Example Economics Essay

Futures and Options in the Commodities Market.

The agreement to buy and sell such commodities is made through contracts tobring in legality in trading as it involves cash payments margins, delivery ofgoods and scope for profit maximisation. The emergence of contract systemeventually led to trading in contracts whereby a middlemen stands in betweenbuyers and sellers. The active trading in such contracts broughtstandardisation which in turn led to the development of futures contracts.

A futurecontract is a standardised, binding agreement to make or take delivery of aspecified quantity and grade of a commodity at an established point in futureat an agreed upon price.The organization of merchants involved in the trading these commodities evolvedinto an organisation that standardised the contracts and trading practises andcame to be known as - The Futures Exchange such as the New York Board of Trade(NYBOT) and the London International Financial & Futures Exchange. Oneessential objective of the exchange is to provide the dealers with allnecessary information with regard to price volatility i.e. the magnitude ofprice movement in either direction. Note that it measures price risk andvolatility but does not remove or eliminate risks. The exchange provides thebenchmark for the determination of price by making price margins mandatory foreffective fair trading.

Futurestransactions do not require full advance payments for the commodity (just themargin), the buyer of a futures contract which increases in value (or theseller of futures contract which decreases in value) can realize a profit whichcan be substantial in relation to the commitment of capital.

Brazil today is the world largest producer of coffee. Considering this figures,it is not surprising to note that it has attracted considerable amount ofspeculation and ever increasing susceptibility to price volatility.

Coffeeproduction have direct linkage with weather besides many other factors such asworld coffee prices. A coffee drink manufacturer will buy coffee beans from acoffee producer at an agreed price if he/she expects to have drastic climaticchanges which will result in coffee being expensive at a future date. A suddendrop in the production in future will cut supply and make it more expensive. He/Shecan, therefore, avoid unnecessary risk by buying a futures contract that willguarantee him delivery of coffee at a future date at a price fixed now.However, it must also be noted that he/she will suffer loss if the futurecurrent/spot price of coffee beans were to fall drastically due to improvedproduction and competitions.

Take an exampleof Brazil - The Brazilian Crop was initially expected to produce about 50 millionbags of coffee. Seasonal disturbances such as rain, harvest delays and qualityproblem caused production to fall to 33.5 million bags. Due to severe droughtin Viet Nam coffee production dropped by almost 1 million bags.These shortages of coffee output distort the supply level which leads to aglobal rise in prices.

So what rolesdoes the future markets play in the production and selling of coffee ? Takingthese points into account the next chapter looks at the Indian and world coffeemarkets and the role future market plays in its pricing. In the analysis, Ihave made use of some articles from the Times of India newspaper and otherwebsites.

It is logical to state that at times of shortage prices tend to go up due tohigher demand and which in turn puts pressure on sellers to sell their productat a lower price. We know from our analysis before that a buyer will resort tofutures contract if he expects the prices to go up in future. Howeverconsidering that the production too has been low the chances of producing therequired amount to meet the demand is less which adds to speculation in themarket.

The report also suggests one sourceas saying that it is better to pay penalty and cancel a contract rather thanto loose significant amount of money by fulfilling it. Note that sometimes thewhole idea of futures contract is not meet the obligation in terms ofdelivering the commodity but to profit from the speculation that theseuncertainties give rise to.

The world coffeeproduction in 2003/2004 was estimated to be around 105.3 million 60 kilogrambags down nearly 2 percent from forecast made in June and down 15 percent fromthe 2002/03 season. Factors such as lower production contribute to great extentthe price determination.For the year 2004/2005 it was widely believed that Brazilian coffee productionto be around 33-35 million bags but due to substandard weather and low level ofinvestment the production is likely to be below 30 million bags.This drop in production is likely to cut the supply level and Brazil being theworld largest producers, any drop in its output will affect the world supplyand thereby raise the price.

Theseuncertainties lead to prices going up in the futures markets. It has long beenfelt that some traders hold stocks to push the prices up and then sell it tomake supernatural profits.

Let's look atthe graphical representation of prices of Robusta class of coffee as determinedat the International Coffee Organisation (ICO) to assess the trends in themarket. The graph below shows that since November 2004 Robusta coffee priceshave increased at a slow and steady pace. However, a report that appeared onthe Economic Times suggests that volatility in the world prices over the lastfew days have affected trading in coffee in the markets.The ICO in its Coffee Market Report seems to suggest that the downturn inmid-April caused a slight fall of 3.19 percent in the monthly average of theICO Composite Indicator Price which dropped from 101.44 cents/lb in March to98.20 cents/lb in April.It also suggests that this has been due to high level of activity from variousinvestment funds.

