Issued in Public Interest

NCDEX Investor (Client) Protection Fund Trust

HEDGING IN COMMODITY FUTURES

A COHERENT APPROACH TO CORPORATE RESILIENCE

Case Study of P. C. Kannan & Co.

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“If you don’t invest in risk management,
it doesn’t matter what business you’re in,
it’s a risky business.”
- Gary Cohn

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 Abstract
To sustain in any business, it is essential to be aware of various risks involved along
with appropriate avenues to mitigate them. Companies with significant exposure to
commodities, experience unprecedented challenges as a result of commodity price
volatility. Unexpected, erratic and adverse movements in commodity prices affect
their bottom lines by way of inflating input costs as they strive to maintain their com-
petitiveness or secure their market share. To avoid this situation of Hobson’s choice,
companies are increasingly seen engaging themselves in commodity trading, which
can add flexibility to their financial position and create certainty in commodity price
risk management.

The current paper presents a case study on Coriander Hedging, based on the experi-
ence of P. C. Kannan & Co., Indore, Madhya Pradesh. It illustrates how this company did
price-risk-hedging using futures contracts, which helped stabilize cash flows and aug-
ment business.
 Key Observations
1 NCDEX future contracts, especially for spices, have become benchmark contracts in the
country and all value chain participants including exporters and importers can track the
future prices simultaneously, which reduces information asymmetry and improves their
negotiation capacities.

2 Futures contracts provide an opportunity to lock at fixed prices thereby helping the exporter
in quoting a realistic price and thereby secure export contract in a competitive market.

3 Importers can also get an idea about the price trend prevailing in the exporting countries
and can cross-check the forward price quoted by the exporter against these price signals.

4 Futures platform provides a tool to offset price risk, i.e, hedging. Exporters as well as import-
ers can cover their price risk emanating from physical markets by taking opposite position in
the futures market. The existence of futures market would allow the exporters to hedge their
proposed purchase by temporarily substituting for actual purchase till the time is ripe to buy
in physical market. In the absence of futures market, the risks will have to be carried by the
firm/exporter.

5 Hedging minimizes the price risk exposure rather than eliminating risk completely, as stand-
ardized terms of futures trade often do not fit to individual’s physical market requirements
due to differences in contract size/product specifications/ delivery months and at times
simply because of non-availability of futures contracts in same commodity.

6 Commodity derivatives markets provide a window into the emanating price signals.

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Introduction
Protecting margins is crucial to survival in business, especially in commodity-based business which
has huge volumes and wafer-thin margins. If costs and selling prices were known in advance, the mar-
gins can be better protected. Commodities are acquired by paying a price and then there is the cost
of value addition, followed by realization through sales. To make positive earnings, the realization
through sales should always be more than the costs of procurement and value addition (such as stor-
age, processing, financing costs) put together. The value addition costs are largely fixed in nature,
making at least one component of the margin equation predictable. However, there are uncertainties
in costs of procurement as markets move all the time, which creates worries about fluctuations in
procurement and sale prices from time to time in turn affecting the margins. A recent experience of
P. C. Kannan & Co. (PCK), the top-most exporter of coriander in India, is illustrative of this routine chal-
lenge faced by manufacturers, processors, traders, exporters involved in the commodity value chain,
where commodity prices account for sizeable portion of their overall cost structure.

Case Study
1
PCK is a Star Export House recognized by the Directorate General of Foreign Trade. It has been
involved in the trade of Spices and other Agro commodities since 1969 with two thirds of its business
coming from the export market. PCK procures raw materials like raw spices directly from various
auction centers across India. Its own processing units carries out grading and sorting of spices. After
grading and packing, the goods are supplied to PCK’s customers.

On the 1st December 2012, PCK received the export order to supply 500 MT high grade coriander
seeds to a firm in the Middle East region by end of January 2013. In order to secure the order, PCK
needed to commit firm dollar prices in a day or two for the entire 500 MT of coriander seeds, while it
had very little inventory on hand to support the order. The firm had no option but to procure 500 MT
of coriander from the physical market at the prevailing rate to fulfill its export commitment. This
raised two kinds of concerns – first being high volatility in coriander prices in the physical market and
second being variation in quality procured as the local market quality differs based on the variety of
the crop and the origin of the crop came.

