Pricing Commodity Futures
Let’s learn more about Pricing Commodity Futures. ‘Price Discovery’ is the method of determining the best possible price at which a buyer and seller can trade a futures contract for a specific expiration date. The process of price discovery continues during the market’s trading session. The prices are openly and competitively derived and therefore it is considered to be superior to the administered or privately decided prices. The low transaction costs and recurrent trading promotes the broad involvement in futures markets reducing the opening for control by a few buyers and sellers.
The free flow of information is important in an active futures market. Futures exchanges behave as a central point for data such as the statistics on supplies, transportation, storage, purchases, exports, imports, currency values, interest rates etc. A change in this data immediately reflects on the market movement as traders adjust their bids, offers and positions according to the new data and its analysis.
This free flow and availability of information allows the market participants to establish the best estimate of today’s and tomorrow’s prices as it reflects of the supply and demand for the commodity being traded.
A futures contract derives its value from the underlying commodity. The spot and futures market are closely interlinked with price and sentiment in one market affecting the price and sentiment in the other. Fair and transparent spot price discovery is importance when it is understood the role it plays in a futures market. The following are the benefits,
- Near real time spot price information helps the trading members to take a view on the future market and vice versa.
- The data helps the Exchange to analyze the price data concurrently to make meaningful analysis of price movement in the futures market and helps in the market surveillance function.
- The Exchange has to track the convergence of spot and futures prices towards the last few days prior to the expiry of a contract.
- The Exchange need to know the spot prices at around closing time of the contract for the Final Settlement Price on the expiry day.
- The Exchange needs to know the spot price at the basis centre of the underlying commodity of which the futures are being traded on the platform.
- The near real-time spot price data when it is disseminated by the Exchange is of great interest to the general public, especially researchers, governmental agencies, international agencies, etc.
In India, there is no effective mechanism or real time spot price information of commodities.
The only government agency which collects spot prices is Agmarknet. This agency collects the post trade mandi data, but such information is not distributed real time. Hence realtime information during the trading hours is needed.
Moreover, agricultural spot markets in India are spread over 7,000 mandis across the country. Prices for the same commodity vary from one mandi to the other mandi. This discrepancy is due to the lack of integration of markets and the lack of good transportation facilities. The price differentials create a problem in the development of a unique representative spot price for the commodity.
Considering the importance of spot price information to the trader and the unavailability of reliable source of real time spot price data, NCDEX has put in place a mechanism to ‘poll’ spot prices prevailing at various mandis throughout the country. This process is analogous to the interest rate polling conducted to find the LIBOR rates.
The Exchange collates spot prices for all commodities on which it offers futures trading and circulates the same to the market through the trading platform. This collection and dissemination of spot prices are done by various reputed external polling agencies which are in direct contact with market participants and collect feedback on spot prices which are then distributed to the market.
