Commodity Market Word

8/2/2019 Commodity Market Word

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Commodities Market in India

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1. Executive Summary

Commodities form an essential part of daily lives of all individuals. Changes in

commodity prices have a direct impact on households as they can lead to a fall or

rise in their cost of living. Commodities are the raw materials which form the basic

input to manufacturing industry. Thus even these industries are affected by the

commodity fluctuations.

With the establishment of online markets,commodities now offer investment

opportunities. Any person can now trade for commodities just like shares and bond

market.

Historical events show that India is one the most ancient countries to trade

commodities and derivatives market. Agricultural commodities, Oil, Gold and silver

form an integral part of Indian society.

The futures commodity market has shown a constant growth ever since its restart

early 2000s. The gap between the equity markets and the commodity markets in

India is closing down, but still the volumes traded are less as compared to the

international exchanges.Since the period recession in 2008 the growth of commodity markets outperformed

the equity markets. With some further reforms in the derivatives markets, there is

tremendous potential for growth of this market in the country.

This project focuses on the commodities exchanges in India with respect to different

exchanges and commodities for trading, available trading mechanisms, regulations,

comparison on Indian commodity derivative market vis--vis equity market and

future prospects.


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2. Introduction

A market is described as a platform where buyers and sellers are allowed to trade,exchange goods, services, and information. Any type of trade can take place in a

market. The two major dependent factors by which a market can operate are

buyers and sellers.

2.1 Types of Market in India

Currency Markets - Currency markets are among the largest traded markets in the

globe, on a continual basis. Money flows are continuous around the globe -

governments, banks, investors and consumers - all of them are involved in buying

and selling currency round the clock.

Stock Markets - Stock markets seem to be the backbone of any economy allowing

investors to buy and sell shares of various companies. Majority of the Indian stock

markets are operating on an electronic network.

Commodity Markets - In India, the commodity markets are starting to gain

attention as the prices of the essential commodities steer the economy to a desired

level. Commodity markets deal in energy, soft commodities and grains, meat etc.

Debt Markets

There are three main segments in the debt markets in India,

(1)Government Securities

(2) Public Sector Units (PSU) bonds and

(3)Corporate securities.

Debt market is predominantly a wholesale market, with dominant institutional

investor participation. The investors in the debt markets are mainly banks, financial

institutions, mutual funds, provident funds, insurance companies and corporates.


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2.2 Commodity and Commodity Trading

A commodity is a product that has commercial value, which can be produced,

bought, sold, and consumed.

India commodity market consists of both the retail and the wholesale market in the

country. The wholesale market is the one where the commodities are bought from

the producers and sold to the retailers by the wholesalers while in retail markets,

retailers sell the goods bought from the wholesalers are sold to the end consumers.

Commodities can also be traded on different exchanges which help in discovering

the price of the commodity and mitigate risks.

Earlier commodity trading was much more an unorganized one as all traders were

required to a common place and call out bids.

In those days the buyer would study the quantity of annual produce of the

commodities and the sellers would calculate the approximate demands. There was

speculation and dictating of terms. This was primarily because there was no

research and techniques of trading speculation.

However, commodity trading has seen a radical change with it shifting to an

organized set up in the form of the commodity exchanges. Actually futures

commodity trading was banned for over forty years in this country because of varied

reasons. And when this ban was lifted, no one could imagine the volume of trading

it has invited.

Commodity markets are similar to equity markets. The commodity market basically

two constituents i.e. spot market and derivative market. In case of a spot market,

the commodities are bought and sold for immediate delivery. In case of a

commodities derivative market, various financial instruments having commodities

as underlying are traded on the exchanges.


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2.3 History of Commodity Trading in India

The history of commodity markets have their roots way back to early civilizations

where people used to barter different goods as per their needs.

Commodity trading was initiated in India and gradually it became popular in the

other parts of the world. Long years of foreign rule, natural disasters and calamities,

lack of sound government policies caused the commodity trading gradually lose it

sheen in the Indian subcontinent.

Major breakthroughs have witnessed an early death due to political negligence and

lack of strong will.

The Bombay Cotton dealers Association was formed in 1855 marked the beginning

of process of formalizing cotton trade in India. Some important events that took

place in the commodity market are as follows:-

1875 - Bombay Cotton Trade Association Ltd. Set up the first organized futures

market.

1900 - Futures trading in oil started

1920 - Futures trading in bullion began in Bombay.

1939 - Cotton derivatives banned

1952 - Forward Contracts (Regulation) Act enacted.

1953 - Forwards Markets Commission (FMC) established .

1963 - Futures trading in commodities banned.

1994 Kabra Committee recommendations

2002 NMCE established

2003 MCX and NCDEX established

2003 - Futures trading in commodities allowed again.


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2.4 Commodity Exchange

A commodity exchange is defined as an association that organizes trading in

commodities.

Due to speculative reasons commodity trading on exchanges was banned in India

for almost 40 years.

However in 2003 the ban was lifted and trading began on exchanges.

The traditional system of open market place was replaced by computerized system

with on-line trading facilities.

The national commodity exchanges in India are:

Multi Commodity Exchange of India Ltd, Mumbai (MCX).

National Commodity and Derivatives Exchange Limited, Mumbai (NCDEX)

National Multi Commodity Exchange of India Ltd , Ahemadabad (NMCE)

Indian Commodity Exchange Limited, New Delhi (ICEX)

Ace Derivatives and Commodity Exchange Limited, Mumbai

Some Regional Exchanges in India are:

NBOT (National Board of Trade), Indore

Bikaner Commodity Exchange Ltd., Bikaner

Bombay Commodity Exchange Ltd., Vashi

Chamber Of Commerce, Hapur

Central India Commercial Exchange Ltd., Gwalior

Cotton Association of India, Mumbai

East India Jute & Hessian Exchange Ltd., Kolkata

First Commodities Exchange of India Ltd., Kochi

Haryana Commodities Ltd., Sirsa

India Pepper & Spice Trade Association., Kochi

Meerut Agro Commodities Exchange Co. Ltd., Meerut

Rajkot Commodity Exchange Ltd., Rajkot

Rajdhani Oils and Oilseeds Exchange Ltd., Delhi

Surendranagar Cotton oil & Oilseeds Association Ltd., Surendranagar

Spices and Oilseeds Exchange Ltd. Sangli


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Vijay Beopar Chamber Ltd., Muzaffarnagar


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2.5 Multi Commodity Exchange

Headquartered in Mumbai, Multi Commodity Exchange of India Ltd (MCX) is

a state-of-the-art electronic commodity futures exchange.

Started operations in November 2003

MCX holds a market share of over 80%* (87.3% during the nine months

ended December 31, 2011 and 82.4% in FY2011) of the Indian commodity

futures market

MCX offers more than 40 commodities across various segments such as

bullion, ferrous and non-ferrous metals, energy, and a number of agri-

commodities on its platform. The Exchange introduces standardised

commodity futures contracts on its platform.

Some rankings of MCX

o The Exchange is the world's largest exchange in Silver

o The second largest in Gold, Copper and Natural Gas and

o The third largest in Crude Oil futures, based on the comparison of

the trading volumes of our Exchange with those of the leading global

commodity futures exchanges in the world, for the calendar year

2010 and the six months ended June 30, 2011.

Trade Timings at MCX

Normal Session:

Days Time CommodifiesTraded

Monday to Friday 10.00am to 5.00pm

Monday to Friday 5.00 pm to 11.30pm /11.55

pm

All commodities except Agri

commodities

Saturday 10.00 am to 2.00pm All commodities

Special Session: Monday to Saturday: 9:45 a.m. to 9:59 a.m. Special Session

(order cancellation session) is held to cancel the pending orders prior to opening of

market.


