initiatives,
included setting-up of national commodity exchange among the important initiatives. The
year 2002-03, certainly, was an eventful year in terms of regulatory changes and market
developments that could set the agenda for development for the years to come.

Policy Initiatives

Firstly, Government of India, in early 2003, has given mandate to four entities to set-up
nation-wide multi-commodity exchanges. Secondly, expansion of permitted list of
commodities under the Forward Contracts (Regulation) Act, 1952 (FC(R)A). This
effectively translates into futures trading in any commodities that can be identified.
Thirdly, 11 days restriction to complete a spot market transaction (ready delivery contract)
is being abolished. Fourthly, non-transferable specific delivery (NTSD) contracts are
removed from the purview of the FC(R). Above four policy decisions have the potential
to proliferate futures contracts’ usage in India to manage price risk. National level
exchanges would make availability of futures contracts across the nation in the most cost
effective manner through technology and at the same time would improve the risk
management systems to improve and maintain financial integrity of futures markets in the
country. Expansion of list of commodities would make available risk management
mechanism for all commodities where such a demand exists but never made possible in
the past. Abolition of the 11 days restriction on spot market transactions, and removal of
NTSD contracts from the purview of FC(R) A would effectively mean unhindered
forward contracting among the constituents of commodity trade value chain.
Forward contracting is an important activity for any economy to meet raw material
requirements, to facilitate storage as a profitable economic activity and also to manage supply
and demand risk; forward contracts give rise to price risk, so to the need of price risk
management.

11
 Performance of commodity exchanges

Year 2002-03 witnessed a surge in volumes in the commodity futures markets in India.
The 20 plus commodity exchanges clocked a volume of about Rs. 100,000 crore in volumes
against the volume of 34,500 crore in 2001-02 –remarkable performance for an industry that is
being revived! This performance is more remarkable because the commodity exchanges as of
now are more regional and are for few commodities namely soybean complex, castor seed,
few other edible oilseed complex, pepper, jute and gur.
Interestingly, commodities in which future contracts are successful are commodities
those are not protected through government policies; and trade constituents of these
commodities are not complaining too. This should act as an eye-opener to the policy makers to
leave pricing and price risk management to the market forces rather than to administered
mechanisms alone. Any economy grows when the constituents willingly accept the risk for
better returns; if risks are not compensated with adequate or more returns, economic activity
will come into a standstill.
With the value of India’s commodity economy being around Rs. 300,000 crore a year
potential for much greater volumes are evident with the expansion of list of commodities and
nationwide availability. Opening up of the world trade barriers would mean more price risk to
be managed. All these factors augur well for the future of futures.

Way ahead
Commodity exchanges in India are expected to contribute significantly in
strengthening Indian economy to face the challenges of globalization. Indian markets are
poised to witness further developments in the areas of electronic warehouse receipts
(equivalent of dematerialized shares), which would facilitate seamless nationwide spot market
for commodities. Amendments to Essential Commodities Act and implementation of Value-
Added-tax would enable movement of across states and more unified tax regime, which would
facilitate easier trading in commodities. Options contracts in commodities are being
considered and this would again boost the commodity risk management markets in the
country. We may see increased interest from the international players in the Indian commodity

12
markets once national exchanges become operational. Commodity derivatives as an industry is
poised to take-off which may provide the numerous investors in this country with another
opportunity to invest and diversify their portfolio. Finally, we may see greater convergence of
markets –equity, commodities, forex and debt – which could enhance the business
opportunities for those have specialized in the above markets. Such integration would create
specialized treasuries and fund houses that would offer a gamut of services to provide
comprehensive risk management solutions to India’s corporate and trade community.
In short, we are poised to witness the resurgence of India’s commodity trading which
has more than 100 years of great history.

Impact of WTO regime

India being a signatory to WTO may open up the agricultural and other commodity
markets more to the global competition. India’s uniqueness as a major consumption market is
an invitation to the world to explore the Indian market. Indian producers and traders too would
have the opportunity to explore the global markets. Price risk management and quality
consciousness are two important factors to succeed in the global competition. Futures and
other derivatives contracts have significant role in price risk management. Indian companies
are allowed to participate in the international commodity exchanges to hedge their price risk
resultant from export and import activities of such companies. Due to the compliance issues
and international exchange rules, 90 percent of the commodity traders and producers are not in
a position to participate in the international exchanges. International exchanges have trading
unit size, which are prohibitive for many of the Indian traders and producers to participate in
the international exchanges. Addressing the risk management requirements of the majority is
of concern and the way to address is through on-shore exchanges. In a more liberalized
environment, Indian exchanges have significant role to play as vital economic institutions to
facilitate risk management and price discovery; price discovery would have greater link to
global demand and supply which could assist the producers to decide on what crops they
should produce.

13
 Commodity Market Characteristics

Given the nature of the Commodity futures market, the calculation of profit and loss
will be slightly different than on a normal stock exchange. Let's take a look at the main
concepts:

Leverage: Leverage refers to having control over large cash amounts of a commodity
with comparatively small levels of capital. In other words, with a relatively small amount of
cash, you can enter into a futures contract that is worth much more than you initially have to
pay (deposit into your margin account). It is said that in the futures market, more than any
other form of investment, price changes are highly leveraged, meaning a small change in a
futures price can translate into a huge gain or loss.

Futures positions are highly leveraged because the initial margins that are set by the
exchanges are relatively small compared to the cash value of the contracts in question (which is
part of the reason why the futures market is useful but also very risky). The smaller the margin
in relation to the cash value of the futures contract, the higher the leverage. So for an initial
margin of $5,000, you may be able to enter into a long position in a futures contract for 30,000
pounds of coffee valued at $50,000, which would be considered highly leveraged investments.

You already know that the futures market can be extremely risky, and therefore not for
the faint of heart. This should become more obvious once you understand the arithmetic of
leverage. Highly leveraged investments can produce two results: great profits or even greater
losses.

Due to leverage, if the price of the futures contract moves up even slightly, the profit
gain will be large in comparison to the initial margin. However, if the price just inches
downwards, that same high leverage will yield huge losses in comparison to the initial margin
deposit. For example, say that in anticipation of a rise in stock prices across the board, you
buy a futures contract with a margin deposit of $10,000, for an index currently standing at
1300. The value of the contract is worth $250 times the index (e.g. $250 x 1300 = $325,000),
meaning that for every point gain or loss, $250 will be gained or lost.

14
 If after a couple of months, the index realized a gain of 5%, this would mean the index
gained 65 points to stand at 1365. In terms of money, this would mean that you as an investor
earned a profit of $16,250 (65 points x $250); a profit of 162%!

On the other hand, if the index declined 5%, it would result in a monetary loss of
$16,250--a huge amount compared to the initial margin deposit made to obtain the contract.
This means you still have to pay $6,250 out of your pocket to cover your losses. The fact that
a small change of 5% to the index could result in such a large profit or loss to the investor
(sometimes even more than the initial investment made) is the risky arithmetic of leverage.
Consequently, while the value of a commodity or a financial instrument may not exhibit very
much price volatility, the same percentage gains and losses are much more dramatic in futures
contracts due to low margins and high leverage.

15
 Derivatives

Another major leap in the development of commodities markets is the growth in

commodities derivative segment. Derivatives are instruments whose value is determined based
on the value of an underlying asset. Forwards, futures and options are some of the well-known
derivatives instruments widely used by the traders in commodities markets. Derivatives
trading have a long history. The first recorded incident of commodities trade was traced back
to the times of ancient Greece. In the year 1688 De la Vega reported the trading in 'time
bargains' which were the then commonly used terms for options and futures. Though the first
recorded futures trade was found to have happened in Japan during the 17th century,
evidences reveal that the trading in rice futures was existent in China, 6000 years ago.
Derivatives are useful for both the producers and the traders for the mitigation of risk in their
business. Trading in futures is an outcome of the mankind's efforts towards maintaining the
supply balance of seasonal commodities throughout the year. Farmers derived the real benefits
of derivatives contracts by assuring the prices they want to procure on their products. The
volatility of prices has made the commodity derivatives not only significant risk hedging
instruments but also strategic exchange traded assets. Slowly, traders and speculators, who
never intended to take the delivery of goods, entered this segment. They traded in these
instruments and made their margins by taking the advantage of price volatility in commodity
markets.

The dawn of the 21st century brought back the good times for commodity markets.
With the end of a 20 year bear market for commodities, following the global economic
recovery and increased demand from China and other developing nations, has revitalized the
charisma of commodities markets. According to the forecasts given by experts commodities
markets are likely to experience a bright future with the depreciation in the value of financial
assets. Furthermore, increasing global consumption, declining U.S. Dollar value, rising factor-
input costs and the recent recovery of the market from the clutches of bear trend are
considered to be the positive symptoms, which contribute to the acceleration of growth in
commodity markets segment.

16
 Margin

Although the value of a contract at time of trading should be zero, its price constantly
fluctuates. This renders the owner liable to adverse changes in value, and creates a credit risk
to the exchange, who always acts as counterparty. To minimize this risk, the exchange
demands that contract owners post a form of collateral, in the US formally called performance
bond,

Settlement

Settlement is the act of consummating the contract, and can be done in one of two
ways, as specified per type of futures contract:

1. Physical delivery - the amount specified of the underlying asset of the contract is
delivered by the seller of the contract to the exchange, and by the exchange to the buyers of
the contract. Physical delivery is common with commodities and bonds. In practice, it occurs
only on a minority of contracts. Most are cancelled out by purchasing a covering position -
that is, buying a contract to cancel out an earlier sale (covering a short), or selling a contract to
liquidate an earlier purchase (covering a long).

2. Cash settlement - a cash payment is made based on the underlying reference rate,
such as a short term interest rate index such as Euribor, or the closing value of a stock market
index.

3. Expiry is the time when the final prices of the future are determined. For many equity
index and interest rate futures contracts (as well as for most equity options), this happens on
the third Friday of certain trading month. On this day the t+1 futures contract becomes the t
forward contract. For example, for most CME and CBOT contracts, at the expiry on
December, the March futures become the nearest contract. This is an exciting time for
arbitrage desks, as they will try to make rapid gains during the short period (normally 30
minutes) where the final prices are averaged from. At this moment the futures and the
underlying assets are extremely liquid and any miss pricing between an index and an
underlying asset is quickly traded by arbitrageurs. At this moment also, the increase in volume
17
is caused by traders rolling over positions to the next contract or, in the case of equity index
futures, purchasing underlying components of those indexes to hedge against current index
positions.

Margins: In the futures market, margin refers to the initial deposit of good faith made
into an account in order to enter into a futures contract. This margin is referred to as good faith
because it is this money that is used to debit any losses.

When you open a futures account, the futures exchange will state a minimum amount of
money that you must deposit into your account. This original deposit of money is called the
initial margin. When your contract is liquidated, you will be refunded the initial margin plus or
minus any gains or losses that occur over the span of the futures contract. In other words, the
amount in your margin account changes daily as the market fluctuates in relation to your
futures contract. The minimum-level margin is determined by the futures exchange and is
usually 5% to 10% of the futures contract. These predetermined initial margin amounts are
continuously under review: at times of high market volatility, initial margin requirements can be
raised.

The initial margin is the minimum amount required to enter into a new futures
contract, but the maintenance margin is the lowest amount an account can reach before
needing to be replenished. For example, if your margin account drops to a certain level
because of a series of daily losses, brokers are required to make a margin call and request that
you make an additional deposit into your account to bring the margin back up to the initial
amount.

Let's say that you had to deposit an initial margin of $1,000 on a contract and the
maintenance margin level is $500. A series of losses dropped the value of your account to
$400. This would then prompt the broker to make a margin call to you, requesting a deposit of
at least an additional $600 to bring the account back up to the initial margin level of $1,000.

Word to the wise: when a margin call is made, the funds usually have to be
delivered immediately. If they are not, the brokerage can have the right to liquidate your
Commodity position completely in order to make up for any losses it may have incurred on
your behalf. but commonly known as margin.

18
 Margin requirements are waived or reduced in some cases for hedgers who have
physical ownership of the covered commodity or spread traders who have offsetting contracts
balancing the position.

1. Initial margin is paid by both buyer and seller. It represents the loss on that contract,
as determined by historical price changes that is not likely to be exceeded on a usual day's
trading. Because a series of adverse price changes may exhaust the initial margin, a further
margin, usually called variation or maintenance margin, is required by the exchange. This is
calculated by the futures contract, i.e. agreeing a price at the end of each day, called the
"settlement" or mark-to-market price of the contract.

2. Margin-equity ratio is a term used by speculators, representing the amount of their

trading capital that is being held as margin at any particular time. Traders would rarely (and
unadvisedly) hold 100% of their capital as margin. The probability of losing their entire
capital at some point would be high. By contrast, if the margin-equity ratio is so low as to
make the trader's capital equal to the value of the futures contract itself, then they would not
profit from the inherent leverage implicit in futures trading. A conservative trader might hold a
margin-equity ratio of 15%, while a more aggressive trader might hold 40%.

