Bullion index futures offer hedging opportunity, but margin, settlement risks linger

bullion gold silver
At a micro level, individuals are attracted to bullion due to the physical characteristics it possesses and the investment opportunities it offers.

By Naliniprava Tripathy, Darshan Gosalia and Tushar Gera

The bullion market has gained traction all over the world. Its fascination is not limited to any particular individual, entity, or nation; it has allured masses, industries, governments, and nations alike. It has transcended the test of time and space to emerge as a popular destination for investors. Bullion is a term used to include gold and silver of the highest level of purity, often kept in the form of bars, coins, or ingots. It is sometimes considered as legal tender and is usually held in the form of reserves by central banks. Thus, the quantum of bullion reserves held by the nations depicts their financial strength.

At a micro level, individuals are attracted to bullion due to the physical characteristics it possesses and the investment opportunities it offers. People are also fascinated by various products made out of bullion such as jewelry, utensils and industrial products. In the Indian context, bullion is considered much more than a mere asset class and has a place in the culture and tradition. Having understood the relevance of bullion to different categories of people, it is essential to look at the current scenario of the bullion market in India. When the world is struggling to cope with the Covid-19 pandemic, gold crossed Rs 56,000 per 10 gm mark for the first time in history. Similarly, silver prices rose sharply and reached Rs 61,280 per kg, the highest in seven and a half years. While all this, the need to trade in physical bullion was a damper. However, gold bonds are available for investment; its investment came with certain limitations. Therefore, there was a need to further monetize bullion to enable the masses to trade effectively in this commodity. In India, the Multi-Commodity Exchange of India (MCX) offers investors a painless way of investing in bullion. MCX facilitates trading in commodities such as gold, silver, copper, crude oil and natural gas, base metals and agricultural commodities. The MCX India Commodity Indices (iCOMDEX) tracks the performance of these commodities. The iCOMDEX is divided into three parts:

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  • Composite index comprising different commodities on MCX. It comprises of eleven commodity futures contracts on the MCX.
  • Sectoral indices comprising of bullion index and base metal index
  • Individual indices that comprise the gold index, silver index, copper index, and crude oil index.

The bullion index (Bulldex), a sectoral index, is used as a benchmark for tracking the performance of the gold and silver in India. Launched on December 31, 2015 with a base value of Rs 10,000, it is currently trading at about Rs.16,000 levels and has returned 32% over the past one year. It comprises gold and silver futures contracts that are traded on MCX. The weights assigned to gold and silver are 70.52% and 29.48%, respectively. These weights are assigned based on the liquidity and physical market size of these commodities in India. These weights are reset annually in January. Until recently, bulldex was available only for tracking the performance of the bullion market and was not available for trading. The bulldex futures, having underlying as the bullion index, are available for trading with the launch of iCOMDEX bullion index futures on August 24, 2020.

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The bulldex futures has a minimum of one trading lot and a maximum of 80 lots with a trading value of Rs 50 times the bulldex. Thus, the minimum trade value for one lot at the present index value is about Rs 8 lakhs. The initial margin of 5% would be required to be deposited; thus, the margin requirement would be about Rs.40,000 per a lot of futures contract. It implies that the exposure, and thus the risk and opportunity from index movement, of Rs.8 lakhs can be obtained by making a minuscule margin investment. The final settlement of the bulldex futures contract would be in cash and not by delivery.

Investing in the bulldex futures offers various benefits to investors. Bullion has a low correlation with equity markets and other financial assets. Thus, investing in bullion helps in portfolio diversification and minimising portfolio risk. Also, the movement of the bullion market is in the opposite direction of the stock market in a long period of time. Therefore, during times of extreme downward volatility in the stock market, the bullion would hedge that risk and provide significant returns during such times.

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Further, by investing in bullion futures, the trader or investor would have exposure to both gold and silver commodities rather than just one specific commodity. It would result in reduced volatility. Bulldex, being an excess return index, the trader or investor would benefit from roll return in addition to the price return. Bullion index futures contract has smaller contract value and, therefore lesser margin requirement compared with individual gold or silver futures contract. Other benefits that the market participant would reap through bulldex futures include the availability of monthly contracts, liquidity of contracts, cash settlement at expiry, optimization of asset allocation, and ease to replicate with minimum tracking error.

On the flip side, the exposure and impact of the bulldex index would be huge if the underlying index declines as it is in the derivative segment. Thus, the investor should be cautious and be willing to take the risk of additional margin payment and cash settlement because of a decline in the index value.

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Having evaluated various aspects of the bulldex futures, it can be said that its launch would provide an additional opportunity for investors to gain exposure to the bullion sector and would boost the bullion market in India. However, investment in the bulldex futures should be made cautiously as the risk of additional margin payment, and the cash settlement can be substantial if the index declines.

(Prof Naliniprava Tripathy teaches finance at IIM Shillong. Darshan Gosalia and Tushar Gera are PGP Students at IIM Shillong.)

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