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The Commodities traded on MCX are

Bullions Metals Energy Oil&OilSeeds Others

Gold Aluminium ATF Crude Palm Oil AlmondGold guinea Aluminium

Mini

Brent Crude

Oil

Refined Soya

Oil

Guar Seed

Gold M Copper Crude Oil Kapasia Khalli Melted

Menthol

Flakes

Gold Petal Copper Mini Electricity

Monthly &

Weekly

Soya Bean Mentha Oil

Gold petal Iron Ore Gasoline Cereals Potato (Agra)

(New delhi) Lead Heating Oil Barley Potato

(Tarkeshwar)

Platinum Lead Mini Imported

Thermal Coal

Maize-Feed /

Industrial

Grade

Sugar M

Silver Mild Steel

Ingot,Billets

Natural Gas Wheat Spices

Silver M Nickel Cardamom

Silver Micro Nickel Mini Coriander

Tin Turmeric

Zinc

Plantations Zinc Mini Weather Fiber Pulses

Rubber Carbon(CER) Kapas ChanaCarbon(CFI) Cotton (29mm)

Trading System and margin calculation at MCX

The best five buy and sell orders for every contract available for trading are visible

to the market and orders are matched based on price time priority logic. For the

purpose of computing and levying the margins, MCX uses SPAN (Standard

Portfolio Analysis of Risk) system which follows a risk-based and portfolio-based

approach.


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Trading Window at MCX


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2.6 NCDEX

National Commodity & Derivatives Exchange Limited (NCDEX), a national

level online multi commodity exchange, commenced operations on

December 15, 2003.

The Exchange has received a permanent recognition from the Ministry of

Consumer Affairs, Food and Public Distribution, Government of India as a

national level exchange.

In just over two years of operations it posted an average daily turnover of

around Rs 4500- 5000 crore a day (over USD 1 billion).

The major share of the volumes come from agricultural commodities and the

balance from bullion, metals, energy and other products. Trading is

facilitated through over 850 Members located across around 700 centers

(having ~20000 trading terminals) across the country.

Most of these terminals are located in the semi-urban and rural regions of

the country. Trading is facilitated through VSATs, leased lines and the

Internet.

Trade Timings

Monday to Friday 10.00 a.m.to 5.00 p.m. for agricultural products.

Monday to Friday 10.00 a.m.to 11.30 p.m for metal and energy products.

On Saturdays trade in all commodities takes place from 10.00 a.m. to 2.00 p.m


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Commodities traded on NCDEX

Metals Precious Metals Energy OthersSteel Gold Crude Oil CER

Copper Gold (100 gms) Thermal Coal

Zinc Gold International Brent Crude Oil

Aluminium Silver Natural Gas Polymers

Nickel Silver (5kg) Gasoline CER

Polypropylene

Lead Silver International Heating Oil Linear Low density

Polyethylene

Platinum Polyvinyl Chloride

Spices Oil and Oilseeds Others agri Plantation

Products

Pepper Castor Seed Guar Seeds Rubber

Chilli Sesame Seeds Potato Coffee-Robusta

Cherry AB

Jeera Cotton Seed Oilcake Mentha Oil Cashew

Turmeric Soya Bean Guar Gum

Coriander Refined Soya Oil Gur

Cereals Soybean meal Almond Pulses

Wheat Mustard Seed Chana

Barley Kachhi Ghani Mustard

Oil

Masoor

Maize(Yellow/Red)

Rapeseed Yellow Peas

Crude Palm Oil

RBD Palmolein

Groundnut in shell

Groundnut Expeller Oil

.

Trading Window at NCDEX


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2.7 Performance of different commodities market

Turnover market Turnover market Turnover market

million share million share million share

MCX 98,415,030 82.4 63,933,025 82.3 45,880,946 87.4

NCDEX 14,106,022 11.8 9,175,847 11.8 5,357,070 10.2

NMCE 2,184,109 1.8 2,279,015 2.9 614,566 1.2

ICEX 3,777,299 3.2 1,364,254 1.8 - -

ACE 300,596 0.3 59,794 0.1 87,810 0.2

Others 706,368 0.6 835,610 1.1 549,176 1

TOTAL 119,489,425 100 77,647,545 100 52,489,568 100

India has over 7,000 regulated agricultural markets, or mandis, and the majority of

the nations agricultural production is consumed domestically, according to the

Agricultural Marketing Information Network.

India is the worlds leading producer of several agricultural commodities. There are

currently 21 commodity exchanges recognised by FMC in India offering trading in

over 60 commodity futures with the approval of FMC.

In the fiscals 2009, 2010 and 2011, the total value of commodities traded oncommodity futures exchanges in India was Rs 52,489.57 billion, Rs 77,647.54

billion and ` 119,489.42 billion, respectively.

The total value of commodities traded on commodity futures exchanges in India for

the first nine months ended December 31, 2011 was Rs.137,228.55 billion

2.8 Background of some commodities

2.8.1 Agricultural Commodity Markets

India has a predominantly agrarian economy and its commodity markets have a

long history. Indias agricultural commodity markets were initially formed when

producers and buyers met at designated locations to trade in their produces. Indias

wholesale spot markets for agricultural commodities have remained relatively

unchanged.

Agricultural commodities are predominantly traded in government-regulated

wholesale markets or mandis. Mandis are often located in or near important towns


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or centres of production, consumption or shipping where sellers, buyers and

intermediaries converge to buy and sell goods.

Since almost all orders flow through the mandis, they are a source of dailyinformation about the quantity of agricultural commodities and the price at which

agricultural commodities trade for the respective geographic areas in which the

mandis are located.

2.8.2 Non-Agricultural Commodity Industry in India

Energy products, precious metals like gold and silver and non-ferrous metals play a

significant and vital role in the growth of the Indian economy. Some of the

commodities which most actively traded on the exchanges (mostly MCX) are

Gold:

Nations have embraced gold as a store of wealth and a medium of international

exchange, and individuals buy gold as insurance against the day-to-day

uncertainties of paper money.

Gold is also a vital industrial metal, used in electronics and other high-tech

applications. Gold occupies an important role in India. Apart from being a symbol of

wealth, many social and cultural elements of Indian culture are associated with

gold.

However, despite being the largest consumer of gold, the Indian market has limited

influence on the price of gold bullion in the world markets as it is heavily dependent

on imports and its markets are scattered across the country.

Crude oil:

Many markets are related with the global crude oil market in various ways. Crude oil

is used for the production of a wide range of products from petrol, diesel, kerosene

and from liquefied petroleum gas to naphtha and other petrochemicals products.

According to provisional data from the oil industry statistics for fiscal 2011 and eight

months ended November 30, 2011 as published by the Petroleum Planning and

Analysis Cell of the Ministry of Petroleum and Natural Gas, a total of 163.13 MMT

and 112.12 million metric tonnes (MMT), respectively, of crude oil, valued at Rs

4,536.34 billion and 4,152.38 billion respectively, was imported into India.

Crude oil production in the country was 37.95 MMT and 25.53 MMT during fiscal

2011 and eight months ended November 30, 2011, respectively. (Source: Official

website of Petroleum Planning and Analysis Cell, Ministry of Petroleum & NaturalGas).


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India imported 81.1% and 81.5% of its crude oil requirements during this fiscal 2011

and eight months ended November 30, 2011, respectively, and was highly exposed

to global crude oil price movements.Silver:

Silver is sought as a valuable and practical industrial commodity, and as an

appealing investment. The largest industrial users of silver in India are in the

photographic, jewellery, and electronic industries.

Copper:

Copper is the worlds third most widely used metal, after iron and aluminium, and is

primarily used in highly cyclical manufacturing industries. In India, copper is the

second most consumed non-ferrous metal, after aluminium.

