Hedging Against Rising Cotton Prices using Cotton Futures

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MCX cotton futures contract sees 294% YoY rise in June 2020

MCX witnessed a 57 per cent jump in its cotton contract’s average daily volume from 2605 lots (1 lot = 25 bales) in June 2020 to 4085 lots in June 2020.

Multi Commodity Exchange of India Ltd. (MCX) has received response with cotton deposits in the current season (October 2020-July 2020) increasing by 294% in June 2020 vis-a-vis June 2020.The cotton futures contract continues to serve as an efficient hedging tool to the market participants—producers, ginners, millers, yarn manufacturers, exporters, that enables them to tackle volatility or any adverse price movement in an efficient manner.

MCX witnessed a 57 per cent jump in its cotton contract’s average daily volume from 2605 lots (1 lot = 25 bales) in June 2020 to 4085 lots in June 2020. Correspondingly, there has been a substantial increase in average daily value from Rs. 132 crores to Rs. 231 crores over the said period. Moreover, the cotton stocks in warehouses hit a five year high at 161,000 bales in June 2020. The open interest stood at 13,581 lots at the end of June 2020.

The basis delivery centre for MCX Cotton contract is Rajkot (Gujarat) with additional delivery centres at Yavatmal and Jalna (Mahasrashtra), Kadi, and Mundra (Gujarat), and Adilabad and Warangal (Telangana), and the deposits are spread all across the delivery centres.

India is the largest producer of cotton in the world accounting for about 27% of the world cotton production. The major cotton producing states are Andhra Pradesh, Maharashtra, Gujarat, Punjab and Haryana. The growth in cotton crop has resulted in greater stability in cotton production. India is the second largest exporter of Cotton in the world. This makes cotton prices very vulnerable to changes in global demand and supply. In this regard, MCX cotton futures contract has emerged as a valuable and effective tool for managing cotton price risk.

Mr. Mrugank Paranjape, MD & CEO, MCX said, “The MCX cotton futures contract continues to go from strength to strength, and has proven to be national price benchmark and effective risk management tool for multiple stakeholder groups across the cotton value chain. It is indeed heartening to note the positive impact our efforts have had on the businesses of the market participants and the trust they repose in MCX drives us to further strengthen our efforts.”

Mr. Sanjay Jain, Chairman, Confederation of Indian Textile Industry (CITI) said, “Ever since the launch of MCX Cotton futures, the cotton industry has immensely benefited from this hedging tool that provides protection against price uncertainty and a robust delivery platform. This adds to sustainability of businesses especially SMEs which play a major role in textile sector, which is one of the largest contributing sectors in the economy of the country.”

India’s annual production of cotton has been steadily increasing in the recent years supported by a rise in acreage, better genetically modified seeds, and improved practices. According to Cotton Advisory Board (CAB), India’s estimated production is 37 million bales of cotton in 2020–18 crop year as compared with 34.5 million bales in 2020-17. The acreage yield was 568 kg/ha in 2020-17 as against of 484 kg per hectare in 2020-16. As per CITI, the area under cotton cultivation increased to 122.59 lakh hectares in 2020-18 (up by almost 13%) from 108.45 lakh hectares. India’s cotton consumption estimates to 31.6 million bales in 2020-18 (including non-mill consumption of 1.9 million bales) against 30.6 million bales in 2020-17. As per Cotton Association of India, India has been a major exporter of cotton since 2005–06, and currently, the world’s second largest exporter. It is estimated that India had exported 7 million bales of cotton in 2020–18 compared with 5.82 million bales in 2020-17.

Using ETFs To Hedge Against Rising Rates

September 29, 2020

The September Federal Reserve meeting passed without much fanfare, quieting markets that had been getting jittery about a rate hike. The central bank―eyeing the uncertainty of a presidential election in November―chose to delay its much-anticipated interest rate increase, but not for long.

After the no-change decision, Federal Reserve Board Chair Janet Yellen told the press that she expects a rate hike sometime this year. That means that an increase may come either at the November or December meeting, with most economists targeting the latter as the likeliest option for a move.

If so, it will be deja vu, for it was last December when the Fed hiked rates for the first time in nearly a decade after months of anticipation. Another hike this December would push the federal funds rate up by 25 basis points to a range of 0.50-0.75% from 0.25-0.50%.

Rates Down From Start Of Year

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Market-set rates are up from their lows ahead of the potential rate increase, though they’re down significantly from where they were at the start of the year.

The two-year Treasury bond yield, for example, is at 0.75%, up from a low of 0.50% in June, but down from 1.05% on Dec. 31. At the same time, the 10-year Treasury bond yield is at 1.56%, up from a record-low 1.32% in July, but down from 2.27% on Dec. 31.

It’s impossible to say whether the next Fed hike will be the catalyst that finally spurs a big rally in interest rates (and sell-off in bonds). But for investors who want to protect themselves, there are many tools available in the ETF world to minimize the impact of higher rates, or even capitalize on them.

Lower Duration Bonds

The classic advice given to investors in a rising rate environment is to reduce the duration of your bond portfolio. Duration is a measure of interest rate risk and is based on a bond’s maturity and coupon payments.

A higher-duration portfolio has more interest rate risk than a lower-duration portfolio. By reducing duration―for example, by buying shorter-term bonds―a portfolio will have less interest rate risk. The flip side is that the portfolio will probably have a smaller yield as well.

There are plenty of low-duration ETFs on the market that can help reduce the average duration of an investor’s portfolio, including the iShares 1-3 Year Treasury Bond ETF (SHY), the PIMCO Enhanced Short Maturity Active ETF (MINT) and many more.

