project report on commodity markets

7/30/2019 project report on commodity markets

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Indian Commodities Market

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I. INTRODUCTION TO COMMODITIES MARKETSThe vast geographical extent of India and her huge population is aptly

complemented by the size of her market. The broadest classification of the

Indian Market can be made in terms of the commodity market and the bondmarket. The commodity market in India comprises of all palpable markets

that we come across in our daily lives. Such markets are social institutions

that facilitate exchange of goods for money. The cost of goods is estimated

in terms of domestic currency. India Commodity Market can be subdivided

into the following two categories:

Wholesale Market

Retail Market

Considering the present growth rate, the total valuation of the

Indian Retail Market is estimated to cross Rs. 10,000 billion by the year

2010. Demand for commodities is likely to become four times by 2010 than

what it was in 2009.

1.1 COMMODITY MARKET IN INDIA

A market is conventionally defined as a place where buyers and sellers meet

to exchange goods or services for a consideration. This consideration is

usually money. In an Information Technology-enabled environment, buyers

and sellers from different locations can transact business in an electronic

marketplace. Hence the physical market place is not necessary for the

exchange of goods or services for a consideration. Electronic trading and

settlement of transactions has created a revolution in global financial and

commodity markets.


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Precious Metal Other metals

Gold, Silver Aluminum,

Zinc, Brass, etc

AgricultureEnergy

Gold, SilverGold, Silver

COMMODITY MARKET


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1.2 DEFINITION OF COMMODITY

Any product that can be used for commerce or an article ofcommerce which is traded on an authorized commodity exchange isknown as commodity. The article should be movable of value,

something which is bought or sold and which is produced or used as

the subject or barter or sale. In short commodity includes all kinds of

goods. Forward Contracts (Regulation) Act (FCRA), 1952 defines

goods as every kind of movable property other than actionable

claims, money and securities.

In current situation, all goods and products of agricultural (includingplantation), mineral and fossil origin are allowed for commodity

trading recognized under the FCRA. The national commodity

exchanges, recognized by the Central Government, permits

commodities which include precious (gold and silver) and non-ferrous

metals: cereals and pulses; ginned and un-ginned cotton; oilseeds, oils

and oilcakes; raw jute and jute goods; sugar and gur; potatoes and

onions; coffee and tea; rubber and spices. Etc.

In the world of business, a commodity is an undifferentiated productwhose market value arises from the owners right to sell rather than

to use. Example commodities from the financial world include oil

(sold by the barrel), wheat, bulk chemicals such as sulfuric acid and

even pork bellies.


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1.3 COMMODITY EXCHANGEA brief description of commodity exchanges are those which trade inparticular commodities, neglecting the trade of securities, stock index

futures and options etc.,

In the middle of 19th

century in the United States, businessmen began

organizing market forums to make the buying and selling of commodities

easier. These central market places provided a place for buyers and sellers

to meet, set quality and quantity standards, and establish rules of business.

Agricultural commodities were mostly traded but as long as there arebuyers and sellers, any commodity can be traded.

The major commodity markets are in the United Kingdom and in the

USA. In India there are 25 recognized future exchanges, of which there are

three national level multi-commodity exchanges. After a gap of almost

three decades, Government of India has allowed forward transactions in

commodities through Online Commodity Exchanges, a modification of

traditional business known as Adhat and Vayda Vyapar to facilitate better

risk coverage and delivery of commodities.

THE THREE EXCHANGES ARE:-

National Commodity & Derivatives Exchange Limited ( NCDEX) Multi Commodity Exchange of India Limited ( MCX) National Multi-Commodity Exchange of India Limited ( NMCEIL)All the exchanges have been set up under overall control of Forward Market

Commission (FMC) of Government of India.


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II. EVOLUTION OF COMMODITY MARKET

Commodities future trading was evolved from need of assured continuous

supply of seasonal agricultural crops. The concept of organized trading in

commodities evolved in Chicago, in 1848. But one can trace its roots in

Japan. In 19th century Chicago in United States had emerged as a major

commercial hub. So that wheat producers from Mid-west attracted here to

sell their produce to dealers & distributors. Due to lack of organized storage

facilities, absence of uniform weighing & grading mechanisms producers

often confined to the mercy of dealers discretion. These situations lead toneed of establishing a common meeting place for farmers and dealers to

transact in spot grain to deliver wheat and receive cash in return. Gradually

sellers & buyers started making commitments to exchange the produce for

cash in future and thus contract for futures trading evolved; Whereby the

producer would agree to sell his produce to the buyer at a future delivery

date at an agreed upon price. Trading of wheat in futures became very

profitable which encouraged the entry of other commodities in futures

market. This created a platform for establishment of a body to regulate andSupervise these contracts. Thats why Chicago Board of Trade (CBOT) was

established in 1848. In 1870 and 1880s the New York Coffee, Cotton and

Produce Exchanges were born. Agricultural commodities were mostly

traded but as long as there are buyers and sellers, any commodity can be

traded. In 1872, a group of Manhattan dairy merchants got together to

bring chaotic condition in New York market to a system in terms of storage,

pricing, and transfer of agricultural products. The largest commodity

exchange in USA is Chicago Board of Trade, The Chicago Mercantile

Exchange, the New York Mercantile Exchange, the New York Commodity

Exchange and New York Coffee, sugar and cocoa Exchange. Worldwide

there are major futures trading exchanges in over twenty countries

including Canada, England, India, France, Singapore, Japan, Australia and

New Zealand.


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III. DIFFERENT COMMODITY EXCHANGE MARKETS INTHE WORLD

COUNTRY EXCHANGEUnited States of

America

Chicago Board of Trade (CBOT)

Chicago Mercantile Exchange

New York Cotton Exchange

New York Board of Trade

United Kingdom The London International Financial Futures

Options Exchange

The London Metal Exchange

Canada The Winnipeg Commodity Exchange

Brazil Brazilian Futures Exchange Commodities

Australia Sydney Futures Exchange Ltd.

People s Republic of

China

Beijing Commodity Exchange Shanghai

Metal Exchange

Hong Kong Hong Kong Futures Exchange

Japan Tokyo International Financial Futures Exchange

Malaysia Kuala Lumpur commodity Exchange

New Zealand New Zealand Futures and Options Exchange Ltd

Singapore Singapore commodity Exchange Ltd

France Le Nouveau Marche MATIF

Italy Italian Derivatives Market

Netherlands Amsterdam Exchanges option Traders

Russia The Russian Exchange

Petersburg Futures Exchange

Spain The Spanish Options Exchange

Citrus Fruit and Commodity Futures Market of

Valencia


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IV. HISTORY OF COMMODITY MARKET IN INDIA

The history of organized commodity derivatives in India goes back to thenineteenth century when Bombay Cotton Trade Association started futures

trading in 1875, about a decade after they started in Chicago. Over the time

derivatives market developed in several commodities in India. Following

Cotton, derivatives trading started in oilseed in Bombay (1900), raw jute and

jute goods in Calcutta (1912), Wheat in Hapur (1913) and Bullion in Bombay

(1920). The parliament passed the Forward Contracts (Regulation) Act,

1952, which regulated contracts in Commodities all over the India. The act

prohibited options trading in Goods along with cash settlement of forwardtrades, rendering a crushing blow to the commodity derivatives market.

Under the act only those associations/exchanges, which are granted

reorganization from the Government, are allowed to organize forward

trading in regulated commodities. The act envisages three tire regulations:

i. Exchange which organizes forward trading in commodities canregulate trading on day-to-day basis;

ii. Forward Markets Commission provides regulatory oversight underthe powers delegated to it by the central Government.

iii. The Central Government- Department of Consumer Affairs, Ministryof Consumer Affairs, Food and Public Distribution- are the ultimate

regulatory authority.