At present, the demand for copper minerals for primary copper production is met

through two sources, namely copper ore mined from indigenous mines, and

imported concentrates.

The production of refined copper in India has increased considerably since the

fiscal 1999 after private sector manufacturers started production of refined copper,

and now a considerable portion of consumption is met through domestic production.

According to the estimates of the Indian Copper Development Centre, in the fiscal

2010, refined copper usage in India was approximately 550,000 MT. (Source:

Annual Report of the Ministry of Mines 2010-11).


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2.9 Exchange industry Growth in India

Commodity futures trading in India has grown since the Government of India issued

a notification on April 1, 2003 permitting futures trading in commodities.

The total value of commodities futures traded in India in the fiscal 2011 was

Rs.119,489.42 billion, representing growth of approximately 90-fold from the value

of commodity futures contracts traded in the fiscal 2004, which was Rs.1,293.67

billion. Commodity futures trading volumes have risen at a compound annual

growth rate of 90.9% between fiscal 2004 and fiscal 2011.

There are currently over 60 commodities futures that have been approved by the

FMC for trading during the calendar year 2011 with gold, silver, crude oil, copper,

zinc, nickel and natural gas comprising the majority of the trading turnover for the

fiscal 2011.


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2.10 Global Commodity Derivatives Exchanges

Some of the global commodity market and the commodities traded are as follows

NYMEX Crude oil, Natural Gas, Gold

CBOT Corn, Soybean, Wheat, Soyabean oil

ICE US Sugar, Coffee, Cotton, Cocoa

CME Live Cattle, Lean Hogs, Feeder Cattle

Shanghai Futures

ExchangeCopper, Rubber, Fuel oil, Zinc, Aluminium

Dalian Commodity

Exchange

Soy Meal, Soy oil, Polyethylene, Soybeans no 1,

Palm oil

Zhengzhou

Commodity

Exchange

Sugar, Pure Terephthalic acid (PTA), Rapeseed oil,

Wheat, Cotton

ICE Futures UK Brent Crude oil, WTI Crude, Gasoil, Natural Gas

LME UK Aluminium, Copper, Zinc, Nickel, Lead

Tokyo Commodity

ExchangeGold, Platinum, Rubber, Gasoline


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2.11 Objectives

To study the commodity derivative market of India. To find differences between equity and commodity market.

To compare the performance of commodity derivative market vis--vis

equity market.

2.12 Methodology

The information was collected through secondary data sources during the

project.

Real time futures market values from websites like MCX, NCDEX were used

as examples to explain the theoretical concepts.


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3. Trading in Commodity Derivatives Market

3.1 Derivatives

Derivatives are contracts which derive their value from an underlying. The most

commonly traded derivative instruments are forwards, futures, swaps and options.

Forward Contracts: It is a simple derivative. These are promises to buy or sell an

asset at a pre-determined date in future at a predetermined price. The contracts are

traded over the counter (i.e. outside the stock exchanges, directly between the two

parties) and are customized according to the needs of the parties. Since these

contracts do not fall under the purview of rules and regulations of an exchange,they generally suffer from counterparty risk i.e. the risk that one of the parties to the

contract may not fulfill his or her obligation.

Futures Contracts: A futures contract is an agreement between two parties to buy

or sell an underlying at a certain time in future at a certain price. These are basically

exchange traded, standardized contracts. The exchange stands guarantee to all

transactions and counterparty risk is largely eliminated. The buyers of futures

contracts are considered having a long position whereas the sellers are considered

to be having a short position. Futures contracts are available on variety ofcommodities, currencies, interest rates, stocks and other tradable assets.

Options Contracts: Options give the buyer (holder) a right but not an obligation to

buy or sell an underlying in future. Options are of two types - calls and puts.

Summary of options is as follows:

Options Call Put

Buyer Right to buy Right to sell

Seller Obligation to sell Obligation to buy

In forwards and futures both the parties (buyer and seller) have an obligation i.e.

the buyer needs to pay for the underlying to the seller and the seller needs to

deliver the underlying to the buyer on the settlement date. In case of options only

the seller (also called option writer) is under an obligation and not the buyer. Incase

the buyer of the option does exercise his right, the seller of the option must fulfill

whatever is his obligation.


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Swaps: Swaps are private agreements between two parties to exchange cash flows

in the future according to a prearranged formula. They can be regarded as

portfolios of forward contracts. The two commonly used swaps are: Interest rate swaps: These entail swapping only the interest related cash

flows between the parties in the same currency.

Currency swaps: These entail swapping both principal and interest between

the parties, with the cash flows in one direction being in a different currency

than those in the opposite direction.

3.2 Commodity Derivatives in India

Commodity derivatives are the products where the underlying is any commodity. As

in case of equity market, the price of derivative is driven by the spot price of the

underlying commodity. The exchange provides the physical facilities and exercises

surveillance on trading practices.

At present trading in permitted only in futures, options are not traded on any of the

commodity exchange in India.

Futures are standardized contract settled on predetermined fixed future date with a

standard quantity and quality of the underlying (commodity). A futures contract maybe offset prior to maturity by entering into an equal and opposite transaction.

The main standardized items in a futures contract are:

Quantity of the underlying

Quality of the underlying

The date and the month of delivery

The units of price quotation and minimum price change ie. Tick size

Delivery center


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3.3 Futures Contracts: Terminology

3.3.1 Long Position :

It basically means

Buying of a futures

contract.

eg. A person has a

bullish view for gold ,

then he may enter into a

long position by buying

futures contract.

The payoff for such

person is as shown in

Figure1. The Strike

price(K) is at 27500, if at

the end of the contract

the spot price(S) is more

than the strike price the

person will be in profit of

amount that equals S

minus K (S K).

However if the prices

reduce and at the end of

the contract the spot

price is lower than the

strike price ie. (K > S)

than he suffers losses of

strike minus spot (K

S).

Profit

Loss

27500

Gold price

Figure 1: Long Position on gold at 27500 per 10gm


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3.3.2 Short Position :

It basically means Selling of a

futures contract.

eg. A person has a bearish view

for chana, then he may enter into

a short position by selling futures

contract.

The payoff for such person is as

shown in Figure 2.

The Strike price (K) for 20th

March 2012 is at 3700 per

quintal, if at the end of the contract the spot price(S) is less than the strike price the

person will be in profit of amount that equals K minus S (K S)

However if the prices increase and at the end of the contract the spot price is higher

than the strike price ie. (K > S) than he suffers losses of strike minus spot (K S).

Profit

Loss

3700

Chana price/quintal

Figure 2 Short position on Chana


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3.4 Pricing of Commodity Futures

Investment Assets Versus Consumption Assets

When considering forward and futures contracts, it is important to distinguish

between investment assets and consumption assets. An investment asset is an

asset that is held for investment purposes by significant numbers of investors.

Stocks, bonds gold and silver are some of the examples of investment assets.

A consumption asset is an asset that is held primarily for consumption. It is not

usually held for investment. Examples of consumption assets are commodities such

as copper, oil, and pork bellies. It is not usually held for investment. Examples of

consumption assets are commodities such as copper, oil, and pork bellies.

For pricing futures we use The Cost Of Carry Model which is as follows

F = S*er T where

F = Futures price

S = Spot price

r = Risk free interest rate or cost of financing

T = Time till expiration

Commodities however may involve storage cost as the exchanges have to hold the

commodity till the end of the contract. In absence of any cost the above equation is

used to calculate the future price of the underlying commodity.

