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  • QA 193
    Question:
    Do "index speculators" affect coffee and if so, how?
    Background:
    I read that index speculators are affecting commodity prices, including coffee. Is this true and what are 'index speculators'?
    Asked by:
    Research/extension - Kenya
    Answer:

    Index trading aims to follow the price movements of specific financial markets, or groups of assets such as commodities. The objective is mainly to minimize the trading of individual components - it is much easier and cheaper to 'trade the index'.  And yes, such trading can affect coffee prices.

    The easiest way for general investors to buy commodities is through the futures markets. These offer excellent liquidity whereas the holders need not concern themselves with quality, storage of the physical goods etc.  As we know, prices on the futures markets impact directly on the cash price for the underlying commodity that is sold and bought in the physical market by producers and, in this case, roasters. Commodities of interest range from oil through metals to coffee with coffee being part of the group known as 'soft commodities'. Other 'softs' are cocoa, sugar etc.

    Visit http://www.bloomberg.com/markets/commodities/cfutures.html for more.

    In recent times "commodities" have become an important asset class that investors wish to hold, no matter what. And this 'no matter what' has become the crux of the matter…

    To explain

    Traditionally the futures markets know two major types of operators. *

    Hedgers: People who want to transfer price risk.  These can be producers wanting to protect themselves against price falls (they sell futures), or roasters who want protection against price rises (they buy futures). So, hedgers operate both long and short but, of course, not at any price…. They are price conscious.

    Speculators and traders: People who are willing to accept risk in return for profits. In fact these are the hedgers' counter parts in that they provide the liquidity without which a futures market cannot operate. They too operate both long and short but, of course, also not at any price… They too are price conscious.

    In a successful futures market there are enough operators on each side to allow the market to fulfil its proper function: price discovery and the transfer of risk.

    Enter the index funds or index speculators: People who are willing to accept risk in return for profits but, only on the long side. They buy commodity futures and hold them, irrespective of daily price movements. As and when the position so held falls due (the delivery position approaches expiry) it is 'rolled over' to later periods. Therefore, it is suggested that index speculation is not price conscious and reduces liquidity.

    In fact, index buying may occur when the underlying fundamentals of a specific commodity in fact suggest prices should decline. But if the strategy is to increase the proportion of investment in commodities then the buying will be done, irrespective of such market sentiment.

    In extreme cases this may result in futures prices deviating completely from what the fundamental supply and demand situation suggests. This can result in serious distortions and problems for the traditional market participants. In such a situation the hedger who is long on physicals and short on futures will find himself facing huge margin calls on his futures position that he may not be able to afford. See Q&A 185 and 186 for more on this stark reality experienced by the coffee industry earlier this year.

    When the price link between futures and physicals becomes distorted, trading of physical coffee is disrupted in that routine transactions become very difficult. Normal traders shy away from accepting further risk whereas growers no longer know where prices may be headed next.  The amassing by individual operators of overly large long positions in futures, and largely static at that, makes it impossible for the futures markets to fulfil their proper role. This is the reason why certain exchanges and/or regulatory authorities place limits on the positions individual operators may hold. However, there are suggestions that 'creative alternative financial instruments' may be making it possible to circumvent such limits.

    For more on this suggestion the following link may be of interest: http://hsgac.senate.gov/public/_files/052008Masters.pdf

    The issue of index speculation has become very topical of late as a result of current very high metals, food and of course oil prices. These are impacting on consumers worldwide and are blamed by some on speculation rather than fundamental change in the underlying markets.

    * Of course there are sub-groups of operators, for example such as day traders etc, but details on these can be found in Chapter 9 of The Coffee Guide.

    Posted 30 May 2008

    Related chapter(s):
    Related Q & A:
    Q&A 051, 054, 156, 172, 185, 186