Sebi issues draft norms for commodity indices

Why in news?

• The Securities and Exchange Board of India (SEBI) has proposed allowing commodity exchanges to create indices on which futures contracts can be introduced.
• Such indices can be based on the most liquid contracts traded on the bourses and have to be diversified with the weightage of a single constituent capped at 20%, according to a consultation paper by the SEBI.
• Index-based products will also encourage the participation of institutions such as mutual funds, insurance companies etc., in the commodity derivatives market.
• Trading in derivatives products on commodity indices may also increase liquidity in underlying commodity derivatives products [futures and options] as entities would like to carry out arbitrage trades across index products and constituents or may use one product to hedge their positions in other.
• Incidentally, the Commodity Derivatives Advisory Committee (CDAC) has recommended that to begin with, futures contracts on commodity indices may be launched by exchanges.

Time frame

• The capital markets regulator has proposed that the indices can include as constituents only those commodity contracts that have been in existence on the respective exchange for at least the previous 12 months, or the previous calendar year, or the previous financial year, and traded for at least 90% of the trading days in the stipulated period.
• Further, the average daily turnover of the constituent futures contracts during the period under consideration has to be at least Rs 75 crore for agricultural and agri-processed commodities. For all other commodities, it has been pegged at Rs 500 crore.
• The maximum weightage for any index constituent in a composite index will be at most 20% and minimum weightage will be at least 1%, as per the SEBI discussion paper.
• Meanwhile, the minimum lot size of a futures contract introduced on such indices has been proposed at Rs 5 lakh.

What is a Commodity Index

• A commodity index is an investment vehicle that tracks a basket of commodities to measure their price and investment return performance. These indexes are often traded on exchanges, allowing investors to gain easier investment access to commodities without having to enter the futures market. The value of these indexes fluctuates based on their underlying commodities, and this value can be traded on an exchange in much the same way as stock index futures.

Limitations of Commodity Indexes

• Commodity indexes differ from other indexes like stocks and bonds in one very important way: The total return of the commodity index is entirely dependent on the capital gains, or price performance, of the commodities in the index.
• For most investments, total return includes periodic cash receipts such as interest and dividends and other distributions as well as capital gains. For example, stocks pay dividends and bonds pay interest, which contributes to the investment’s total return even if there is no increase in the investment’s price.
• Commodities do not pay dividends or interest, so an investor is dependent solely on capital gains for the investment performance.
• If the commodity price does not go up, the investor experiences a zero return on investment. This zero return scenario is not the case for bonds that pay interest and stocks that pay dividends. For example, if a stock price is the same at the end of the investment horizon, but has paid a dividend, the investor will have a positive return on investment.

(General economy)(Source:- The Hindu)