NCFM - fi.gb. NSE's CERTIFICATION IN FINANCIAL MARKETS Commodities Market Module Work Book

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  • NCFM NSE's CERTIFICATION IN FINANCIAL MARKETS

    Commodities Market Module

    Work Book

  • Contents

    1 Introduction to derivatives ............................................................................ 11

    1.1 Derivatives defined ................................................................................. 11

    1.2 Products, participants and functions ........................................................ 12

    1.3 Derivatives markets ................................................................................ 13

    1.3.1 Spot versus forward transaction .................................................. 14

    1.3.2 Exchange traded versus OTC derivatives .................................... 14

    1.3.3 Some commonly used derivatives ............................................... 16

    2 Commodity derivatives ................................................................................. 19

    2.1 Difference between commodity and financial derivatives ....................... 19

    2.1.1 Physical settlement ..................................................................... 19

    2.1.2 Warehousing .............................................................................. 21

    2.1.3 Quality of underlying assets ........................................................ 22

    2.2 Global commodities derivatives exchanges ............................................. 22

    2.2.1 Africa .......................................................................................... 24

    2.2.2 Asia ............................................................................................ 24

    2.2.3 Latin America ............................................................................. 24

    2.3 Evolution of the commodity market in India............................................ 24

    2.3.1 The Kabra committee report ....................................................... 25

    2.3.2 Latest developments ................................................................... 27

    3 The NCDEX platform ................................................................................... 31

    3.1 Structure of NCDEX ............................................................................... 31

    3.1:1 Promoters.................................................................................... 32