Comparing theresults put forward by the ICO to the recent reports in the Economic Timesnewspaper (24/05/2005) the volatility in the world prices have triggered abullish trend in the Indian markets which explains why trading in the coffeeauctions markets have suffered. Estimates shows that there was a 40 percentdrop in the overall quantum sold when compared to the previous ICTA auction.

- The beginning of the year showed a significant climb in the moving averagesbetween January and mid-March and then a significant drop till the mid ofApril.One of the least complex ways to use a moving average is to simply look at theslope - a rising slope indicates that the market is in an uptrend and fallingslope indicates a downward trend in the market.Moving Averages is a statistical technique for smoothing price movement inorder to identify the trends more easily. It is equally important to understandthat moving averages are sensitive to the number of days used to calculate theaverage i.e. the more days that are used; the less sensitive is the average.

Some experts areof the view that MA can be a critical factor in decision making. For e.g.traders can make use of one or more MA to determine buy or sell decisions i.e.to use a slow MA together with a fast MA. A slow moving average can becalculated by taking more days opening or closing prices and fast movingaverage by taking fewer days prices. In a more elaborate way, what it means isthat you must buy when the faster MA goes above the slower one and sell whenthe faster MA goes below the slower one [or] buy when prices are above bothfast and slow MA and sell when prices are below both MA.

The chart belowis a graphical example of how a Moving Average looks like as of 05/27/2005. TheRed Line (price line) is above the moving average so the trend is up indicatingthat the market is bullish and also the fast moving average (dark blue) isabove the slow moving average (light blue).

Volume of7078.00 suggests the measure of trading activity during the selected period oftime. It refers to the number of futures contract that are either bought orsold during that period. Open Interests, on the other hand, measures the numberof futures contract that remains open at a particular point in time, usually atthe closing of trade.

In the nextchapter, I have looked at India as a producer of Coffee. India is relativelynews into the coffee future markets and has performed exceedingly well. However,due to the speculative nature of the futures market and also bureaucratichurdles have led to decrease in contract sales and increased price andnon-competitiveness in the global coffee market.

The two principal species of coffee grown in India are Robusta and Arabica. Tradingin coffee futures was introduced only recently and prices are extensivelydepended on the coffee trading in the New York and London futures markets as ithas considerable influence on the world coffee prices. These prices are notoriouslyvolatile and varies considerably due to factors such as weather forecast, sizeof the coffee stock worldwide and speculations in the futures markets

The Indiancoffee production and physical trade is worth over $ 430 million annually.The production of Indian coffee is greatly influenced by world pricesparticularly since it is the second largest actively traded commodity in theworld market. The Coffee Futures Exchange India Limited was formed under thesupervision of Forwards Markets Commission to look into all trading practicesaffecting coffee prices. The main objectives are -

To providehedging opportunity against coffee price risk.
To ensureguaranteed delivery of coffee.
To provide aprice discovery mechanism for future period up to 18 months at any givenpoint of time.

Besides these itis important to look at the mechanism COFEI uses to ensure that marketparticipants follows the rules in ensure financial integrity. Factors such asMargins, Price limits for trading, daily marking-to-market of all trades andsufficient capital including guarantee funds ensures that proper procedures arefollowed when a contract is bought and sold. In India, coffee has beencategorized into 4 different types with each having different margins for smoothand efficient trading. The table next page gives a snapshot view of how coffeein India is traded and in particular the different class of coffee whether rawor clean.

The coffeeindustry, in general, has seen surge in prices by almost 40 percent. Exports inrecent times have been hit quiet badly. Reports on the Financial Expressnewspaper suggest that export have suffered especially due to the pricenon-competitiveness in the world markets. India exported nearly 225,000 tonnesof coffee last year with majority (50 %) of it going to Europe. India's coffeeproduction and exports for the year 2005-06 (October-September) are forecast toincrease by 5% and 29%, respectively. The anticipated rise in coffee export isagainst the backdrop of almost 26% decline in the current year(2004-05/Oct-Sep).

Coffee exports are expected tofall to an eight-year low of 169,980 tonne, or 2.83 million 60-kilogram bags,in the current year ending Sept 30, from 229,320 tonne, or 3.82 million bags, ayear earlier. India, the world's fifth-biggest coffee exporter is set towitness decline as farmers and traders are withholding beans on expectations ofhigher prices.

One of the biggest problemsfacing the traders in the Indian coffee industry is the time difference betweenIndia and the New York and London trading centres. Indian traders were nowfinding it difficult to hedge their risk. The local exchange functioned onlytill 5 pm when the LIFFE and NYBOT and other European markets functioned tillover 11.30 pm IST.