Commodity & Equity Markets

The commodity derivatives markets in India remained subdued for almost 4 decades due to prohibitions and excessive regulations till 2002, when the Government decided to permit national level electronic exchanges like MCX to trade in futrures contracts on commodities.  Since then, the commodity derivatives markets have witnessed phenomenal growth in trading.  The equity markets, on the other hand, were well established much before.  During stock markets went through prolonged bearish state starting from January 2008 and continue to remain so, with minor improvements now and then.  Commodity derivatives markets witnessed a steady growth during the same period, lead primarily by the growth in trade in bullion contracts. The volume of trade in bullion rose from Rs.17.26 trillion in 2007-08 to Rs.101.82 trillion in 2011-12, with CAGR of 156%.  This kind of growth pattern raised several questions like whether there is any relationship between the equity and commodity market movements in India or are they moving independently.

In a recent research work, it was found these two markets do not exhibit statistically significant co-movements (or long term equilibrium in movements).  The study was conducted based on the relationship between the movements of equity markets (measured by NSE Nifty and BSE Sensex) and commodity markets (measured by MCX Comdex, Metal and Energy indices).  Period of the study was 4 years from January 2008 to December 2011.  Correlation and Engle-Granger Test for Cointegration were used to analyse the data.  Though there was positive correlation between both the markets (about 0.60), the Cointegration test proved that there was no significant co-movement between these two markets.

(The above post is based on a research paper co-authored by me and Dr. M R Shollapur, which was presented in an International Conference recently at Bangalore)

Series on Financial Markets - VI

After a brief gap (due to various preoccupations), let me resume my blogs.  Let me brief on the past posts in the above series.  The first one dealt with basics of real assets and financial assets.  The second one explained the characteristics of financial assets; the third one was about the financial system and the fourth and fifth dealt with raising funds (capital) from through borrowing and from the shareholders through the primary markets respectively.  The last post ended with a question: when raising funds directly from public involves lot of costs (in various forms), why do firms raise funds from the public?  Let me try to answer.

Let us first understand why firms do not like too much of debt.  Debt capital, though less costly as the interest rates are fixed and they do not participate in the profits of the firs, has its own disadvantages.  Firstly, the interest payments on debt are committed costs and the firm has to pay the same, irrespective of whether the firm makes profit or not and whether it has enough cash balance or not.  Default in payment payment leads to lot of complications like hampering the image of the firm, reduced credit rating, and even legal proceedings by the lenders in extreme cases.  Secondly, the lenders start insisting on certain operational restrictions.  They would require the firm to take them into confidence before implementing major decisions like expansion of business, payment of dividend, raising further funds etc.  Thirdly, as the going gets tough for a firm (may be due to unfavourable external environment), firms with more debt find it difficult to sail through, as they have to deal simultaneously with the hostile business conditions and the highly demanding lenders.  This is exactly what the aviation sector is facing now.

Now let me explain, why equity (owner's funds) may be attractive inspite of relatively higher costs.  The equity capital is almost a permanent source of capital.  The firm is under no obligation to repay this capital under any circumstances, except in case of winding up of business or buyback of shares.  Here again, the decision to buyback the shares is not demanded by the shareholders.  The firm is also not under any obligation as far as payment of dividend (the share of profit) is concerned.  A firm with more equity capital attracts a better image in the business circles and financial markets.  Such a firm also enjoys better bargaining power with the lenders, when it comes to raising additional funds through borrowing.