It was difficult for PCK to commit a price without running risk of losing money for two reasons – first,
it is not possible to predict periods of stable or volatile prices and second, the completion of procure-
ments generally takes time and if market prices rise during the procurement period to a level greater
than the one committed to the buyer, then the deal ends up as a loss (Box 1).

Like any other commodity, the coriander business is all about margins. Hence risk arising from price
movement was a matter of primary concern for PCK whose significant portion of annual sales is
contributed by coriander. PCK had taken debt from banks, which was another strong reason to ensure
steady business revenues and profits.

1 The dates and quantities relating to P. C. Kannan & Co. have been changed from the actual, in order to maintain business confidentiality.
 Box 1: Coriander Price Volatility
With a variety of factors that come into play with respect to demand and production, prices of corian-
1.
der fluctuate a lot. Coriander prices vary significantly even in a year’s time. For example, over the last
four years, such difference between highs and lows is 42% on average.

Over spans of a quarter, the prices have changed from as little as 12% to as high as 39%, in the last few
2.
years. As dynamics of the production and consumption of coriander change, the prices change too.
Sometimes there are periods of prolonged stability, for example in 2010, over a period of 9 months
(Mar-Nov) the prices were reasonably stable remaining in a range of around 20%. But the next set of
3.
nine months saw large price movements of nearly 90%.

4.
Even within coriander as a commodity, the demand-supply situation may vary from one grade to
another --- aggravating the price risk.

Coriander Spot Market Prices

5. (January 2009 to November 2012)
7,000.00

6,000.00

5,000.00
Rs. per quintal

4,000.00
6.
3,000.00

2,000.00

1,000.00

0.00
01-Jun-09

01-Jun-11

01-Jun-12
01-Apr-09
01-May-09

01-Nov-09

01-Jun-10
01-Apr-10
01-May-10

01-Nov-10

01-Apr-11

01-Nov-11

01-Apr-12
01-May-12

01-Nov-12
01-Feb-09
01-Mar-09
01-Jan-09

01-Aug-09
01-Sep-09

01-Dec-09

01-Feb-10
01-Mar-10

01-Aug-10
01-Sep-10

01-Dec-10

01-May-11
01-Feb-11
01-Mar-11

01-Aug-11
01-Sep-11

01-Dec-11

01-Feb-12
01-Mar-12

01-Aug-12
01-Sep-12
01-Oct-09

01-Jan-10

01-Oct-10

01-Jan-11

01-Oct-11

01-Jan-12

01-Oct-12
01-Jul-09

01-Jul-10

01-Jul-11

01-Jul-12

Coriander Volatility - Monthly (in %)

20.0%

18.0%

16.0%

14.0%

12.0%

10.0%

8.0%

6.0%

4.0%

2.0%

0.0%
Aug-08 Nov-08 Feb-09 May-09 Aug-09 Nov-09 Feb-10 May-10 Aug-10 Nov-10 Feb-11 May-11 Aug-11 Nov-11 Feb-12 May-12 Aug-12 Nov-12 Feb-13 May-13 Aug-13 Nov-13 Feb-14 May-14 Aug-14 Nov-14
Box 2: Risks Involved in Over-stocking and Under-stocking
Maintaining optimal level of inventories is crucial in commodity-based businesses. Due to the
seasonal nature of agricultural products, procurements tend to be skewed towards one part of the
year. Over stocking of the commodity, with sales taking place after a time lag, as well as the lack or
insufficient quantities creates risk.

For instance, say, 10 MT of coriander seeds were procured by a firm in April 2009 at a cost of Rs. 4,436
per quintal, totaling Rs. 4.44 lakh. The firm found its buyers by the 1st week of June 2009, when the
prices had moved lower to Rs. 4,126 per quintal, giving sales realization of only Rs. 4.13 lakh. The
margin has been negative in this case, resulting in loss to the firm concerned. In fact, added to this
loss figure is also the cost of value addition through processing and storage.