3. Mark-to-Market margin

Mark-to-market margins (MTM or M2M or valan) are payable based on closing prices at the
end of each trading day. These margins will be paid by the buyer if the price declines and by
the seller if the price rises. This margin is worked out on difference between the
closing/clearing rate and the rate of the contract (if it is entered into on that day) or the
previous day's clearing rate. The Exchange collects these margins from buyers if the prices
decline and pays to the sellers and vice versa

19
 Key Characteristics

Nature of Commodities –

Commodities are real assets that are produced and consumed in an industrial or other
process. In contrast, other asset classes of interest rates, currency or equity represent financial
claims on different aspects of real assets. This aspect of commodities ha a number of
dimensions, including:

1. Consumption goods – commodities are primarily consumption goods rather than

investment products. This means that demand is not purely price dependent. In addition, some
commodities may display characteristics not normally found in financial assets. For example,
zero or negative price may occur in electricity markets where generators seek to ensure that
their plants are dispatched for contiguous blocks of time longer than a simple slot for which
separate time bids are accepted. This is driven by the desire of the generator to shed excess
output as electricity cannot be stored.

2. Non standard structure – commodities are generally not standardized. This reflects the
heterogeneous nature of commodity production in terms of quality or grade. This contrasts
with other financial assets that are homogenous. This dictates that the commodity market has
two layers. The physical or cash market that trades a range of commodities of varying quality,
location and structure, and a commodity derivatives market that trades a range of instruments
on (artificially) standardized commodities. This is driven by the need to facilitate trading. It
creates basis risk in commodity derivatives.

3. Cost of production – commodity prices frequently gravitate towards the cost of

production. This is because the market will adjust over time. If prices are significantly above
or below the cost of production (including a "normal" profit component), then supply will
adjust in the longer term.

4. Price behavior – commodity prices display seasonality and may change over different
phases of the commodity life. Seasonal patterns in consumption and production are manifested
in recurring behavior of prices and volatility. Forward prices of commodities will generally
change as time to maturity changes.

20
 Hedger and Speculator

The players in the futures market fall into two categories: hedger and speculator. A
Hedger can be Farmers, manufacturers, importers and exporter. A hedger buys or sells in the
futures market to secure the future price of a commodity intended to be sold at a later date in
the cash market. This helps protect against price risks.

The holders of the long position in futures contracts (buyers of the commodity), are
trying to secure as low a price as possible. The short holders of the contract ( sellers of the
commodity) will want to secure as high a price as possible. The commodity contract, however,
provides a definite price certainty for both parties, which reduces the risks associated with
price volatility. By means of futures contracts, Hedging can also be used as a means to lock in
an acceptable price margin between the cost of the raw material and the retail cost of the final
product sold.

Example:
A silversmith must secure a certain amount of silver in six months time for earrings
and bracelets that have already been advertised in an upcoming catalog with specific prices.
But what if the price of silver goes up over the next six months? Because the prices of the
earrings and bracelets are already set, the extra cost of the silver can't be passed onto the retail
buyer, meaning it would be passed onto the silversmith. The silversmith needs to hedge, or
minimize his risk against a possible price increase in silver. How? The silversmith would enter
the futures market and purchase a silver contract for settlement in six months time (let's say
June) at a price of $5 per ounce. At the end of the six months, the price of silver in the cash
market is actually $6 per ounce, so the silversmith benefits from the futures contract and
escapes the higher price. Had the price of silver declined in the cash market, the silversmith
would, in the end, have been better off without the futures contract. At the same time,
however, because the silver market is very volatile, the silver maker was still sheltering
himself from risk by entering into the futures contract. So that's basically what a hedger is: the
attempt to minimize risk as much as possible by locking in prices for a later date purchase and
sale.

Someone going long in a securities future contract now can hedge against rising equity prices
in three months. If at the time of the contract's expiration the equity price has risen, the

21
investor's contract can be closed out at the higher price. The opposite could happen as well: a
hedger could go short in a contract today to hedge against declining stock prices in the future.

A potato farmer would hedge against lower French fry prices, while a fast food chain would
hedge against higher potato prices. A company in need of a loan in six months could hedge
against rising in the interest rates future, while a coffee beanery could hedge against rising
coffee bean prices next year.

Speculators
Other commodity market participants, however, do not aim to minimize risk but rather
to benefit from the inherently risky nature of the commodity market. These are the
speculators, and they aim to profit from the very price change that hedgers are protecting
themselves against. A hedger would want to minimize their risk no matter what they're
investing in, while speculators want to increase their risk and therefore maximize their profits.
In the commodity market, a speculator buying a contract low in order to sell high in the future
would most likely be buying that contract from a hedger selling a contract low in anticipation
of declining prices in the future.

Unlike the hedger, the speculator does not actually seek to own the commodity in question.
Rather, he or she will enter the market seeking profits by off setting rising and declining prices
through the buying and selling of contracts.

Long Short
Secure a price now to protect Secure a price now to protect against
Hedger
against future rising prices future declining prices
Secure a price now in Secure a price now in anticipation of
Speculator
anticipation of rising prices declining prices

In a fast-paced market into which information is continuously being fed, speculators and
hedgers bounce off of--and benefit from--each other. The closer it gets to the time of the
contract's expiration, the more solid the information entering the market will be regarding the
commodity in question. Thus, all can expect a more accurate reflection of supply and demand
and the corresponding price. Regulatory Bodies The United States' futures market is regulated
by the Commodity Futures Trading Commission, CFTC, an independent agency of the U.S.
government. The market is also subject to regulation by the National Futures Association,
22
NFA, a self-regulatory body authorized by the U.S. Congress and subject to CFTC
supervision.

A Commodity broker and/or firm must be registered with the CFTC in order to issue or
buy or sell futures contracts. Futures brokers must also be registered with the NFA and the
CFTC in order to conduct business. The CFTC has the power to seek criminal prosecution
through the Department of Justice in cases of illegal activity, while violations against the
NFA's business ethics and code of conduct can permanently bar a company or a person from
dealing on the futures exchange. It is imperative for investors wanting to enter the futures
market to understand these regulations and make sure that the brokers, traders or companies
acting on their behalf are licensed by the CFTC.

Arbitrators

According to dictionary definition, a person who has been officially chosen to make a
decision between two people or groups who do not agree is known as Arbitrator. In
commodity market Arbitrators are the people who take the advantage of a discrepancy
between prices in two different markets. If he finds future prices of a commodity edging out
with the cash price, he will take offsetting positions in both the markets to lock in a profit.
Moreover the commodity futures investor is not charged interest on the difference between
margin and the full contract value.

23
 How Market Works:

The futures market is a centralized market place for buyers and sellers from around
the world who meet and enter into commodity futures contracts. Pricing mostly is based on an
open cry system, or bids and offers that can be matched electronically. The commodity
contract will state the price that will be paid and the date of delivery. Almost all futures
contracts end without the actual physical delivery of the commodity.

What exactly is a commodity Contract? Let's say, for example, that you decide to
subscribe to satellite TV. As the buyer, you enter into an agreement with the company to
receive a specific number of channels at a certain price every month for the next year. This
contract made with the satellite company is similar to a futures contract, in that you have
agreed to receive a product or commodity at a later date, with the price and terms for delivery
already set. You have secured your cost for now and the next year, even if the price of satellite
rises during that time. By entering into this agreement, you have reduced your risk of higher
prices.

That's how the futures market works. Except instead of a satellite TV provider, a
producer of wheat may be trying to secure a selling price for next season's crop, while a bread
maker may be trying to secure a buying price to determine how much bread can be made and
at what profit. So the farmer and the bread maker may enter into a futures contract requiring
the delivery of 5,000 bushels of grain to the buyer in June at a price of $4 per bushel. By
entering into this futures contract, the farmer and the bread maker secure a price that both
parties believe will be a fair price in June. It is this contract that can then be bought and sold in
the commodity market.

A futures contract is an agreement between two parties: a short position, the party who
agrees to deliver a commodity, and a long position, the party who agrees to receive a
commodity. In the above scenario, the farmer would be the holder of the short position
(agreeing to sell) while the bread maker would be the holder of the long (agreeing to buy).
(We will talk more about the outlooks of the long and short positions in the section on
strategies, but for now it's important to know that every contract involves both positions.)

24
 In every commodity contract, everything is specified: the quantity and quality of the
commodity, the specific price per unit, and the date and method of delivery. The price of a
futures contract is represented by the agreed - upon price of the underlying commodity or
financial instrument that will be delivered in the future. For example, in the above scenario,
the price of the contract is 5,000 bushels of grain at a price of $4 per bushel.

Profit And Loss - Cash Settlement. The profits and losses of futures depend on the
daily movements of the market for that contract and is calculated on a daily basis. For
example, say the futures contracts for wheat increases to $5 per bushel the day after the above
farmer and bread maker enter into their commodity contract of $4 per bushel. The farmer, as
the holder of the short position, has lost $1 per bushel because the selling price just increased
from the future price at which he is obliged to sell his wheat. The bread maker, as the long
position, has profited by $1 per bushel because the price he is obliged to pay is less than what
the rest of the market is obliged to pay in the future for wheat.

On the day the change occurs, the farmer's account is debited $5,000 ($1 per bushel X
5,000 bushels) and the bread maker's account is credited by $5,000 ($1 per bushel X 5,000
bushels). As the market moves every day, these kinds of adjustments are made accordingly.
Unlike the stock market, futures positions are settled on a daily basis, which means that gains
and losses from a day's trading are deducted or credited to a person's account each day. In the
stock market, the capital gains or losses from movements in price aren't realized until the
investor decides to sell the stock or cover his or her short position.

As the accounts of the parties in futures contracts are adjusted every day, most
transactions in the futures market are settled in cash, and the actual physical commodity is
bought or sold in the cash market. Prices in the cash and futures market tend to move parallel
to one another, and when a futures contract expires, the prices merge into one price. So on the
date either party decides to close out their futures position, the contract will be settled. If the
contract was settled at $5 per bushel, the farmer would lose $5,000 on the contract and the
bread maker would have made $5,000 on the contract.

But after the settlement of the wheat futures contract, the bread maker still needs wheat
to make bread, so he will in actuality buy his wheat in the cash market (or from a wheat pool)
for $5 per bushel (a total of $25,000) because that's the price of wheat in the cash market when

25
he closes out his contract. However, technically, the bread maker's futures profits of $5,000 go
towards his purchase, which means he still pays his locked-in price of $4 per bushel ($25,000
- $5,000 = $20,000). The farmer, after also closing out the contract, can sell his wheat on the
cash market at $5 per bushel, but, because of his losses from the futures contract with the
bread maker, the farmer still actually receives only $4 per bushel. In other words, the farmer's
loss in the commodity contract is offset by the higher selling price in the cash market--this is
referred to as hedging.

Now that you see that a futures contract is really more like a financial position, you can
also see that the two parties in the wheat futures contract discussed above could be two
speculators rather than a farmer and a bread maker. In such a case, the short speculator would
simply have lost $5,000 while the long speculator would have gained that amount. (Neither
would have to go to the cash market to buy or sell the commodity after the contract expires.)

26
 How to Trade?

You can invest in the futures market in a number of different ways, but before taking
the plunge, you must be sure of the amount of risk you're willing to take. As a futures trader,
you should have a solid understanding of how the market works and contracts function. You'll
also need to determine how much time, attention, and research you can dedicate to the
investment. Talk to your broker and ask questions before opening a futures account.

Unlike traditional equity traders, futures traders are advised to only use funds that have
been earmarked as risk capital. Once you've made the initial decision to enter the market, the
next question should be, How? Here are three different approaches to consider:

Self Directed - As an investor, you can trade your own account, without the aid or advice of a
Commodity broker. This involves the most risk because you become responsible for managing
funds, ordering trades, maintaining margins, acquiring research, and coming up with your own
analysis of how the market will move in relation to the commodity in which you've invested. It
requires time and complete attention to the market.

Full Service - Another way to participate in the market is by opening a managed account,
similar to an equity account. Your broker would have the power to trade on your behalf,
following conditions agreed upon when the account was opened. This method could lessen
your financial risk, because a professional broker would be assisting you, or making informed
decisions on your behalf. However, you would still be responsible for any losses incurred and
margin calls.

Commodity pool - A third way to enter the market, and one that offers the smallest risk, is to
join a commodity pool. Like a mutual fund, the commodity pool is a group of
commodities which can be invested in. No one person has an individual account; funds
are combined with others and traded as one. The profits and losses are directly
proportionate to the amount of money invested. By entering a commodity pool, you also
gain the opportunity to invest in diverse types of commodities. You are also not subject
to margin calls. However, it is essential that the pool be managed by a skilled broker, for
the risks of the futures market are still present in the commodity pool.

27
 Economic Importance of the Futures Market

Because the commodity market is both highly active and central to the global
marketplace, it's a good source for vital market information and sentiment indicators.

Price Discovery - Due to its highly competitive nature, the futures market has become an
important economic tool to determine prices, based on today's and tomorrow's estimated
amount of supply and demand. Futures market prices depend on a continuous flow of
information from around the world and thus require a high amount of transparency. Factors
such as weather, war, debt default, refugee displacement, land reclamation, and deforestation
can all have a major effect on supply and demand, and hence the present and future price of a
commodity. This kind of information and the way people absorb it constantly changes the
price of a commodity. This process is known as price discovery.

