Cotton is one of the major Cash Crop of India. Being a fiber crop, it is primarily used as a raw material for textile industry(55-60% of requirements). Because of its wide scale of usage, it happens to be one of the most traded commodities in the World. India invariably ranks 2nd/ 3rd in terms of production, and is also the 2nd largest exporter in the world. Hence, Indian prices depend not only on domestic, but also international demand & supply scenario, and are interlinked with global prices
VOLATILITY IN COTTON PRICES
Cotton prices are known to be extremely volatile, with 16.6% average annualized volatility observed in domestic markets, and 30.6% in international markets. Prices of raw cotton for the season 2010-11, jumped 142% to ` 6,900 a quintal from a year ago in early February due to short global
supply despite record domestic produce of 325 lakh bales of 170 kg each. Prices remained at elevated level through April, post which it moved to a downward spiral bottoming out to 3,300 per quintal by June, due to export restrictions imposed by Govt., and absence of off take from the market
NEED FOR PRICE RISK MANAGEMENT HEDGING
High spot price volatility, both in domestic and international markets, poses enormous amount of price risk to all the categories of participant involved in the value chain of this broad commodity, be it Ginners, Spinners, Textile Mills, Exporters, or Traders. In 2010-11, when prices moved bylarge multiples bothways, registering a volatility of 23%, itintensified the risk of losses to all the value chain participants. Result, as we all know, were huge losses suffered by trade, coupled with a record number of defaults on bilateral contracts in the physical market. As per press reports, total disputes quintupled to 10% of total cotton contracts globally. This makes a case for an appropriate instrument to mitigate price risk. Futures contracts in Cotton, as offered by NCDEX, are aimed to fulfill this need of the trade participants.
COTTON FUTURE CONTRACT
Commodity exchange which offers trading in 25 odd agricultural commodities, with a cumulative average daily trading volume of more than 6,000 Crores. It offers futures trading in Kalyan Kapas (V797) and Shankar Kapas varieties of cotton.
- Futures trading would help all the value chain participants to effectively hedge their price risk by allowing the opportunity to take positions in advance so as to counter the unexpected adverse price movement.
- Additionally, the futures contracts allow for efficient risk management by allowing high leverage. This means that you need to pay only a small fraction of the value of contract as ‘margin’ to execute a trade.
- Daily marking to market of positions minimizes risk of default by trade participants
- Foremost, presence of a central counterparty for an exchange traded futures contract ensures performance of the contract obligation
- With an average daily trading volume of around ` 100 Crores (or 5000 contracts), and an open interest of around 8000 lots, NCDEX Kapas happens to be the benchmark and only liquid futures contract of Cotton in India today.
How Hedging is done? – An example
A Ginner needs to procure 50,000 MT of Raw Cotton, sometime in the end of Dec, as per his production schedule.He intends to produce lint and further sell it to the Textile Mills, with whom he has a contract at a pre-agreed price. Now, if the prices of Raw Cotton rise in the month of Dec, his profit margins might shrink, or he may even run into losses. He can reduce this Price Risk, by means of hedging his Raw Material requirement, at NCDEX platform.
Let us assume that, on current date, the Ginner finds that:
Spot Price of Shankar Kapas =1100.00/ 20 Kgs
Dec Futures Contract on NCDEX = ` 1400.00/ 20 Kgs
He buys the Dec expiry contract at NCDEX on current date.
On 30th Dec (i.e. on the day of expiry of contract), 2 cases may arise:
Case 1: Spot price increases to 1450.00
On final settlement, MTM Profit = 50.00
Buying Price = 1450.00
Effective price = 1450.00 – 50.00 = 1400.00
Case 2: Spot price decreases to 1350.00
On final settlement, MTM Loss = 50.00
Buying Price = 1350.00
Effective price = 1350.00 + 50.00 = 1400.00
Therefore, irrespective of the Spot Price movement, his Effective Purchase Price, and hence his Profit Margin, remains locked-in. This is called Hedging.
Why Hedging is NOT same as Speculation or Gambling? Hedging, Speculation & Gambling are three different things. Gambling is when you yourself create a risk that didn’t exist in its own, like betting your money on a game of cards. Speculation on the other hand, is taking up an existing risk (not creating one), with the intent to benefit from it, like taking on market risk in order to benefit from price movements. And Hedging is a transaction to reduce the exposure to any market risk, so that one can focus on core business activities.
“Hedging is definitely NOT Speculation, but NOT Hedging can be Speculation”