Need of electronic exchange

� A commodity refers to any goods,merchandise or produce of land that canbe bought and sold.

� A commodity is an article or product that� is used for commerce� is movableis used for commerce

� is movable�has a value�can be brought and sold� is produced or used as a subject in abarter or sale

TheTheTheThe ChicagoChicagoChicagoChicago BoardBoardBoardBoard ofofofof TradeTradeTradeTrade (CBOT)(CBOT)(CBOT)(CBOT) definesdefinesdefinesdefines aaaa

commoditycommoditycommoditycommodity asasasas:::: “An article of commerce or a

product that can be used for commerce. In a

narrow sense, products traded on an authorizednarrow sense, products traded on an authorized

commodity exchange. Types of commodities

include agricultural products, metals,

petroleum, foreign currency and financial

instruments, to name a few.”

� Referred to as “cashcashcashcash andandandand carrycarrycarrycarry marketmarketmarketmarket” or the

“spotspotspotspot marketmarketmarketmarket”.

� In this market, the seller agrees to deliver the

commodity and the buyer agrees to make thecommodity and the buyer agrees to make the

payment “on the spot”. This agreement

between the seller and buyer is termed as

“spotspotspotspot contractcontractcontractcontract”.

� AdvantageAdvantageAdvantageAdvantage:::: Buyer can select and buy the

specific commodity required.

� LimitationLimitationLimitationLimitation:::: The inherent characteristic of the

physical market is that the transactions in

this market are subject to pricepricepriceprice riskriskriskrisk....

� ProducersProducersProducersProducers use inputs such as seeds, fertilizers, labour

and implements to produce raw materials.

� AssemblersAssemblersAssemblersAssemblers andandandand TradersTradersTradersTraders purchase these materials in

bulk.

� ProcessorsProcessorsProcessorsProcessors orororor manufacturersmanufacturersmanufacturersmanufacturers then convert these raw� ProcessorsProcessorsProcessorsProcessors orororor manufacturersmanufacturersmanufacturersmanufacturers then convert these raw

materials into finished goods.

� DistributorsDistributorsDistributorsDistributors who are generally wholesalers procured

the finished goods.

� From distributors goods reach consumersconsumersconsumersconsumers through

retailersretailersretailersretailers....

Traders, brokers and commission agents act

as “intermediariesintermediariesintermediariesintermediaries” connecting the other

participants and the various segments of the

value chain.

FarmersPrimary

Aggregator

Sales Commission Agent

Buyer Commission

AgentProcessor

Wholesaler Raw /

Finished Product

Processor

Retailer

Auction

MARKET MARKET MARKET MARKET YARDYARDYARDYARD

Fig: Physical agricultural commodity market structure

PRODUCER

Katcha Arathiyas(Commission

Agents)

STOCKISTPVT.

AGENCYGOVT.

AGENCY

Pakka Arathiyas(Commission

Agents)

PROCESSOR

OIL WHOLESALER

INDUSTRIAL USER

OTHER CONSUMER

EXPORTER

Fig: Value chain for Castor seeds

� In India agricultural commodities are traded

in wholesale markets called mandismandismandismandis....

� Setting up Mandis

� Products� Products

� Participants

� Mandi Fee

� Trading

� 1111stststst TypeTypeTypeType:::: The farmer approaches the trader for

a price quote. When they mutually agree on a

price, the produce is considered to be sold to

the trader.

� 2222ndndndnd TypeTypeTypeType:::: It is an “outcryoutcryoutcryoutcry auctionauctionauctionauction” for which

there is a designated time at each mandi. The

auction is done in sequence, typically going

from a lot with a fixed grade to the next.

� PricePricePricePrice:

� No real time price dissemination in Mandi.

� Wide difference between Farm Gate Farm Gate Farm Gate Farm Gate Price

and ConsumerConsumerConsumerConsumer priceand ConsumerConsumerConsumerConsumer price

� Clearing Clearing Clearing Clearing has to be done immediately for cash

contracts.

� Delivery & paymentDelivery & paymentDelivery & paymentDelivery & payment has to be made within 11111111

days

� APMCAPMCAPMCAPMC ActActActAct is a State Act constituted by each State

to establish and regulate agricultural markets. The

whole geographical area in the State is divided and

declared as a market area wherein the markets are

managed by the Market Committees constituted bymanaged by the Market Committees constituted by

the State Govt.

� TheTheTheThe EssentialEssentialEssentialEssential CommoditiesCommoditiesCommoditiesCommodities Act,Act,Act,Act, 1955195519551955 was enacted

to ensure easy availability of essential

commodities to the consumers and to protect

them from exploitation by unscrupulous traders.

� Lack of proper price dissemination and transparency in

price discovery process.

� Very fragmented, isolated and unorganized markets.

� Restrictions in interstate movement of goods.

� Lack of proper certification and standardization of� Lack of proper certification and standardization of

commodities.

� Lack of proper warehousing and transportation

facilities.

� Long chain of intermediaries.

� Cartelization of intermediaries with multiple levels of

intermediation.

� Processors not allowed to buy directly from cultivators in most

states.

� Excessive dependence on and consequent exploitation by

money lenders.

� Distress sales by farmers.

� Stock limits in essential commodities.

� High volatility of spot market prices.

� States having different tax and tariff structures

� In physical market a wide gap exists between

the prices paid by the end-consumers and

price received by the farmers.

� Reasons:

� Very high costs of intermediation.� Very high costs of intermediation.

� Farmers’ ignorance about the spot price of the

commodity in the mandi – Leads to distress sales.

� Price uncertainty making it difficult to predict the

market accurately.

� Lack if effective mechanism to eliminate price risk.

