Introduction to Commodity Market What is “Commodity”? Any product that can be used for commerce or an article of commerce which is traded on an authorized commodity exchange is known 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. Indian Forward Contracts (Regulation) Act (FCRA), 1952 defines “goods” as “every kind of movable property other than actionable claims, money and securities”. “The term refers to a whole range of natural resources that are used to create the goods that people buy and the food they eat. ” Says Jeremy Baker, USB's Zurich-based head of Commodity Research'. A commodity may be defined as an article, a product or material that is bought and sold. It can be classified as every kind of movable property, except Actionable Claims, Money & Securities. Commodities actually offer immense potential to become a separate asset class for market-savvy investors, arbitrageurs and speculators.
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Introduction to Commodity Market
What is “Commodity”?
Any product that can be used for commerce or an article of commerce
which is traded on an authorized commodity exchange is known 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. Indian Forward Contracts (Regulation) Act (FCRA), 1952 defines “goods” as
“every kind of movable property other than actionable claims, money and securities”.
“The term refers to a whole range of natural resources that are used to create the
goods that people buy and the food they eat.” Says Jeremy Baker, USB's Zurich-
based head of Commodity Research'.
A commodity may be defined as an article, a product or material that is bought
and sold. It can be classified as every kind of movable property, except Actionable
Claims, Money & Securities. Commodities actually offer immense potential to become a
separate asset class for market-savvy investors, arbitrageurs and speculators.
Retail investors, who claim to understand the equity markets, may find commodities an
unfathomable market. But commodities are easy to understand as far as fundamentals
of demand and supply are concerned. Retail investors should understand the, risks and
advantages of trading in commodities futures before taking a leap. Historically, pricing in
commodities futures has been less volatile compared with equity and bonds, thus
providing an efficient portfolio diversification option.
What is a commodity Market?
Commodity market is a place where trading in commodities takes place.
Markets where raw or primary products are exchanged. These raw commodities are
traded on regulated commodities exchanges, in which they are bought and sold in
standardized Contracts. It is similar to an Equity market, but instead of buying or selling
shares one buys or sells commodities.
Commodity market is an important constituent of the financial markets of any
country. It is the market where a wide range of products, viz., precious metals, base
metals, crude oil, energy and soft commodities like palm oil, coffee etc. are traded. It is
important to develop a vibrant, active and liquid commodity market. This would help
investors hedge their commodity risk, take speculative positions in commodities and
exploit arbitrage opportunities in the market.
In fact, the size of the commodities markets in India is also quite significant. Of
the country's GDP of Rs 13, 20,730 crores (Rs 13,207.3 billion), commodities related
(and dependent) industries constitute about 58 per cent. Currently, the various
commodities across the country clock an annual turnover of Rs 1, 40,000 crores (Rs
1,400 billion). With the introduction of futures trading, the size of the commodities
market grows many folds here on.
In current situation, all goods and products of agricultural (including plantation),
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.
History of Evolution of commodity markets
Historically, dating from ancient Sumerian use of sheep or goats, or other
peoples using pigs, rare seashells, or other items as commodity money, people have
sought ways to standardize and trade contracts in the delivery of such items, to render
trade itself more smooth and predictable.
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 Japan merchants used to
store Rice in warehouses for future use. To raise cash warehouse holders sold receipts
against the stored rice. These were known as “rice tickets”.
Eventually, these rice tickets become accepted as a kind of commercial currency.
Latter on rules came in to being, to standardize the trading in rice tickets. In 19 th 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 to need 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. In this way producer was aware of what price he would fetch for his
produce and dealer would know about his cost involved, in advance.
This kind of as 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. In 1933, during the Great
Depression, the Commodity Exchange, Inc. was established in New York through the
merger of four small exchanges – the National Metal Exchange, the Rubber Exchange
of New York, the National Raw Silk Exchange, and the New York Hide Exchange.
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.
History of Commodity Futures
Commodities futures trading have evolved from the need for ensuring continuous
supply of seasonal agricultural crops. In Japan, merchants stored rice in warehouse for
future use. In order to raise case warehouse holders sold receipts against the stored
rice. These were known as rice tickets.
Eventually such rice tickets became accepted as a kind of general commercial
currency Rules came into being, to standardize the trading in rice tickets. The futures
contract, as we know it today, evolved as farmers (sellers) and dealers (buyers) began
to commit to future exchanges of grain for cash. For instance, the farmer would agree
with the dealer on a price to deliver to him 5,000 bushels of wheat at the end of June.
The bargain suited both parties. The farmer knew how much he would be paid for his
wheat, and the dealer knew his costs in advance. The two parties may have exchanged
a written contract to this effect and even a small amount of money representing a
"guarantee."
