Arbitage tends to reduce price discrimination by encouraging people to buy a commodity where the price is low and resell it where the price is high. Price convergence is what allows futures prices to be interpreted as reliable price benchmarks for forward contracting of commodities, both by commodity sellers and buyers.
The pressure on the Chicago Mercantile Exchange (CME) and other US wheat trading exchanges to solve the price convergence problem has become more acute with the release of Senate investigation into wheat prices in 2009.
The delivery on the exchange is one of the most contentious issues. In India, commodity exchanges have pursued two routes — one which has promoted mainly exchange deliveries and the other which has ensured that no delivery is made. Neither route solves the core issue which is the convergence of the spot price with future price. Overall, the empirical results do not support the convergence hypothesis but rather a pattern of fluctuating divergences has been observed.
The existence of high ‘badla’ (cash futures arbitrage) opportunity in agricultural commodities during the initial days was caused by flaws in futures contract design. It was assumed that the differentials (premiums & discounts) between different locations as fixed (constant) and thus premium and discounts were introduced as part of the futures contract. In reality, the differentials between locations are multivariate function of transportation, quality, supply and demand situation at a point of time and do not remain fixed over a period of time.
The point that was missed is that the differentials are market driven rather than a constant factor on a time axis. Differentials have the same variability attributes that of the commodity price. Therefore, by having a constant (fixed) premium and discounts embedded in the contract itself leads to a flawed price discovery, delivery issues and proliferation of speculators.
On the other hand, the non deliverable route has caused the physical market participants to look at the futures market as punters paradise. Price manipulation during the pre-tender trading period does not create sufficient fear among speculators of getting stuck with exchange delivery in the absence of a delivery mechanism and this causes huge volatility in trading.
Some of the contracts even have two kinds of allowable deliverable quality. All these flawed contracts continue to be allowed for trading on the futures platform. The non-convergence of settlement price and spot price throws non-existent ‘quality issues’. Obviously one never understood the underpinning of the problem and had been barking at the wrong tree with quality issues, storage protocols.
Constant (fixed) premium and discount matrix has caused trading shift from location to location on screen while the benchmark has remained theoretical. The price quoted on the futures screen becomes a derivative of the non-representational premium and discount prevailing in the spot market rather than a future price.
No comments:
Post a Comment