Risk Reduction - Futures markets are also a place for people to reduce risk when making
purchases. Risks are reduced because the price is pre-set, therefore letting participants know
how much of the commodity they will need to buy or sell. This helps reduce the ultimate cost
to the retail buyer, because with less risk there is less chance of manufacturers hiking up prices
to make up for profit losses in the cash market.

28
 Pricing and Limits
As we mentioned before, contracts in the Commodity futures market are a result of
competitive price discovery. Prices are quoted as they would be in the cash market: in
dollars and cents or per unit (gold ounces, bushels, barrels, index points, percentages and
so on).

Prices on futures contracts, however, have a minimum amount that they can move.
These minimums are established by the futures exchanges and are known as ticks. For
example, the minimum sum that a bushel of grain can move upwards or downwards in a day is
a quarter of one U.S. cent. For futures investors, it's important to understand how the
minimum price movement for each commodity will affect the size of the contract in question.
If you had a grain contract for 3,000 bushels, a minimum of $7.50 (0.25 cents x 3,000) could
be gained or lost on that particular contract in one day.

Futures prices also have a price change limit that determines the prices between which
the contracts can trade on a daily basis. The price change limit is added to and subtracted from
the previous day's close, and the results remain the upper and lower price boundary for the
day.

Say that the price change limit on silver per ounce is $0.25. Yesterday, the price per
ounce closed at $5. Today's upper price boundary for silver would be $5.25 and the lower
boundary would be $4.75. If at any moment during the day the price of futures contracts for
silver reaches either boundary, the exchange shuts down all trading of silver futures for the
day. The next day, the new boundaries are again calculated by adding and subtracting $0.25 to
the previous day's close. Each day the silver ounce could increase or decrease by $0.25 until
an equilibrium price is found. Because trading shuts down if prices reach their daily limits,
there may be occasions when it is NOT possible to liquidate an existing futures position at
will.

The exchange can revise this price limit if it feels it's necessary. It's not uncommon for
the exchange to abolish daily price limits in the month that the contract expires (delivery or
spot month). This is because trading is often volatile during this month, as sellers and buyers
try to obtain the best price possible before the expiration of the contract.

29
 In order to avoid any unfair advantages, the CTFC and the Commodity futures exchanges

impose limits on the total amount of contracts or units of a commodity in which any single
person can invest. These are known as position limits and they ensure that no one person can
control the market price for a particular commodity.

Concept of Over-The-Counter
30
OTC is an alternative trading platform, linked to a network of dealers who do not physically
meet but instead communicate through a network of phones and computers. Trades are usually
transacted between financial institutions that can also act as market makers for the commonly
trade instruments. All transactions over the telephone are recorded, incase of future disputes
that may arise. The buyer and seller to suit their requirements can customize the contracts
traded in these markets. Hence terms of the contract need not be specified as in the case of an
exchange.

Concept of Havala Markets

These are the unofficial commodity exchanges, which, have operated for many decades and
have built up a reasonable reputation in terms of integrity and liquidity and some of these
trade up to 20 to 30 times the volume of the official futures exchanges. They are often
localized in close proximity to official exchanges. The offer not only futures, but also options
contracts. Transactions costs are low, and they therefore attract many speculators and the
smaller hedgers. Absence of regulation and proper clearing arrangements, however, mean that
these markets are mostly "regulated" by the reputation of the main players.

31
 Elements of Commodity Futures Market

Forward Contracts

Commodity Futures contracts are based on what’s termed "Forward" Contracts. Early on these
"forward" contracts (agreements to buy now, pay and deliver later) were used as a way of
getting products from producer to the consumer. These typically were only for food and
agricultural Products. Forward contracts have evolved and have been standardized into what
we know today as futures contracts. Although more complex today, early “Forward” contracts
for example, were used for rice in seventeenth century Japan. Modern "forward", or futures
agreements, began in Chicago in the 1840s, with the appearance of the railroads, Chicago
being centrally located emerged as the hub between Midwestern farmers and producers and
the east coast consumer population centers.

Meaning of a future contract

A futures contract is a type of "forward contract". Forward Contract (Regulation) Act,

1952 (FCRA) defines forward contract as "a contract for the delivery of goods and which is
not a ready delivery contract". Under the Act, a ready delivery contract is one, which provides
for the delivery of goods and the payment of price therefore, either immediately or within such
period not exceeding 11 days after the date of the contract, subject to such conditions as may
be prescribed by the Central Government.

A ready delivery contract is required by law to be fulfilled by giving and taking the
physical delivery of goods. In market parlance, the ready delivery contracts are commonly
known as "spot" or "cash" contracts. All contracts in commodities providing for delivery of
goods and/or payment of price after 11 days from the date of the contract are "forward"
contracts.

Forward contracts are of two types - "Specific Delivery contracts" and "Futures
Contracts". Specific delivery contracts provide for the actual delivery of specific quantities
and types of goods during a specified future period, and in which the names of both the buyer
and the seller are mentioned.

32
 The term 'Futures contract' is nowhere defined in the FCRA. But the Act implies that it
is a forward contract, which is not a specific delivery contract. However, being a forward
contract, it is necessarily "a contract for the delivery of goods". A futures contract in which
delivery is not intended is void (i.e., not enforceable by law), and is, therefore, not permitted
for trading at any commodity exchange.

Commodity Futures Contracts

A commodity futures contract is a tradable standardized contract, the terms of which

are set in advance by the commodity exchange organizing trading in it. The futures contract is
for a specified variety of a commodity, known as the "basis", though quite a few other similar
varieties, both inferior and superior, are allowed to be deliverable or tender able for delivery
against the specified futures contract. The quality parameters of the "basis" and the
permissible tender able varieties; the delivery months and schedules; the places of delivery;
the "on" and "off" allowances for the quality differences and the transport costs; the tradable
lots; the modes of price quotes; the procedures for regular periodical (mostly daily) clearings;
the payment of prescribed clearing and margin monies; the transaction, clearing and other
fees; the arbitration, survey and other dispute redressing methods; the manner of settlement of
outstanding transactions after the last trading day, the penalties for non-issuance or non-
acceptance of deliveries, etc., are all predetermined by the rules and regulations of the
commodity exchange.

Consequently, the parties to the contract are required to negotiate only the quantity to
be bought and sold, and the price. Everything else is prescribed by the Exchange. Because of
the standardized nature of the futures contract, it can be traded with ease at a moment's notice.

Advantages of Futures Contracts

1. If price moves are favorable, the producer realizes the greatest return with this marketing
alternative.

33
2. No premium charge is associated with futures market contracts.

Disadvantages of Future Contracts

1. Subject to margin calls.

2. Unable to take advantage of favorable price moves.

3. Net price is subject to Basis change.

The main differences between the physical and futures markets

The physical markets for commodities deal in either cash or spot contract for ready
delivery and payment within 11 days, or forward (not futures) contracts for delivery of goods
and/or payment of price after 11 days. These contracts are essentially party to party contracts,
and are fulfilled by the seller giving delivery of goods of a specified variety of a commodity as
agreed to between the parties. Rarely are these contracts for the actual or physical delivery
allowed to be settled otherwise than by issuing or giving deliveries. Such situations may arise
when unforeseen and uncontrolled circumstances prevent the buyers and sellers from
receiving or taking deliveries.

The contracts may then be settled mutually. Unlike the physical markets, futures
markets trade in futures contracts which are primarily used for risk management (hedging) on
commodity stocks or forward physical market) purchases and sales. Futures contracts are
mostly offset before their maturity and, therefore, scarcely end in deliveries. Speculators also
use these futures contracts to benefit from changes in prices and are hardly interested in either
taking or receiving deliveries of goods.

34
 Strategies for Trading Futures

Essentially, futures contracts try to predict what the value of an index or commodity will be at
some date in the future. Speculators in the futures market can use different strategies to take
advantage of rising and declining prices. The most common strategies are known as going
long, going short and spreads.

Going Long- When an investor goes long, that is, enters a contract by agreeing to buy and
receive delivery of the underlying at a set price, it means that he or she is trying to profit from
an anticipated future price increase.

For example, let's say that, with an initial margin of $2,000 in June, Joe the speculator buys
one September contract of gold at $350 per ounce, for a total of 1,000 ounces or $350,000. By
buying in June, Joe is going long, with the expectation that the price of gold will rise by the
time the contract expires in September.

By August, the price of gold increases by $2 to $352 per ounce and Joe decides to sell the
contract in order to realize a profit. The 1,000 ounce contract would now be worth $352,000
and the profit would be $2,000. Given the very high leverage (remember the initial margin
was $2,000), by going long, Joe made a 100% profit!

Of course, the opposite would be true if the price of gold per ounce had fallen by $2. The
speculator would have realized a 100% loss. It's also important to remember that throughout
the time the contract was held by Joe, the margin may have dropped below the maintenance

margin level. He would have thus had to respond to several margin calls, resulting in an even
bigger loss or smaller profit.

Going Short; A speculator who goes short, that is, enters into a futures contract by agreeing to
sell and deliver the underlying at a set price, is looking to make a profit from declining price
levels. By selling high now, the contract can be repurchased in the future at a lower price, thus
generating a profit for the speculator.

Let's say that Sara did some research and came to the conclusion that the price of Crude Oil was
going to decline over the next six months. She could sell a contract today, in November, at the

35
current higher price, and buy it back within the next six months after the price has declined.
This strategy is called going short and is used when speculators take advantage of a declining
market.

Suppose that, with an initial margin deposit of $3,000, Sara sold one May crude oil contract
(one contract is equivalent to 1,000 barrels) at $25 per barrel, for a total value of $25,000.

By March, the price of oil had reached $20 per barrel and Sara felt it was time to cash in on
her profits. As such, she bought back the contract which was valued at $20,000. By going
short, Sara made a profit of $5,000! But again, if Sara's research had not been thorough, and
she had made a different decision, her strategy could have ended in a big loss.

Spreads; As you can see these strategies, going long and going short, are positions that
basically involve the buying or selling of a contract now in order to take advantage of rising or
declining prices in the future. Another common strategy used by commodity traders is called
spreads. Spreads involve taking advantage of the price difference between two different
contracts of the same commodity. Spreading is considered to be one of the most conservative
forms of trading in the futures market because it is much safer than the trading of long / short
(naked) futures contracts.

There are many different types of spreads, including:

Calendar spread - This involves the simultaneous purchase and sale of two futures of the
same type, having the same price, but different delivery dates.

Inter-Market spread - Here the investor, with contracts of the same month, goes long in one
market and short in another market. For example, the investor may take Short June Wheat and
Long June Pork Bellies.

Inter-Exchange spread - This is any type of spread in which each position is created in
different futures exchanges. For example, the investor may create a position in the Chicago
Board of Trade, CBOT and the London International Financial Futures and Options Exchange, LIFFE.

Options: Meaning

36
Futures contracts are similar to Options. Both represent actions that occur in future. But
Options are contract on the underlying futures contract where as futures are either to accept or
deliver the actual physical commodity. To make a decision between using a futures contract or
an options contract, producers need to evaluate both alternatives

An option on futures gives the right to but not the obligation on the part of the holder to buy or
sell the underlying futures contract by a certain date at a certain price.

Types of Options.

There are two types of options

1. A call option is a contract that gives the owner of the call option the right, but not
obligation to buy the underlying asset by a specified date and a specified price.

2. A put option is a contract that gives the owner of the put option, the right, but not
obligation to sell the underlying asset by a specified date and a specified price. A Commodity
option gives the owner a right to buy or sell a commodity at a specified price and before a
specified time. Options can be traded either in an exchange or over the counter. Over the
counter option contracts are tailor-made contracts matching the specific needs of investors.
The initial cash transfer (premium) is to be paid by the buyer of the option to the seller (option
writer). The purchase of an option limits the maximum loss and at the same time allows the
buyer to take advantage of favorable price movements.

Sellers of option contracts (option writers) are exposed to margin requirements.

Commodity options are exercisable into the corresponding future contracts of the commodity

rather than the physical commodity.

Based on the exercise mode there are two types of options that are
currently traded.

1. American Style Options:

37
In an American option, the buyer of the option can choose to exercise his option at any
given period of time between the purchase date and the expiry date of the underlying
futures contract.

2. European Style Options:

In a European option, the buyer of the option can choose to exercise his option only on the
date of expiration of the underlying futures contract. Since the American option provides
greater degree of flexibility to the investor, the premium paid to buy an American Style
Option is equal to or greater than the European Style Option. However in India options
have still not been introduced as necessary legal formalities are yet to be completed.

38
List of International Commodities Derivatives Exchanges

39
40
National Level Multi Commodity Exchanges

41
42
Regional Exchanges

43
44
Participation of FII and Mutual Funds in Commodity Markets

Mutual Funds and Foreign Institutional Investors are presently not allowed to trade in
commodity markets. The Government is considering the proposal to allow these entities to
trade in commodity future markets.