If there is any storage cost involved then,

F = (S + U) * er T where

U = Present value of all the storage cost involved

Eg. For silver

Spot price = 55000 / kgDays to expiration T = 30 days

Risk free rate = 7%

Cost of storage = Rs 300 for 30 days paid in advance

Hence the futures price will be

F = (55000 + 300 ) * e0.07 * 30/365

F = Rs. 55619


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Scenario 1: (Cash and Carry arbitrage)

If the price of the futures contract is more than 55619 then theoretically, the futuresare said to over priced and thus it creates an arbitrage opportunity.

Suppose Futures are trading at 55700 then one can earn riskless profit as follows:

1) Borrow an amount of S+U at risk free interest rate and Buy in spot market

2) Sell the futures

If contract closes at 55650

Cost = 55000 + 300 = 55300 Profit in spot = 350

Futures = 55700 Profit in futures = 50

Net profit = Rs. 400

Sell in spot at 55650 and return the borrowed amount



Futures = 55700 Loss in futures = 100




Cost = 55000 + 300 = 55300 Loss in spot = 200




Scenario 2: (Reverse Cash and Carry arbitrage)

If the price of the futures contract is less than 55619 then theoretically, the futures

are said to under priced and it creates an arbitrage opportunity.

Suppose Futures are trading at 55200 then one can earn riskless profit as follows:

1) Sell in spot market saving storage cost and invest the amount in risk free

asset

2) Buy the futures


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Cost = 55000 + 300 = 55300 loss in spot = 250

Futures = 55200 Profit in futures = 350Net profit = Rs. 100

Buy in spot at 55550 if required.


Cost = 55000 + 300 = 55300 Loss in spot = 700






Futures = 55200 Loss in futures = 5700




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3.5 Pricing Futures Contracts on Consumption Commodities

We used the arbitrage argument to price futures on investment commodities. For

commodities that are consumption commodities rather than investment assets, the

arbitrage arguments used to determine futures prices need to be reviewed carefully.

Suppose we have

F > (S + U) * erT

To take advantage of this opportunity, an arbitrager can implement the following

strategy:

1. Borrow an amount S+U at the risk-free interest rate and use it to purchase one

unit of

the commodity and pay storage costs.

2. Short a forward contract on one unit of the commodity.

If we regard the futures contract as a forward contract, this strategy leads to a profit

of F-(S+U) * erT at the expiration of the futures contract. As arbitragers exploit this

opportunity, the spot price will increase and the futures price will decrease until the

equation does not hold good.

Suppose next that

F < (S + U) * erT

In case of investment assets such as gold and silver, many investors hold the

commodity purely for investment. When they observe the inequality , they will find it

profitable to trade in the following manner:

1. Sell the commodity, save the storage costs, and invest the proceeds at the risk-

free interest rate.

2. Take a long position in a forward contract.

This would result in a profit at maturity of (S + U) * erT - F relative to the position

that the

investors would have been in had they held the underlying commodity. As

arbitragers exploit this opportunity, the spot price will decrease and the futures price

will increase until equation does not hold good. This means that for investment

assets, equation holds good.

However, for commodities like cotton or wheat that are held for consumption

purpose, this argument cannot be used. Individuals and companies, who keep such

a commodity in inventory, do so, because of its consumption value - not because of

its value as an investment. They are reluctant to sell these commodities and buy


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forward or futures contracts because these contracts cannot be consumed.

Therefore, there is unlikely to be arbitrage when equation holds good. In short, for a

consumption commodity therefore,F


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On the other hand, low inventories tend to lead to high convenience yields.

The Futures BasisThe cost-of-carry model defines the relationship between the futures price and the

related spot price.

The difference between the spot price and the futures price is called the basis. As a

futures contract nears expiration, the basis reduces to zero. This means that there

is a convergence of the futures price to the price of the underlying asset.

If the futures price is above the spot price during the delivery period it gives

rise to a clear arbitrage opportunity for traders.

This will lead to a profit equal to the difference between the futures price and

spot price. Traders start using this arbitrage opportunity, demand for the

contract in spot will increase ie. Spot price will increase & he will short

futures and prices will fall leading to the convergence of the future price with

the spot price.

If the futures price is below the spot price during the delivery period all

parties interested in buying the asset will take a long position.

The trader would buy the contract and sell the asset in the spot market

making a profit equal to the difference between the future price and the spot

price. As more traders take a long position the demand for the particular

asset would increase and the futures price would rise nullifying the arbitrage

opportunity.

Contango refers to a situation where the future price of a commodity is higher than

the spot price. A contango is normal for investment asset which has cost of carry. A

contango should equal the cost of carry because the producers and consumers

compare the futures price against the spot price plus storage cost.


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3.7 Participants in Futures market

There are 3 types of participants in futures markets namely

1) Hedgers.

2) Speculators

3) Arbitragers

3.7.1 Hedgers

These are people with a present or anticipated exposure to a commodity which is

subject to price risks. Hedgers use the derivatives markets primarily for price risk

management .

Hedger tries to avert the unfavorable risk he may face in the future.

A hedger buys or sells in the futures market to secure the future price of a

commodity intended to be sold at a later date in the cash market. This helps protect

against price risks.

The holders of the long position in futures contracts (buyers of the commodity), are

trying to secure as low a price as possible eg. A manufacturer who might need raw

materials after 3 months finds them trading at a low price will enter into a longposition. This is called as long hedge.

Cotton in spot market is trading at Rs.782 per 20 kg cotton

April 2012 Futures is trading at Rs.857 per 20 kg cotton


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Company will require cotton in April and fears prices will rise further. Hence it can

lock the buy price.

The company buys 1 future contract of 1 lot @ 857*200 = Rs.171400.

Case1:

Spot on the last day is 860.

Futures will the same ie. Company closes contract at 860.

Company buys in spot at 860 .

Total Cost =Rs.172000 and receives profits from futures of Rs. 3 (860-857).

Total receipt =Rs 600.

Net Cost = Rs.171400

Case2: Spot on the last day is 840. Futures will the same ie. Company closes

contract at 840.

Company buys in spot at 840 .Total Cost =Rs.168000 and suffers losses from

futures of Rs. 17 (840-857).

Losses = Rs 3400.

Net Cost = Rs.171400

Profit

Loss

857

Cotton price

Long in

futures

Short position to close long

position


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The short holders of the contract (sellers of the commodity) will want to secure as

high a price as possible. eg. A farmer who produces a crop that is currently tradingat a higher price and has a view that in coming months due to increased supply of

the crop , the prices might

reduce will enter into a

short hedge.

Pepper in spot market is

trading at Rs.37610 per

quintal

June 2012 Futures is

trading at Rs.37835 per

quintal

The farmer fears prices

might fall further. Hence he

short hedges.

Short 1 Futures contract @ 37835

Profit

Loss

37835

Pepper price

Long position to close

short position

Short position


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Case1: Spot on the last day is 37800. Futures will the same ie. farmer closes

contract at 37835.Farmer sells in spot at 37800 .Total sell value = Rs.378000 and receives profits

from futures of Rs. 35 (37835 - 37800).

Total receipt =Rs 350.

Net receipt = Rs.378350

Case2:

Spot on the last day is 38840. Futures will the same ie. Farmer closes contract at

38840.

Farmer sells in spot at 38840 .Total sell value =Rs.388400 and suffers losses from

futures of Rs. 1005 (37835 - 38840).

Losses = Rs 10050.

Net receipt = Rs.378350

The commodity contract, however, provides a definite price certainty for both

parties, which reduces the risks associated with price volatility. By means of futures

contracts, Hedging can also be used as a means to lock in an acceptable price

margin between the cost of the raw material and the retail cost of the final product

sold.

A Hedger can be Farmers, manufacturers, importers and exporter.


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3.7.2 Speculator

These persons are basically high risk takers.