    3.1.2 Governance ................................................................................. 32

    3.2 Exchange membership ............................................................................ 32

    3.2.1 Trading cum clearing members (TCMs) ...................................... 32

    3.2.2 Professional clearing members (PCMs) ....................................... 33

    3.3 Capital requirements ............................................................................... 33

    3.4 The NCDEX system ............................................................................... 34

    3.4.1 Trading ....................................................................................... 34

    3.4.2 Clearing...................................................................................... 35

    3.4.3 Settlement .................................................................................. 35

  • CONTENTS 4

    4 Commodities traded on the NCDEX platform ............................................. 37

    4.1 Agricultural commodities ....................................................................... 37

    4.1.1 Cotton ........................................................................................ 38

    4.1.2 Crude palm oil ............................................................................ 40

    4.1.3 RBD Palmolein........................................................................... 42

    4.1.4 Soy oil ........................................................................................ 43

    4.1.5 Rapeseedoil ................................................................................ 45

    4.1.6 Soybean ...................................................................................... 46

    4.1.7 Rapeseed .................................................................................... 47

    4.2 Precious metals ....................................................................................... 49

    4.2.1 Gold ........................................................................................... 50

    4.2.2 Silver .......................................................................................... 54

    5 Instruments available for trading ................................................................. 59

    5.1 Forward contracts ................................................................................... 59

    5.1.1 Limitations of forward markets................................................... 60

    5.2 Introduction to futures ............................................................................. 60

    5.2.1 Distinction between future and forwards contracts ..................... 61

    5.2.2 Futures terminology .................................................................... 62

    5.3 Introduction to options ............................................................................ 62

    5.3.1 Option terminology .................................................................... 63

    5.4 Basic payoffs .......................................................................................... 64

    5.4.1 Payoff for buyer of asset: Long asset ........................................... 65

    5.4.2 Payoff for seller of asset: Short asset ........................................... 65

    5.5 Payoff for futures .................................................................................... 65

    5.5.1 Payoff for buyer of futures: Long futures .................................... 65

    5.5.2 Payoff for seller of futures: Short futures .................................... 67

    5.6 Payoff for options ................................................................................... 68

    5.6.1 Payoff for buyer of call options: Long call .................................. 68

    5.6.2 Payoff for writer of call options: Shortcall................................... 69

    5.6.3 Payoff for buyer of put options: Longput .................................... 69

    5.6.4 Payoff for writer of put options: Shortput .................................... 70

    5.7 Using futures versus us mg options ......................................................... 71

    6 Pricing commodity futures ............................................................................. 77

    6.1 Investment assets versus consumption assets ........................................... 77

    6.2 The cost of carry model .......................................................................... 78

    6.2.1 Pricing futures contracts on investment commodities .................. 80

    6.2.2 Pricing .futures contracts on consumption commodities .............. 82

    6.3 The futures basis ..................................................................................... 83

  • CONTENTS 5

    7 Using commodity futures .............................................................................. 87

    7.1 Hedging .................................................................................................. 87

    7.1.1 Basic principles of hedging ......................................................... 87

    7.1.2 Short hedge................................................................................ 88

    7.1.3 Long hedge ................................................................................. 89

    7.1.4 Hedge ratio ................................................................................. 91

    7.1.5 Advantages of hedging ............................................................... 92

    7.1.6 Limitation of hedging: basis Risk ................................................ 93

    7.2 Speculation ............................................................................................. 94

    7.2.1 Speculation: Bullish commodity, buy futures .............................. 94

    7.2.2 Speculation: Bearish commodity, sell futures .............................. 95

    7.3 Arbitrage ................................................................................................ 95

    7.3.1 Overpriced commodity futures: buy spot, sell futures .................. 96

    7.3.2 Underpriced commodity futures: buy futures, sell spot ................ 97

    8 Trading .......................................................................................................... 101

    8.1 Futures trading system ............................................................................ 101

    8.2 Entities in the trading system ................................................................. 101

    8.2.1 Guidelines for allotment of client code ....................................... 102

    8.3 Contract specifications for commodity futures........................................ 103

    8.4 Commodity futures trading cycle ............................................................ 103

    8.5 Order types and trading parameters ......................................................... 104

    8.5.1 Permitted lot size ........................................................................ 108

    8.5.2 Tick size for contracts ................................................................. 108

    8.5.3 Quantity freeze ........................................................................... 109

    8.5.4 Base price ................................................................................... 109

    8.5.5 Price ranges of contracts ............................................................. 109

    8.5.6 Order entry on the trading system ............................................... 110

    8.6 Margins for trading in futures.................................................................. 112

    8.7 Charges .................................................................................................. 113

    9 Clearing and settlement ................................................................................ 117

    9.1 Clearing .................................................................................................. 117

    9.1.1. Clearing mechanism .................................................................... 118

    9.1.2 Clearing banks ............................................................................ 118

    9.1.3 Depository participants ............................................................... 119

    9.2 Settlement ............................................................................................... 119

    9.2.1 Settlement mechanism ................................................................ 119

    9.2.2 Settlement methods..................................................................... 122

    9.2.3 Entities involved in physical settlement....................................... 124

    9.3 Risk management ................................................................................... 125

    9.4 Margining at NCDEX ............................................................................. 126

    9.4.1 SPAN ......................................................................................... 126

  • 6 CONTENTS

    9.4.2 Initial margin .............................................................................. 126

    9.4.3 Computation of initial margin ..................................................... 126

    9.4.4 Implementation aspects of margining and risk management ........ 128

    9.4.5 Effect of violation ...................................................................... 130

    10 Regulatory framework .................................................................................. 135

    10.1 Rules governing commodity derivatives exchanges ................................. 135

    10.2 Rules governing intermediaries ............................................................... 136

    10.2.1 Trading ....................................................................................... 136

    10.2.2 Clearing ...................................................................................... 140

    10.3 Rules governing investor grievances, arbitration..................................... 144

    10.3.1 Procedure for arbitration ............................................................. 145

    10.3.2 Hearings and arbitral award ........................................................ 146

    11 Implications of sales tax ................................................................................ 149

  • List of Tables

    2.1 The global derivatives industry ........................................................................ 23

    2.2 Volume on existing exchanges........................................................................ 27

    2.3 Registered commodity exchanges in India ....................................................... 28

    3.1 Fee / deposit structure and networth requirement: TCM .................................... 33

    3.2 Fee / deposit structure and networth requirement: PCM .................................... 33

    4.1 Country-wise share in gold production; 1968 and 1999 .................................... 51

    5.1 Distinction between futures and forwards ........................................................ 61

    5.2 Distinction between futures and options .......................................................... 72

    6.1 NCDEX - indicative ware house charges .......................................................... 82

    7.1 Refined soy oil futures contract specification ................................................... 89

    7.2 Silver futures contract specification ................................................................. 90

  • 8 List of Tables

    7.3 Gold futures contract specification ................................................................... 93

    8.1 Commodity futures contract and their symbols ................................................ 103

    8.2 Gold futures contract specification................................................................... 104

    8.3 Long staple cotton futures contract specification .............................................. 105

    8.4 Commodity futures: Quantity freeze unit ......................................................... 109

    8.5 Commodity futures: Lot size another parameters ............................................. 111

    9.1 MTM on along position in cotton futures ......................................................... 120

    9.2 MTM on a short position in cotton futures ....................................................... 121

    9.3 Calculating outstanding position at TCM level ................................................. 127

    9.4 Minimum margin percentage on commodity futures contracts ............................

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