After Liberalization and Globalization in 1990, the Government set up

a committee (1993) to examine the role of futures trading. The Committee

(headed by Prof. K.N.Kabra) recommended allowing futures trading in 17

commodity groups. It also recommended strengthening Forward Markets

Commission, and certain amendments to Forward Contracts (Regulation)

Act 1952, particularly allowing option trading in good sand registration of

brokers with Forward Markets Commission. The Government accepted most

of these recommendations and futures trading was permitted in all

recommended commodities.


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V. COMMODITY MARKETS IN INDIAToday, commodity exchanges are purely speculative in nature. Before

discovering the price, they reach to the producers, endorsers, and even the

retail investors, at a grassroots level. It brings a price transparency and risk

management in the vital market. By Exchange rules and by law, no one can

bid under a higher bid, and no one can offer to sell higher than someone

elses lower offer. That keeps the market as efficient as possible, and keeps

the traders on their toes to make sure no one gets the purchase or sale

before they do. Since 2002, the commodities future market in India has

experienced an unexpected boom in terms of modern exchanges, number

of commodities allowed for derivatives trading as well as the value offutures trading in commodities, which crossed $ 1 trillion mark in 2006.In

India there are 25 recognized future exchanges, of which there are four

national level multi-commodity exchanges. After a gap of almost three

decades, Government of India has allowed forward transactions in

commodities through Online Commodity Exchanges, a modification of

traditional business known as Adhat and Vayda Vyapar to facilitate better

risk coverage and delivery of commodities. The four exchanges are:

i. National Commodity & Derivatives ExchangeLimited (NCDEX) Mumbai,

ii. Multi Commodity Exchange of India Limited (MCX) Mumbaiiii. National Multi- Commodity Exchange of India

Limited (NMCEIL) Ahmadabad.

iv. Indian Commodity Exchange Limited (ICEX) , Gurgaon


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THERE ARE OTHER REGIONAL COMMODITY EXCHANGES SITUATED IN

DIFFERENT PARTS OF INDIA.

MAJOR REGIONAL COMMODITY EXCHANGES IN INDIA

a) BATINDA COMMODITY & OIL EXCHANGE LTD.

b) THE BOMBAY COMMODITY EXCHANGE

c) THE RAJKOT SEEDS OIL AND BULLION MERCHAT

d) THE KANPUR COMMODITY EXCHANGE

e) THE MEERUT AGRO COMMODITY EXCHANGE THE SPICES AND OILSEEDS

EXCHANGE (SANGI)f) AHEMDABAD COMMODITY EXCHANGE

g) VIJAY BEOPAR CHAMBER LTD. (MUZAFFARNAGAR)

h) INDIA PEPPERS AND SPICE TRADE ASSOCIATION (KOCHI)

I) RAJDHANI OILS AND SEEDS EXCHANGE (DELHI)

j) THE CHAMBER OF COMMERCE (HAPUR)

k) THE EAST INDIA COTTON ASSOCIATION (MUMBAI)

l) THE CENTRAL COMMERCIAL EXCHANGE (GWALIOR)

m) THE EAST INDIA JUTE & HESSIAN EXCHANGE OF INDIA (KOLKATA)n) FIRST COMMODITY EXCHANGE OF INDIA (KOCHI)

o) BIKANER COMMODITY EXCHANGE LTD. (BIKANER)

p) THE COFEE FUTURE EXCHANGE LTD. (BANGALORE)

q) SUGAR INDIA LTD. (MUMBAI)


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VI. INDIAN COMMODITY MARKET STRUCTURE


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6.1 COMMODITIES TRADED IN INDIA

COMMODITIES

FIBERS &

MANUFACT

URERS

SPICES

VEGETABLES

EDIBLE OIL

ENERGY

PRODUCTS

METALS

OTHERS

PULSES


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6.2 COMMODITY FUTURE MARKET

i. Evolution of the commodity futures trading in India and presentstatus

rganized futures market evolved in India by the setting up of

"Bombay Cotton Trade Association Ltd." in 1875. In 1893, following

widespread discontent amongst leading cotton mill owners and merchants

over the functioning of the Bombay Cotton Trade Association, a separate

association by the name "Bombay Cotton Exchange Ltd." was constituted.

Futures trading in oilseeds were organized in India for the first time with

the setting up of Gujarati Vyapari Mandali in 1900, which carried onfutures trading in groundnut, castor seed and cotton. Before the Second

World War broke out in 1939 several futures markets in oilseeds were

functioning in Gujarat and Punjab.

Futures trading in Raw Jute and Jute Goods began in Calcutta with the

establishment of the Calcutta Hessian Exchange Ltd., in 1919. Later East

Indian Jute Association Ltd. was set up in 1927 for organizing futures

trading in Raw Jute. These two associations amalgamated in 1945 to form

the present East India Jute & Hessian Ltd., to conduct organized trading in

both Raw Jute and Jute goods. In case of wheat, futures markets were in

existence at several centers at Punjab and U.P. The most notable amongst

them was the Chamber of Commerce at Hapur, which was established in

1913.

Futures market in Bullion began at Mumbai in 1920 and later similar

markets came up at Rajkot, Jaipur, Jamnagar, Kanpur, Delhi and Calcutta. In

due course several other exchanges were also created in the country to

trade in such diverse commodities as pepper, turmeric, potato, sugar and

gur (jag gory).

After independence, the Constitution of India brought the subject of

"Stock Exchanges and futures markets" in the Union list. As a result, the

responsibility for regulation of commodity futures markets devolved on

Govt. of India. A Bill on forward contracts was referred to an expert

O


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committee headed by Prof. A.D.Shroffand Select Committees of two

successive Parliaments and finally in December 1952Forward Contracts

(Regulation) Act, 1952, was enacted.

The Act provided for 3-tierregulatory system;

(a) An association recognized by the Government of India on therecommendation of Forward Markets Commission,

(b) The Forward Markets Commission (it was set up in September 1953)and,

(c) The Central Government Forward Contracts (Regulation) Rules werenotified by the Central Government July, 1954.

The Act divides the commodities into 3 categories with reference to extent

of regulation, viz;

The commodities in which futures trading can be organized under theauspices of recognized association.

The Commodities in which futures trading is prohibited. Those commodities which have neither been regulated for being

traded under the recognized association nor prohibited are referred

as Free Commodities and the association organized in such freecommodities is required to obtain the Certificate of Registration from

the Forward Markets Commission.

In the seventies, most of the registered associations became inactive,

as futures as well as forward trading in the commodities for which they

were registered came to be either suspended or prohibited altogether.

The Khusro Committee (June 1980) had recommended reintroduction

of futures trading in most of the major commodities , including cotton,kapas, raw jute and jute goods and suggested that steps may be taken for

introducing futures trading in commodities, like potatoes, onions, etc. at

appropriate time. The government, accordingly initiated futures trading in

Potato during the latter half of 1980 in quite a few markets in Punjab and

Uttar Pradesh.


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After the introduction of economic reforms since June 1991 and the

consequent gradual trade and industry liberalization in both the domestic

and external sectors, the Govt. of India appointed in June 1993 one more

committee on Forward Markets under Chairmanship of Prof. K.N. Kabra. The

Committee submitted its report in September 1994. The majority report of

the Committee recommended that futures trading be introduced in

1) Basmati Rice

2) Cotton and Kapas

3) Raw Jute and Jute Goods

4) Groundnut, rapeseed/mustard seed, cottonseed, sesame seed, sunflower

seed, safflower seed, copra and soybean, and oils and oilcakes of all of

them.

5) Rice bran oil

6) Castor oil and its oilcake

7) Linseed

8) Silver and

9) Onions.