Procured 10 MT Found a buyer

at Rs. 4,436/quintal at Rs. 4,126/quintal

April 2009 June 2009

Procured at
Rs. 4,436/quintal
Found a buyer
at Rs. 4,126/quintal

Rs. Actual Loss =

4.44 Reduction in Inventory Value + Storage Cost Rs.
Lakh 4.13
Lakh

The opposite situation can also arise, wherein the buyers demand a firm price to be committed, even
when a business has insufficient or no inventories. Take case of a firm that committed a price of Rs.
4,552 per quintal to its buyers on 15th of March 2011, for delivering 10 MT coriander in 2 months’ time
i.e. by 15th of May 2011. Thus the sales under this deal are certain to bring in revenue worth Rs. 4.55
lakh, with coriander spot price on that day being around Rs. 4,552 per quintal. However, prices began
to move up and as the procurement was undertaken and completed over the next month and half
(i.e. by 30th of April), it reflected in a procurement price of Rs. 4.86 lakh. With cost of Rs. 4.86 lakh, it
exceeded revenues from the contract, with the firm making a loss of equivalent to around 7% of the
sale value.
Risk Management at PCK
PCK management fully acknowledges the presence of price risk, originating from the coriander busi-
ness. Prior to launch of coriander futures, i.e. prior to 2008 2 , PCK used to manage its price risks by
limiting itself to limited orders, which it was confident of executing by procuring from the physical
market in a very short period. This constraint meant that large orders could not be taken.

All that changed after coriander futures were introduced on NCDEX and hedging of price risk became
a reality. The essence of its hedge program is to take a position in the futures market that is opposite
to the one it has in the physical market thereby offsetting the risks arising out of the physical
market/business exposure. This locks the margin minimising the price risik. It does not fully eliminate
price risk for PCK since there are some residual risks, mainly emanating from the fact that actual
coriander prices in the physical market for PCK may not move fully parallel with the prices on futures
exchange, chiefly owing to the difference in quality of the two varieties. It nevertheless provides a
hedge, compensating for price risks and making a workable risk mitigation framework. In words of its
management: “we are able to prevent any major loss when we deal in bulk volume”.

The Hedge Programme

Quoting firm prices to the buyer without running risks of coriander price movements can be done by
acquire a hedge through futures contracts. The hedge could be made in such a way that it coincides
with the underlying risks and the hedge retires coterminous the underlying risk. On the 1 stof Decem-
ber, Coriander futures trading on the NCDEX were showing prices as follows:

Contract Expiry Price (Rs. per quintal)

20-Dec-2012 4,874.00
18-Jan-2013 4,972.00
19-Apr-2013 5,582.00
20-May-2013 5,642.00

The firm needed a month’s time to complete the procurement of material. From this perspective, the
contract expiring on 18-Jan-2013 seemed suitable. With the 18-Jan contract’s rate of Rs. 4,972 per
quintal as the hedgeable rate, PCK decided to quote a price to its buyer in the Middle East. PCK added
a margin of Rs. 228 for its various costs (including transaction costs and margin for trading on NCDEX
platform) and returns, to quote the buyer a price of Rs. 5,200 per quintal.3

From a risk management perspective, the objective for PCK was to ensure that it can protect the
margin of Rs. 11.40 lakh on the contract. PCK immediately bought January expiry futures contract on
NCDEX at Rs. 4,972, for a total quantity of 500 MT. Each future contract on NCDEX being 10 MT.

After receiving the confirmation of order on the quoted price, PCK began its procurement exercise.
On 18th of December, the firm purchased 100 MT of coriander from the market at a rate of Rs. 5,062
per quintal. Simultaneously, position in coriander futures was reduced by 100 MT by squaring the
futures position to that extent. The futures price for January expiry contract at the time of squaring
off was Rs. 5,176, resulting in a cash inflow of Rs. 2.04 lakh.

2 The mechanism for a price hedge was not available in absence of futures market in coriander in the years preceding 2008. Futures contracts in on coriander
were launched on NCDEX in the year 2008.
3 This rate would be translated into a USD rate for the buyer and PCK may decide to hedge the exchange rate risk on the contract separately.
 1st Dec 18th Dec 27 th Dec 5 th Jan

Received Order
to export 500MT
Coriander at the
end of January

Futures Spot Spot Spot

Rs. 4,874.00 Dec

Price signal Purchase Purchase Purchase Purchase
of 500 of 100 MT of 350 MT of 350 MT
Rs. 4,972.00 Jan
Futures
Quote
Rs. 5,582.00 Feb Suitable 100 - - - - - - - - - - - - 100
Export Price Rs. 5,176 Rs. 5,062