They have a view on the direction of the market and buy or sell in futures / optionmarket to try and make profits of the market movement.

Speculation of commodities is different from that of speculation of equity

speculation. A person can speculate a direction of companys movement , buy the

shares and keep it with him as long as wants. But commodities involve various

storage costs associated with them.

With availability of derivatives any person can speculate the prices of commodities,

even if he doesnot hold the commodity as some derivatives are available with

option of cash settlement rather than physical delivery.

Entry into the futures market will only involve the person to deposit margin money

with corresponding exchange.

The speculation logic may be of demand supply logic of the commodities.

Eg1. Due to political tensions between the western world and Iran, one can

speculate Crude oil prices can move up in near future. A speculator thus being

bullish on Crude oil can buy the futures contract. This strategy is Bullish security,

buy futures.

Spot price of Crude oil on MCX 5266 / barrel

March Futures Trading at 5321 / barrel


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The speculator buys one contract ie. 100 barrels of crude oil, he pays an initial

margin for entering into the contract.

At the end of contract the

spot and futures close at

5355 / barrel.

Speculators profit =

5355 * 100 - 5321 * 100

Speculators profit =

Rs 3400

This profit is exclusive of other transaction costs involved in carrying out the trade.

Eg2

If a speculator feels that that due excessive production or reduction in demand of a

particular commodity , the prices may fall in the near future than he can sell the

future contract of the commodity and earn profits

Spot price of gur = 1031

March futures trading at 1066

Speculator belives that due to excessive supply the prices may fall in the near

future.

Even though he does produce Gur, because of futures market availability he can

just sell the futures trading at 1066.

Profit

Loss

5321

Crude price

Long futures


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The speculator sell 1 futures contract worth of Rs.266500 (1066*10000/40).

In futures market he

only has to pay an initial

margin to enter into a

futures contract.

If he gets his bet correct

and the value of gur

falls to 1050, the profit

he earns will be =

(1066-1050) *

(10000/40) = Rs. 4000

Profit

Loss

1066

Gur price

Short futures


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3.7.3 Arbitrageurs

They take positions in markets to earn riskless profits.The arbitrageurs take short and long positions in the same or different contracts at

the same time to create a position which can generate a riskless profit.

The arbitrage condition is possible if:-

1) If the price of the same commodity is different in two markets, there will be

operators who will buy in the market where the asset sells cheap and sell in

the market where it is costly.

2) The futures price of a commodity is theoretically different from the calculated

spot price plus the carry cost compounded using risk free interest rate.

This activity termed as arbitrage, involves the simultaneous purchase and sale of

the same or essentially similar security in two different markets for advantageously

different prices.

The buying cheap and selling expensive continues till prices in the two markets

reach an equilibrium. Hence, arbitrage helps to equalize prices and restore market

efficiency.

The arbitrageur can make the use of cash and carry arbitrage and reverse

cash and carry arbitrage explained earlier in pricing of futures, to earn riskless

profits. The summary of them is as follows:

Cash and carry 1)Borrow an amount at risk free interest rate and Buy in spot

market

2)Sell the futures

Reverse Cash

and carry

1)Sell in spot market saving storage cost and invest the amount

in risk free asset

2)Buy the futures


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3.8 Trading in Futures

3.8.1 Trading methods

Trading on exchange takes place in following manner

1) Open out cry

2) Electronic trading

Open Out Cry system

While most exchanges the world over are moving towards the electronic form of

trading, some still follow the open outcry

method.

Open outcry trading is a face-to-face and highly

activate form of trading used on the floors of the

exchanges. In open outcry system the futures

contracts are traded in pits.

A pit is a raised platform in octagonal shape

with descending steps on the inside that permit

buyers and sellers to see each other. Normally only one type of contract is traded in

each pit like a Eurodollar pit, Live Cattle pit etc. Each side of the octagon forms a pie

slice in the pit. All the traders dealing

with a certain delivery month trade in

the same slice.

The brokers, who work for institutions

or the general public stand on the

edges of the pit so that they can easily

see other traders and have easy

access to their runners who bring orders.

Chicago Mercentile Exchange follows open cry system as well as electronic trading

system.


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Electronic Trading

Electronic trading offers significant advantages like:

a) Easy accessibility to remote investors in real time.b) Improved efficiency.

c) Low transaction cost.

d) Greater transparency.

e) Automated transaction.

The orders are placed in the system by the broker. The host computer matches

bids with offers according to the pre-determined rules. In a simplest case if a trader

places a buy order equal to or higher than the sell order matching occurs and the

host computer automatically executes the order.

Trading at MCX

The Trader Work Station (TWS) is the application through which members access

the trading platform, place orders and execute trades. The TWS offers a multitude

of user friendly trading features which include commodity price ticker, market watch

screen displaying best buy, best sell, last traded price, volume for the day, open

interest etc,top gainer and loser contracts, net position, on-line back up facility etc

Trading System

The best five buy and sell orders for every contract available for trading are visible

to the market and orders are matched based on price time priority logic. Orders can

be placed with time conditions and/ or price conditions

Trading at NCDEX

The trading system on the NCDEX, provides a fully automated screen-based

trading for futures on commodities on a nationwide basis as well as an online

monitoring and surveillance mechanism.

It supports an order driven market and provides complete transparency of trading

operations.

The NCDEX system supports an order driven market, where orders match

automatically. Order matching is essentially on the basis of commodity, its price,

time and quantity.

All quantity fields are in units and price in rupees.

The Exchange specifies the unit of trading and the delivery unit for futures contracts

on various commodities.

The Exchange notifies the regular lot size and tick size for each of the contracts

traded from time to time.


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When any order enters the trading system, it is an active order. It tries to find a

match on the other side of the book.

If it finds a match, a trade is generated. If it does not find a match, the orderbecomes passive and gets queued in the respective outstanding order book in the

system.

Time stamping is done for each trade and provides the possibility for a complete

audit trail if required.

3.9 Orders in Futures Market

Customers can place different type of orders with brokers. The instructions given by

the clients should be clearly specified in terms of

a) Buy or sell

b) Number of contracts.

c) Type of commodity

d) Month of contract.

e) Price.

f) Period of validity.

g) Validity of order.

Some important orders used in futures market are

1) Market Order

2) Limit Order

3) Stop - loss order

4) Time Order

5) Spread order

6) Exchange for physicals

Orders used at MCX1) Time related Conditions

a. DAY order

b. GTC - A Good Till Cancelled (GTC) order

c. GTD - A Good Till Date (GTD) order

d. IOC - An Immediate or Cancel (IOC)

2) Price Conditions

a. Limit Orderb. Market Order


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Orders used at NCDEX

1) Time conditions

a. Good till day orderb. Good till cancelled (GTC):

c. Good till date (GTD)

d. Immediate or Cancel (IOC)

e. All or none order

2) Price conditions

a. Limit order

b. Stop-loss

3) Other conditions

a. Market price

b. Trigger price

c. Spread order

Note : Meanings of all the orders are mentioned in appendix

3.10 Margin requirement for futures.

To enter in to a futures contract every member has to deposit a particular amount.This amount is called as margin. It has to be deposited by both buyer and sellers of

futures contract. Margin in futures is not a complete down payment value as in

securities spot market but it is kind of bond. The margin varies from one contract to

another and they are set by the respective exchanges depending on the volatility of

the commodity.

Kinds of margin in general:

1) Initial margin: This amount is deposited by the customer while entering into

a contract. Initial margin is collected by the clearing agency forallowing members to take positions on their own behalf or on behalf of their

clients. In a rough sense, a clearing agency assumes that everyone in the

market is going to default on his/ her position at the end of the day.