The committee also recommended that some of the existing

commodity exchanges particularly the ones in pepper and castor seed, may

be upgraded to the level of international futures markets. The liberalizedpolicy being followed by the Government of India and the gradual

withdrawal of the procurement and distribution channel necessitated

setting in place a market mechanism to perform the economic functions of

price discovery and risk management.

The National Agriculture Policy announced in July 2000 and the

announcements of Finance Minister in the Budget Speech for 2002-2003

were indicative of the Governments resolve to put in place a mechanism of

futures trade/market. As a follow up the Government issued notificationson 1.4.2003permitting futures trading in the commodities, with the issue of

these notifications futures trading is not prohibited in any commodity.

Options trading in commodity are, however presently prohibited.


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ii. OBJECTIVES OF COMMODITY FUTURES Hedging with the objective of transferring risk related to the

possession of physical assets through any adverse moments in price.

Liquidity and Price discovery to ensure base minimum volume in

trading of a commodity through market information and demand

supply factors that facilitates a regular and authentic price discovery

mechanism.

Maintaining buffer stock and better allocation of resources as itaugments reduction in inventory requirement and thus the exposure

to risks related with price fluctuation declines. Resources can thus be

diversified for investments.

Price stabilization along with balancing demand and supply position.Futures trading leads to predictability in assessing the domestic

prices, which maintains stability, thus safeguarding against any short

term adverse price movements. Liquidity in Contracts of the

commodities traded also ensures in maintaining the equilibrium

between demand and supply.

Flexibility, certainty and transparency in purchasing commoditiesfacilitate bank financing. Predictability in prices of commodity would

lead to stability, which in turn would eliminate the risks associatedwith running the business of trading commodities. This would make

funding easier and less stringent for banks to commodity market

players.


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iii. BENEFITS OF COMMODITY FUTURES MARKETSThe primary objectives of any futures exchange are authentic price

discovery and an efficient price risk management. The beneficiaries include

those who trade in the commodities being offered in the exchange as wellas those who have nothing to do with futures trading. It is because of price

discovery and risk management through the existence of futures exchanges

that a lot of businesses and services are able to function smoothly.

Price Discovery:-Based on inputs regarding specific market information, the demand

and supply equilibrium, weather forecasts, expert views andcomments, inflation rates, Government policies, market dynamics,

hopes and fears, buyers and sellers conduct trading at futures

exchanges. This transforms in to continuous price discovery

mechanism. The execution of trade between buyers and sellers leads

to assessment of fair value of a particular commodity that is

immediately disseminated on the trading terminal.

Price Risk Management: -Hedging is the most common method of price risk management. It is

strategy of offering price risk that is inherent in spot market by taking

an equal but opposite position in the futures market. Futures markets

are used as a mode by hedgers to protect their business from adverse

price change. This could dent the profitability of their business.

Hedging benefits who are involved in trading of commodities like

farmers, processors, merchandisers, manufacturers, exporters,

importers etc.

Import- Export competitiveness: -The exporters can hedge their price risk and improve their

competitiveness by making use of futures market. A majority

of traders which are involved in physical trade internationally intend


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to buy forwards. The purchases made from the physical market might

expose them to the risk of price risk resulting to losses. The existence

of futures market would allow the exporters to hedge their proposed

purchase by temporarily substituting for actual purchase till the time

is ripe to buy in physical market. In the absence of futures market it

will be meticulous, time consuming and costly physical transactions.

Predictable Pricing:-The demand for certain commodities is highly price elastic. The

manufacturers have to ensure that the prices should be stable in

order to protect their market share with the free entry of imports.

Futures contracts will enable predictability in domestic prices. The

manufacturers can, as a result, smooth out the influence of changes

in their input prices very easily. With no futures market, the

manufacturer can be caught between severe short-term price

movements of oils and necessity to maintain price stability, which

could only be possible through sufficient financial reserves that could

otherwise be utilized for making other profitable investments.

Benefits for farmers/Agriculturalists:-Price instability has a direct bearing on farmers in the absence of

futures market. There would be no need to have large reserves to

cover against unfavorable price fluctuations. This would reduce the

risk premiums associated with the marketing or processing margins

enabling more returns on produce. Storing more and being more

active in the markets. The price information accessible to the farmers

determines the extent to which traders/processors increase price to

them. Since one of the objectives of futures exchange is to makeavailable these prices as far as possible, it is very likely to benefit the

farmers. Also, due to the time lag between planning and production,

the market-determined price information disseminated by futures

exchanges would be crucial for their production decisions.


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Credit accessibility: -The absence of proper risk management tools would attract the

marketing and processing of commodities to high-risk exposure

making it risky business activity to fund. Even a small movement in

prices can eat up a huge proportion of capital owned by traders, at

times making it virtually impossible to pay back the loan. There is a

high degree of reluctance among banks to fund commodity traders,

especially those who do not manage price risks. If in case they do, the

interest rate is likely to be high and terms and conditions very

stringent. This possesses a huge obstacle in the smooth functioning

and competition of commodities market. Hedging, which is possible

through futures markets, would cut down the discount rate in

commodity lending.

Improved product quality:-The existence of warehouses for facilitating delivery with grading

facilities along with other related benefits provides a very strong

reason to upgrade and enhance the quality of the commodity to

grade that is acceptable by the exchange. It ensures uniform

standardization of commodity trade, including the terms of qualitystandard: the quality certificates that are issued by the exchange-

certified warehouses have the potential to become the norm for

physical trade.

Commodities as an asset class for diversification of portfolio risk:-Commodities have historically an inverse correlation of daily returns

as compared to equities. The scenes of daily returns favors

commodities, thereby indicating that in a given time periodcommodities have a greater probability of providing positive returns

as compared to equities. Another aspect to be noted is that the

Sharpe ratio of a portfolio consisting of different asset classes is

higher in the case of a portfolio consisting of commodities as well as

equities. Thus, an Investor can effectively minimize the portfolio risk


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arising due to price fluctuations in other asset classes by including

commodities in the portfolio.

Commodity derivatives markets are extremely transparent:-In the sense that the manipulation of prices of a commodity is

extremely difficult due to globalization of economies, thereby

providing for prices benchmarked across different countries and

continents. For example, gold, silver, crude oil, natural gas, etc. are

international commodities, whose prices in India are indicative of the

global situation.

An option for high net worth investors:-With the rapid spread of derivatives trading in commodities, the

commodities route too has become an option for high net worth and

savvy investors to consider in their overall asset allocation.

Useful to the producer:-Commodity trade is useful to the producer because he can get an idea

of the price likely to prevail on a future date and therefore can decide

between various competing commodities, the best that suits him.

Useful for the consumer:-Commodity trade is useful for the consumer because he gets an idea

of the price at which the commodity would be available at a future

point of time. He can do proper costing/financial planning and also

cover his purchases by making forward contracts. Predictable pricing

and transparency is an added advantage.


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In this case, the question arises about who will maintain the buffer

stock, how will we smoothen the price fluctuations, how will farmers not be

vulnerable that tomorrow the price will crash when the crop comes out,

how will farmers get signals that in the future there will be a great need for

wheat or rice. In all these aspects the futures market has a very big role to

play.

If you think there will be a shortage of wheat tomorrow, the futures

prices will go up today, and it will carry signals back to the farmer making

sowing decisions today. In this fashion, a system of futures markets will

improve cropping patterns.

Next, if I am growing wheat and am worried that by the time theharvest comes out prices will go down, then I can sell my wheat on the

futures market. I can sell my wheat at a price which is fixed today, which

eliminates my risk from price fluctuations. These days, agriculture requires

investments -- farmers spend money on fertilizers, high yielding varieties,

etc. They are worried when making these investments that by the time the

crop comes out prices might have dropped, resulting in losses. Thus a

farmer would like to lock in his future price and not be exposed to

fluctuations in prices.

