Indian Commodity Derivatives – A steady bull run ?

V.Shunmugam and DG Praveeni

Retail investors and institutional funds (if allowed) would be wary of trading in commodity derivatives due
to fear of ending up in delivery and lack of an efficient portfolio that would keep up the growth momentum
in their value of investment in commodities. Hence an approach has been made here to compare one of
the Indian commodity indices (MCX Comdex) and its global counterparts to find if there is a steady bull
run in the Indian commodities compared with the global markets. Investing in commodity indices that are
efficiently designed for such purposes would serve the dual purpose of removal of the fear of physical
deliveries and would yield them better returns with a moderate risk. Such commodity indices not only
provide an investment opportunity, but also provide with an alternative risk mitigation mechanism for
investors with intention to spread their eggs across different commodity baskets. This would also help
mitigate risks for those with exposure to more commodity related industries such as Refineries, Copper
wire manufacturers, edible oil crushers/refiners. As such, investing in indices is not a new phenomenon to
the investors in India, as indices designed based on spot and futures securities market are commonly
traded in the Indian stock exchanges. However, globally commodity derivative indices are different from
their financial derivative counterparts in that their underlying physical/futures markets in commodities
ranges from paper pulp to gold, pork bellies to live cattle and crude oil.

Globally, there are about ‘half a dozen’ popular indices that reflect the futures prices of commodities from
different underlying markets. The list includes indices such as Goldman Sachs Commodity index (GSCI),
Dow Jones-AIG Commodity Index (DJ-AIGCI), Reuters CRB Commodity Index (RCRBCI), S&P Commodity
Index (S&PCI), Rogers International Commodity Index (RICI), and Deutsche Bank Liquid Commodity
Index (DBLCI). An interesting feature in these commodity indices is that, unlike stock indices, all are
based on futures contract prices due to the non-availability of reliable spot prices of commodities at short
regular intervals.

According to Goldman Sachs, about $80 billion have

been invested globally in the commodity derivatives
of which 60 percent (about $48 billion) has been
invested in passive index-tracking instruments. Of
these, a bulk has been invested in instruments linked
to the Goldman Sachs Commodity Index (GSCI), DJ-
AIGCI, and RCRBCI that are traded on global
benchmark exchanges – CME, CBOT and NYBOT
respectively. Apart from futures and options, huge
investments have been done on these commodity
indices through over-the-counter instruments such as
swaps and structured notes.

Trading houses and derivatives dealers are the principal players involved in trading and designing of these
instruments. Apart from this, smaller funds such as Pimco’s Commodity Real Return Strategy Fund,
Oppenheimer’s Real Asset Fund, and Rogers International Raw Materials Funds are available to retail
investors interested in accessing global commodity markets through index funds. These funds either
invest in futures markets directly or Over-The-Counter instruments or both for their commodities
exposure. Recently, Scudder’s Commodity Securities Fund, a path-breaking and an innovative fund based

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on commodity derivatives associated with GSCI benchmark (50 percent) and the shares of companies
involved in commodity-based industries, (50 percent) was launched. However, the current RBI
regulations do not allow individuals and entities from India to participate in trading in these global indices
or global funds tracking these indices.

How are Commodity Indices different from Stock Indices?

The cash prices of the exchange-traded stocks are available on a regular and continuous basis; hence
construction of index based on this data is simple and continuous. Contrarily, cash prices of commodities
are not readily available on a continuous basis. To have an index that is indicative of the fundamentals
and actively tradeable, it would be better to construct an index using futures prices rather than cash
prices in the absence of effective spot exchanges for commodities in the country, commodity futures
traded on an organized platform provides the best platform to base the indices. However, futures contract
expires on the date of their maturity. In order to have continuous futures prices, commodity indices are
constructed in such a way that futures prices of given maturities (preferably near (front) months) are
considered and all are replaced with (rollover to) the subsequent month’s contracts during a definite
rollover period.