� Develop a common Indian market by setting up a

national-level electronic spot market that area

accessible to across the country.

� Provide effective, transparent method of

discovering nationwide spot price in variousdiscovering nationwide spot price in various

commodities.

� Create a market where farmers can get the best

prices and receive prompt payments.

� Facilitate better efficiency in procurement and bring

down the levels and costs of intermediation.

� Create a market where traders, processors and end

users can procure agricultural produces at a

competitive price without any quality and counter

party risk.

� Provide quality certification, warehousing facilities

and other services.

� Create a structured, organized and standardized

spot market to help the future exchanges in

facilitating physical delivery in agricultural

commodities.

� CashCashCashCash ForwardForwardForwardForward TransactionsTransactionsTransactionsTransactions

Cash transactions in the physical market

involve two types of contracts that require:

1. Immediate delivery in the spot market.

2. Delivery of a specific commodity to the buyer2. Delivery of a specific commodity to the buyer

sometime in the future.

The second type of contract that specifies

delivery of a commodity to the buyer at a future

date is called a “cashcashcashcash forwardforwardforwardforward contractcontractcontractcontract”.

� A forward contract is a bilateral agreement in

which a buyer and seller agree upon the

delivery of a specified quality and quantity of

an asset on a specified future date at a

predetermined price.

�Long PositionLong PositionLong PositionLong Position: Party agrees to buy the commodity

�Short PositionShort PositionShort PositionShort Position: Party agrees to sell the commodity

� Forward contracts are over-the-counter

(OTC) contracts.

� Each contract is custom designed

Only parties to the contract know the� Only parties to the contract know the

contract price.

� On the expiration date, the contract has

to be settled by delivery of the asset.

� TradingTradingTradingTrading: In a trading process, the buyer with the

demand for the product interacts with the seller

supplying the product. The buyer and seller negotiate

and arrive at an agreement regarding quantity, quality

and price.

� ClearingClearingClearingClearing: In the clearing process, the buyer and seller

decide on the quantum of goods and the amount of

cash that would be exchanged among them.

� SettlementSettlementSettlementSettlement: In this process, the actual exchange

happens

� In a spotspotspotspot transactiontransactiontransactiontransaction, trading, clearing and

settlement happen simultaneously and

instantaneously – that is “onononon thethethethe spotspotspotspot”.

� In a forwardforwardforwardforward transactiontransactiontransactiontransaction, cash does not change� In a forwardforwardforwardforward transactiontransactiontransactiontransaction, cash does not change

hands on the date of entering into the

contract. Hence, in forward contract, the

trading, clearing and settlement do not happen

simultaneously

� The contracts are private and negotiated bilaterally

between two parties.

� The prices are not transparent.

� No regulations for establishing market stability and

protection of market players.protection of market players.

� Lack of standardization leads to illiquidity in the

absence of a secondary market.

� The profit or loss is realized only on the maturity date.

� Settlement is only through actual delivery or offsetting

by cash delivery.

� These contracts are exchange-traded version

of forward contracts.

� Future contracts contain standard

specifications.specifications.

� Need not be settled through physical delivery.

� Can be closed by entering into an equal and

opposite contract.

� Price discovery and price dissemination

� Price risk management

� Price stability

� Common platform for all traders

� Low transaction costs

� Absence of counter party credit risk

� Lower credit risk

� Liquidity

�Characteristics

�Price determination

�Function of the market�Function of the market

�Advantages

�Limitations

Forward ContractsForward ContractsForward ContractsForward Contracts Future ContractsFuture ContractsFuture ContractsFuture Contracts

• These contracts are

OTC contracts

• Bilateral contract –

Counter-part risk

• Futures are exchange traded

• Large number of participants –

Exchange takes care of risk management

• Contracts are standardised

•Each contract is custom

designed

• Contract has to settled

by the delivery of asset

on the expiration date.

• Contracts is a price fixing contract. The

buyer or seller is obligated to close the

contract.

• In futures market, actual delivery of

good takes place only in few cases.

Transaction are squared up before due

date with the payment of difference


• Forward Price for an asset depend on

following:

� Spot or Cash price at the time of

transaction

� Carrying cost

• Future markets have a

large number of market

participants. Price discovery

takes place based on

following:� Carrying cost

� Transportation cost

� Storage cost

� Others – Interest, dividend

� Neither market mechanism nor

price discovery

following:

� Supply

� Demand

� Market perception of

the above two situation


• Simple agreement to buy

or sell an asset at a certain

future time for a certain

price.

• Traded in OTC market and

• This markets perform various

important economic functions. These

market meet the needs of the 3

groups of futures market:

� Those who wish to discover• Traded in OTC market and

not in an exchange.

• Neither market nor

exchange has role to play

in the transaction

� Those who wish to discover

information about future prices

� Those who wish to speculate or

exploit any arbitrage opportunity

� Those who wish to hedge their

price risk.


• These contract has no

margin system.

• Contracts are customised

• Contracts contain standard

specification of the underlying asset.

• Absence of credit risk. At the most

credit risk is limited to one day

and the contract terms can

include specification as

agreed upon between the

buyer and seller.

movement of futures prices.

• High liquidity

• High leverage

• Price Stabilisation

• Easy and convenient access to all

market participants


• Contracts are bilateral. Therefore,

there are no exchange guarantee.

• Prices are not transparent

• Profit are loss are realised only on

• Perfect hedge is not

possible due to

standardisation of

contracts.

the maturity date.

• Settlement only through delivery.

Closing out is not possible.

• Lack of standardisation – No

Secondary market.

• Futures contracts cannot

be tailored to the specific

needs of firms and financial

institutions.

Self Improvement

Need of electronic exchange