The third is the role about storage. Today we have the Food

Corporation of India which is doing a huge job of storage, and it is a system

which -- in my opinion -- does not work. Futures market will produce their

own kind of smoothing between the present and the future. If the future

price is high and the present price is low, an arbitrager will buy today and

sell in the future. The converse is also true, thus if the future price is low the

arbitrageur will buy in the futures market. These activities produce theirown "optimal" buffer stocks, smooth prices. They also work very effectively

when there is trade in agricultural commodities; arbitrageurs on the futures

market will use imports and exports to smooth Indian prices using foreign

spot markets.


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vi. Trading in commodity futuresThe commodity trading system consists of certain prescribed steps or stages

as follows:

Entities in the trading systema. Trading cum Clearing membersTCMs can trade and clear either on their own account or on behalf of

their clients including participants. Each TCM has a unique ID and can havemore than one user.

Trading

order executionposition limit

reporting

price limits

Clearing

matchingregistering

clearing

clearing limit

notation

margining

Settlements

marking tomarket

receipts andpayments

delivering uponexpiration ormaturity


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b. Professional clearing membersPCMs are members of NSCCL. The PCM membership entitles the

members to clear trades executed though trading cum Clearing Members

both for themselves and/or on behalf of their clients.

Methods of trading:a. Open outcry:-

Open outcry trading is a face- to-face and highly activated form of

trading used on the floors of the exchanges. In open outcry system the

futures contracts are traded in pits. Normally one type of contract is traded

in each pit.

b. Electronic trading:-Electronic trading: Electronic trading systems have become

increasingly popular in the past decade. The driving factor for the rise in the

popularity of these systems is their potential to improve efficiency and

lower the cost of transactions. In addition, electronic trading systems make

exchanges available to remote investors in real time, which is an important

benefit in the present situation of increased trading from remote locations.

vii.

Components of the system: Computer terminals, where customer orders are keyed in and

confirmations are received

A host compute that processes trade. A network that links the terminals to the host computer.

viii. Format for tickers:XXXYYYZZZ

XXX: Three letters for the commodityYYY: three letters for the grade

ZZZ: Three letters for the location

E.g.: SYOREFIND:

SYO: Soya oil

REF: Refined

IND: Indore


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Instrument Type is to denote whether the ticker is a future contract

or a spot price being disseminate or an options contract.

E.g.: COMDTY- Used for commodity spot price dissemination

FUTCOM- Used for future on commodity

OPTCOM- Used for options on futures on commodity.

Contract expiry for futures contract will be written as 20mmmYYYY

Mmm - denotes the month, e.g. DEC, JAN etc.

YYYY denotes the year e.g. 2005, 2006 etc

For spot price, no expiry will be displayed or required

ix. Types of orders in futures tradingith electronic trading, a lot of flexibility is available to investors in

executing various types of orders. They must familiarize themselves with the

various types. The orders can be categorized into time conditions, price

conditions and other conditions.

Time conditions order Day order: The order is valid for the day on which it is entered. If the

order is not executed during the trading session, the system itself will

cancel the order at the end of the day. Fresh order has to be enteredfor the next day.

Good till cancelled: It remains in the system till the order is cancelledby the user. The maximum number of days the order will remain in

the system will be notified by the Exchange.

Good till date: The order will remain in the system up to the date theuser has specified, if it is not executed.

Immediate or cancel: An immediate or cancel order allows the user tobuy or sell a contract as soon as it is entered into the system. If it is

not matched or partial match has been done, any balance portion of

the contract will be automatically cancelled.

All or none order: It is a limit order in which the order will beexecuted in its fully entirety or not executed.

W


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Fill or kill order: Like the previous one, it is a limit order. It should beexecuted immediately and if the order is not executed, it gets

cancelled.

Limit order: This is an order to buy or sell the futures contract of acommodity at a specified price.

Stop Loss order: Stop Loss order is a facility given to thetraders/clients to use it to limit their amount of loss, if the futures

contracts move against their position. It is an order to buy or sell

when the market price reaches the specified level. When the price

reaches the point, the order gets triggered and it becomes a market

order. For example, a trader has purchased gold futures at Rs.7, 000/-

He is uncertain about the market movement. He plans to limit his

loss, if the prices go down. He will place a stop order if the price falls

less than Rs.6900/-. When the market goes down, the stop order gets

executed at this price.

Other conditions Market Price: Market orders are those for which no price is

specified at the time of entering the order.

Market on open: This kind of orders will be executed during themarket open within the opening range.

Market on close: These types of orders are executed on themarket close.

Spread Order: It is an order in which two positions are taken,i.e. one long position and one short position with different

months of maturity in the same commodity or in closely related

commodities. The prices of the futures contract tend to go up and

down and by entering the spread order, investor would have

locked in the price and the amount of profit. The trader will

unwind the position depending on the market movement.


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x. Margin requirements.(a) The initial security deposit paid by a member will be considered as

his initial margin deposit for the purpose of allowable exposure limit.

Initially, every member is allowed to take exposure up to the level

permissible on the basis of such initial deposit. However, if a member

wishes to create more exposure, he has to pay additional deposit.

(b) If there is a surplus deposit lying with the Exchange towards margin,it is not refunded to the member, unless a written request is received from

the member for refund. However, the member continues to get additional

exposure limit on account of such additional/surplus deposit.

Different types of margins collected by the Exchange are as follows:

a. Ordinary (Initial) Margin:Ordinary margin requirement is calculated by applying the margin

percentage applicable for a contract on the value of the open position of a

member in that contract. If a member has net position in various contracts

of the same commodity running concurrently, he is required to pay margin

separately on each of these contracts. Similarly, if a member has open

position in various commodities, the total amount required is calculated as

sum total of margin required in respective of each commodities and

contracts separately. The computation methodology in respect of ordinary

margin is as follows:

Intraday: During the trading session, the margin is calculated on the

absolute difference between total sales in value terms and total buy in value

terms in respect of all transactions executed in a contract during the day in

addition to previous day s open position carried forward at the official

closing price of previous day.

End of day: At end of the trading session, the margin amount is

computed on net position in a contract in quantitative terms multiplied by

the official closing price.


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b. Special Margin:In case the price fluctuation in a contract during the trading session is

more than 50% of the circuit filter limit applicable on that contract

compared to the base price of the day, a special margin equivalent to 50%of the circuit filter limit is applied. Such special margin amount is

immediately blocked out of available margin deposits of the members

having outstanding position in that contract and in case the available

margin of a member is not sufficient to cover such special margin required,

then a margin call is sent to the member which is required to be remitted

by the member immediately. In such case, since the available deposit is

already exhausted, he is suspended from trading and such suspension

continues during such trading session till collection of required marginamount is completed. If the price volatility reaches 100 % of the circuit filter

limit, orders will be accepted by the system only up to the price level

equivalent to such circuit filter.

c. Delivery Period Margin:When a contract enters into delivery period towards the end of its life

cycle, delivery period margin is imposed. Such margin is applicable on both

outstanding buy and sales side, which continues up to the settlement of

delivery obligation or expiry of the contract, whichever is earlier. The

delivery period margin is calculated at the rate specified for respective

commodity multiplied by the net open position held by a member in the

expiring contract. When a seller submits delivery documents along with

surveyor s certificate, his position is treated as settled and his delivery

period margin to such extent is reduced. When a buyer pays money for the

delivery allocated to him, his delivery period margin is reduced on such

quantity for which he has paid the amount. If delivery does not happen

with respect to certain open position and is finally settled by way of

difference as per the Due Date Rate, the delivery period margin is released

only after final settlement of difference arising out of such closing out as

per the Due Date Rate.