The popularity of the commodity futures indices would have wide implications on the futures industry as
well. Investment in indices is normally a long-term strategy that could help increase open up interests in
futures contracts for various commodities as investor gain better grip of the fundamentals. A significant
spurt in trading activity could be witnessed during the rollover days, when traders rolled over their
positions into new contracts. As the indices undertakes the movements in the nearest deferred months,
funds would like to hold positions in those underlying contracts. And, in the process this would increase
the trading activity in nearest deferred month contracts as well during the roll-over period. Another
interesting proposition could be that the trading and investment community would get new trading
opportunities whereby they can take the strategic positions in both the indices and the underlying
commodities to profit out of the mismatched pricing between the two instruments

Performance Analysis of Global Benchmarks with MCX COMDEX

A comparative financial performance analysis of four benchmark commodity indices - Goldman Sachs
Commodity Index (GSCI), Dow Jones AIG Commodity Index (DJCI), Roger International Commodity Index
(RICI) and Reuters/Jefferies CRB Index (R/J CRB) - and an Indian counterpart (MCXCOMDEX) were done
for the period December ’05 to December ’06 (till date) to look at their performance.

Goldman Sachs Commodity Index (GSCI): is the most widely followed commodity index. This was
created in 1991. The weights are assigned to the underlying commodities based on their average
production value in the last five years of available data. The trading interest (liquidity) on the exchanges is
also considered for the composition of index basket. Weights and composition are reviewed and re-
assigned annually. The commodity basket for this index is unlimited, which means there would not be any
cap on the number of underlying commodities in the index. At present, the GSCI contains 24 commodities,
ranging from crude oil to live stock to precious metals. GSCI is highly volatile, as it gives nearly 75% of its
index weight to commodities in energy sector. The futures on GSCI are listed on Chicago Mercantile
Exchange (CME).

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Dow Jones AIG Commodity Index (DJ-AIGCI): was created in 1998. A section of institutional
investors keenly follow this index of 19 commodities. The weights to the underlying commodities are
assigned and re-adjusted annually based on average global production and average trading volume over
the recent five years. Unlike GSCI, this is primarily designed for diversity i.e. moderate risk with secured
but low returns. No single commodity can have more than 15% or less than 2% of the index. Further, no
one sector can hold more than 33% of the index. Implicitly, these rules curtail the volatility of the index,
as against GSCI. However, this would generate interest in institutional1 investors such as pension funds
looking for a moderate return/risk ration. Futures on the DJ-AIGCI are traded at the Chicago Board of
Trade (CBOT).

Reuters/Jefferies Commodity Research Bureau (R/J CRB) Index: was developed originally in 1957.
It is one of the most popular indicators of overall commodity prices. It reflects prices of 19 commodity
futures traded on benchmark exchanges. CRB, was traded first on New York Board of Trade (NYBOT) in
1986, was renamed to the Reuters CRB index in 2001 and then now renamed again to the
Reuters/Jefferies CRB index. Reuters announced major revision in the index in partnership with Jefferies
Financial Group. .

Rogers International Commodity Index (RICI): was developed in 1998 by Jim Rogers to record the
price movements of raw materials on a worldwide basis. It contains the largest commodity basket among
the popular commodity indices with 35 commodities. Weights for the underlying are assigned according to
their importance in international commerce. RICI is rebalanced monthly. The Rogers International
Commodity TRAKRS Index (popularly known as Rogers TRAKRS), which is a total return index that will
equal the product of Rogers International Commodity Index (RICI) and the Multiplier, plus the Amortizing
spread is traded at the Chicago Mercantile Exchange (CME

