Supply Chain Cost Management Role of Commodity DerivativesMCX).pdf · 2019-11-23 · A FEW CHALLENGES IN SUPPLY CHAIN MANAGEMENT 2 Planning & risk mgmt. Cost control Stakeholder relationship

Supply Chain Cost Management – Role of Commodity Derivatives

- Dr. V Shunmugam,

Head, Dept. of Research

A FEW CHALLENGES IN SUPPLY CHAIN MANAGEMENT

2

Planning & risk mgmt.

Cost control

Stakeholder relationship

mgmt.

Customer service

Fast changing markets

Quality Compliances

Technological advancement

Talent retention

A few directly linked to commodity price volatility…..

RISK: COMMODITY PRICES IMPACTED BY MULTIPLE FORCES

COMMODITY PRICES IN RECENT PAST

COMMODITY PRICES MOVEMENT: FINANCIAL IMPACT

5

Sr. No.

Price movement

Impact

Inventory Sales Purchasing Earnings

1 Fall in commodity price

Higher cost of inventory - lead

to a constraint in cash flow

Reduced sales values due to lower price –

impacts profitability

Increase in purchasing power

– higher volumes

purchased

Net realizable value is below cost and sales realizes at lower value –

reducing earnings

2 Rise in commodity price

Lower cost of inventory - lead to increase in

cash flow

Increased sales values due to higher price

Decrease in purchasing power

Net realizable value is above cost and sales realizes at

same or higher value –

increasing earnings

Source: Commodity Risk Management – A manual of hedging commodity price risk for corporates; Deloitte – MCX Investor (Client) Protection Fund

COMMODITY RISK VS FOREX RISK….

Commodity price risks - volatility in commodities - greater than forex volatility 6

Annualized Volatility for USD-INR

Period 2013-14 2014-15 2015-16 2016-17 2017-18 2018-19

Volatility 12.3% 5.5% 5.1% 4.2% 4.3% 6.9%

Data source: Bloomberg

Annualized Volatility for some of the Commodities Listed on MCX

FY ALUMINIUM COPPER ZINC CRUDEOIL COTTON SILVER GOLD

2013-14 17.7% 18.2% 17.5% 21.9% 16.8% 30.0% 22.2%

2014-15 16.5% 18.1% 17.3% 29.6% 15.8% 23.7% 14.8%

2015-16 17.9% 20.4% 26.9% 44.3% 13.2% 21.6% 14.9%

2016-17 14.9% 19.8% 25.7% 34.5% 18.3% 20.3% 12.1%

2017-18 15.9% 17.3% 22.4% 24.1% 19.3% 14.6% 8.7%

2018-19 26.7% 18.6% 24.0% 32.8% 16.2% 14.8% 9.5%

ROLE OF COMMODITY DERIVATIVES IN SCM CHALLENGES

Reduction in both risk and cost

Cost control

Protects business margins;

Better cash management

Helps in better future planning

Enhances efficiency and competitiveness

Alternative marketing channel

Assurance on quality

Supplier/partner relationship management

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eNWR – TRANSFORMATION OF CREDIT MOBILISATION

• On Sept 26, 2017, “Electronic Negotiable Warehouse Receipt (e-NWR) System” was launched.

• Negotiable warehouse receipt, allows transfer of ownership of that commodity stored in a warehouse without having to deliver the physical commodity.

• Warehouse receipts are made negotiable under the Warehouse (Development and Regulation) Act, 2007, and regulated by the Warehousing Development and Regulatory Authority (WDRA).

• With no threat of any tempering, mutilation, fudging, loss & with no possibility of any multiple financing, eNWRs facilitates an easy pledge financing by banks and other financial institutions

• Huge savings in logistics cost as the stocks traded without physical movement.

• Currently WDRA has notified 123 agricultural commodities and 26 horticultural commodities.

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27/04/2019 9

FUTURES CONTRACT & ITS FUNCTIONS

A futures contract is a binding agreement between a seller and a buyer to give (by the seller) and to take (by the buyer) delivery of the underlying commodity (or a financial instrument) at a specified future date with agreed upon payment terms.

Main functions of exchange-traded futures contracts are:

● Trade guarantee

● Risk management (hedging)

● Price discovery

● Transactional efficiency

● Liquidity

WHAT ARE OPTIONS?

An option contract offers the buyer of the contract protection if the price of the

underlying moves against him but allows him to walk away from the deal if the

underlying price moves in his favour.

Options:

• Give buyer the “right”, but not the “obligation”

• To buy or to sell an agreed amount of underlying asset

(Notional Value)

• On or before an agreed future date (expiry date)

• At an agreed exchange rate (Strike Price)

• In exchange for

fee (Option Premium)

FUTURES OPTIONS

Buy / sell at pre-determined price & time (Obligation)

Buy / sell right to but / sell at pre-determined price & time (Right)

Exchange Traded Exchange Traded & OTC

Margins Upfront Premium

Future Price reflects holding cost & market perceptions

The Premium reflects holding cost & market perceptions

Square-up positions Buyer- no obligation

CALL OPTION Buyer has the right but not the obligation to buy

specified quantity of the underlying asset at the set strike price on or before a specified date.