For commodity markets to grow rapidly, retail participation is essential as has been the
experience in developed countries. But the extent of knowledge dissemination of commodity
futures among the mass market is at an abysmal level.

Unlike the financial derivatives market, one can enter the commodity derivatives
market with a much lower investment, since margins are lower in the range of 5-10%. The
leverage that can be obtained in the commodity futures market is much higher. In case mutual
funds are allowed to participate in commodity markets by structuring commodity funds for
retail investors, this would prove to be an added advantage for the lay investor, who may not
have the knowledge and wherewithal to trade in such markets. The commodity futures
exchange remain largely in the shadows of the booming equity market exchanges due to low
awareness levels.

Tracking commodity prices is not just a balance sheet analysis or a company specific study.
Global factors and rather macro factors play a much important role in it. That demands
domain expertise in commodities, market dynamics and price forecasting. This is the reason
for mutual funds to participate in commodity markets since, they are equipped with qualified
analysts and fund management who undertake value investing and boost up the reliability for
the retail investors.

Globally, commodity markets are being acknowledged as an effective market to hedge

against the vagaries of the equity markets. The presence of foreign funds in the securities
market has been found to have correlation with the interest as well as activity in equity
segment. A similar scenario is expected to be replicated in the commodity market, in case
regulation permits the entry of Foreign Institutional Investors into this market.

Yet the other set of challenges in front of the exchanges are creating awareness and
information dissemination. While volumes are important for commodity exchanges, what is

45
probably more critical is awareness. There is a need for exchanges to keep relentlessly
pursuing an awareness creation strategy. Awareness at the grassroots will be essential to
materialize and sustain the success it is foreseeing. Disseminating market discovered prices to
the farmer level calls for a mammoth structural framework and massive investments.

46
 Taxation Issues in Commodity Market

Sales tax implications on commodity future transactions

A commodity future is an agreement to buy or sell a specified quantity and quality of a

commodity in future at a certain price. Commodity futures contracts can be settled either by
way of squaring off or by physical settlement. Commodity futures contracts, which are
squared off before expiry of the contracts, do not have implications of sales tax. In other
words, sales tax is not applicable on futures contracts, because selling a futures contract means
a commitment to sale, which is different from actual sale. Therefore it is not necessary to
obtain sales tax registration prior to entering into a futures contract. However, if the seller does
not square off the position and intends to deliver the goods in respect of his sale position, then
he is required to have sales tax registration.

As per law, in respect of any commodity that attracts sales tax, only sellers having
sales tax registration can give delivery; otherwise it becomes URD (Un Registered Dealer)
transaction. At the time of sale, the seller must submit a sale bill specifying the commodity,
quantity, rate, name of the buyer, etc. and the bill must contain his LST (Local Sales Tax) and
CST (Central Sales Tax number). Such sales tax registration should pertain to the state, where
the specified delivery centre of the futures contract as per MCX rules us located.

For example, if the designated delivery centre for a commodity is Ahmedabad, a seller
having sales tax registration of Gujarat is entitled to deliver goods at Ahmedabad along with a
bill specifying Gujarat sales tax no., but a seller having sales tax registration of Delhi is not
entitled to deliver to deliver at Ahmedabad along with a bill having Delhi sales tax registration
number. Further, in case it is URD transaction, it would attract higher amount of tax, which
must be collected by the buyer from the seller in case of URD and deposited with the Sales tax
department. Due to higher tax rates, it is practically not possible to carry out URD sales.

In case the seller is not registered with the sales tax department in the relevant state, another
option available to him is to deliver through a consignment agent having relevant sales tax
registration. It is not necessary for the buyer to have a sales tax registration, but if the buyer
takes delivery in one contract and wants to give delivery in a subsequent contract, he needs to

47
have sales tax registration for offering delivery; otherwise it would URD attracting higher tax
rates.

Sale tax implications in Commodity Futures Transactions resulting in delivery from the seller
and buyers point of view is as follows.

Sellers Point of View:

1. All sellers giving delivery of the physical commodity against open positions in a futures
contract shall have the necessary Registration with the corresponding Sales tax authority of the
state where delivery is being offered.

2. In case the selling member does not have a Sales Tax Registration number, then he can
appoint n Agent / Nominee who had the required Sales tax registration and deliver the
commodity through him.

3. Goods being delivered by the seller may be of different types – taxable, tax-paid or tax-
exempted. If the goods are taxable (which means if sales tax is not already paid on such goods
in that state), then it is the seller's responsibility to pay sales tax to the State Government on
the basis of sales tax applicable on such commodity. In such cases, whether he has to recover
sales tax from the buyer will depend on the price quotation as specified in the contract
specifications. If the price quotations as per the contract is inclusive of sales tax, then the
seller cannot recover sales tax from the buyer. If the price quotation is exclusive of sales tax,
then the seller will charge sales tax from the buyer as per the applicable rate.

4. If the goods being delivered by the seller are tax paid (that is in case of resale), then the
seller is not required to pay sales tax to the state govt. provided the buyer is also located in the
same state. If the buyer is located in some other state then the seller is required to pay CST,
which will be recovered by him from the buyer, irrespective of the fact whether the price
quotation specified in the contract is exclusive or inclusive of tax.

5. If the price quotation is exclusive of tax, then the seller will claim the tax from the buyer
irrespective of the fact whether the goods were taxable or tax paid.

6. If the goods are tax exempted then there is no question of sales tax being paid.

48
Buyer's Point of View.

1. It is not necessary for buyers taking delivery of the physical commodity against their
positions in the futures contract to be registered with the Sales Tax Authorities if
delivery is in the same state. But if they wish to deliver goods in future, they have to
have sales tax registration.

Service Tax

Members of Commodity Exchanges are liable to pay service tax @ 12% in addition to an
Education Cess @ 2% on the service tax. Therefore, the members are required to collect
Service Tax and Education Cess effectively @ 12.24% of the brokerage charged from
client or persons to whom they provide service relating to future contracts and receive
brokerage or any other charges for providing such services.

Bombay Stamp Act, 1948

Based on the provisions of the relevant articles of the Bombay Stamp Act 1958, the stamp
duty applicable for all commodities future transactions is Rs.1 per lakh of turnover.

Background Information on Issues Faced In India.

49
Situation of the Indian Commodity Exchanges

India does not have a large nation-wide commodity market, but isolated regional
commodity markets. In parallel with the underlying cash markets, Indian commodity
futures markets too are dispersed and fragmented, with separate trading communities in
different regions and with little contact with one another. While the exchanges have
varying degrees of success, the industry is generally viewed as unsuccessful. The
exchanges – with a few exceptions – have acknowledged that they need to embrace new
technologies, and, above all, modern – and transparent – methods of doing business. But
management often finds it difficult to chart out a route into the future, and have had
difficulties in convincing their membership. Next to the officially approved exchanges,
there are many Havala markets. Many market participants feel that as this system has
worked well for a long time, there is no reason to fear a breakdown of this system based
on trust. However, this clearly cannot be the base for government policy, which has a
duty to protect the public against the risks that use of these markets pose.

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 International Trends

As a result of globalization and liberalization, more and more farmers and traders are
becoming exposed to the vagaries of world commodity prices, and to heightened
international competition. As s result, the importance of commodity exchanges and other
tools for the transfer of risk (essential elements of an efficient market place) is increasing.
Meanwhile, developments in, primarily, technology and communications are driving a
drastic upheaval of the commodity exchange sector. Key factors affecting exchanges
include:

1. The trend towards electronic trading; even the exchanges that have a legacy of open outcry
(and the concomitant problem of floor brokers keen on defending their turf) are now
moving towards electronic trading.

2. The emergence of Internet-based commodity exchanges and Electronic Communication

Networks (ECNs) using a combination of dedicated networks and the Internet, as
competitors to exchanges.

3. Globalization of financial markets, where players now use multiple products on multiple
exchanges.

4. Few new products available for futures exchanges to launch.

These factors have forced exchanges to:

1. Compete with each other - many of them are now trying to steal products that are trading
on other exchanges.

2. Attempt to globalize their operations to cater to a more internationalized set of customers.

3. Seek alliances, often international, in order to compete more effectively against other
exchanges and ECNs. Futures Exchanges and stock exchanges are merging due to
increased competition and the need to get overhead costs down.

51
4. Become for-profit organizations and de-mutualize to be able to raise capital, in particular
for the technology necessary to adapt to new trading realities, and increase the speed of
decision-making (indeed, the largest single benefit of de-mutualization has probably been
a change of culture).

These developments have also had a dramatic impact on the way that those involved
in the futures industry, and in particular brokers, function. Key developments are
as follows:

1. Futures Brokers are downsizing and cutting costs to remain profitable in the new screen
based environment.

2. Brokers have much less loyalty to any one particular exchange.

3. Large players are getting direct access to the futures markets, via exchange screens, and,
therefore, have less need for brokers.

4. Brokers have to access other markets around the world to offer full services to retain their
larger clients, who are already internationalized; further, even small trading clients have
diversified the markets that they trade and require international access.

5. Globally the industry is merging. Futures brokers who have not been profitable – and this is
a substantial number – are being sold or merged.

6. There is increasing interest by brokers in harnessing their clearing services to generate

profits from this sector. Execution is less important. Clearing margins is now the major
profit source.

7. Micro brokers are growing. This has been through either a large brokerage service
organization providing all administrative services for a number of smaller brokers or
having a small broker buy a complete brokerage [execution/ processing] facility through
the internet and using this service to offer futures trading products.

52
 Regulatory Issues

Broad Government Policies

Various government policies still hinder the growth of commodity exchanges. Given the
recognized need for India to have efficient exchanges in the face of liberalization and
globalization, FMC should take the lead in coordinating with the responsible Ministries
and other government entities a change of these policies. This would not necessarily
reduce the government's possibilities to intervene in commodity markets, but would
ensure that such intervention does not hinder, or even critically damage, commodity
futures markets.

A first issue is taxes. Different tax treatment of speculative gains and losses discourage
many speculators from participating in official futures exchanges, thereby affecting the
liquidity of the markets. Hedgers are affected as well: the necessary link between futures
and physical market transactions is too rigidly defined. Tax issues need to be clarified so
that futures losses can be offset against profits on the underlying physical trade and vice
versa.

A second problem is stamp duty. Stamp duties on trade in commodity futures exchanges
should be nil, except when physical delivery is made. Now, stamp duty can be arbitrarily
imposed by the state in which the futures exchange is located. Clarification from the
Indian states in which there are exchanges that there will be no arbitrary position on
stamp duty is recommended.

Third, many institutions (particularly financial institutions but also, in a less direct
manner, cooperatives) are not permitted to engage in commodity futures trade. The rules
which prevent such engagement need to be modified.

Finally, the role of government entities directly involved in commodity trade should be
reconsidered. The direct purchasing practices of these entities now damage the potential
of commodity exchanges. If a federal or state government wishes to continue direct
interventions in commodity markets, it could, if it wished, pass through the commodity
exchanges.

53
This would ensure effective market intervention (the effect on prices will be immediate),
and, as long as done within clear policy guidelines, does not destroy market mechanisms.

54
 Regulatory Perspectives - What Should the Forward Markets
Commission Focus On?

Focus

Regulators should move away from a concern about preventing volatility towards protecting
market integrity. The regulators must set the regulatory template under which each of the
exchanges is permitted to operate and is expected to run its business.

Second, the FMC should move more aggressively to limit the Havala markets (or at least
increase their regulation to be on par with those of the futures industry).

Third, the FMC should allow exchanges to introduce option contracts. Knowledge has
now sufficiently spread, and technology sufficiently improved, to make this possible. The
FMC policy of approving futures contracts for exchanges near the regions producing the
underlying commodities should be discontinued. Instead, FMC approval should be given
to exchanges with the acceptable infrastructure and a potentially large trading
community/membership, irrespective of the exchange location in relation to the
commodity-producing centre.

Furthermore, it is important that the FMC seriously re-examine its priorities in its process
of regulatory reform. The FMC’s current market monitoring system functions in a
reasonably satisfactory manner most of the time in the current environment of small,
single commodity exchanges with low volumes, contracts of short duration and exchange
self-regulation. But if exchanges are to grow and are to play a bigger role, better
regulation is needed

With respect to the established exchanges, the FMC can also take a two-track approach.
For sufficiently well-managed exchanges (with strong trading, information, clearing and
self-regulatory systems) there are at least two items the FMC must change soon: One of
these is the requirement that the FMC approve a new futures contract each time a contract
expires on a commodity exchange. The other is the establishment of minimum and
maximum prices for futures contracts. Furthermore, it should consider offering these
exchanges the possibility to introduce option contracts.

55
 New roles for FMC

As an industry grows, as technology changes, as customer needs change the appropriate type
and scope of regulation are almost certain to change also. Thus, regulatory flexibility is
critical to the long run success of both regulation and the industry it regulates. In the
particular case of FMC, there are two key roles that it has to take on: setting up brokerage
regulation, and enhancing its promotional role.