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xi. Matching Rules(a) The Exchange may launch more than one order book running

either parallel or at different time spans, either with the same order

matching rules or with different matching rules. The Exchange is also

entitled to modify or change the matching rules relevant to any market or

order books any time where it is necessary to do so

(b) Without prejudice to the generality of the above, the ordermatching rules will have the following features:

Orders in the Normal market will be matched on price -time prioritybasis.

Best buy order shall match with the best sell order.

(The best buy order would be the one with the highest price and

the best sell order would be the one with the lowest price.)


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xii. SettlementFutures contracts have two types of settlements, the MTM settlement

which happens on a continuous basis at the end of each day, and the final

settlement which happens on the last trading day of the futures contract.

TYPES OF SETTLEMENTS

DAILY

SETTLEMENT

FINAL

SETTLEMENT

HANDLE DAILY PRICE

FLUCTUATION FOR ALL

TRADES

(MARK TO THE MARKET)

DAILY PROCESS AT

END OF THE DAY

DANDLES FINAL

SETTLEMENT

OF ALL POSITION ON

CONTRACT

EXPIRY DATE


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a. Daily settlement: mark to the marketThis is done to take care of daily price fluctuation for all traders. All

open positions of the members are marked to market at the end of day

and the profit/loss is determined as below:

On the day of entering into the contract, it is the difference betweenthe entry value and daily settlement price for that day.

On any intervening days, when the member holds an open position, itis the difference between the daily settlement price for that day and

the previous day settlement price.

On the expiry date if the member has an open position, it is thedifference between the final settlement price and the previous day

settlement price.

Illustration:

A clearing member buys one December expiration cotton futures at

Rs> 6435 per quintal on December 15. The unit of trading is 11 bales and

each contract is for delivery of 55 bales of cotton. The member closes the

position on December 19. The MTM profit/losses get added/ deducted

from his initial margin on a daily basis.

Date Settlement Price MTM

Dec 15, 2004 6320 -115Dec 16, 2004 6250 -70

Dec 17, 2004 6312 +62

Dec 18, 2004 6310 -2

Dec 19, 2004 6315 +5

Daily MTM settlement flow

Information to members- end of trade day T Settlement through designated clearing Bank Arrangement of funds in settlement A/c by member Collection and payment of fund T +1


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Exchange clearing

House

Member

Margin Daily MTM

Settlement

Initial Margin

Any special margin

Daily P/L ForPositions closed out

MTM of open

position

Member s bankA/c


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Indian commodities market

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Settlement banking operations

b. Final settlement:The settlement done for open Buy and Sell positions on the contract expiry

date is called final settlement.

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

day. The prices are collected from the members across the country throughpolling. The polled bid/ask prices are bootstrapped and the mid of the two

bootstrapped is taken as the final settlement price.

The responsibility of settlement is on a trading cum clearing member (TCM)

for all trades done on his own A/c and his client s trades. A professional clearing

member (PCM) is responsible for settling all the participants trades, which he has

confirmed to the exchange.

xiii. Settlement methods: Physical delivery of the underlying asset Closing out by offsetting position Cash settlement

CLIENT 1

Exchange

Clearing

HouseClearing

Bank(HDFC)

CLIENT 2 BROKER 2

BROKER 1


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a. Physical delivery settlementMembers can give and take delivery of commodities by completing the

delivery formalities and giving delivery information to the exchange.

Entities involved in physical delivery: Accredited warehouse Approved registrar and transfer agents Approved assayerb. Closing out by offsetting positionIn closing out the opposite transaction is affected to close out the original

futures position. A buy contract is closed by a sell contract and a sale contract is

closed buy a sell contract. For example, an investor took a long position in Gold

futures contract on the January 30 2005 at Rs 6000 can close his position by

selling gold futures contract on February 25 2005 at 5780. In this case, over the

period of holding the position, he has suffered a loss of Rs 220 per unit. This loss

would have been debited from his margin Account over the holding period by way

of MTM at the end of each day.

c. Cash settlement:Contract held till the last day of trading can be cash settled. When a contract is

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

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

equal to the closing spot price of the underlying asset ensuring the convergence

of future prices and the spot prices. For example an investor took a short position

in five long staple cotton futures contracts on December 15 at Rs 6950. On 20th

February, the last trading day of the contract, the spot price of long staple cotton

is Rs. 6725. This is the settlement price for his contract. As a holder of a short

position on cotton, he does not have to actually deliver the underlying cotton, but

simply takes away the profit of Rs. 225 per trading unit of cotton in the form of

cash.


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VII. NATIONAL LEVEL COMMODITY EXCHANGES IN INDIAi. NMCE (National Multi Commodity Exchange of India Ltd.)

NMCE is the first demutualised electronic commodity exchange of India granted

the National exchange on Govt. of India and operational since 26th Nov,

2002.Promoters of NMCE are, Central warehousing corporation (CWC), National

Agricultural Cooperative Marketing Federation of India (NAFED), Gujarat Agro-

Industries Corporation Limited (GAICL), Gujarat state agricultural Marketing Board

(GSAMB), National Institute of Agricultural Marketing (NIAM) and Neptune

Overseas Ltd. (NOL). Main equity holders are PNB. The Head Office of NMCE is

located in Ahmadabad. There are various commodity trades on NMCE Platform

including Agro and non-agro commodities.

ii. NCDEX (National Commodity & Derivates Exchange Ltd.)NCDEX is a public limited co. incorporated on April 2003 under the Companies Act

1956; It obtained its certificate for commencement of Business on May 9, 2003. It

commenced its operational on Dec 15, 2003.Promoters shareholders are: Life

Insurance Corporation of India (LIC), National Bank for Agriculture and Rural

Development (NABARD) and National Stock Exchange of India(NSE) other

shareholder of NCDEX are: Canara Bank, CRISIL limited, Goldman Sachs,Intercontinental Exchange (ICE), Indian farmers fertilizer corporation Ltd (IFFCO)

and Punjab National Bank (PNB).NCDEX is located in Mumbai and currently

facilitates trading in 57 commodities mainly in Agro product.

iii. MCX (Multi Commodity Exchange of India Ltd.)Headquartered in Mumbai, MCX is a demutualised nationwide electronic

commodity future exchange. Set up by Financial Technologies (India) Ltd.

permanent recognition from government of India for facilitating online trading,

clearing and settlement operations for future market across the country. The

exchange started operation in Nov, 2003. MCX equity partners include, NYSE Euro

next, State Bank of India and its associated, NABARD NSE, SBI Life Insurance Co.


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Ltd., Bank of India, Bank of Baroda, Union Bank of India, Corporation Bank, Canara

Bank, HDFC Bank, etc.MCX is well known for bullion and metal trading platform.

iv. ICEX (Indian Commodity Exchange Ltd.)ICEX is latest commodity exchange of India Started Function from 27 Nov, 09. It

is jointly promote by India bulls Financial Services Ltd. and MMTC Ltd. and has

Indian Potash Ltd. KRIBHCO and IFC among others, as its partners having its head

office located at Gurgaon (Haryana).

BSE is also planning to set up a Commodity exchange.

UNIQUE FEATURES OF NATIONAL LEVEL COMMODITY EXCHANGES:

The unique features of national level commodity exchanges are:

They are demutualized, meaning thereby that they are run professionallyand there is separation of management from ownership. The independent

management does not have any trading interest in the commodities dealt

with on the exchange.

They provide online platforms or screen based trading as distinct from theopen outcry systems (ring trading) seen on conventional exchanges. This

ensures transparency in operations as everyone has access to the sameinformation.

They allow trading in a number of commodities and are hence multi-commodity exchanges.

They are national level exchanges which facilitate trading from anywhere inthe country. This corollary of being an online exchange.