Inverse Bond ETFs

Another method with which to hedge against rising rates is inverse ETFs. These funds short Treasury bonds, meaning they rise in price when interest rates increase (bond prices and rates generally move inversely).

The ProShares Short 20+ Year Treasury ETF (TBF) provides daily inverse exposure to Treasurys with maturities greater than 20 years.

Meanwhile, the Sit Rising Rate ETF (RISE) shorts futures contracts on two-, five- and 10-year Treasurys with a specific goal of maintaining a duration of negative 10. That means if interest rate rise by 1%, the ETF should rise by 10% (and vice versa).

TBF, RISE and similar ETFs can be used to hedge other bond funds in a portfolio or as stand-alone products to speculate on the direction of interest rates.

Keep in mind, however, that any product that shorts positive-yielding bonds will have to pay a cost to maintain that position over time. This can result in losses even if interest rates remain flat.

YTD Returns For TBF, RISE, TLT, IEF

Long/Short Bond Funds

Another group of ETFs attempts to reduce duration by simultaneously holding long and short positions in bonds. The WisdomTree Barclays US Aggregate Bond Negative Duration Fund (AGND) holds the bonds in the Barclays Aggregate Bond Index and a short position in Treasurys at the same time. The result is a portfolio of bonds with a duration of negative 5.

Once again, AGND could be used as a stand-alone product to speculate on interest rates or combined with, say, another position in the iShares Core U.S. Aggregate Bond ETF (AGG) (which incidentally has a duration of positive 5) to reduce an investor’s interest rate risk.

ETFs that use a similar strategy as AGND’s include the VanEck Vectors Treasury-Hedged High Yield Bond ETF (THHY) and the ProShares High Yield-Interest Rate Hedged ETF (HYHG), which short Treasurys to hedge a portfolio of high-yield bonds. Both target a duration of zero.

YTD Returns For AGND, THHY, HYHG, AGG, HYG

Floaters

For investors who want to do away completely with interest rate risk, a straightforward solution floating-rate ETFs. The iShares Floating Rate Bond ETF (FLOT) holds a basket of bonds with maturities of five years or less. As floating rate notes, the interest rates on these securities resets periodically based on market rates; so if rates increase, the payout increases too (the downside is that rates on floaters will tend to be lower to account for the smaller risk).

Floaters are attractive compared to fixed-rate bonds when rates are expected to increase, but not as attractive when rates are expected to decline.

The PowerShares Senior Loan Portfolio (BKLN) is another type of floating-rate ETF. It tracks an index of the 100 largest bank loans with floating rate coupons. The fund has little interest rate risk, but relatively high credit risk due to its below-investment-grade portfolio.

YTD Returns For FLOT, BKLN, SLQD, HYG

Commodities explained: Hedging oil volatility

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The plunge in oil prices has strained the balance sheets of drillers and reduced costs for airlines. One way that companies manage the risks from commodities market swings is through hedging.

So what is hedging exactly?

No silly gardening jokes please. Hedging involves locking in a price to buy or sell a commodity in the future. It is a form of insurance against adverse moves in markets notorious for them. Hedging is also employed in currencies, interest rates and stock indices, but it originated in grain markets.

Who hedges commodities?

Businesses that are exposed to commodity price swings find hedging useful. A farmer worried that corn prices will fall after harvest might lock in a sale price during spring planting. Mexico annually hedges the value of its crude oil exports, paying banks a premium to ensure predictable revenue for its federal budget. Hedging “gives greater freedom for business action”, wrote Holbrook Working, a leading 20th-century economist of commodities markets.

OK, how do companies hedge?

Traditionally with derivatives such as futures and options. Futures contracts have two sides: a “long,” or buyer, and a “short,” or seller. An airline concerned about a future rise in the price of jet fuel might buy oil futures and take a long position. If crude jumps from $60 to $70 a barrel, the corresponding increase in the value of the airline’s futures position will help offset the higher price it will pay fuel suppliers. Conversely, an international oil producer worried that crude will fall from $60 a barrel to $50 might sell, or go short, in oil futures, locking in the sale price at $60.

Who takes the other side of the trade?

Futures markets are anonymous, so anybody from the oil producer to a hedge fund or bank could be the counterparty to the airline’s trade. Despite the name, hedge funds are classic speculators, or traders seeking to make money on price moves rather than insure against them. Commercial companies can also sometimes take speculative positions, meaning data (such as the US Commodity Futures Trading Commission’s “Commitments of Traders” reports) categorising trader positions as commercial or noncommercial should be viewed with care.

Can hedging have an impact on markets?

Big volumes from the execution of a hedging programme can move the price of futures markets and influence the value of options.

Hedges already in place can affect how companies respond to price signals. For example, US oil prices have declined more than 50 per cent since last June.

According to Barclays, US producers have hedged 22 per cent of their 2020 oil output. These hedges help soften the blow from oil’s fall and delay the imperative to cut production. The US government forecasts onshore production will keeping rising until May 2020 despite low prices — a phenomenon partly explained by hedging.

Hmm, if hedges are so handy, why doesn’t every company hedge?

Hedges can be costly. Mexico paid banks $773m for options to hedge its 2020 oil exports at a sale price of $76.40 per barrel. (The deal already appears worthwhile, since Mexico’s oil now fetches less than $50 on the spot market.)

Companies using futures can face hefty margin calls — or demands for more collateral — if the market moves against them. Margin calls prompted by a cotton price increase bankrupted some merchants in 2008.

Investors seeking to play a commodities rebound without becoming futures speculators themselves may also prefer shares of companies that don’t hedge. All things equal, an unhedged driller has more to gain from a rising oil price than one already enmeshed in hedges.

This article is the eighth in an online series on commodities made easy
Click here for other articles in the series, or go to our Flipboard page

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