Monsoon proxy

India has no monsoon derivative on its exchanges. But it has agricultural commodity index futures, and rain moves crop prices.

So the workbook suggests using one as a stand-in for the other. An agricultural commodity futures index may be considered a proxy for the performance of the monsoon, to some extent.

The direction is the part to get right, and it is the opposite of instinct.

Buying the index futures is a bet on a deficit monsoon. Poor rain means short supply, and short supply means dearer produce.

Short selling the index futures is a bet on a very good monsoon. Plenty of rain means abundant supply and softer prices.

The workbook is careful about how far this goes. It says the index may not have perfect correlation with the monsoon. So it is an approximation, not an instrument.

And it has a second use. A trader who already holds goods to be sold can use the same position to protect them.

The workbook's framing. Buying index futures may imply a bet on a deficit monsoon, as the prices of produce may rise due to short supply. Similarly, if a trader expects a very good monsoon, he may short sell index futures. The approach can be used to bet and gain from that view and to protect himself against goods already available with him to be sold.

Its own worked case is a short. The hedging bullet in the same section says that in the case of estimated surplus production in agricultural commodities — due to larger sowing and a strong and well-distributed monsoon — farmers may short sell an agri commodity index future consisting of a basket of agricultural commodities, rather than picking and choosing individual futures of multiple commodities. So the monsoon short is the farmer's trade, and the basket is what spares him from guessing which crops will be hit.

Why a proxy is needed at all. The real instrument is not available here. Chapter 1 lists weather derivatives, monsoon derivatives, electricity derivatives, power derivatives and environmental emissions trading among the exotic products introduced globally as commodity investing grew sophisticated. And Chapter 8's own sample question asks which of four items does not fall within the definition of securities under SCRA, with the answer being monsoon derivatives. A monsoon derivative is not a security in India, so the agri index has to do the job.

What the proxy costs. The same averaging that makes the basket convenient damps the move. The law of averages means a monsoon view expressed through an index is a smaller trade than the identical view on one crop, and the workbook separately notes that a price disruption in one or two constituents may barely register at index level.

A practical problem with the best candidate. NCDEX's AGRIDEX, the agri composite index of 10 commodities in 2021, had its calculation and display discontinued with effect from 1 February 2022, because trading in many of its constituents had been discontinued on regulatory concerns. The surviving agri index in the workbook is GUAREX, which is two guar commodities — a proxy for one crop family, not for a national monsoon.

No figure in the passage. The monsoon-proxy bullet gives no sensitivity, correlation coefficient or rainfall threshold. Its only quantified anchor is the AGRIDEX basket it would have been traded on, whose 2021 weights the workbook prints in full.

Price a deficit monsoon through AGRIDEX on its 2021 weights, which are the workbook's own. The price moves are illustrative; the weights are not.

The index moves from 1,000 to 1,107.33.

A trader who bought 3 lots in June on a deficit-monsoon view, at a lot size of 500 units:

Contract value at entry = 1,000 x 500 x 3 = Rs 15,00,000 Gain = 107.33 x 500 x 3 = Rs 1,60,995

Now the mirror. A farmers' producer organisation expecting a bumper harvest after a strong, well-distributed monsoon shorts the same 3 lots. If the index instead falls 8% to 920, it gains 80 x 500 x 3 = Rs 1,20,000, which offsets the weaker price it will get for its own produce.

Finally, see what the proxy cost the deficit-monsoon trader. Chana alone rose 14% and carries 20% weight. Had he simply bought chana futures he would have caught 14% against the index's 10.73% — 3.3 percentage points surrendered. That gap is the price of not having to guess which crop the rain would hurt, and it is why the workbook calls this a proxy rather than a hedge.

Chapter 2 (Commodity Indices), section 2.5 on the uses of index futures, where it is listed as the proxy of monsoon derivative immediately after hedging. Chapter 1 supplies the list of exotic global products including monsoon derivatives, and Chapter 8's sample question supplies the reason the proxy is needed — monsoon derivatives are not securities under SCRA.

Expect a direction question: buying an agricultural commodity index future implies a bet on a ____ monsoon — deficit. The qualifier is examined too: the index may not have perfect correlation with the monsoon. And the farmer's version — short selling an agri index on expected surplus production — is the same fact from the other side.

• Buy for a deficit monsoon; short for a good one. The direction feels backwards and is asked directly. Deficit means short supply means higher prices.
• The imperfect correlation is part of the fact. The workbook offers the proxy with the qualifier attached, so an answer claiming the index tracks the monsoon is wrong.
• A monsoon derivative is not a security under SCRA. That is precisely why an agri index is pressed into service. Weather and monsoon derivatives appear in this paper as globally traded exotic products, not as Indian exchange products.
• It works as a hedge as well as a bet. The workbook says a trader can use it to protect goods already available with him to be sold, and its named example is farmers shorting on expected surplus.
• The averaging shrinks the trade. The law of averages that makes the index a convenient basket also makes a monsoon view smaller than it would be on a single crop.
• AGRIDEX, the natural monsoon proxy, was discontinued with effect from 1 February 2022. The surviving agri sectoral index is GUAREX, two guar commodities, which is not a national monsoon proxy.
• The monsoon bullet carries no figure. Any sensitivity, correlation or rainfall number attached to this idea is not from this paper.