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Commodity trading happens similar to ‘stocks’ (shares, securities, debentures, bonds) trading in the stock market. However, commodities are actual physical goods such as corn, silver, gold, crude oil, etc. Futures are contracts for commodities that are traded at a futures exchange like the Chicago Board of Trade (CBOT). Futures contracts have expanded beyond just commodities, now there are futures contracts on financial markets like foreign currencies, interest rates, etc.
Commodity futures serve a great purpose in any economy. As we see in the case of agricultural commodity—their prices play a key role in determining the fortune of the agriculture and food processing industry in India. These prices undergo a large degree of fluctuation. Reasons for price fluctuation are crop failure, bad weather, demand-supply imbalance, etc. This fluctuation, in turn, leads to a ‘price risk’. This price risk is largely borne by the farmer and the industries where agricultural commodities are used as raw material. Commodity exchanges are associations that determine and enforce rule, and set procedures for trading of commodities. The main objective of the exchange is to protect the participants from adverse movement in prices by facilitating futures trading in commodities.
If the participants hedge themselves against this price risk, then they would be able to insulate themselves against the inherent price fluctuations associated with agricultural commodities. One of the methods of doing this would be by using commodity exchanges as a trading platform. Apart from hedging against price risk, a commodity exchange helps in production and procurement planning as one can buy in small lots. Further as the exchange consists of various informed industry participants, price discovery is more efficient and discounts the local and global factors.
Let us take a very simple example to understand how trading on commodity exchanges help industry participants. A farmer who is producing wheat can sell ‘wheat futures’ on a commodity exchange. This will help him
lock in a sale price of a specified quantity of wheat at a future date. Hence the farmer would now be able to get an assured price for his produce in future and any decline in the price of wheat would not impact his earnings. On the other hand, a user industry (e.g., a flour mill) could purchase the wheat futures from the exchange. Hence the flour mill would now be able to fix its future purchase cost for a specified quantity of wheat. Therefore, any increase in the price of wheat in future would not impact its cost of production.
However, what needs to be kept in mind is that farmers do not largely operate in the futures market. This is partly due to operational difficulties and lack of knowledge. Though, they observe the price trends emerging from a futures market and then decide what commodity in what proportion to cultivate.
In case of user industries, commodity exchanges help them to plan their production and determine their cost of production. Commodity exchanges are an effective tool to hedge price risk. However, the government needs to improve infrastructure, put in place vigilant governing systems, etc., to encourage trading on these exchanges.
Big money started flowing into commodity futures with the advent of online multi-commodity exchange. The boom, which began when the stock market was sluggish, has surprisingly not waned even after the Sensex crossed 20,000 (by 2004–06). High stakes, long trading hours and comparatively little knowledge about the derivative products have underscored the role of a regulator. The Forward Markets Commission (FMC), which for decades was entrusted with the job to curb forward trades, now has the job to develop and regulate the commodity futures market.