2) Maintenance margin: Maintenance margin is lower than initial margin and is

minimum amount that must be present in the account of the customer who

has entered into a futures contract .If the balance in the margin account falls

below the maintenance margin, the investor receives a margin call and is

expected to top up the margin account to the initial margin level.


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3) Additional margin: It is a precautionary step taken by the exchange if it

fears that market has become very volatile and there might payment crisis.

4) Mark-to-Market margin:At the end of each trading day, the margin accountis adjusted to reflect the trader's gain or loss. This is known as marking to

market the account of each trader.

All futures contracts are settled daily reducing the credit exposure to one

day's movement. Based on the settlement price, the value of all positions is

marked-to-market each day after the official close. i.e. the accounts are

either debited or credited based on how well the positions fared in that day's

trading session.

If the account falls below the required margin level the clearing member

needs to replenish the account by giving additional funds or closing

positions either partially/ fully.

On the other hand, if the position generates a gain, the funds can be

withdrawn (those funds above the required initial margin) or can be used to

fund additional trades.

5) Margin for Calendar Spread positions: Calendar spread is defined as the

purchase of one delivery month of a given futures contract and

simultaneous sale of another delivery month of the same commodity by a

client/ member. Since price moves across contract months do not generally

exhibit perfect correlation, calendar spread margin is imposed to cover the

calendar basis risk that may exist for portfolios containing contracts with

different expirations.

These margins and some other margins are levied by both MCX and

NCDEX.


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3.11 Clearing and Settlement of futures contract

3.11.1 ClearingClearing of trades that take place on an Exchange happens through the Exchange

clearing house. A clearing house is a system by which Exchanges guarantee the

faithful compliance of all trade commitments undertaken on the trading floor or

electronically over the electronic trading systems.

The main task of the clearing house is to keep track of all the transactions that take

place during a day so that the net position of each of its members can becalculated.

It guarantees the performance of the parties to each transaction. Typically it is

responsible for the following:

1. Effecting timely settlement.

2. Trade registration and follow up.

3. Control of the open interest.

4. Financial clearing of the payment flow.

5. Physical settlement or financial settlement of contracts.

6. Administration of financial guarantees demanded by the participants.

The clearing house is a guarantor for all transactions that take place in the

exchange and it stipulates margins to manage the default risk.

Depending on a day's transactions and price movement, the members either need

to add funds or can withdraw funds from their margin accounts at the end of the day

as calculated by the clearing house. Thus clearing house will never have any open

position in the market.

National Commodity Clearing Limited (NCCL) undertakes clearing of tradesexecuted on the NCDEX. After the trading hours on the expiry date, based on the


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available information, the matching for deliveries takes place firstly, on the basis of

locations and men randomly, keeping in view the factors such as available capacity

of the vault/ warehouse, commodities already deposited and dematerialized andoffered for delivery etc.

Matching done by this process is binding on the clearing members. After completion

of the matching process, clearing members are informed of the deliverable/

receivable positions and the unmatched positions. Unmatched positions have to be

settled in cash. The cash settlement is only for the incremental gain/ loss as

determined on the basis of f inal settlement price.

MCX has an in house clearing house which monitors and performs all activities

relating to delivery, fund settlement, margining and managing the settlement

guarantee funds. It operates a well-defined settlement cycle to ensure no deviations

or deferments from this cycle.

3.11.2 Settlement

Futures contracts have two types of settlement, the MTM settlement which happenson a continuous basis at the end of each day, and the final settlement which

happens on the last trading day of the futures contract. On the NCDEX daily mtm

settlement and final MTM settlement in respect of admitted deals in futures

contracts are cash settled by debiting/ crediting the clearing accounts of CMs with

the respecting clearing bank. All position of a CM, either brought forward, created

during the day or closed out during the day, are market to market at the daily

settlement price or the final settlement price at the close of trading hours on a day.

On the date of expiry, the final settlement price is the spot price on the expiry day.

The responsibility of settlement is on a trading cum clearing members for all the

trades done on own account and his clients trades. A professional clearing member

is responsible for settling all the participant trades which he has confirmed to the

exchange. On the expiry date of a futures contract, member submits delivery

information through delivery request window on the trader workstations provided by

NCDEX for all open positions for a commodity for all constituents individually.

NCDEX on receipt of such information and arrives at a delivery position for amember for a commodity.


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The seller intending to make delivery takes the commodity to the designated

warehouse. These commodities have to be assayed by the exchange specified

assayer. The commodities have to meet the contracts specification with allowedvariances. If the commodities meet the specifications, the warehouse accepts them.

Warehouse ensures that the recipes get updated in the depository system giving a

credit in the depositors electronic account. The seller then gives the invoice to his

clearing member, who would courier the same to the buyers clearing member. On

an appointed date, the buyer goes to the warehouse and takes physical possession

of the commodities.

3.11.2.1 Settlement Mechanism

Settlement of commodity futures contracts is a little different from settlement of

financial future which are mostly cash settled. The possibility of physical settlement

makes the process a little more complicated.

Daily mark to market settlement

Example of calculation of mark to market

Spot Price of Sugar = Rs.2903 / 100 kg

Futures price for 15/03/2012 contract = Rs. 2855 /100 kg

Trading unit = 10 metric tonne

long 2855 MTM

10-Mar-12 2857 +2

11-Mar-12 2858 +1

12-Mar-12 2864 +6

13-Mar-12 2861 -3

14-Mar-12 2866 +5

15-Mar-12 2859 -7

Total +4

Total profit = 4 * 100 = Rs 400


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short 2855 MTM

10-Feb-12 2852 +3

11-Feb-12 2857 -5

12-Feb-12 2860 -3

13-Feb-12 2855 +5

14-Feb-12 2856 -1

15-Feb-12 2850 +6

Total +5

Total profit = 5 * 100 = 500

Final settlement

On the date of expiry, the final settlement price is the spot price on the expiry day. It

is final price at which the contract is closed down. All open positions in a futures

contract cease to exist after its expiration day. The settlement price may be varied

by the exchange if it finds the trading of commodity was volatile in the last trading

days.


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3.11.2.2 Settlement MethodsSettlement of futures contracts can be done in three ways:

1) Physical delivery of the underlying commodity

For open position on the expiry date of the contract, the buyer and the seller can

announce intention for delivery. Deliveries take place in the electronic form. All the

other position are settled in cash.

When a contract comes to settlement, the exchange provides alternatives

like delivery place, month and quality specifications. Trading period, delivery

date etc. are all defined as per the settlement calendar. A member is bound

to provide delivery information. If he fails to give information, it is closed out

with penalty as decided by the exchange.

The delivery place is very important for commodities with significant

transportation costs. The exchange also specifies the precise period (date

and time) during which the delivery can be made.

For many commodities, the delivery period may be an entire month. The

party in the short position (seller) gets the opportunity to make choices from

the above alternatives.

The exchange collects delivery information. Then the exchange selects a

party with an outstanding long position to accept delivery.

After the trading hours on the expiry date, based on the available

information, the matching for deliveries is done, firstly, on the basis of

locations and then randomly keeping in view factors such as available

capacity of the vault/ warehouse, commodities already deposited anddematerialized and offered for delivery and any other factor as may be

specified by the exchange from time to time.


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2) Closing out by offsetting positions

Most of the contracts are settled by closing out open position. In closing out, the

opposite transaction is effected to close out the original future position. A buy

contract is closed out by a sale and a sale contract is closed out by a buy. For

example, Spot for almond is Rs.365 an investor who takes a long position in one

almond futures contract for 30/4/2012 at 364.5, can close his position by selling one

almond futures contracts on 27/04/2012 suppose that Rs.370 is the futures price on

that date. Trading unit for almond at MCX is 500 kg.