A self-regulatory organization (a “national brokers association”) which, apart from arbitrating

disputes and the like, also sets and enforces educational standards should be set up. This
is a model that is surely advisable for India; but as brokers so far have failed to organize
themselves in this manner, the task will fall on FMC (eventually in cooperation with
SEBI).

Furthermore, the exchanges will have to be marketed aggressively to a wide range of potential
users, from domestic traders and financial institutions to international traders and
financial institutions to retail speculators (again, domestic and international) and,
ultimately, commodity funds. The FMC will need to participate in this marketing process,
partly to clear the regulatory hurdles (notably tax and banking) and partly to assist the
exchanges in encouraging the development of national – and, ultimately, international –
brokerages.

The FMC could encourage domestic financial institutions to build commodity trading desks.
This move has already started with gold, which should be seen as the most sensitive of
commodities. The FMC should work with RBI and SEBI to encourage the setting up of
commodity funds, either by banks, bank subsidiaries, mutual funds or NBFCs.

The broad structure of the day-to-day oversight of exchanges FMC should try to give as
much self-regulatory powers as possible to exchanges and to the brokerage community. It
should set the general framework, and have the right to ask for various types of
information from the exchange in respect of the dealing that is taking place. FMC must
be careful not to impose too restrictive or too onerous a set of responsibilities in respect of
reporting on the exchanges.

The Day-to-Day Oversight of the Exchanges

56
 In its day-to-day oversight of exchanges, the FMC should firstly, ensure that the
exchanges properly follow the rules; and secondly, should deter and punish manipulation
attempts.

The FMC should establish a group of surveillance and monitoring experts within its staff.
Among others, these should monitor the exchanges to ensure that trading remains open in
all contract months at all times as stipulated and impose a reporting requirement on any
disruptions or closures, the details thereof, and the reasons thereof. The board should be
held responsible for the justification and ought to be warned if it appears that the
disruption was not warranted.

Furthermore, commission staff should work with exchanges to establish reportable and
speculative position limits and to be able to receive data from the exchanges in a timely
manner. The FMC must to acquire additional hardware and software, and develop
programs for preparing the necessary reports.

Brokerage Regulation

Regulating the brokers

The global futures industry is undergoing a period of immense change, and previous
international brokerage models may no longer be as appropriate a benchmark to guide
India’s development of its brokerage industry. Nevertheless, a few guidelines for
stimulating this development can be given. Firstly, the entry of international broking
houses, either in joint ventures with domestic brokers or independently, should be
stimulated. Second, FMC should stimulate the evolution of hub-and-spoke type set-ups,
where a large number of micro-brokers would share services such as centralized back
office, administration, clearing and direct access into the trading system – this will enable
many of the current brokers to survive. Third, the FMC should stimulate the brokers to
organize themselves, and take on as many self-regulatory functions as possible.

The FMC needs to set standards on an umbrella basis; but each exchange will also have to
define the minimum standards for brokers (as for market makers and other users) based
on capital, expertise and experience. There should be a transition period (not exceeding
one year), where each exchange sets initial standards for their brokers.

57
 Protecting the customers

A key role of the regulator is to protect customers. While ultimately, customers are
responsible for their own actions, the regulator has to ensure that:

1. Potential users of exchanges are properly informed about the benefits and risks of futures
exchanges (that is to say, there has to be a "code of conduct" for brokers);

2. Users are able to obtain information about whether a particular broker is "legitimate" (so
there needs to be a licensing system, and information about brokers should be easily
accessible);

3. It is easy for customers to complain when they feel their broker has not done his job
properly;

4. There needs to be a good mechanism to investigate brokers, when there are such
complaints;

5. Brokers who break the rules are banned from the industry (which implies the need for a
nationwide brokerage registration system);

6. And there is a customer protection fund in case a broker falls bankrupt.

The regulators need to ensure that brokers follow Conduct of Business Rules. These rules
seek to regulate the way in which authorized firms conduct their business with their
customers.

Combating bucket shops

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 Bucket shops are companies that take customer orders for buying or selling futures (or
options), but never execute these orders on the exchange. Instead, they keep the orders
(or the largest part of them) on their books, often reporting profits on initial trades so that
customers increase their investments. They commonly employ high-pressure "boiler-
room" practices, making exaggerated claims on profit potential of futures and options
trading. Ultimately, they will report to customers that all their funds have been lost in an
unexpected market move. If customers try to claim their money before this happens, they
will either hold off payments (possibly using strong-arm techniques), or disappear. They
often target relatively vulnerable groups, such as poor, recent immigrants (a practice
known as "affinity trading") who have limited knowledge of the futures industry and may
not know where to find legal or regulatory recourse.

Bucket shops do not commonly use the exchanges, and thus fall outside of the normal
regulatory remit of the exchange regulator. However, given the damage that bucket shops
can do to the reputation of futures trade, and the overriding objective of the regulator to
protect the public at large, regulators commonly deal with bucket shops in an active
manner. It would be advisable for the FMC, preferably in cooperation with SEBI, to play
such an active role.

Educating brokers

The FMC should create a national education resource center which exchanges can utilize
to provide training, education and examinations in order to train and register their
members and staff.

Clearing

The regulator’s role with respect to clearing is to ensure that the system is strong enough to
defend market integrity even in times of crisis. However, in the Indian context, a more
pro-active role of FMC is defendable, or even desirable, in particular to point out the
consequences of certain choices

59
 Conclusion

Conclusion and Review

Buying and selling in the commodities market can seem risky and complicated. As
we've already said, futures trading is not for everyone, but it works for a wide range of people.
This tutorial has introduced you to the fundamentals of futures trading . If you want to
know more, contact your broker.

Let's review the basics:

The commodity market is a global marketplace, created initially as a place for farmers
and merchants to buy and sell commodities for either spot or future delivery. This was done to
lessen the risk to both and prevent waste of product.

Rather than trade a physical commodity, commodity markets buy and sell contracts,
which state the contract specifications, such as price per unit, type, value, quality and quantity
of the commodity in question, as well as the month the contract expires.

The players in the futures market are hedgers and speculators. A hedger tries to
minimize risk by buying or selling now in an effort to avoid rising or declining prices.
Conversely, the speculator will try to profit from the risks by buying or selling now in
anticipation of rising or declining prices.

The CFTC and the NFA are the regulatory bodies governing and monitoring futures
markets in the U.S.

Commodity accounts are credited or debited daily depending on profits or losses

incurred. The futures market is also characterized as being highly leveraged due to its margins;
although leverage works as a double-edged sword. It's important to understand the arithmetic
of leverage when calculating profit and loss, as well as the minimum price movements and
daily price limits at which contracts can trade.

Going long, going short and spreads are the most common strategies used when
trading on the futures market.Once you make the decision to trade in commodities, there are

60
several ways to participate in the market. All involve risk, some more than others. You can
trade your own account, find a Commodity Broker or join a commodity pool.

India is rapidly doing away with its barriers on commodity imports and exports,
opening up the country’s commodity sector to foreign competition. In order for the domestic
industry to be able to compete on an equal footing to its counterparts in other countries, India
must develop commodity exchanges that meet international standards in the areas of market
integrity, financial integrity and customer protection. Unless these standards are met,
exchanges will make only minor contributions to the growth and stability of the Indian
economy, and international firms and large domestic firms with significant hedging needs will
not use these exchanges.

The thirty-year ban on futures exchanges has had an adverse repercussion on the
growth and functioning of Indian commodity exchanges. It has forced people, skills and
money to flow to other markets, leaving an older generation of traders in charge not in tune
with the new market infrastructure and regulatory practices. While commodity exchanges
have done remarkably well in the face of adverse conditions, these conditions have now
changed. What was appropriate for the exchanges in the mid-1990s is no longer so today.
The FMC has been trying to modernize the exchanges by requiring them to implement
changes and using the withdrawal or even suspension of approval for trading in some
commodities. Many of the commodity exchanges are now responding and have been making
efforts to deal with their problems and imperfections.

India needs a more efficient, more comprehensive commodity futures industry. This
futures industry should be organized in line with best international practice. That is to say, the
system must rely to the extent possible on self-regulation (with powers vested in the
exchanges and in the brokerage community, and the government's regulatory role limited to
setting the general framework and ensuring that exchange- and broker-level self-regulation
works properly); enable very low transaction costs; be financially secure; and be dynamic.

61
Case Study

FALLING COMMODITY PRICES AND INDUSTRY RESPONSES: SOME LESSONS

FROM THE INTERNATIONAL COFFEE CRISIS

This case examines the nature, origins and implications of the sharp decline in coffee
prices since 1998. The decline is attributed to the significant expansion in global supplies against
sluggish demand growth. Recent efforts on the part of producers and exporters to control supply
growth or to promote demand growth are reviewed. It is argued that so-called "producer-only
agreements" to restrict production or exports are unlikely to succeed because of the difficulties in
maintaining the commitment of participants and policing such schemes. The organization of
demand promotion is also problematic where stakeholders may see their interests as competing,
and the experience with coffee indicates that there is a need to establish clear strategic aims to
which all can subscribe. However, in the longer term the tendency towards oversupply in the
coffee market can only be addressed by encouragement of diversification out of coffee production
at least in marginal areas.

1. Introduction

Although depressed prices have been common to most commodities, much attention has
focused on coffee. As the single most important tropical commodity accounting for almost half of
total net exports of tropical products, coffee has become emblematic of the problems faced by all
developing country agricultural commodity exports. Price falls for coffee have been particularly
dramatic: after a brief recovery in the mid-1990s when buffer stocks were finally cleared, real
coffee prices had fallen by 2001 to levels lower than ever recorded. In real terms coffee prices
today are less than one third of their 1960 level, and for many producers less than the cost of
production. According to the International Coffee Organization (ICO), this impacts directly upon
an estimated 20-25 million households in coffee-producing countries, and indirectly upon up to a
further 100 million engaged in upstream and downstream activities. The wider economic and
political implications are clear: as James Wolfensohn, President of the World Bank, noted, "The
reduction of coffee prices and also other commodities... is undermining the economic
sustainability of countries and millions of families in Latin America, Africa and Asia".

62
 Many different explanations have been proposed for the precipitous decline in coffee
prices. These include the emergence of Viet Nam as a major producer and exporter, the
depreciation of the Brazilian real, "under consumption", exploitation of market power by roasters
and retailers, technological change in roasting, domestic market liberalization and the abolition of
parastatal marketing agencies. In its recent resolution, the European Parliament attributes the
crisis to the dismantling of the international coffee agreement and the policies implemented by the
World Bank, the International Monetary Fund (IMF) and the World Trade Organization (WTO).
But basically the explanation lies in the market fundamentals of supply and demand. While it is
tempting to assume that such a precipitous fall in prices must be due to some new factor or some
change in market behavior, according to FAO price determination models the operation of market
fundamentals has not changed. Specifically it is the recent rapid growth in global supplies against
sluggish demand growth which has led to falling prices, and the low price elasticity of demand
means that these price falls are severe.

Suggested solutions to the crisis have been as various as the explanations. These have
included supply control, demand promotion, guaranteed prices, product differentiation, support
for diversification (and trade liberalization to provide opportunities for diversification), vertical
coordination or integration through the value chain, raising the profile of commodity problems in
international fora, fair trade initiatives (including obliging the four main coffee roasters to pay a
fair price to farmers and end "exploitation"), and even grower support funded by a windfall tax on
roasters.

A tendency for expanding supplies to outstrip demand growth on world markets is not
peculiar to coffee. The resulting market imbalances coupled with low price elasticities of demand
led to the same downward pressure on prices across a broad spectrum of commodities, albeit less
dramatically than for coffee. Some of the same solutions notably demand promotion and supply
control, have been implemented or are under active discussion in a variety of other international
industry initiatives.

This case examines the nature of the coffee crisis and discusses industry responses.
Specifically, it focuses on the persistent decline in prices and its origins in the tendency for supply
on world markets to grow ahead of demand. It considers experiences in internationally
coordinated attempts on the part of producers and exporters to influence those market

63
fundamentals by seeking to regulate supply or promote demand. It reviews recent efforts in these
directions and examines what lessons can be learned for other commodities.

2. The nature of the international coffee crisis

The collapse in international coffee prices since 1998 is evident from Figures 1 and 2. The
average ICO composite price fell by 21 percent in 1999, 25 percent in 2000, and 29 percent in
2001 to reach the lowest annual average since 1971. Apart from the upturn in the second half of
the 1990s, prices have trended steadily downwards since the peak in 1977. Since mid 2001 prices
appear to have leveled out a little but at very low levels, and this greater stability appears to have
continued into the first three quarters of 2003.