Rs. 5,642.00 Mar Rs. 4,972 350 - - - - - - - - - - - - - - - - - - - - - - - - - - - - Rs.350

5,282
Jan Rs. 5,296
Contract
Price 50 - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - Rs.50
5,500
+ Rs. 5,666
Margin Squared off
Rs. 228 quantities

Revenue from Sales + Total Cashflow

Rs. 2,60,00,000 Rs. 16,85,000 - Total Cost of Procurement = Actual Margin Achieved from Sale
Rs. 2,62,99,000 Rs. 13,86,000

On 27 th December, majority of the stock was procured was achieved by purchasing 350 MT of coriander
at the going rate of Rs. 5,282 in the physical market. The proportionate amount of futures contract was
squared off on the NCDEX exchange at the prevailing futures rate of Rs. 5,296. This resulted in a cash
inflow of Rs. 11.34 lakh. The balance 50 MT was finally purchased at the rate of Rs. 5,500 on 5th of January
2013. The January expiry futures prices that day was Rs. 5,666, resulting in a cash inflow of around Rs.
3.47 lakh on square-off.

PCK Hedging Transactions – Synopsis:

On one hand, the physical market prices kept moving up during the procurement period, resulting in
higher cash outflow compared to rate used for making the contract bid. On the other, this cash outflow
was being compensated by the cash inflows from the futures position. On the whole, the firm was able
to protect its margin target of Rs. 11.40 lakh.

While cash flows from futures more than offset the higher price of procurement, in another scenario
the opposite could also be true, i.e., cash flows from futures could have been somewhat less than
required to fully compensate the price increases in the physical market.

What was important from PCK’s point of risk management is that this hedging strategy worked and it
helped to protect margin at a broad level. To recount, such strategy helped “prevent any major loss”.
While an exact or 100% hedge for the particular variety/grade of coriander may not be possible, a
reliable hedge program could be undertaken in the futures market to minimize price risks to a large
extent.
 What was important from PCK’s point of risk management is that this hedging strategy worked and
it helped to protect margin at a broad level. To recount, such strategy helped “prevent any major
loss”. While an exact or 100% hedge for the particular variety/grade of coriander may not be possible,
a reliable hedge program could be undertaken in the futures market to minimize price risks to a
large extent.

Cost of Physical Market Purchases:

Amount Paid in
Date Quantity (MT) Rate per quintal
Rs.
18-Dec-12 100 5,062 50,62,000
27-Dec-12 350 5,282 1,84,87,000
05-Jan-13 50 5,500 27,50,000
TOTAL COST 2,62,99,000 (A)
Cash flow from Futures contract:
Contracted Rate Rate at which squared Position squared Cash
Date
(Rs. per quintal) off (Rs. per quintal) off (MT) Flow
18-Dec-12 4,972 5,176 100 2,04,000
27-Dec-12 4,972 5,296 350 11,34,000
05-Jan-13 4,972 5,666 50 3,47,000
TOTAL CASHFLOW 16,85,000 (B)

Revenue from Sales i.e. price contracted with overseas buyer: Rs. 2,60,00,000 (C)
Targeted Margin from the Sale: Rs. 11,40,000
Actual margin achieved from sale: Rs. 13,86,000 (C - A + B)

Summing Up
Under circumstances of high volatility of cash flows, any kind of business planning becomes difficult.
Commodity futures, however, provide a window into the future by emanating price signals for future
months. Advanced price signals help value chain participants take informed production, purchasing
and investment decisions. These decisions lead to more efficient outcomes that can increase the net
welfare gains to sector participants.

As the case study reveals that commodity futures enable exporters quote a realistic price and
thereby secure export contract in a competitive market. It also indicates that heading in commodity
futures have help streamlined the procurement transactions which otherwise are found meticulous,
time consuming and costly. Effective adoption of hedging practices on a larger scale has potential to
improve export competitiveness of Indian commodities fetching valuable foreign exchange fuelling
the growth of Indian economy.

Disclaimer
NCDEX does not represent or guarantee the accuracy or completeness of the data/Information included in this publication even though NCDEX has taken efforts
to ensure that the data/information provided is as accurate as possible at the time of inclusion in the report. NCDEX accepts no responsibility whatsoever for any
consequence of the use of data/information contained in this publication.
 Issued in Public Interest

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