Futures contract value = 364.5 * 500 = 182250

Close out price = 370 * 500 = 185000

Profit = 2750

This profit will be credited in his margin account by way of MTM at the end of each

day, and finally at the price that he closes his position, that is Rs.370 in this case.


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3) Cash settlement

Contracts held till the last day of trading can be cash settled. When a contract is

settled in cash, it is marked to market at the end of the last trading day and all

positions are declared closed. The settlement price on the last trading day is the

price closing spot price of the underlying commodity ensuring the convergence of

future prices and the spot prices.

For example On MCX Spot price of Cardamom = Rs.845 and an investor takes a

short position in one cardamom futures contracts expiring on 15/03/2012 at Rs.968

/ kg.

On 15/03/12 the last trading day of the contract, suppose the spot price is Rs.970/

kg.

This is the settlement price for his contract. Trading unit for cardamom is 100 kg.

As a holder of a short position on cardamom, he does not have to actually deliver

the same, but he suffers a loss of Rs.200 (968 * 100 970 *100).This amount is

debited from his account

Settlement dates at MCX and NCDEX

Daily Mark to Market settlement where 'T' is the trading day

Mark to Market Pay-in (Payment): T+1 working day.

Mark to Market Pay-out (Receipt): T+1 working day.

Final settlement for Futures Contracts

The settlement schedule for Final settlement for futures contracts is given by theExchange in detail for each commodity.

Timings for Funds settlement:

Pay-in: On Scheduled day as per settlement calendars.

Pay-out: On Scheduled day as per settlement calendars.


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3.12 Regulation of commodity exchanges

The Forward Contracts (Regulation) Act, 1952 (FCRA) is the principal legislation

for the commodity futures market in India.

The FCRA and the Forward Contracts (Regulation) Rules, 1954 (FCRR) provide

for the regulation of commodity futures trading under a three-tier system, which

consists of the following governing bodies:

the Department of Consumer Affairs, Ministry of Consumer Affairs Food and

Public Distribution

FMC and

an Exchange or Association recognised by the Central Government on the

recommendation of FMC.

FCRA exercises overall regulatory supervision over the commodity exchanges, and

also has the authority to grant or withdraw recognition of any commodity exchange.

The FMC (Forwards Market Commission) was set up in 1953. Most of the

regulatory powers of the Central Government were delegated to the FMC.

The FCRA categorizes commodities into 3 categories for purposes of regulation:

commodities in which forward trading can be undertaken through a

recognized association

commodities in which forward trading is prohibited and

commodities which have neither been regulated for being traded under the

recognized association nor prohibited. Such commodities are referred to as

free commodities and the associations dealing in such free commodities

are required to obtain a certificate of registration from the FMC for trading

thereof.


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3.12.1 Forward Markets Commission

Establishment of the FMC

The FMC has its headquarters at Mumbai and a regional office at Kolkata.

Under the FCRA, it is stipulated that the FMC shall consist of

A Chairman

Two members from amongst the officials of the Ministries or Departments of

the Central Government dealing with Consumer Affairs, Commodity

Derivatives, Food and Public Distribution, Agriculture or Finance

One member from amongst the officials of the Reserve Bank,

Five other members of whom at least three shall be the whole- time

members

Functions of the FMC:

To advise the Central Government in respect of matters arising out of the

administration of the FCRA

To grant or withdraw recognition of any association

To keep forward markets under observation and to take such action in

relation to them as it may consider necessary, in exercise of the powers

assigned to it by or under the FCRA

To collect and publish information regarding the trading conditions in respect

of goods including information regarding supply, demand and prices,etc

To make recommendations generally with a view to improving the

organisation and working of forward markets

Impose circuit filters on commodities and keep a watch on volatility

To regulate the functioning of members of the associations, clearing houses,warehouses and intermediaries

To levy fees for carrying out the purposes of the FCRA

To conduct research for the purpose of development and regulation of

commodity derivatives market

To protect the interests of the market participants in commodity derivatives

markets

To prohibit fraudulent and unfair trade practices relating to commodity

derivatives markets


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To prohibit insider trading in commodity derivative

SupervisionThe FMC has powers to conduct inspection of accounts of the exchanges and their

members and to inquire into the affairs of the exchanges.

In addition, the FMC shall have the power to suspend member of recognised

association or to prohibit him from trading; supercede governing body of recognised

association and power to suspend business of recognised associations.

Penal Provisions

The FCRA provides for penal provisions in relation to offences involving

contravention of the FCRA and most offences under the FCRA constitute

cognizable offences. The powers of search, seizure and investigation are with the

respective state police authorities.


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3.13 Difference Between Commodity And Financial

Derivatives

There are some features which are very peculiar to commodity derivative markets.

Those are as follows

Physical Settlement

Financial derivatives are cash settled but commodity derivative may be cash settled

or may involve a physical settlement.

The seller will have to deliver the goods to the warehouse and the buyer has to

collect it from the there.

This may sound simple, but the physical settlement of commodities is a complex

process. The issues faced in physical settlement are enormous. There are limits on

storage facilities in different states.

There are restrictions on interstate movement of commodities. Besides state level

octroi and duties have an impact on the cost of movement of goods across

locations.

Warehousing

As the case of physical settlement arises, the exchange requires to make anarrangement with warehouses to handle the settlements.

Such warehouses must have requisite infrastructure and take all precautionary

measures for storing the commodities.

Quality of Underlying Assets

When the underlying asset is a commodity, the quality of the underlying asset is of

prime importance. There may be quite some variation in the quality of what is

available in the marketplace.When the asset is specified, it is therefore important that the Exchange stipulate the

grade or grades of the commodity that are acceptable.

Trading in commodity derivatives also requires quality assurance and certifications

from specialized agencies. In India, for example, the Bureau of Indian Standards

(BIS) under the Department of Consumer Affairs specifies standards for processed

agricultural commodities.

AGMARK, another certifying body under the Department of Agriculture and

Cooperation, specifies standards for basic agricultural commodities.


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Importance of offsetting positions

In equity derivatives if the member has open positions at the end of the contract,

the difference will be settled in cash. But in commodity futures contract if thecontract is of compulsory delivery type and the member does not reverse his

position before the end of the contract than he will have to deliver or collect the

goods.


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3.14 Commodity v/s Equity derivatives

Ever since the first national level commodity exchange was introduced in 2003,commodity exchanges have seen an exponential growth. In the last fiscal, that is,

2010-11 the total turnover of the Indian commodity markets was approximately

Rs.112.52 trillion, an increase of more than 50% as compared to the year 2009-10.

Following the sharp surge in turnover and trade volumes in recent years, the stakes

in commodity trading are higher than ever before. Investment and trading in

commodities is now considered a good alternative investment in the country.

Growth in the commodity market as compared to the equity market

The Indian commodity futures volumes have grown 5.5 times from Rs.20.53 trillion

in 2005-06 to Rs.112.52 trillion in 2010-11. Currently, the average monthly volume

on the Indian commodity exchanges is Rs.6 trillion.

MCX leads the industry, followed by NCDEX. MCX is not only number one in Indiabut has achieved some global milestones too. It was the largest exchange in silver

(in terms of number of futures contracts traded in 2010), number two in gold, copper

and natural gas and number three in crude oil. When we say India is the largest

exchange in silver, it is a great achievement for the Multi Commodity Exchange.

The Indian agricultural commodities market has futures contracts of commodities

such as black pepper, cumin seed, mentha oil and many more which are

internationally traded but only listed in India, internationally traders tend to considerthese as benchmark rates.

For example, exporters from Vietnam, the largest producer of black pepper, are

keeping a close watch on Indian pepper futures. Slowly but steadily the Indian

commodity market is laying a strong foundation for a takeoff in the near future.