Figure 1. Trends and variability in international coffee prices (annual averages)

Figure 2. Trends and variability in real coffee prices (annual average prices deflated by
MUV, 1999 = 100)

64
 The recent variability of prices is also apparent in Figures 1 and 2 with the downward
trend interrupted by periodic peaks on average every nine or ten years since the maximum in 1977
with the most recent peak in 1998. Variability is important since the duration and amplitude of
price movements are relevant to the design of countermeasures to stabilize prices. If shocks are
long-lived then the costs of stabilization in terms of storage and financing will probably outweigh
any consumption or income benefits. The persistence of shocks in commodity prices has been
explored in a recent IMF study. This found that shocks to commodity prices are typically finite in
duration but long-lived. For coffee, persistence (measured as the length of time until the effects of
a shock decline to half the original magnitude) is at least nine years. This is also evident from
Figures 1 and 2. In these circumstances the IMF study concluded that the costs of operating any
kind of stabilization are likely to exceed any smoothing benefits. Ironically the International
Coffee Agreement was regarded as relatively successful.

Price movements reflect the evolving demand and supply situation. It is clear from Figure 3 that
supplies of coffee on the world market have typically run ahead of the growth in demand. Since
domestic consumption in producing countries did not expand sufficiently to absorb growing
supplies, coffee exports increased. But as developed country markets became increasingly
saturated growth in export earnings lagged behind growth in export volumes. The export earnings
of coffee producing countries have fallen from US$10-12 billion in the early 1990s to US$5-6

65
billion currently. However the value of retail sales of coffee has increased over the same period
from around US$30 billion to around US$70 billion.

Figure 3. International market balance for coffee

Imbalance in the world coffee market and the consequent low prices were exacerbated by
new plantings in Viet Nam, and by an increase in Brazilian exports following expansion of
plantings into frost-free areas, productivity improvements and devaluation of the real in early
1999. These supply side developments outweighed the steady increase in global coffee demand.
In the ten years to 2000/01 the area under coffee in Viet Nam expanded from 60 578 hectares to
463 450 hectares and coffee bean output increased from 96 000 tonnes to 800 000 tonnes, making
Viet Nam the largest robusta producer and second largest coffee producer in the world. The
consequent increase in export revenues provided a boost to the country's overall rural economy
with multiplier effects on incomes and employment in upstream and downstream activities and
leading to significant declines in the incidence of poverty and hunger. However, the subsequent
decline in robusta prices, by 39 percent in 2000 and 33 percent in 2001 had a "domino effect" on
arabica prices which were already under pressure from the 30 percent increase in coffee exports
from Brazil in 1999.

Over the last four years, consumption has remained virtually unchanged, and against this
background of saturated markets coupled with low price elasticity of demand, prices tend to
decline rapidly and sharply. However, falling prices do not necessarily prompt the expected
supply response. The perennial nature of the crop means that adjustment to the scale of

66
production through diversification and exit from the industry is slow: in the short run the price
elasticity of supply appears to be very small, around 0.25. It may also be that, as is often argued
for perennial crops, supply responses to price incentives are asymmetric: periods of rising prices
stimulate new plantings and other fixed asset investments which are not scrapped when prices
fall, but rather are simply not replaced when they reach the end of their productive life. Supply
responses to falling prices have also been slowed in some cases by national efforts to assist
producers, for example through price supports and debt relief. In the short-term adjustments can
be made to reduce application of inputs including labour, but creating unemployment and
stimulating migration. Reduced labour input through less care of trees and in harvesting also has
adverse effects on quality which in turn leads to additional pressure on average price levels. This,
together with the fact that much of the expansion in production from Viet Nam was of inferior
quality has lowered average quality, posing a threat to the various product differentiation
initiatives to develop markets for high-quality "specialist" coffees. However, there are signs that
areas planted are being cut back, in Viet Nam and Brazil, for example, and it is partly this which
is giving some strength to prices in the last few months of 2003. Elsewhere, the abandonment of
farms by smallholders and increased migration to urban centres have been reported to the ICO by
Cameroon, Central African Republic, Colombia, Costa Rica, Ecuador, Nicaragua, and
Philippines. Colombia further reported coffee land being used for illicit crops. Nevertheless,
stocks remain at high levels with an apparent reduction in exporting country stocks being offset
by further increases in importing country stocks.

The "coffee crisis" results not only from the price fall but also from the economic
importance of coffee in many producing countries. The effects of the fall in coffee prices after
1998 were particularly severe in those countries where productivity growth has lagged behind,
and coffee producers faced a tightening price-cost squeeze. However, such has been the extent of
the fall in prices that the adverse economic and social impacts have become generalized with
declining incomes, increasing unemployment and increasing rural poverty across all producing
countries and all production systems. Any gains which might have derived from domestic market
liberalization increasing the share of the export price going to farmers have been swamped.

While some traditional coffee exporters such as Brazil have diversified and reduced export
dependency on coffee - from more than 40 percent in 1960 to less than 5 percent today -
dependency remains a major problem, especially for poor African countries: Burundi derives

67
nearly 80 percent of export earnings from coffee; Uganda and Ethiopia more than 50 percent; and
Rwanda slightly less than 50 percent. A number of Latin American countries also have high
dependency on coffee, notably Colombia and El Salvador where coffee has accounted for around
15 percent of export earnings, and Guatemala, Honduras and Nicaragua with around 20 percent of
export earnings. Export dependency is also reflected in significant shares of employment related
to coffee: in Colombia for example 30 percent of the rural population is directly dependent on
coffee. Such dependency means that coffee price variations have significant multiplier effects on
employment and incomes beyond production itself in related upstream and downstream
industries, and across the economy in general.

The economic and social effects of falling coffee prices are documented by a recent ICO
survey of producing countries. Nicaragua reported 122 000 job losses, Costa Rica 10 000. In
Papua New Guinea employment in the estates sector has fallen by 40 percent. In Ecuador the
coffee processing sector is operating at only one third capacity. Almost all countries reported
falling incomes and expenditures among coffee-dependent households. An apparently common
coping strategy is reduced spending on health and education. In Papua New Guinea 50 percent of
parents in the Eastern Highlands had not paid school fees this year. Food security has inevitably
been reduced. Increased incidence of malnutrition is documented in Colombia where the number
of households in coffee growing areas living below the poverty line increased from 54 to 61
percent between 1997 and 2000. Malnutrition is also reported to be affecting 45 percent of
children in the coffee growing areas of El Salvador, where the World Food Programme
distributed emergency food supplies to some 10 000 coffee producing families. A March 2002
survey in Viet Nam showed 45 percent of coffee growing families lacking adequate nutrition. A
similar picture of impacts on incomes and rural poverty emerges from case studies in Tanzania
and Mexico reported earlier by Oxfam.

Declining prices and export revenues also have macroeconomic consequences. Especially
in the case of the highly dependent producers/exporters, declining prices and export revenues, and
declining incomes in the coffee sector can have an impact on government revenues. Recent
research shows this link continues to be particularly strong for African coffee exporting countries
in spite of market liberalization, although there is apparently no significant statistical relationship
in Latin America. Clearly, the strength of any such effect is likely to reflect the degree of
dependency on commodity exports which is typically higher in Africa. However, more anecdotal

68
evidence appears to indicate that the kind of extreme price falls observed for coffee over the last
five years do have macroeconomic impacts elsewhere. In the ICO's survey, Côte d'Ivoire,
Ethiopia, Nicaragua and Philippines all reported fiscal constraints on the national investment
budget. In the case of Nicaragua, the fall in foreign exchange earnings from coffee amounted to
around US$300 million between 2000/01 and 2002/03, while the reduction in income tax receipts
from the coffee sector is estimated at around US$13.2 million.

In the wide reporting of the coffee crisis, the media was quick to contrast the plight of
coffee growers with the apparent buoyancy of sales and profits in the retail coffee markets in
importing countries, prompting questions concerning the producers' share in retail prices. Figure 4
gives one illustrative example of marketing margin behavior as producer prices fell. It does
appear that margins were maintained as coffee prices received by growers fell and hence the share
of growers in the final retail price diminished. The latter was already small - perhaps between 20
and 30 percent of the retail price of coffee, and only between one and two percent of the price of a
cup of coffee sold in a coffee shop. Of course, the green coffee is only one element in the final
retail product which includes costs of processing, transport, services and so on as well as the
margins taken by firms at the various stages in the value chain. It would not be expected that
transmission of prices through the value chain would be perfect in the sense that changes in
grower or world prices would be mirrored by equivalent changes in final prices, especially in
proportionate terms. The extent to which world price variations are transmitted depends inter alia
on market structures at different stages in the value chain, the technology of processing, and the
share of the basic commodity in final products. As noted above, the latter is reduced as
processing, packaging and services increase in importance. Nevertheless much concern has been
expressed at the "fairness" or otherwise of the small share of global coffee income accruing to
growers.

Figure 4. Price spread between US retail price and Colombia producer price

69
The apparent tendency for falling international and producer prices not to be reflected in prices in
final markets, and hence for consumer to world price spreads to widen has a further dimension
which is that there is some evidence to suggest some asymmetry in price transmission with a
tendency for falling world prices not to be passed on but rising prices to be passed on at least to
some extent.The implication of this is that final demand does not rise as world prices fall because
the price falls are not passed on into final markets. To the extent that retail demand responds to
price changes, demand does not rise to absorb increasing levels of supply contributing further to
supply-demand imbalance. At the same time, as noted earlier, the characteristics of the product
and the production system are such that falling prices do not provoke significant reductions in
supply at least in the short-run. The net result is persistence of falling prices.

3. International action on coffee prices

3.1 Supply control

Depressed prices have prompted calls for international action to address problems of
market imbalance with proposals both to control supply and to promote demand. For coffee, the
Association of Coffee Producing Countries (ACPC) promoted a retention scheme from 1 October
2000 to retain 20 percent of exports to maintain prices above 95 cents/pound and release supplies
onto the market when prices exceeded 105 cents/pound. While 19 countries joined, including non-

70
members of ACPC such as Viet Nam, few actually retained any coffee at all: only Brazil,
Colombia, and Costa Rica and, temporarily, Viet Nam cooperated. Exports and stocks continued
to rise, and prices continued to fall.

Analysis based on a simple partial equilibrium model of the world coffee market
developed in the FAO Commodities and Trade Division indicates that if 20 percent of exports had
actually been retained off the market in 2001, international prices would have been up to 32
percent higher, and the total export revenue accruing to all exporters would have been 5 - 6
percent higher. However, in spite of this apparently large increase in prices, the specified floor
price of 95 cents per pound would still not have been reached, so low had prices fallen. In practice
few exporters actually committed to retaining any exports. If Brazil, Colombia, Costa Rica and
Viet Nam had actually implemented the 20 percent retention world prices would have risen by
around 17 percent. However, this would not have compensated for the revenue loss due to the
reduced volume of exports, and the revenue accruing to these countries would have fallen by
about 6.5 percent. On the other hand, those countries not participating in the scheme and
maintaining export volumes would have increased their revenues by 17 percent in line with the
price increase. These results are summarized in Table 1.

Table 1. Estimated effects of coffee export retention scheme in 2001

Participation Price effect Revenue

effect
All exporters +32 percent +5.5
percent
Brazil, Colombia, Costa Rica, Viet Nam +17 percent -6.5
percent
Non-participants +17 percent +17
percent

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 It appears from these results that prices could have been raised significantly in 2001,
although not to the target level, even without full participation in the scheme. However, the most
active supporters of the scheme would have lost revenues, while the free-riders would have
gained. It is not surprising therefore that even those exporters initially declaring an intention to
participate withdrew their support. The main difficulty with such schemes is to devise an
appropriate institutional structure to maintain general support and compliance and control free-
riders, especially where consuming-countries are not party to the agreement, and where financing
is uncertain.

Such schemes hark back to the international commodity agreements (ICAs) with
"economic clauses" which were widely seen in the 1970s as a solution to the problems of tropical
commodities facing weak markets and variable prices. However, at that time support was
forthcoming from the importing countries who wished to offset the threat of the use of the newly
acquired producer power as revealed in the petroleum and food price peaks reached in 1972-74.
Market interventions ended for sugar in 1984, for coffee in 1989 and for cocoa in 1993, while for
jute and rubber the arrangements continued until 2000. The ICAs are not now widely regarded as
a success, although the coffee agreement did succeed in keeping prices within the agreed range
for some time. The coffee agreement also succeeded in raising prices above what they would
otherwise have been, and its passing is seen by some as one reason for the coffee crisis. Today
existing ICAs focus on measures to improve the functioning of markets, and there is little
prospect of the resurrection of their economic clauses.

Nevertheless, interest persists in supply management by producing countries to counter

the long-run fall in international commodity prices.The ACPC coffee export retention scheme has
already been mentioned, but a similar scheme exists for rubber, and there has been active
discussion of the need for such a scheme for tea. These "producer-only agreements" involve
export retention or international stock management schemes, or diversion of low quality into
alternative uses. However, as the ACPC scheme illustrates, the experience to date has not been
encouraging. It seems difficult to maintain the continuing commitment of the parties to the
discipline of the agreement, while free-rider problems persist with those suppliers outside. Even
so, the issue of market interventions was seriously discussed again at the recent ICO/World Bank
round table on the coffee crisis which recorded "A recognition that a totally free market entailed
excessive social costs and that some forms of action with an impact on the market might be

72
considered, notwithstanding the fact that finding such a form of action with an agreement between
the various parties may be difficult".