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VIII.INTRODUCTION TO DERIVATIVESi. DERIVATIVES DEFINITION:

erivative is a product whose value is derived from the value of one or moreunderlying variables or assets in a contractual manner. The underlying asset can

be equity, forex, commodity or any other assets.

ii. PRODUCTS OF DERIVATIVES MARKET:erivative contracts are of different types. The most common ones are

forwards, futures, options, warrant and swaps.

Forwards: A forward contract is an agreement between two entitles to buyor sell the underlying assets at a future date, at today s pre-agreed price

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

sell the underlying assets at a future date, at today s future price. Futures

contracts differ from forward contracts in the sense that they are standardized

and exchange traded.

Options: There are two types of options Calls and Put. Calls give the buyer

the right but not the obligation to buy a given quantity of the underlying assets, at

a given price on or before a given future date. Puts give 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 date.

Warrants: Options generally have lives of up to one year, the majority of

options traded on options exchanges having a maximum maturity of nine months.

Longer-date options are called warrants and are generally traded over- the-

counter.

Baskets: Basket options on portfolios of underlying assets. The underlying

asset is usually a weighted average of assets. Equity index options are a form of

basket options.

D

D


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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.

Swaptions: Swaptions are options to buy or sell a swap that will becomeoperative at the expiry of the options. Thus a Swaptions is an option on a forward

swap.

iii. PARTICIPANTS IN DERIVATIVES MARKET:articipants who trade in the derivatives market can be classified under the

following three broad categories:

Hedgers: Ones who offset the price risk inherent in any cash marketposition by taking the opposite position in the futures market. Hedgers use

the market to protect their businesses from adverse price changes.

Speculator: One who tries to profit from buying and selling futurecontracts by anticipating future price movements.

Arbitragers: Ones simultaneously purchase and sale of similar commoditiesin different exchanges or in different contracts of the same commodity in

one exchange to take advantage of a price discrepancy.

iv. FUNCTIONS OF DERIVATIVES: The prices of derivatives converge with the prices of the underlying at the

expiration of the derivative contract. Thus derivatives help in discovery of

future as well as current prices.

The derivatives market helps to transfer risks from those who have thembut may not like them to those who have an appetite for them.

Derivatives, due to their inherent nature, are linked to the underlying cashmarket. With the introduction of derivatives, the underlying market witness

higher trading volumes because of participation by more players who

would not otherwise participate for lack of an arrangement to transfer risk.

P


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Speculative traders shift to a more controlled environment of thederivatives market. In the absence of an organized derivatives market,

speculators trade in the underlying cash markets. Margining, monitoring

and surveillance of the activities of various participants become extremely

difficult in these kinds of mixed markets.

An important incidental benefit that flows from derivatives trading is that itacts as a catalyst for new entrepreneurial activity. Derivatives shave 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 opportunity, the benefit of

which are immense.

Derivatives markets help increase savings and investment in the long run.The transfer of risk enables market participants to expand their volume of

activity.

v. DERIVATIVES MARKETS:erivatives can broadly be classified as commodity derivative market and

financial derivatives markets. As the name suggest, commodity derivatives

market trade contracts for which the underlying asset is a commodity. It can bean agricultural commodity like wheat, soybean, cotton, etc or precious metals.

Financial derivatives markets trade contracts that have a financial asset or

variable as the underlying.

D

DERIVATIVES MARKETS

FINANCIAL MARKET COMMODITY


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vi. DIFFERENCES BETWEEN SPOT TRANSACTION ANDFORWARD/FUTURES TRANSACTION

Using the example of a forward contract, let us try to understand the

difference between a spot and derivatives contract. Every transaction has three

components: trading, clearing and settlements

In spot transaction, the trading, clearing and settlement is the actual

process of exchanging money and goods and at the spot. Consider this example.

On 1st January2004 B wants to buy some gold. The gold quotes at Rs 6,000 per 10grams. B payRs12, 000 and get the gold, this is spot transaction.

In forward/future contracts trading happens today, but the clearing and

settlement happen at the end of the specified period. Now suppose B does not

want to buy gold on the 1st January 2004, but wants to buy it a month later. The

gold quotes 6,015 per 10 gram. They agree upon the forward price for 20 gram of

gold that B wants to buy and B leaves. One month later B pays Rs 12,030 and

collects his gold. This is a forward contract.

TRANSACTIONS

SPOT TRANSACTIONS FUTURE TRANSACTIONS


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IX. INSTRUMENTS AVAILABLE FOR TRADINGIn recent years, derivatives have become increasingly popular due to their

applications for hedging, speculation and arbitrage. While futures and options arenow actively traded on many exchanges, forward contracts are popular on the

OTC market. While at the moment only commodity futures trade on the NCDEX,

eventually, as the market grows, we also have commodity options being traded.

i. FORWARD CONTRACTSForward contract is a contract between two people who agree to

buy/sell a specified quantity of a financial instrument/commodity at a certainprice at a certain date in future.

For example, Mr. X and Mr. Y. Mr. X is a wholesale sugar dealer and Mr. Y is

the prospective buyer. Mr. Y agrees to buy 30 kg of sugar at Rs 15 per kg after

three months. The price is arrived at on the basis of prevailing market conditions

and future perceptions about the price of sugar.

If after three months, the market price of sugar is Rs 20 per kg, then Mr. Y is

a gainer and if the price of sugar is Rs 10 per kg, then Mr. X is a gainer.

The salient features of forward contract are: They are bilateral contracts and hence exposed to counter party risk. Each contract is custom designed, and hence is unique in terms of contract

size, expiration date and the asset type and quality.

The contract price is generally not available in public domain. On the expiration date, the contract has to be settled by delivery of the

asset.

If the party wishes to reverse the contract, it has to compulsorily go to thesame counterparty, which often results in high prices being charged.

A


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Advantages of forward markets Use for hedging Use for speculation Limitations of forward markets Lack of centralization of trading. Illiquidity Counterparty risk

ii. FUTURES MARKETFutures markets were designed to solve the problems that exist in forward

markets. A futures contract is an agreement between two parties to buy or sell an

asset at a certain time in the future at a certain price. But unlike forward

contracts, the futures contracts are standardized and exchange traded. To

facilitate liquidity in the futures contracts, the exchange specifies certain standard

features of the contracts. Its a standardized contract with standard underlying

instrument, a standard quantity and quality of the underlying instrument that canbe delivered, and a standardized time of such settlement. A futures contract may

be offset prior to maturity by entering into an equal and opposite transaction.

More than 99% of futures transactions are offset this way.

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 Location of settlement Unlike Equity futures, the commodity future contract expires on the 20th

day of the delivery month.


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What are futures?are standardized financial contracts traded in a futures exchange.

A futures contract is an agreement to buy or sell a certain quantity of anunderlying asset at a certain time in the future at a predetermined price.

When futures contracts are traded, there isnt necessarily an actual

delivery of goods. The trader only speculates on the future direction of the price

of the underlying asset, which may be a commodity, foreign exchange, bonds,

money market instruments, equity or any other item. The terms "buy" and "sell"

only indicate the direction the trader expects future prices to take , i.e. he would

buy it if he expects the price of the underlying asset to rise in the future and sell if

he expects it to fall. Futures contracts are usually closed by making an oppositetransaction, i.e. the buyer of the contract sells it before the expiration date.

The price at which the contract is traded in the futures market is called the

futures price. Futures contracts have one-month, two-month and three-month

expiry cycles, and they usually expire on the last Thursday of the respective

month.

There are two systems that may be followed in the settlement of futures

contracts:

Futures Rolling Settlement: At the end of each day, all outstandingtrades are settled, i.e. the buyer makes payments for securities

purchased and the seller delivers the securities sold. In India, futures

exchanges function on the T+5 settlement cycle, wherein transactions

are settled after 5 working days from the date on which the transaction

has been entered.

