Since the introduction of Future trading in the commodity exchanges in India, it has reduced the volatility in the market. It has not only discovered the Future spot price of different commodities however it has provided an opportunity to hedge the risk against the adverse price movement in the commodity. The present study explains the relationship of future and spot price of different commodities Gold, Silver Channa, Zeera, Zinc, and Natural Gas including the crude oil and their inter-relationship. It also examines the relationship between the future and spot price of two commodity exchanges in India. It finds out the possibility of arbitrage gain to between the two commodity exchanges of India i.e. MCX, and NCDEX. It is revealed that there is a positive correlation between future and spot prices of the commodities. It was also observed that there is possibility of arbitrage in those commodities which are traded at both NCDEX and MCX.

Introduction:

Traditionally, commodity futures contracts are settled by physical delivery. A seller with an open position at contract expiration must make deliveries to liquidate the position. Similarly, a buyer must take deliveries to liquidate an open position held at the contract maturity. In spite of high transportation, inspection, and storage costs, this settlement specification was adopted to ensure the convergence between spot and futures prices at the contract expiration date. As a result, the futures price will converge to the cheapest deliverable grade. This creates additional uncertainty, the so-called delivery risk, which leads to a larger basis risk (Leuthold, 1992). The risk transferring and price discovery functions of a futures market are damaged. Since the advent of stock index futures contracts and the forward market Commission (FMC) allows for the possibility of cash settlement specifications. Under this system, a futures contract is settled by a cash payment transfer. The payment is dictated by a cash index. Consequently, the effectiveness of a cash-settled futures contract hints on the construction of a reasonable index. An optimal index should reflect the market conditions. Heterogeneity and non-storability of agricultural commodities create difficulties in constructing an appropriate cash index. As a result, commodity futures contracts continue to rely for the most part on physical delivery settlement. Further trading in the commodity derivatives in different Exchanges provides an opportunity to hedge their risk and arbitrage gain from the difference in the price of these commodities.

Historical background

The futures trading in commodities in India started in the later part of 19th century when the first commodity exchange, viz.. the Bombay Cotton Trade Association Ltd was set up for organizing futures trading. The early 20th century saw the mushrooming of a number of commodity Exchanges. The principal commodity markets functioning in pre-independence era were the cotton markets of Bombay, Karachi, Ahmedabad and Indore, the wheat markets of Bombay, Hapur, Karachi, Lyallpur, Amritsar, Okara and Calcutta; the groundnut markets of Madras and Bombay; the linseed markets of Bombay and Calcutta; Jute and Hessian markets of Calcutta; Bullion markets of Bombay, Calcutta, Delhi and Amritsar and sugar markets of Bombay, Calcutta, Kanpur and Muzaffarnagar. The history of organized commodity derivatives in India goes back to the nineteenth century when the Cotton Trade Association started futures trading in 1875, barely about a decade after the commodity derivatives started in Chicago. Over time the derivatives market developed in several other commodities in India. Following cotton, derivatives trading started in oilseeds in Bombay (1900), raw jute and jute goods in Calcutta (1912), wheat in Hapur (1913) and in Bullion in Bombay (1920). However, many feared that derivatives fuelled unnecessary speculation in essential commodities, and were detrimental to the healthy functioning of the markets for the underlying commodities, and hence to the farmers. With a view to restricting speculative activity in cotton market, the Government of Bombay prohibited options business in cotton in 1939. There were no uniform guidelines or regulations. These were essentially outcomes of needs of particular trade communities and were based on mutual trust and faith. They were regulated by social control of close-knit groups and whenever such control failed, there would be a crisis. In order to provide constant vigil to prevent crisis, rather than combat these after they occurred, a comprehensive legislation was enacted by the Bombay State in 1947 in the form of the Bombay Forward Contracts Control Act. On adoption of the Constitution of the Republic, the subject, “Stock Exchanges and Futures Markets” was included in the Union List and a central legislation called Forward Contract (Regulation) Act 1952 was enacted which provided the legal framework for organizing forward trading in the country and provided, inter alia, for recognition of Exchanges. This framework continues to exist even today. One of the important features of this Act is to notify a commodity for prohibition or regulation of forward contract. Under these provisions, a large number of commodities were notified for prohibition during the 1960s which left only a handful of insignificant commodities open for forward trade. This scenario continued for about four decades although the Dantawala Committee(1966) and Khusro Committee (1980) had recommended steps to revive futures trading in more agriculture commodities. Subsequent to liberalization of Indian economy in 1991, a series of steps were taken to liberalise the commodity forward markets. This found expression in many reports and studies of committees and groups to recommend reforms in commodity futures market. The Kabra Committee (1994), the earliest post-1991, recommended opening up of futures trading in 17 selected commodities, although it was not unanimous regarding some of these. Importantly, this committee was unanimous in recommending that futures trading not be resumed in case of wheat, pulses, non- basmati rice, tea, coffee, dry chilli, maize, vanaspati and sugar. For most of these, it recommended that case by case reviews of suitability of each commodity be carried out in light of developments in the future. UNCTAD and World Bank joint Mission. In the Report “India: Managing Price Risk in India’s Liberalized Agriculture: Can Futures Market Help? (1996) highlighted the role of futures markets as market based instruments for managing risks and suggested the strengthening of institutional capacity of the Regulator and the exchanges for efficient performance of these markets. This report also noted that government intervention was pervasive in some sensitive major commodities like wheat, rice and sugar and was of the view that future markets in these commodities were unlikely to be viable because of this. Another major policy statement, the National Agricultural Policy, 2000, also expressed support for commodity futures. The Expert Committee on Strengthening and Developing Agricultural Marketing (Guru Committee: 2001) emphasized the need for and role of futures trading in price risk management and in marketing of agricultural produce. This Committee’s Group on Forward and Futures Markets recommended that it should be left to interested exchanges to decide the appropriateness/usefulness of commencing futures trading in products (not necessarily of just commodities) based on concrete studies of feasibility on a case-to-case basis. It, however, noted that: “All the commodities are not suited for futures trading.

Spot and future market :

Spot market is a market of commodities or securities in which goods are sold for ready cash and delivered immediately is known as Spot Market. Spot market is real time market for instant sale of commodities like grain, gold and other precious metals, Ram chips etc. It is a spot market because transactions take place on the spot. For example merchants and traders go to the fields and buy the standing crop or the freshly reaped crop at the spot. Since cash changes hands it is also called a Cash Market and since stock is physically delivered it is also called physical market. The contract entered in the spot market becomes immediately effective. Prices are settled at current prices. The primary activities of buying and selling are carried out in spot market. A spot market can operate only where necessary infrastructure is available. Thus internet provides a spot market for securities. Grains, cotton and other agricultural commodities are traded at the farms. While spot market provides a ready market for the farm produce which reduces the farmer’s cost on transportation and warehousing, not to speak of the legal hurdles that the farmer has to face in commodity movement, there is a wide gap between the farm gate price and consumer price. The traders enjoy monopoly and there is less transparency in pricing. Unless the farmer has complete knowledge about the prevailing price, he would be put to insufferable loss.

As opposed to spot markets, deals are stuck for future action in the future markets. A future contract can be defined as a type of financial contract wherein parties agree to exchange financial instruments like securities or physical commodities for future delivery at a particular price. F