The seller (writer) has the obligation to sell the underlying asset if the buyer decides to exercise his option to buy.

PUT OPTION Buyer has the right but not the obligation to sell specified

quantity of the underlying asset at the set strike price on or before a specified date.

The seller (writer) has the obligation to buy the underlying

asset if the buyer decides to exercise his option to sell.

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Taking a position in the futures market that is opposite to a exposure in the physical market

The objective behind this mechanism is to offset a loss in one market with a gain in another

Reduces or limits risks associated with unpredictable price changes

HEDGING USING FUTURES

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ILLUSTRATION OF HEDGING

Time CASH FUTURES

30th Sep'

201X Spot market at Rs. 187/kg

Buys 50 lots of MCX Nov'201X at Rs.

185/kg

16th

Nov'201X Buys at Rs.194/kg

Sells 50 lots of MCX Nov' 201X at Rs.

192/kg

Result A potential loss of Rs.7/kg Gained Rs.7/kg

On 30th Sept’ 201X ABC Galvanizer got an order to be delivered in December 201X, which requires 250 MT of Zinc.

Company cannot purchase the required quantity of zinc before November due to warehousing concerns.

To protect against unforeseen rise in Zinc price, company decides to hedge by buying 50 lots of MCX Zinc Futures.

The profit of Rs. 7/Kg made in the futures market was used by the company to reduce the cost of buying zinc in physical market and was able to offset its potential loss.

ELEMENTS OF RISK MANAGEMENT STRATEGY

Identification

of exposure

Measurement of

exposure and risk

Design of hedging strategies to achieve set

objectives

Identification of hedging vehicles

Monitoring of risks against predetermined limits via appropriate mechanisms

and governance structure

Execution of risk management activities

HEDGING ON DOMESTIC EXCHANGE IS HEDGING AGAINST BOTH VOLATILITY IN GLOBAL COMMODITY PRICES AND USDINR

MCX Commodity Benchmark Exchange

Correlation* in FY 2018-19 (%)

Gold CME (COMEX) 99.3%

Silver CME (COMEX) 97.6%

Crude Oil CME (NYMEX) 99.8%

Copper CME (COMEX) 99.1%

Zinc LME 99.2%

Lead LME 99.3%

Nickel LME 99.8%

Aluminium LME 87.6%

* - Correlation of MCX Closing prices with INR - denominated benchmark prices

REGULATORY INITIATIVES ON HEDGING

• Govt. of India Income tax benefits for hedging

The Finance Act, 2013 provided for coverage of commodity derivatives transactions undertaken in recognized commodity exchanges under the ambit of Section 43(5) of the Income Tax Act, 1961.

Hedgers are no longer forced to undertake physical delivery of commodities in order to prove that their transactions are in the nature of hedging and not ‘speculation’.

• Reserve Bank of India Liberalized access to overseas hedging markets

Advisory to banks to encourage their large borrowers to hedge their risks related to agricultural commodity prices

• Ministry of Corporate Affairs Notified Ind AS Accounting Disclosures

• Ind AS 107 – Financial Instruments : Disclosures; specifies comprehensive

• Quantitative & qualitative risks disclosure requirements for financial instruments

• Hedge Accounting Norms

• Ind AS 109 Financial Instruments

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Phase I from 1 Apr. ‘16 : Listed or unlisted companies (net worth >= INR 500 Crs) Phase 2 from 1 Apr. ‘17: Listed companies (net worth < INR 500 Crs); Unlisted companies (networth >= INR 250 Crs but < INR 500 Crs)

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INITIATIVES FROM SEBI

• Enhanced LODR w.r.t commodity price risk and its management

• Listed companies to disclose commodity price risks and commodity hedging activities in AR (Cir. dt. Sep 2, 2015)

• Format prescribed by SEBI (Cir. dt. Nov. 15, 2018)

• All listed entities shall make the

disclosures in a prescribed format as part of the Corporate Governance Report in the Annual Report under clause 9(n) of Part C of Schedule V.

• Strengthened RMS in domestic exchanges and Oversight over intermediaries

• Permitted foreign entities having exposure to Indian commodity markets in domestic commodity derivatives markets • Entities classified as ‘Eligible Foreign Entities’

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INDIAN COMMODITY DERIVATIVES MARKETS – REGULATORY OVERVIEW

• National online multi commodity exchanges started operations during 2003-04

• Under SEBI regulations since September 28, 2015

• Futures contracts on commodities are predominantly traded

• Options commenced from Oct. 17, 2017.