Weekly Settlement Cycle: This system provides the traders a longertime frame to speculate because the settlement is made at the end ofeach week.

There are three categories of participants in the futures market

speculators, who bet on the future movement of the price of an asset; hedgers,

who try to eliminate the risks involved in the price fluctuations of an asset by

Futures


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entering futures contracts; and arbitrageurs, who try to take advantage of the

discrepancy b between prices in different markets.

While hedgers participate in the market to offset risk, speculators make it

possible for hedgers to do so by assuming the risk. Arbitrageurs ensure that the

futures and cash markets move in the same direction.

Why futures trading?ver the past two decades, food prices have been more volatile than the

prices of manufactured goods. The uncertainty of commodity prices leaves a

farmer open to the risk of receiving a price lower than the expected price for his

yield. At times, the crop prices fall so low that the farmer is unable to repay the

loan. Inadequate price risk management is one of the most important reasons forpoor farmers remaining poor.

Price risk management refers to minimizing the risk involved in

commodities trading. Through futures contracts, the risk may be shifted to

speculators or traders who are willing to assume the risk. A hedger would try to

minimize risk by taking opposite positions in the futures and cash markets. Since

the two markets usually move in the same direction, the profits of one market will

cover the losses in the other. In the case of a commodity seller, like a farmer or a

merchant, futures contracts offer protection from declining prices.

Price discovery refers to the process of determining the price level of a

commodity based on demand and supply factors. Every trader in the trading pit

of a commodities exchange has specific market information like demand, supply

and inflation rates. When trades between buyers and sellers are executed, the

market price of a commodity is discovered. According to V. Shunmugam, Chief

Economist at the Multi Commodity Exchange of India Ltd., commodity futures

help policy makers take better preventive measures by indicating price raises

beforehand.

Apart from the basic functions of price discovery and price risk

management, futures contracts have a number of other benefits like providing

liquidity, bringing transparency and controlling black marketing.

O


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Futures contracts can easily be converted into cash, i.e. they are liquid. By

buying or selling the contract in order to make profits, speculators provide the

capital required for ensuring liquidity in the market. They provide certainty of

future revenues or expenditures, hence ensuring concrete cash flows for the user.

Futures markets allow speculative trade in a more controlled environment

where monitoring and surveillance of the participants is possible. Hence, futures

ensure transparency. The transparency benefits the farmers as well by spreading

awareness about prices in the open market.

Futures also help in standardization of quality, quantity and time of

delivery, since these variables are agreed upon by the participants and specified

in the futures contract.

Distinction between futures and forwards contractsorward contracts are often confused with futures contracts. However

there are some differences between forward contracts and future contracts.

Future contracts area significant improvement over the forward contracts as

they eliminate counter party risk and offer more liquidity.

A futures contract is an agreement between two parties to buy or sell aspecified quantity and quality of asset at a certain time in future at a certain price

agreed at the time of entering into the contract on the futures exchange. Forward

contract is an agreement entered between two parties to buy or sell an asset at a

future date for an agreed price. Forward contract is not traded on an exchange.

Trading place:

A future contract is entered on the centralized trading platform of theexchange. Forward contract is OTC in nature.

Size of the contract:

Futures contract is standardized in terms of quantity as specified by theexchange. Size of the forward contract is customized as per the terms of

agreement between buyer and seller.

F


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Transparency in contract price:

Contract price of futures contract is transparent as it is available on thecentralized trading screen of the exchange. Contract price of forward

contract is not transparent, as it is not publicly disclosed.

Valuation of open position and margin requirement:

In case of futures contract valuation of open position is calculated as perofficial closing price on daily basis and Mark to Market margin requirement

exist. In case of forward contract valuation of open position is not

calculated on daily basis and there is no provision of Mark to Market

margin requirement.

Liquidity:

Futures contract is more liquid as it is traded on the exchange. Forwardcontract is less liquid due to customized nature and mutual trade.

Counter party risk:

In futures contract Clearing House becomes counter party to eachtransaction, which is called Notation, so counter party risk is nil. In forward

contract counterparty risk is high due to decentralized nature of thetransaction.

Regulations:

A government regulatory authority and the exchange regulate futurescontract. Forward contract is not regulated by any authority or exchange.

Settlement:

Futures contract is generally cash settled but option of physical settlementis available. Forward contract is generally settled by physical delivery.


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Delivery:

Delivery tendered in case of futures contract should be of standardquantity and standard quality as per contract specification at designated

delivery centers of the exchange. Delivery in case of forward contract is

carried out at delivery center specified in customized bilateral agreement.

Futures Forward

Trade on an organized exchange OTC (over the counter) in nature

Standardized contract terms Customized contract terms

More liquid Less liquid

Requires margin payments No margin payment

Follows daily settlement Settlement happens at end of period

iii. OPTIONS As the word suggests option is a contract that gives you an option, but not the

obligation to buy or sell something. Unlike futures, there is an option writer

who initiates the contract. An option writer is treated as the seller of the

contract. The purchase of options requires an up-front payment.

Commodity options are totally prohibited in Indian market.Call option: A call option gives the holder the right but not the obligation to

buy an asset by a certain date for a certain price.


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Put option: A put option gives the holder the right but not the obligation tosell an asset by a certain date for a certain price.

iv. BASIC PAYOFFSA Payoff is the likely profit/loss that would accrue to a market participant with

change in the price of the underlying asset. This is generally depicted in the form

of payoff diagrams which show the price of the underlying asset on X-axis ant the

profits/loss on the Y-axis.

a.Payoff for futures Pay off for buyer of futures: long futures

The payoff for a person who buys a future contract is similar to the payoff

for a person who holds an asset. He has a potentially unlimited upside as well as a

potentially unlimited downside.

PROFIT

+500

-500

LOSS

The Figure shows the profits/losses for a long futures position. The investor

bought gold when gold futures were trading at Rs. 6000 per 10 gm. If the price of

the underlying gold goes up, the gold futures price too would go up and his future

5500 6000 6500 GOLD

0


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position starts making profits. If the price of gold falls, the futures price falls too

and his futures position starts showing losses.

Payoff for a seller of futures: short position.The payoff for a person who sells a future contract is similar to the payoff

for a person who sells an asset. He has a potentially unlimited upside as well as a

potentially unlimited downside.

PROFIT

+500

-500

LOSS

The figure shows the profits and losses for a short futures position. The

investor sold cotton futures at Rs. 6500 per quintal. If the price of the underlying

cotton goes down, the futures prices also fall, and the short position starts making

profits. If the price of the underlying cotton rises, the futures too rise, and the

short position starts showing losses.

6000 6500 7000


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b.Payoff for options Pay off for buyer of call option: long call

Call option give the buyer the right to buy the underlying asset at the strike

price specification in the option.

The figure shows the profits/loss for the buyer of a three month call option

on gold at a strike of Rs 7,000 per 10 gram, bought at premium of Rs 500.

PROFIT

500

LOSS

PAYOFF FOR SELLER (WRITER) OF CALL OPTIONS: SHORT CALLThe figure shows the profits/loss for the seller of a three month call option

on gold at a strike of Rs 7,000 per 10 gram, sold at premium of Rs 500.

PROFIT

500

7000

GOLD

LOSS

7000

GOLD

0


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Payoff for buyer of put options: long putThe figure shows the profit/loss for the buyer of a three month put option

on gold at a strike of Rs 7,000 per 10 gram, bought at premium of Rs 500.

PROFIT

500

LOSS

Payoff for a seller (writer) of put option: short putPROFIT

500

0

LOSS

GOLD

70000

7000

GOLD


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X. PARTICIPANTS IN COMMODITIES MARKETSFor a market to succeed/ it must have all three kinds of participants hedgers,

speculators and arbitragers. The confluence of these participants ensures liquidityand efficient price discovery on the market. Commodity markets give opportunity

for all three kinds of participants.