In principle, the conditions for a successful - in the sense of raising prices or slowing their
fall - producer-only agreement do not appear demanding. The basic requirements are:

• the parties to the agreement should control a high percentage of production

• price inelastic demand
• modest price objectives
• a high degree of commitment to a simple instrument.

The conditions are not prohibitive and the share of trade that a group needs to command
(which depends on elasticities of import demand and export supply in non-members) need not be
impossibly high to achieve gains in export earnings by withholding some supplies from the
market in the short-run. In the longer-run the elasticities rise and with them the critical share
required for the successful operation of an agreement, but this should not rule out modestly aimed
agreements for a limited number of years. It is not a requirement for an international agreement
that it should be designed to last for ever; periodic re-assessments of the membership and tactics
make good sense. In any case market intervention cannot be sustained in a one-sided way to
counter the tendency for relative commodity prices to decline in the long-run. This can only be
achieved by bringing about a permanently improved balance between supply and demand.

The first two conditions are generally relatively easy to fulfil since production of many
commodities, although not coffee, is geographically concentrated, and commodity demand is
indeed typically inelastic. However, there is a tendency to be overambitious with respect to target
prices and to be unwilling to recognize the need to adjust targets in line with changing market
conditions, with politics rather than economics governing decisions. There are also difficulties in
choosing the currency to denominate the target prices. If the target price is set in US dollars then
devaluation of national currencies against this can offset falls in the dollar price. The devaluation
of the Brazilian real is one factor which led to growth in world coffee output in spite of falling
dollar prices, for example. Above all maintaining commitment, including financial support to
establish and implement a scheme, is the most difficult as the experience with the ACPC coffee
export retention scheme and the tripartite rubber agreement indicate. The higher the target prices

73
set the greater the incentive for low-cost producers to cheat, and for those outside the agreement
to increase their production and market share.

Control of cheating and free-riders is much easier if the agreement has full participation of
importers, which, by definition, a producer only agreement presumably does not have.
Consuming countries and the multinational trading companies which buy and process many
commodities are not likely to favor higher prices, although under the old ICAs importers saw it in
their interest to participate. Participation of consumers is not only desirable from the policing
point of view; it may also be a legal requirement that importers are represented under WTO rules,
although the constraints on WTO members forming producer-only agreements are not entirely
clear. Administration of an agreement has also become more difficult after market liberalization
which reformed or removed institutional mechanisms for this.

In spite of the continuing interest in such arrangements, it is clear that market intervention
of the producer-only agreement type is fraught with difficulties and unlikely to be successful. The
ICO has recently launched a Quality Improvement Programme, which although portrayed as a
demand enhancement scheme would also have supply side effects by eliminating a certain volume
of inferior quality coffee from international markets. The programme was agreed in 2002 under
Resolution 407 as the International Coffee Council proposed to prohibit from October 2002 the
export of coffee failing to meet specified minimum standards in terms of numbers of defects and
moisture content.[13] Exporting member countries are expected to develop and implement national
measures to implement the resolution.

If financing does not prove a problem, the scheme should have both demand and supply
side benefits since higher quality might be expected to stimulate demand and command a higher
price, while the elimination of low quality coffee would reduce overall supply. However, the
burden of implementing the scheme will fall most heavily on those producers with the lowest
quality at least in the short-run until their quality is improved. In terms of enforcement, coffee
failing to meet the specified standards can be refused the ICO certificate of origin by exporting
countries, but the cooperation of importers in policing the scheme and informing the ICO of
shipments failing to meet the quality standards is purely voluntary. Furthermore, the participation
of importers requires their agreement on the quality standards to be specified and a willingness to
give up some flexibility in the range of quality entering their blends. More generally, if superior
quality is to be demanded and to command a higher price, consumers must be able to recognize

74
quality differences and be willing to pay for them. Quality improvement schemes may therefore
need to be supported by educative information and promotion activities.

The impact of the coffee scheme on quality and prices and its costs is to be reviewed in
late 2003. However, analysis using the world price determination model referred to above
suggests that such a scheme could have beneficial effects. The impact on the demand side of the
market is difficult to judge a priori, although estimates of the likely reduction in export volumes
might be made. The extent of this reduction depends upon the percentage of production failing to
achieve standards. The ICO estimates that around 600 000 tonnes would have fallen below the
standard in 2002. However, perhaps 50 percent of this would not have been exported anyway.
The model results suggest that withholding this quantity from the market in 2002 would mean that
prices would be up to 8 percent higher than they otherwise would have been. This estimate seems
in broad accord with the 4.7 percent increase in the average price for 2002 in spite of a 5.3 percent
increase in global production. However, as noted above the burden of the scheme will fall most
heavily on those producers with the lowest quality. In the case of Viet Nam it is estimated that as
much as sixty percent of production in 2001/2002 was substandard.

A similar scheme is under active consideration by the world tea industry. Under this
scheme, tea failing to meet ISO standard 3720 would be excluded from the world market. The
details, and particularly the policing arrangements, remain to be worked out, and an international
working group has been established to develop the proposal. There is some concern that the ISO
standard involved may not be sufficiently stringent to be effectively constraining on volumes of
inferior quality tea coming on to the world market and hence have little real impact. Most
importantly, however, as with the coffee scheme, effective policing to ensure full cooperation is
essential. The tea industry is less well-placed to ensure this in the absence of a relevant
international body. Furthermore, it requires active participation of importers against a background
that inferior quality does find a market.

3.2 Demand promotion

Difficulties in coordinating international action on the supply side have led to interest in
demand side measures, and particularly demand promotion. However, from the outset it must be
recognized that generic promotion is primarily a means of influencing longer-term trends in
demand, not addressing short-run price variability. Nevertheless, there are certain common

75
problems faced by internationally coordinated attempts to regulate supply or stimulate demand.
Key amongst these is the need to secure continuing commitment to cooperative activities of
participants who may see their interests as competitive. The current ICO promotional work
emphasizes activities likely to command general support, and together with the arrangements for
finance and organization, reflects a realistic response in the current depressed market conditions.
In both respects, the lessons of past experience in coffee promotion are evident. Promotional
messages are not the concern here, but rather how to organize and finance promotional
programmes where there is not only the familiar free-rider problem, but also where there are
conflicts of interest between participants and tensions between generic and "brand" interests.
These controversies extend beyond coffee, of course, as evidenced by the current debates and
legal challenges to various generic promotion schemes across a range of agricultural products in
the United States. In particular the coffee experience offers some insights into how best to deal
with the three challenges faced by all promotional programmes: obtaining agreement on
programme objectives; generating financial backing for the programme; and sustaining
promotional programmes long enough to generate the desired results.

The international coffee industry has a long history of promotional activity, through the
Promotion Committee of the ICO which was charged under the terms of the various International
Coffee Agreements with the responsibility for undertaking generic promotion for coffee without
reference to brand, type or origin. The ICO was most active between 1976 and 1990. During this
period over US$43 million was spent on activities and campaigns specifically designed to build
the market for coffee. Financial support for market building activities was internationally-based
among virtually all coffee producing countries while activity implementation was typically
national in conjunction with national coffee associations. The ICO was dominated by Brazil and
Colombia, the two primary producers (and campaign financers as monies were raised pro rata by
market share). Although monies were raised through a compulsory levy on coffee producing
countries that were signatories to the ICO, expenditure was closely scrutinized and members
focused on return for investment. Contributions were most difficult for the smaller countries. At
the same time, Colombia's contribution was in addition to the monies it was already spending on
its national efforts, Café de Colombia. Tight budgets in the late 1980s and early 1990s combined
with lack of unanimity among coffee roasters who typically proposed promotion campaign ideas
and co-financed them led to the discontinuation of internationally backed generic promotion and
emergence of campaigns for specific market segments or national interests.[14]

76
 Stakeholders in the industry must be the primary source of funds for market development
activities. There is therefore a close link between the fortunes of the industry, financial support for
promotion and the scope and nature of promotional activities undertaken. Promotion has typically
been funded primarily by producing/exporting countries, and generally on a pro rata basis
relative to market share as in the case of ICO promotional activities. However, at times of
protracted low prices the capacity and willingness of producers to fund such programmes may be
limited. Consumers/importers may also cooperate in promotion activities in which case there will
be a need for a financial formula for cost sharing. Budgetary limitations have led to a need for
greater private sector contributions, and the need to attract private sector support is an explicit
provision in the most recent ICO promotional plans. Generally speaking, the narrower the
financial backing the more focused promotional efforts and greater likelihood of effectiveness.
However, the narrower international participation the more limited the funding base and
consequently the more limited the possible activity mix and geographical range. It is an ongoing
balancing challenge to secure financing and support (especially where each country perceives a
commensurate return on expenditure) for promotion campaigns. In such cases high emphasis
should be placed on clear targeted campaigns and routine feedback to all participants on
campaign progress. Where possible, feedback should identify the return for each country to make
it more meaningful to each participant. It also forms an essential tool for participating countries to
justify expenditure on generic promotion to their trade and government.

The funding possibilities obviously constrain what can be done and there is little prospect
that conventional advertising campaigns to compete with global brands could be mounted or
would necessarily find favour with all participants. In the face of financial constraints, including
those posed by depressed commodity prices and revenues, promotional activity needs to be
carefully targeted and guided by market research. There appears to be much scope for the
promotion of demand in producing countries: Brazil successfully raised coffee consumption
during the 1990s from around 480 000 tonnes to 750 000 tonnes, and is now second to the United
States as a consumer. However, even here, not all market segments offer the same prospects.
Increasing consumption among younger age groups in particular poses a particular challenge
where per capita consumption is low and heavily advertised soft drinks are the main competitive
challenge. Market growth possibilities in the high income developed countries where most coffee
has traditionally been consumed are relatively limited: only the specialist coffee markets have
seen significant growth recently, again indicating product differentiation as a potentially

77
successful marketing strategy. The same strategic priorities would be appropriate mutatis
mutandis for tea. The emphasis must be on general information provision which all participants
acknowledge to be of value, or campaigns targeted on specific market segments where those
participants with most to gain contribute most. In the ICO's most recent promotional plans the
priority is information provision, notably related to positive links between coffee consumption
and health, and on targeted markets, especially in producing countries and emerging markets, for
which generic programmes need to be developed on a country-by-country basis reflecting the
unique characteristics of each market. The expectation is that counterpart funding would be
forthcoming, especially for the latter. The basis for promotional activity of all kinds is research
and studies related to coffee consumption for which the ICO Promotion Committee also has
responsibility. Among producing and consuming countries alike there is common interest in the
coordination of a programme of market research to generate an internationally comparable
database of information on consumer attitudes and habits, and in the Promotion Committee acting
as a clearinghouse for educational, informational and public relations material. Particular points
of interest are the challenges of increasing sales to young people lured away from coffee in favour
of ready-to-drink, cold beverages, and attacks on coffee on health grounds.

The scope of backing for generic promotion activities is an important determinant of the
focus of activities and the marketing message or position. It serves as the basis for setting
marketing objectives and targets. If the interests or priorities of backers differ one from another it
becomes increasingly hard to secure collective ongoing support, whether that support is
conceptual, political or financial. Every marketing proposition must have clear and commonly
shared objectives. In the case of Cotton Council International (CCI) responsible for internal
cotton promotion, the industry agrees to overall objectives and priorities. Once these are set
specific country targets are developed internally as are the activities aimed to address those
targets. This information is shared with the industry who agrees to them as a collective approach
to promotion. The broader the financial and political support for a generic promotion campaign
the bigger the task of gaining support for activity proposals; securing funding; and reporting on
how monies were spent and what resulted from that expenditure. Accountability is paramount for
generic promotion since all stakeholders need to receive clear, ongoing evidence that monies have
been spent efficiently and generated the targeted results. Back-sell communication is essential on
at least a semi-annual basis to maintain support for activities that likely take several years to
generate significant results.

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 Regardless of campaign objectives generic promotion campaigns depend on a long-term
commitment by backers to allow sufficient time for results to be generated. A minimum of three
to five years is a realistic timeframe for most generic promotion activities. Defensive activities
that are fundamentally issues management might achieve their objectives in a shorter period.
Without exception the longer-term the objectives of the project, the bigger the challenge to
maintain political support and campaign funding. Maintaining support over the longer term is a
clear challenge for all advertising and marketing campaigns. It can be even more difficult to
convey the benefits derived from generic promotion to stakeholders when each has competitive
and varied interests. Promotional campaigns need to include demonstrable effective use of funds;
commonly agreed goals and realistic targets; specific measurable activities to track campaign
effectiveness. In addition, generic promotion campaigns have the challenge of communicating to
each stakeholder how those measured results impact the interests of that particular stakeholder to
justify ongoing support. However, even the best conceived and managed campaign cannot always
anticipate the effect of a changing market and the evolving consumer. For example, Café de
Colombia did not expect that the emergence of a strong gourmet following for coffee in the 1990s
would undermine its premium position, relegating Colombian coffee to "second best". This single
factor caused the Federación Nacional de Cafeteros de Colombia (FNC) to rethink its marketing
strategy and the platform for its ongoing promotional efforts for the late 1990s and beyond -
despite its success to date in developing a premium position for Colombian coffee over the
previous 30 years. An alternative way to view this market development is that the FNC was so
successful in its efforts that it set new standards for the industry as a whole which made its current
market position redundant.

