• Commodity is a product that has commercial value, which can be Produced by

companies/firms without any qualitative difference.

A derivative is a financial instrument whose value is derived from some other

financial instrument, called the underlying asset. Common examples of underlying

assets are ƒ stocks, bonds, corn, pork, wheat, rainfall, etc

A commodity derivatives market (or exchange) is, in simple terms, nothing more or

less than a public market place where commodities are contracted for purchase or

sale at an agreed price for delivery at a specified date. These purchases and sales,

which must be made through a broker who is a member of an organized exchange,

are made under the terms and conditions of a standardized futures contract.

Aristotle (1750 BC) derivative contracts – thales- olive crop – agreement with oil mill owners for pressing

Osaka (1730) rice futures – organised Dojima rice market

1744 – Baltic Exchange at coffee house in london

1849 – Chicago Board of International Trade - CBOT

1854 – Bolsa De Cereales -Argentina,

1877 London Metal Exchange

1898 – Chicago Butter and Egg Board – Chicago Mercantile Exchange (CME)

1990 – china 40- 1999 – 3, 1. Dalaian CE, 2.Zhengshou CE, 3.Shanghai FE.

1939 – India 300

19th – London Mercantile Exchange

Baltic Exchange

International Petroleum Exchange

Chicago Climate Exchange,

The Bombay Cotton trade association started future trading in 1875

In 1952 the government banned cash settlement and option trading.

In 1995 a prohibition on trading options was lifted.

In 1996, NSE sent a proposal to SEBI for listing exchange traded

derivatives.

In 1999, the Securities Contract (Regulation) Act of 1956 was

amended and derivatives could be declared “securities”.

Index future were introduced in June 2000 and Index option in 2001.

NSE started trade in future and option by 2005

• Forward: A forward contract is an agreement between two parties

to buy or sell the underlying asset at a future date at a today’s pre-

agreed price.

• Futures: A futures contract is an agreement for buying or selling a

commodity for a predetermined delivery price at a specific future

time. Futures are standardized contracts that are traded on organized

futures exchanges that ensure performance of the contracts and thus

remove the default risk

Ex: Suppose a farmer is expecting a crop of wheat to be ready in 2

months time, but is worried that the price of wheat may decline in

this period. In order to minimize a risk ,he can enter to futures

contract to sell his crop in 2 months time at a price determined now.

This way he is able to hedge his risk arising from a possible adverse

change in the price of his commodity

• Swaps: A swap is an agreement between two parties to exchange sequences of cash flows for a set period of time. Usually, at the time the contract is initiated, at least one of these series of cash flows is determined by a random or uncertain variable, such as an interest rate, foreign exchange rate, equity price or commodity price.

• Options: The commodity option holder has the right, but not the obligation, to buy(or sell) a specific quantity of a commodity at a specified price on or a before a specified date. The seller of the option writes the option in favour of the buyer (holder) who pays a certain premium to the seller as a price for the options.

Call option: It gives the buyer the right but not the obligation to buy a given quantity of the underlying asset , at a given price on or before a given future date

Put option: It gives the buyer the right but not the obligation to sell a given quantity of the underlying asset , at a given price on or before a given future date

Ex: Suppose a farmer buys a put option to sell 100 quintals of wheat

at price of 25dollar per quintal and pays a premium of 0.5 dollar per

quintal (or a total of 50 dollar). If the price of wheat declines to 20

dollar before expiry, the farmer will exercise his option to sell his

wheat at the agreed price of dollar 25 per quintal.However ,if the

market price of wheat increases to say 30 dollar per quintal it would

be advantageous for the farmer to sell it directly in the open market

at the spot price rather then exercise his option to sell at 25 dollar per

quintal.