A. HEDGINGMany participants in the commodity futures market are hedgers. The use

the futures market to reduce a particular risk that they face. This risk might relate

to the price of wheat or oil or any other commodity that the person deals in. The

classic hedging example is that of wheat farmer who wants to hedge the risk of

fluctuations in the price of wheat around the time that his crop is ready for

harvesting. By selling his crop forward, he obtains a hedge by locking in to a

predetermined price. Hedging does not necessarily improve the financial

outcome; indeed, it could make the outcome worse. What it does however is

that it makes the outcome more certain. Hedgers could be government

institutions, private corporations like financial institutions, trading companies and

even other participants in the value chain, for instance farmers, extractors,

ginners, processors etc., who are influenced by the commodity prices.

B. SPECULATION

An entity having an opinion on the price movements of a given commodity

can speculate using the commodity market. While the basics of speculation apply

to any market, speculating in commodities is not as simple as speculating on

stocks in the financial market. For a speculator who thinks the shares of a given

company will rise. It is easy to buy the shares and hold them for whatever

duration he wants to. However, commodities are bulky products and come with

all the costs and procedures of handling these products. The commodities futures


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markets provide speculators with an easy mechanism to speculate on the price of

underlying commodities.

To trade commodity futures on the NCDEX, a customer must open a futures

trading account with a commodity derivatives broker. Buying futures simplyinvolves putting in the margin money. This enables futures traders to take a

position in the underlying commodity without having to actually hold that

commodity. With the purchase of futures contract on a commodity, the holder

essentially makes a legally binding promise or obligation to buy the underlying

security at some point in the future (the expiration date of the contract).

C. ARBITRAGEA central idea in modern economics is the law of one price. This states that

in a competitive market, if two assets are equivalent from the point of view of risk

and return, they should sell at the same price. If the price of the same asset 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. 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 swelling expensive continues till prices in the twomarkets reach equilibrium. Hence, arbitrage helps to equalize prices and restore

market efficiency.


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XI. REGULATORY ISSUES FOR COMMODITY FUTURESTRADING

i.

Government Policies on futures trading

arious government policies still hinder the growth of commodity

exchanges. Given the recognized need for India to have efficient exchanges in the

face of liberalization and globalization, FMC should take the lead in coordinating

with the responsible Ministries and other government entities a change of these

policies. This would not necessarily reduce the government's possibilities to

intervene in commodity markets, but would ensure that such intervention does

not hinder, or even critically damage, commodity futures markets.

A first issue is taxes. Different tax treatment of speculative gains and losses

discourage many speculators from participating in official futures exchanges,

thereby affecting the liquidity of the markets. Hedgers are affected as well: the

necessary link between futures and physical market transactions is too rigidly

defined. Tax issues need to be clarified so that futures losses can be offset against

profits on the underlying physical trade and vice versa.

A second problem is stamp duty. Stamp duties on trade in commodityfutures exchanges should be nil, except when physical delivery is made. Now,

stamp duty can be arbitrarily imposed by the state in which the futures exchange

is located. Clarification from the Indian states in which there are exchanges that

there will be no arbitrary position on stamp duty is recommended.

Third, many institutions (particularly financial institutions but also, in a less

direct manner, cooperatives) are not permitted to engage in commodity futures

trade. The rules which prevent such engagement need to be modified.

Finally, the role of government entities directly involved in commodity

trade should be reconsidered. The direct purchasing practices of these entities

now damage the potential of commodity exchanges. If a federal or state

government wishes to continue direct interventions in commodity markets, it

could, if it wished, pass through the commodity exchanges. This would ensure

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effective market intervention (the effect on prices will be immediate), and, as

long as done within clear policy guidelines, does not destroy market mechanisms.

ii. The forward contracts regulation Act.The forward contracts (regulation) Act, 1992, a central Act, governs

commodity derivatives trading in India, The Act defines various forms of contract.

The Act envisages a three-tier regulation.

Exchange: The exchange which organizes forward trading I regulatedcommodities can prepare its own Articles of Association, Rules and

Regulations, byelaws and regulate trading on a day to-day basis. FMC (Forward Markets Commission): The commission approves the rules

and byelaws of the exchange and provides a regulatory oversight. It also

acquires concurrent powers of regulation while approving the rules and

byelaws of by making such rules and byelaws under the delegated powers.

Central Government: Ministry of Consumer affairs and Public Distributionunder the Govt. of India is the ultimate regulatory authority. Only those

associations, which are granted recognition by the Government, are allowed

to organize forward trading in regulated commodities. Government has the

power to suspend trading, call for information, nominate directors of the

Exchange etc. Central Govt. has delegated most these powers to FMC.\

iii. Forward market commissionorward Markets Commission (FMC) headquartered at Mumbai, is a

regulatory authority which is overseen by the Ministry of Consumer Affairs and

Public Distribution, Govt. of India. It is a statutory body set up in 1953 under theForward Contracts (Regulation) Act, 1952.

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The functions of the Forward Markets Commission are as follows:

(a) To advise the Central Government in respect of the recognition or thewithdrawal of recognition from any association or in respect of any other matter

arising out of the administration of the Forward Contracts (Regulation) Act 1952.

(b) To keep forward markets under observation and to take such action inrelation to them, as it may consider necessary, in exercise of the powers assigned

to it by or under the Act.

(c) To collect and whenever the Commission thinks it necessary, to publishinformation regarding the trading conditions in respect of goods to which any of

the provisions of the act is made applicable, including information regarding

supply, demand and prices, and to submit to the Central Government, periodicalreports on the working of forward markets relating to such goods;

(d) To make recommendations generally with a view to improving theorganization and working of forward markets;

(e)To undertake the inspection of the accounts and other documents of anyrecognized association or registered association or any member of such

association whenever it considerers it necessary.

iv. Regulation for Brokers in commodity futures tradingBrokers should meet the following requirements:

Mandated capital adequacy. The regulators should seek to minimize any riskto investors and threat to the stability of the market from the failure of an

institution because it becomes unable to meet its liabilities. Currently, a

broker's membership at the exchange is solely dependent upon fulfilling the

financial requirements (in form of upfront payment or equity participation,

membership, admission fees etc.) levied by the different exchanges. There is a

need for mandated capital adequacy for brokers together with measures to

monitor that the capital is, in fact, maintained.


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Licensing: In India, there is no requirement of any form of licensing. A brokercan start trading once he fulfills the exchange requirements. There is no

educational requirement. It is advisable that anyone dealing in futures for

clients is registered. To be registered, one would need to:

Be a member/employee of an exchange Pass a character assessment e.g., no conviction of fraud. - Pass an

examination.

Advertising: The Conduct of Business Rules insists that adverting must befair and not misleading. Additionally, an investment advertisement must contain a

risk warning relating to the risks associated with the investments being

advertised. The unsolicited oral promotion of services or products, commonlyknown as cold calling, is also heavily regulated. Customer agreements. Before an

exchange member can operate on behalf of a customer a client agreement should

be in place. The exchange or the regulator may wish to define the minimum

acceptable content of such an agreement.

Suitability: A broker needs to check the capacities of his client beforeundertaking any agreement. Before opening any account for a customer the

broker must satisfy himself of the bona fide commercial need for the customer toopen the account. He must be satisfied that the customer s quality of

management, commodity experience and commodity business knowledge

together with their systems and staff will enable them to fulfill the obligations and

commitments they undertake when they sign the agreement. Such agreements

need to be reviewed regularly and the brokers will need to be sure that the

customers continue, at all times, to demonstrate that they are fit and proper

persons to be conducting derivatives business

project report on commodity markets

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