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Turnover Growth of Indian commodity Exchanges in Rs Trillions

From Rs.20 trillion, the volumes have reached Rs.112.52 trillion in FY10-11and it

has been a futures market, without Options.

Foreign institutional investors, domestic institutions, banks and insurance

companies are not allowed to trade on the Indian commodity bourses and a

majority of volumes come from jobbers, arbitrageurs, retail traders and small scale

enterprises and corporates (for hedging). Even portfolio management services are

not permitted.

Globally, commodity derivatives volumes are 35x-40x of the physical market but in

India it is just 4x. As the number of participants is increasing by the day and the

overall interest in commodity futures market among traders and investors is

increasing rapidly, the growth potential of this market is immense.

20.53

34.639.01

52.21

73.3

112.52

0

20

40

60

80

100

120

2005-06 2006-07 2007-08 2008-09 2009-10 2010-11


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Turnover Growth of Indian Equity Exchanges in Rs Trillions

Comparison of equity and commodity markets.

While the turnover in the equity derivatives segment has grown at a CAGR of

21.70% since FY08, the turnover in the commodity futures market has grown at a

CAGR of 30.32% in the same period.

Over the last few years, the equity market has seen turbulent times due to themeltdown in the global financial markets. In FY09, the equity derivatives turnover

48.24

74.15

133.52

110.22

176.63

292.48

0

50

100

150

200

250

300

350

2005-06 2006-07 2007-08 2008-09 2009-10 2010-11

-40.00%

-20.00%

0.00%

20.00%

40.00%

60.00%

80.00%

100.00%

2006-07 2007-08 2008-09 2009-10 2010-11

Commodity

Equity


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had fallen from Rs.133.32 trillion in 2007-08 to Rs.110.22 trillion in 2008-09, a fall of

21%.

On the other hand, the commodities market has seen a steady growth rate over the

years. Being in a nascent stage, the commodities futures market is catching up

rapidly with equities and in the coming years, it has the potential to equal or surpass

the equity turnover.

Reasons for growth of commodities volumes

The reason for the rising trade volumes on the Indian commodity futures exchanges

are:

They provide an efficient platform for hedging against price uncertainty and

global volatility.

The exchanges provide transparent price discovery and hedging platform for

trading futures contracts of different commodities.

On these exchanges, the fair value prices are determined through active

participation of a large number of stakeholders of the commodity value

chain, who have access to information on the demand and supply

conditions.


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3.15 Future Prospects of Indian Commodity exchange.

Introduction of option contracts: Option contracts are currently notallowed on the Indian exchanges. If these contracts are introduced, the

trading volumes will definitely increase.

Allowing for institutional investors participation:FIIs are not allowed to

participate in commodity exchanges, with their participation there will be

benefits like more liquidity, better practices, global experiences etc. But they

also have some risks involved like concentration and control over crucial

commodities, withdrawal from markets etc.

Mutual funds in the market: With commodities like gold providing

interesting returns, the mutual funds can invest in such commodities like

they do in equity market and thus indirectly the retail investors in mutual

funds will get the benefit.

Index Trading: This will give small investors a diversified investment option

that can be easily tracked with an overall knowledge of the commodity

market.

Amendment in Banking Regulations Act: According to the Banking

Regulations Act, banks are not allowed to trade in the commodity

derivatives. But banks have a big role to play in the development of the

commodity market. As they have exposure to agriculture, they would be

better off in case they were able to hedge their positions.

Imposition of Commodity transaction tax: There is a buzz around the

market that the Finance Minster might introduce a Commodity Transaction

Tax(CTT) in the union budget of 2012-13. A CTT of 0.017 per cent, or Rs 17

for every lakh of transactions, on commodity derivatives was announced in

the 2008-09 Budget. However, it was never put to practice, as there were

apprehensions from then the Prime Ministers Economic Advisory Council

(PMEAC).

Impact of CTT

The commodity markets are relatively new and the tax would impact the

volume and liquidity of commodity exchanges.

Though the Agricultural Produce Marketing Committee (APMC) Act has a

provision that says no tax, cess or mandi fee is payable by the farmers, theywill have to pay CTT as it is proposed to be levied on sellers.


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It implies that a farmer, who sells a futures contract to protect himself

against price risk, will be required to pay CTT.

Due to higher volume requirements, exchange charges etc. the participationof farmers is lower and with this kind of tax, the participation will reduce

further.

The commodity, before it comes for trading on the exchange platforms, is

already taxed to the tune of almost 12%, with taxes such as mandi tax,

cess, handling costs and warehousing charges, hence the prices will

increase futher if CTT is introduced.


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4. Conclusion

Due to increasing demand from the developing countries like India and China the

period from 2000 has been a boom for the commodities market. With India being

susceptible to oil prices which drives the overall inflation, investing in commodities

helps in hedging against it and also diversify the investors portfolio.

Since the restart of futures market, the commodity has not seen a backward step

and there is a lot of scope for growth. The government now has to play an active

role to get the farmers educated about the market so that they receive the worth of

their efforts. Banks and NGOs which have their presence in rural India can provide

a helping hand for this purpose.

The infrastructure facilities like warehouses, transportation etc. should be improved

so that the genuine buyers can take physical delivery of goods instead of settling

transaction in cash.

Amendments of FCRA to make FMC autonomous and permitting new derivative

products like options are the need of the future.This introduction will further help

deepen the market & would help in increasing the popularity of such exchanges and

lead to a wider investor base & lesser power in the hands of ruthless traders &

speculators.

With these kinds of reforms there is no doubt that Indian commodity market will

outperform the Indian equity markets.


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5. Bibliography

John C Hull, Options Futures and other derivatives 8th Edition, TMH

publications.

IIBF. Commodity Derivatives Published in 2007. MACMILLAN Publications.

Madhoo Pavaskar, Readings in Commodity Derivative Markets,2010.

Takshashila Academia of Economic Research Publishers.

Magazines Articles-

o Commodity as Asset Class - Commodity Vision, Aug 2011 Edition

Websites

www.mcxindia.com

www.ncdex.com

www.fmc.gov.in

www.business.mapsofindia.com


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6. Appendix


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DAY order- A Day order is valid for the day on which it is entered. If the order is not

matched during the day, the order gets cancelled automatically at the end of the

trading day.

GTC - A Good Till Cancelled (GTC) order is an order that remains in the system

until the expiry of the respective contract in which it is entered or until when the

same is cancelled by the member.

GTD - A Good Till Date (GTD) order is valid till the date specified by the member.

After the specified date the unexecuted orders get automatically cancelled by the

system.

IOC - An Immediate or Cancel (IOC) order allows a member to execute the orders

as soon as the same is placed in the market, failing which the order will get

cancelled immediately

Limit Order The order wherein the price is to be specified while placing the

same.

Market Order The order at the best available price at the time of placing the

same.

All or none order - All or none order (AON) is a limit order, which is to be executed

in its entirety, or not at all.

Market price: Market orders are orders for which no price is specified at the time

the order is entered (i.e. price is market price). For such orders, the system

determines the price. Only the position to be taken long/ short is stated. When this

kind of order is placed, it gets executed irrespective of the current market price of

that particular commodity.

Trigger price: Price at which an order gets triggered from the stop-loss book.


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Spread order: A simple spread order involves two positions, one long and one

short.

They are taken in the same commodity with different months (calendar spread) or inclosely related commodities. Prices of the two futures contract therefore tend to go

up and down together, and gains on one side of the spread are offset by losses on

the other. The spreaders goal is to profit from a change in the difference between

the two futures prices. The trader is virtually unconcerned whether the entire price

structure moves up or down, just so long as the futures contract he bought goes up

more (or down less) than the futures contract he sold.

Documents

Commodity Market Word