• AIF Cat III is the first institutional investor permitted to participate

• Custodians permitted to offer services for commodity derivatives and ‘goods’

• SEBI Board approved participation of Mutual Funds and Portfolio Managers in commodity derivatives

• Universal Exchanges : Single exchange operating various segments w.e.f October 1, 2018

SEBI

Stock Exchanges

Members

Clients

COMMODITIES TRADED ON NATIONAL EXCHANGES

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BULLION Gold, Silver, Diamond

ENERGY Crude Oil Natural Gas

METALS & ALLOYS Aluminium, Copper, Lead Nickel, Zinc, Brass , Steel

AGRICULTURAL Grains: Barley, Maize, Wheat Spices: Black Pepper, Cardamom, Coriander, Jeera, Turmeric

Fibre: Cotton (Bales), Kapas, Raw Jute

Oil Complex: Castorseed, CPO, Soybean, Soyoil, RBD Palmolein

Others: Guarseed, Guargum, Mentha Oil, Isabgul, Rubber, Sugar

91 notified commodities; 36 commodities traded on futures segment

HEALTHY TRADING IN COMMODITY FUTURES & EMERGING COMMODITY OPTIONS

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Avg. Daily Futures Turnover (Rs. Crs)*

Commodity 2018-19 2017-18

GOLD 3,393 2,876

SILVER 2,497 2,493

CRUDE OIL 8,169 5,693

NATURAL GAS 1,367 1,365

COPPER 2,388 1,840

LEAD 1,550 1,564

NICKEL 1,235 1,041

ZINC 3,546 3,109

ALUMINIUM 1,107 763

COTTON 177 162

CPO 135 167

MENTHA OIL 81 117 * on MCX

Avg. Daily Options Turnover (Rs. Crs)*

Commodities 2018-19 2017-18

All 1,80,945 10,354

* On MCX; Options trading launched in gold on MCX on October 17, 2017, followed by options trading in crude oil, copper, zinc, silver in phased manner.

Parameters Trading

Unit Price

Quote Tick Size

Basis Centre

No. of Contracts in

a Year

Max Contract Duration

(in months)

Delivery Logic

Gold 1 Kg Rs/10g Re 1 Ahmedabad 6 12 Physical

Gold Mini 100 g Rs/10g Re 1 Ahmedabad 12 4 Physical

Gold Guinea

8 g Rs/8g Re 1 Ahmedabad 12 4 Physical

Gold Petal 1 g Rs/1g Re 1 Mumbai 12 4 Physical

Silver 30 kg Rs/Kg Re 1 Ahmedabad 5

12

Physical

Silver Mini 5 Kg Rs/kg Re 1 Ahmedabad 5 Intention Matching

Silver Micro 1 kg Rs/Kg Re 1 Ahmedabad 5

BULLION FUTURES

Parameters Trading

Unit Price

Quote

Tick Size (Rs)

No. of Contracts in a Year

Max Contract Duration

(in months) Delivery Logic

Light sweet Crude Oil

100 Barrels

Rs./bbl 1 12 5

Cash Settlement Crude oil Mini 10

barrels Rs./bbl 1 12

Natural Gas 1250

mmBtu Rs./mm

Btu 0.1 12 3

Aluminium 5 MT Rs/Kg 0.05 12 5

Physical Alu. Mini 1 MT Rs/Kg 0.05 12 Physical (from June expiry) Copper 1 MT Rs/Kg 0.05 5

6 Intention Matching Copper Mini 250 Kg Rs/Kg 0.05 5

Lead 5 MT Rs/Kg 0.05 12

5

Physical (from June expiry) Lead Mini 1 MT Rs/Kg 0.05 12 Intention Matching

Nickel 250 Kg Rs/Kg 0.10 12 Physical (from June expiry) Nickel Mini 100 Kg Rs/Kg 0.10 12 Intention Matching

Zinc 5 MT Rs/Kg 0.05 12 Physical Zinc Mini 1 MT Rs/Kg 0.05 12 Physical (from June expiry)

FUTURES IN ENERGY AND BASE METALS

Parameters Basis Centre Trading

Unit Price

Quote Tick Size

No. of Contracts in a Year

Max Contract Duration

(in months)

Delivery Logic

Cotton Rajkot 25 bales Rs/bale Re 1 10 6 Physical

CPO Kandala 10 MT Rs/10 Kg 10 p 12 5 Intention Matching

Mentha Oil Chandausi 360 kgs Rs./kg 10 p 12 6 Physical

Cardamom Vandanmedu 100 Kg Rs/Kg 10 p 12 5 Physical

A FEW AGRI. FUTURES CONTRACTS

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USE COMMODITY DERIVATIVES TO TACKLE A FEW CHALLENGES OF SCM

• Price volatility risk can potentially threaten the mere survival of firm in current era of ever-increasing competition, if not managed appropriately.

• Research studies suggest the use of commodity derivatives to tackle a few challenges of SCM esp. linked to price volatility • Shi, Daniels & Grey (2003) shows how options enhance information flows, encourage risk sharing, and improve

supply chain efficiency1.

• Maamoun (2015) finds that use of financial derivatives in supply chain risk management is better when facing high levels of price volatility2.

• Addition of commodity options trading to existing robust commodity futures trading on domestic

exchanges – Firms can now better customize their price risk management strategies with in-built forex hedge.

1 IBM Research Report 2 School of Graduate Studies, CONCORDIA UNIVERSITY

THANK YOU!