The experience of the development of ICO promotional campaigns provides some useful
pointers to the design and implementation of promotional strategies for other commodities. The
difficulty facing collaborative action on the demand side as with action on the supply side is to
organize joint activities amongst stakeholders who may see their interests as competing. There is
therefore a need to establish clear strategic aims to which all can subscribe, and clear targets
based on rigorous market research. Activities in targeted markets need to be adapted to particular
local needs in collaboration with local organizations and in these cases those with most to gain
should provide the bulk of funding. In periods of declining prices and restricted public budgets it
seems inevitable that the private sector must play a greater role in market development activities.

79
Some concluding comments

This case has looked at the problems facing the international coffee market and
specifically at two areas of industry level initiatives to help improve market balance. It is clear
that industry level co-ordinated activities are not straightforward to organize, and attention has
also focused on a more micro-level at options available to individual producers to secure better
returns from the market.

Product differentiation into specialty varieties can achieve premium prices for coffee
beans, although such product differentiation opportunities are not open to all. More generally,
organic and fair trade products can also command a premium price. The International Trade
Centre (ITC) has been active in researching market opportunities in these areas, through the
Gourmet Coffee Project, for example. Coffee offers substantial scope for product differentiation
in view of its quite different characteristics according to geographic origin. So-called specialty or
gourmet coffees often associated with a particular producing region have continued to command a
premium and enjoy market growth even when prices in general have been depressed. Of course,
not all producers can enjoy the benefits of favored locations, but alternative bases for
differentiation are also possible - environmentally friendly production systems or organic or fair
trade, for example. Exploiting such niche markets requires that segments offering higher returns
must be identified and targeted, and quality maintained throughout the value chain. It may also be
that the market needs to be educated to appreciate and be willing to pay for "specialty" coffees.

In these areas there may be a role for government and for international agencies, but
basically they require investment. The problem is who will reap the benefits of any such
differentiation - roasters, traders, retailers, governments or growers. A recent study [16] shows that
for coffee, while international prices have displayed increasing variability across coffee types as a
result of increasing differentiation in final products markets this has not been reflected in prices
paid to farmers - in fact variance of grower prices has actually declined. So a growing share of
total incomes in the value chain has accrued to economic agents in the importing countries. Fitter
and Kaplinsky attribute this to the imbalance in market power between the two ends of the value

80
chain: while coffee growing is typically atomistic following abolition of marketing boards,
importing is concentrated with the top five importers accounting for over 40 percent of total
global trade, and roasting is even more highly concentrated with the top five roasters in Europe
accounting for nearly 60 percent of coffee produced.

In the longer term the tendency towards oversupply in the coffee market can only be
addressed by encouragement of diversification out of coffee production at least in marginal areas.
Horizontal diversification into alternative crops is the obvious direction, but the important
objective is to enhance income and employment opportunities, including outside agriculture.
Vertical diversification can be a means of capturing a share of processing and distribution
margins which have expanded even as prices of basic products have declined. Such vertical
diversification faces tariff escalation and needs to overcome the barriers to entry which are a
feature of the concentrated international market.

Ultimately, non-competitive producers must diversify out of coffee production. This will
require public assistance to growers to identify market opportunities and to obtain the necessary
knowledge, skills and resources to exploit them. Even for competitive producers, price variability
and exposure to price risk will remain even if the protracted slumps seen in recent years resulting
from global overproduction and stagnant demand may be limited. Attention can then increasingly
focus on management of these risks.

81
 Answers to Some General Questions

 What is a commodity market?

Commodity market is a place where trading in commodities takes place. It is

similar to an Equity market, but instead of buying or selling shares one buys or sells
commodities.

 How old are the commodities market?

The commodities markets are one of the oldest prevailing markets in the human
history. In fact derivatives trading started off in commodities with the earliest records
being traced back to the 17th century when Rice futures were traded in Japan.

 What are the different types of commodities that are traded in these
markets?

World-over one will find that a market exits for almost all the commodities
known to us. These commodities can be broadly classified into the following:

• Precious Metals: Gold, Silver, Platinum etc

• Other Metals: Nickel, Aluminum, Copper etc
• Agro-Based Commodities: Wheat, Corn, Cotton, Oils, Oilseeds, etc.
• Soft Commodities: Coffee, Cocoa, Sugar etc
• Live-Stock: Live Cattle, Pork Bellies etc

Energy: Crude Oil, Natural Gas, Gasoline etc

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 What are the different segments in the commodities market?

The commodities market exits in two distinct forms namely the Over the
Counter (OTC) market and the Exchange based market. Also, as in equities, there
exists the spot and the derivatives segment. The spot markets are essentially over the
counter markets and the participation is restricted to people who are involved with that
commodity say the farmer, processor, wholesaler etc. Majority of the derivative
trading takes place through exchange-based markets with standardized contracts,
settlements etc.

 What are the characteristics of Over The Counter (OTC) commodity

markets?

The OTC markets are essentially spot markets and are localized for specific
commodities. Almost all the trading that takes place in these markets is delivery based.
The buyers as well as the sellers have their set of brokers who negotiate the prices for
them. This can be illustrated with the help of the following example: A farmer, who
produces castor, wishing to sell his produce, would go to the local ‘mandi’. There he
would contact his broker who would in turn contact the brokers representing the
buyers. The buyers in this case would be wholesalers or refiners. In event of a deal
taking place the goods and the money would be exchanged directly between the buyer
and the seller. Thus it can be seen that this market is restricted to only those people
who are directly involved with the commodity.
In addition to the spot transactions, forward deals also take place in these
markets. However, they too happen on a delivery basis and hence are restricted to the
participants in the spot markets.

 What are the characteristics of the Exchange Traded markets?

The exchange-traded markets are essentially only derivative markets and are
similar to equity derivatives in their working. I.e. everything is standardized and a

83
 person can purchase a contract by paying only a percentage of the contract value. A
person can also go short on these exchanges. Also, even though there is a provision for
delivery most of the contracts are squared-off before expiry and are settled in cash. As
a result, one can see an active participation by people who are not associated with the
commodity.

 Do the commodity exchanges facilitate delivery?

The commodity exchanges do facilitate delivery, although it has been observed

world-over that only 2% of all the trades result in actual delivery.

 Why is the percentage of delivery ratio very low in the exchange based commodity
derivatives?

Many people who participate in the exchanges are those who are not involved
with the physical trading of the commodity. Thus they would not like receiving
delivery and would not be in a position to give delivery. Standardized contracts make
an unfeasible proposition for any trader to give or take delivery. E.g. if the size of 1
soya contract is 10MT, a trader cannot buy / sell 15MT of soya through the exchange.
Also one cannot avail a credit facility in the exchanges that may be available in the
local market. These and a host of other factors deter a person from giving / receiving
delivery through the exchanges.

 What is the size of the commodities market as compared to the equity market?

In the developed markets the volumes on the exchange-based commodity

derivates markets are about five times more than that of the equity markets.

 Which are the leading commodity exchanges around the world?

Some of the leading exchanges of the world are New York Mercantile
Exchange (NYMEX), the London Metal Exchange (LME) and the Chicago
Board of Trade (CBOT).

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 What is the history of commodities markets in India?

India, being an agro-based economy, has markets for most of the agro-based
commodities. India is the largest consumer of Gold in the world, which implies a huge
market for the yellow metal. India has huge spot markets for all these commodities.
E.g. Indore has a huge market for soya, Ahmedabad for castor seeds and
Surendranagar for Cotton etc.
During the pre-independence era India also had a thriving futures market for
commodities such as gold, silver, cotton, edible oils etc. In mid 1960’s, due to wars,
natural calamities and the consequent shortages, futures trading in most commodities
were banned.

Currently, the futures markets that exist in India are localized for specific
commodities. For example, Kerala has an exchange for pepper; Ahmedabad for castor
seeds and Mumbai is the major center for Gold etc. These exchanges, however, have
only a regional presence and are dominated by people who are involved with the
physical trade of that commodity.

 What are the current developments in this market?

The government has now allowed national commodity exchanges, similar to

the BSE & NSE, to come up and let them deal in commodity derivatives in an
electronic trading environment. These exchanges are expected to offer a nation-wide
anonymous, order driven; screen based trading system for trading. The Forward
Markets Commission (FMC) will regulate these exchanges.
Consequently four commodity exchanges have been approved to commence business
in this regard. They are:

1. Multi Commodity Exchange (MCX) located at Mumbai

2. National Commodity and Derivatives Exchange Ltd (NCDEX) located at Mumbai
3. National Board of Trade (NBOT) located at Indore
4. National Multi Commodity Exchange (NMCE) located at Ahmedabad.

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 What is the need for the exchange-traded commodity derivatives market?

The biggest advantage of having an exchange-based platform is reach. A wider reach

ensures greater participation, which results into a more efficient price discovery mechanism.
In fact it comes to a stage where the derivative market guides the spot market in terms of
pricing.
This can be well understood by looking at the following example:
Imagine a soya wholesaler in Madhya Pradesh who, having bought the crop from the farmer,
wishes to sell it to the oil refiners. To sell his crop he has to go to the local market at Indore.
The price that he will get for his crop would be solely dependent upon the demand supply
condition prevailing at that point of time at that market place. Also as the number of players

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 is less there are chances of the prices being biased.
In contrast the prices in the futures market are determined not only by the local demand
supply conditions but also by the global scenario. Add to that the view taken on a
commodity by various sets of people depending upon different parameters such as technical
analysis, political news, exchange rates etc. The price that is thus quoted can be safely
regarded as the most efficient price.
So, now looking at the futures price the trader can price his crop appropriately.

 What opportunities do the commodity derivatives provide for investors?

Futures contract in the commodities market, similar to equity derivatives segment, will
facilitate the activities of speculation, hedging and arbitrage to all class of investors.
Speculation: It facilitates speculation by providing opportunity to people, although not
involved with the commodity, to trade on the views in the movement of commodity prices.
The speculative position is taken with a small margin amount that is paid to the exchange,
and the contract can be squared-off anytime during the trading hours.
Hedging: For the people associated with the commodities the futures market can
provide an effective hedging mechanism against price movements.
For example an oil-seed farmer may go short in oil-seed futures, thus ‘locking’ his sale price
and in the process hedging against any adverse price movements. On the other hand a
processor of oil seeds may buy oil-seed futures and thus assure him a supply of oil-seeds at a
pre-determined price. Similarly the oil-seed processor may go short in oil futures, which
may be bought by a wholesaler of oil.
Also, there is a saying that ‘Gold shines when everything fails’. Thus, gold can be used
as a hedging tool against other investments.
Arbitrage: Traders may exploit arbitrage opportunities that arise on account of different
prices between the two exchanges or between different maturities in the same underlying

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 What commodity futures markets do?

A well-developed and effective commodity futures market, unlike physical market,

facilitates offsetting the transactions without impacting on physical goods until the expiry of a
contract. Futures market attracts hedgers who minimize their risks, and encourage competition
from other traders who possess market information and price judgment. While hedgers have
long-term perspective of the market, the traders, or arbitragers as they are often called, hold an
immediate view of the market. A large number of different market players participate in
buying and selling activities in the market based on diverse domestic and global information,
such as price, demand and supply, climatic conditions and other market related information.
All these factors put together result in efficient price discovery as a result of large number of
buyers and sellers transacting in the futures market.
Futures market, as observed from the cross-country experience of active commodity
futures markets, helps in efficient price discovery of the respective commodities and does not
impair the long-run equilibrium price of commodities. At times, however, price behavior of a
commodity in the futures market might show some aberrations reacting to the element of
speculation and ‘bandwagon effect’ inherent in any market, but it quickly reverts to long-run
equilibrium price, as information flows in, reflecting fundamentals of the respective
commodity. In futures market, speculators play a role in providing liquidity to the markets and
may sometimes benefit from price movements, but do not have a systematic causal influence
on prices.
An effective architecture for regulation of trading and for ensuring transparency as
well as timely flow of information to the market participants would enhance the utility of
commodity exchanges in efficient price discovery and minimize price shocks triggered by
unanticipated supply demand mismatches.

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 Bibliography

Web

• http://en.wikipedia.org/wiki/Commodity_markets
• http://en.wikipedia.org/wiki/Image:Chicago_bot.jpg
• http://en.wikipedia.org/wiki/Futures_contract
• http://www.fmc.gov.in/
• http://www.ncdex.com/
• http://www.mcxindia.com/
• http://futures.tradingcharts.com/tafm/
• http://web.worldbank.org/WBSITE/EXTERNAL/EXTDEC/EXTDECPROSPECTS/E
XTGB
• http://www.libraries.rutgers.edu/rul/rr_gateway/research_guides/busi/stocks.shtml
• http://finance.indiamart.com/markets/commodity/commodity_exchanges.html
• http://finance.indiamart.com/markets/commodity/traders_derivatives_market.html
• http://finance.indiamart.com/markets/commodity/future_contracts.html

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