features Advantages Disadvantages

Counter party risk •Offers complete hedge •Default risk

Underlying Assrt •Over the counter products

•Difficult to cancel the contracts

Flexibility •Price protection • Not standardized

Settlement •Easy to understand •Not transparent

Contract Price • Difficult to find counter parties

Unique •No intermediate cashflows before settlement

Features Advantages Disadvantages

Organised Exchanges •Commission charges are less

•High risk

Standardisation • leverage •Partial hedge

Clearing House • Can open short as well as long positions

•Basis risk

Margins •High liquidity •Complex for new investors

Marking to Market

Forwards Futures

•Are not traded on an exchange •Are traded on an exchange

•Are private, and are negotiated between parties, with no exchange guarantees

•With the help of clearing house it provides protection for both parties

•Involve no margin payments as mutual goodwill is the basis for contracting

•Requires a margin to be paid as good-faith money

•Are used for hedging and physical delivery

•Are used for hedging and speculating

•Terms of the contract are dependent on the negotiated contract

•Terms of the contract are standardised and published by the exchange

•Contracts are settled by physical delivery •Most contracts (almost98%) are cash settled against delivery

•Are not transparent as they are private deals

•Are transparent and are reported by the exchange

Features Advantages Disadvantages

High Flexible •standardized • high spread

•Down Payment • limited loses • complexity

Settlement • enhances portfolio return

• not available for all stocks

• hedge against risk • diversification cannot eliminate systematic risk

• terms of listed options are regulated

• less capital requirement

Futures Options

•Both the buyer and the seller are under an obligation to fulfil the contract

•It is one-dimensional as its price depends on the on the underlying only.

•The buyer and seller are subject to unlimited risk of losing

•Seller – unlimited risk & buyer has limited (premium)

•The buyer and seller have unlimited potential to gain

•The seller has limited potential to gain than buyer

•It is one-dimensional as its price depends on the on the underlying only

•It is multidimensional price depends on spot, strike, time to maturity, implied volatility and risk free interest rate

By organisation – OTC: are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary.

By trading system

Futures

Options

By settlement

Delivery

Cash

Termination of contract

By complexity

Bid price: The highest price at which a dealer is willing to buy

commodities

Ask price: The ask price represents the lowest priced sell order

that is currently available, or the lowest price someone is

willing to go short or sell at

Arbitrage:Arbitrage is the simultaneous purchase and sale of

an asset to profit from a difference in the price. It is a trade that

profits by exploiting the price differences of identical or similar

financial instruments on different markets or in different forms.

Hedgers: These are investors with a present or anticipated exposure

to the underlying asset which is subject to price risks. Hedgers use

the derivatives markets primarily for price risk management of assets

and portfolios

Stockiest (protection against lower prices from the time they

purchase till they sold)

Exporters (protection against higher prices for the goods contracted

for future delivery but not yet purchased)

Producers (protection against increasing raw material costs or to

avoid decrease in the values of inventories.

Farmers (protection against declining prices)

Advantages Disadvantages

• Risk management tool • Minimizes overall profits

• To lock in profits •Reducing the risk can reduce profits

• Protection against price changes,

inflation, interest rate changes, etc…

•Not commonly used by the short-term

trader

• Maximizes returns •requires an increase in account balances

• Minimizes time • requires excellent trading skills and

experience

Speculators: These are individuals who take a view on the future

direction of the markets. They take a view whether prices would rise

or fall in future and accordingly buy or sell futures and options to try

and make a profit from the future price movements of the underlying

asset

Speculators are interested in favourable price fluctuations

They are prepared to accept the risk being transferred by hedgers.

Speculators provide liquidity to the market

Arbitrageurs: They take positions in financial 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.

They simultaneously sell and purchase in two markets to avail

benefit of price fluctuation

Their behaviour will help removing price imperfections in different

markets

Help in discovery of future as well as current prices. Helps to transfer risks from those who have them but do

not like them to those who have an appetite for them. With the introduction of derivatives, the underlying

market witnesses higher trading volumes. Speculative trades shift to a more controlled environment

in derivatives market. In the absence of an organized derivatives market, speculators trade in the underlying cash markets.

The derivatives have a history of attracting many bright, creative, well-educated people with an entrepreneurial attitude. They often energize others to create new businesses, new products and new employment opportunities, the benefit of which are immense.

THANK YOU

- By

- Monika Jain

- Yogitha Jain