MCX COMDEX (MCXCOMDEX): was created in June

2005. It reflects the price actions of commodity MCX
futures traded on the Multi Commodity Exchange of 33.3 33.3 33.3
COMDEX
India (MCX). Similar to the GSCI, the index does not
have any limit on the number of underlying RICI 44.0 21.1 34.9
commodities. Currently, it consists of ten commodities
selected based on their liquidity. Equal weights are RJ/CRB 39.0 20.0 41.0
assigned at group level (energy, agriculture and
metals). It relies on a unique combination of liquidity DJ-AIGCI 33.0 40.7 26.3
on MCX and physical market size to determine its
component weightings. Only near or near deferred GSCI 74.2 10.8 15.0
contract months are taken for the index computation.
Gold, Silver and Copper represent metal group, while 0% 20% 40% 60% 80% 100%
energy and agriculture groups are comprised of crude
oil, and soyoil, cottonseed oilcake, wheat, rubber, urad Energy Metals Agriculture
and guarseed. The index is not traded on any of the
exchanges in India, as the present regulation does not allow trading on index in the Indian commodity
markets.

The idea behind the common weighting approach is to allow markets to have a say in determination of the
relative significance of the various commodities. By relying on factors that are both endogenous to the

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futures market (liquidity) and exogenous (physical market), the effect of its dominance in the physical
markets would be taken care.
Among the benchmark indices covered for the study it was found that only MCX Comdex and RICI had
positive returns for the period between December – December till date (05-06) (see Table I below).
Indian benchmark, MCX COMDEX provided the highest annualized return of about 18.33 percent with a
moderately higher annualized risk (19.31 percent). MCX COMDEX was followed by the RICI with an
annualized return of 5.56 percent (annualized risk – 17.04 percent). The other benchmarks showed
negative returns, ranging between 1 percent and 7 percent. This implies that the Indian index made a
steady bullish run at a time compared with its global counterparts most of whom were in the negative
return zone.

Table 1: Risks and Returns – MCX Comdex VS Global Benchmark Indices

GSCI DJAIG RICI CRB COMDEX

Annualized Return -1.35% -5.21% 5.56% -6.70% 18.83%
Annualised Risk 21.84% 17.81% 17.04% 16.82% 19.31%
A. Max/Min return (on closing) 22.87% 18.41% 18.05% 21.34% 34.24%
Max. per day drawdown -3.77% -3.06% -2.85% -2.91% -5.05%
Return/Risk Ratio -6.18% -29.26% 32.63% -39.84% 97.50%

Return from the date of MCX

COMDEX inception (I.e. June
'05) 18.10% 9.11% 11.98% 1.90% 35.20%

Looking at the basket of commodities considered for these indices, the over emphasis on energy made
GSCI highly volatile compared with others with an annualized risk of 22.87 percent. The high volatility
reduced the return-risk ratio to – 1.35. Measured in terms of return to risk ratio, MCX COMDEX tops the
charts leaving behind its counter parts with the highest return of 97.5 percent, though with a risk of 100
percent. Despite the closed borders for trading in various commodities, MCX COMDEX had a very high
correlation with its global counterparts ranging from 66.1 percent to 82.7 percent (Table 2) due to its
unique combination consisting of commodities from metals, energy, and agricultural verticals representing
the entire range of primary commodities. Surely, through its innovative design comprising of various
primary commodities, MCX Comdex had not only proven that the Indian commodities had a steady bull
run in the international markets during the last one year, but also that it is a better barometer of the
primary commodities price complex by having better correlation with its global counterparts.

Table 2: Correlation between COMDEX and Global Benchmark Commodity Indices

GSCI DJAIG RICI CRB COMDEX

GSCI 100.0% 93.3% 90.7% 95.3% 75.2%
DJAIG 100.0% 86.9% 96.4% 82.7%
RICIX 100.0% 90.2% 66.1%
CRB 100.0% 76.4%
COMDEX 100.0%

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 For further information please contact:

Ravi Muthreja
Head, Communications, MCX
Phone No.: +91 22 66497000
Mobile No.: +91 9867726000
Email: Ravi.muthreja@mcxindia.com

i
Authors are Chief Economist and Manager, Multi Commodity Exchange of India Limited, respectively. Views expressed above are
personal. They can be contacted at v.shunmugam@mcxindia.com or Praveen.d@mcxindia.com for any further clarification.

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