The Carry in Turmeric: Hedging a Stored Crop
A turmeric exporter in Erode holds 2,000 quintals (200 MT) of polished finger turmeric that it must sell over the next three months. The local spot price is Rs 13,500 per quintal. The exchange's turmeric futures contract, where one lot equals 5 MT (50 quintals), is quoting Rs 14,400 for the contract expiring in three months. The exporter's bank charges 9% per annum on working-capital borrowing; warehouse rent and insurance together cost Rs 55 per quintal per month; grading, bagging and transport to the delivery centre would cost Rs 180 per quintal. The risk manager calls the Rs 900 gap between futures and spot 'free money' and wants to sell 40 lots while keeping the physical stock. The CFO is worried about margin calls, about the exchange's minimum curcumin specification, which roughly 15% of the stock does not meet, and about stock limits and periodic suspension of trading in agricultural commodities.
1. Compute the three-month cost of carry per quintal and decide whether the futures price offers a genuine arbitrage. State clearly what that implies for hedge size.
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Cost of carry per quintal over three months:
- Interest: 13,500 x 9% x 3/12 = Rs 303.75
- Storage and insurance: 55 x 3 = Rs 165.00
- Grading, bagging and transport: Rs 180.00
- Total = Rs 648.75, so the fair futures price is about Rs 14,149.
The quoted Rs 14,400 is a premium of Rs 900, against a carry of about Rs 649, leaving roughly Rs 251 per quintal (about 1.9% over three months, or 7.7% annualised). That is an arbitrage only if the position can be closed by delivery. Delivery is what makes the trade riskless, and only about 1,700 quintals (85%) meet the curcumin specification. Quality rejection at the assayer, stock limits, a trading suspension, and the cost of funding variation margin all convert the 'free money' into a risky basis trade. The hedge should therefore be sized to the deliverable quantity, not to the entire stock.
2. The risk manager nevertheless sells 40 lots against the 2,000 quintals. Identify the risks this creates at expiry and recommend a corrected hedge size, showing the lot arithmetic.
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Forty lots equal 2,000 quintals, but only about 1,700 quintals are of tenderable quality. If the exporter declares delivery on all 40 lots, 300 quintals (6 lots) cannot be backed by acceptable warehouse receipts, exposing it to the exchange's delivery-default provisions: buy-in at the default price, penalty, and recovery from its margins.
If it instead declares no delivery, all 40 lots must be squared off and the physical sold locally, so the protection is only as good as the local basis, and the non-tenderable 300 quintals will trade at a discount.
Corrected size: 1,700 quintals / 50 quintals per lot = 34 lots. Given assaying variability, a hedge of 30 lots leaves a buffer and avoids a default. The residual 300 quintals is unhedged price risk and should be disclosed to the CFO as such, not treated as hedged.
3. Two months later the spot price is Rs 14,800 while the near futures contract trades at Rs 14,650. Explain what this backwardation signals, and whether the exporter should roll its short hedge or accelerate physical sales.
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A futures price below spot means the market is in backwardation. The negative basis is the market paying for immediate availability: holders of stock earn a convenience yield, and the storage-plus-interest arbitrage no longer covers the futures discount. Scarcity, not surplus, is being priced.
For a short hedger this matters twice over. First, inventory is now more valuable held than carried against futures, so the exporter should accelerate physical sales or sell on the spot market rather than wait. Second, rolling a short from a higher-priced near contract into a lower-priced far contract locks in a negative roll: it buys back the near at 14,650 and sells the far lower, surrendering protection. Rolling a long would be favourable in backwardation; rolling a short is not.
The correct response is to reduce or close the futures short as the physical is sold, harvesting the spot strength directly, rather than mechanically rolling into a contract that pays less.