Such contracts became common and were even used as collateral for bank
loans. They also began to change hands before the delivery date. If the dealer decided
he didn't want the wheat, he would sell the contract to someone who did. Or, the farmer
who didn't want to deliver his wheat might pass his obligation on to another farmer. The
price would go up and down depending on what was happening in the wheat market. If
bad weather had come, the people who had contracted to sell wheat would hold more
valuable contracts because the supply would be lower; if the harvest were bigger than
expected, the seller's contract would become less valuable. It wasn't long before people
who had no intention of ever buying or selling wheat began trading the contracts. They
were speculators, hoping to buy low and sell high or sell high and buy low.
In the early 20th century, advanced communication & transportation, centralized
warehouses built in the principal markets, to distribute goods more economically, paved
the way to expanded interstate and international trade. Agricultural commodities were
the most commonly traded, but it led to the fact that a market can flourish for any
underlying a long as there is an active pool of buyers and sellers
The Indian Perspective
History of Commodity Market in India:-
The history of organized commodity derivatives in India goes back to the
nineteenth century when Cotton Trade Association started futures trading in 1875,
about a decade after they started in Chicago. Over the time datives 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).
However many feared that derivatives fuelled unnecessary speculation and
were detrimental to the healthy functioning of the market for the underlying
commodities, resulting in to banning of commodity options trading and cash settlement
of commodities futures after independence in 1952.
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 forward trades, 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 can regulate trading on day-to-day
basis; (ii) Forward Markets Commission provides regulatory oversight under the powers
delegated to it by the central Government. (iii) The Central Government- Department of
Consumer Affairs, Ministry of Consumer Affairs, Food and Public Distribution- is the
ultimate regulatory authority.
The commodities future market remained dismantled and remained
dormant for about four decades until the new millennium when the Government, in a
complete change in a policy, started actively encouraging commodity market. 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 goods and
registration of brokers with Forward Markets Commission.
The Government accepted most of these recommendations and futures’
trading was permitted in all recommended commodities. It is timely decision since
internationally the commodity cycle is on upswing and the next decade being touched
as the decade of Commodities. Commodity exchange in India plays an important role
where the prices of any commodity are not fixed, in an organized way. Earlier only the
buyer of produce and its seller in the market judged upon the prices. Others never had a
say.
Today, commodity exchanges are purely speculative in nature. Before
discovering the price, they reach to the producers, end-users, and even the retail
investors, at a grassroots level. It brings a price transparency and risk management in
the vital market. A big difference between a typical auction, where a single auctioneer
announces the bids and the Exchange is that people are not only competing to buy but
also to sell. By Exchange rules and by law, no one can bid under a higher bid, and no
one can offer to sell higher than someone else’s 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 of futures trading in commodities, which crossed
$ 1 trillion mark in 2006. Since 1952 till 2002 commodity datives market was virtually
non- existent, except some negligible activities on OTC basis.
In 2002-03, Prime Minister, Shri. A. B. Vajpayee, in his Independence Day
address to the nation on 15th August 2002, demonstrated its commitment to revive the
Indian agriculture sector and commodity futures markets. The GOI in that very year took
two steps that gave a fillip to the commodity markets. The first one was setting up of
nation wide multi commodity exchanges and the second one was expansion of list of
commodities permitted for trading under (FC(R) A).
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) Mumbai, Multi Commodity Exchange of India Limited (MCX) Mumbai and National Multi-
Commodity Exchange of India Limited (NMCEIL) Ahmedabad. There are other regional
commodity exchanges situated in different parts of India.
mmodity Markets – Key Characteristics
Nature of Commodities –
Commodities are real assets that are produced and consumed in an
industrial or other process. In contrast, other asset classes of interest rates,
currency or equity represent financial claims on different aspects of real assets.
This aspect of commodities ha a number of dimensions, including:
1. Consumption goods – commodities are primarily consumption goods
rather than investment products. This means that demand is not purely price
dependent. In addition, some commodities may display characteristics not
normally found in financial assets.
For example, zero or negative price may occur in electricity markets where
generators seek to ensure that their plants are dispatched for contiguous blocks
of time longer than a simple slot for which separate time bids are accepted. This
is driven by the desire of the generator to shed excess output as electricity
cannot be stored.
2. Non standard structure – commodities are generally not standardized.
This reflects the heterogeneous nature of commodity production in terms of
quality or grade. This contrasts with other financial assets that are homogenous.
This dictates that the commodity market has two layers.
The physical or cash market that trades a range of commodities of varying
quality, location and structure, and a commodity derivatives market that trades a
range of instruments on (artificially) standardized commodities. This is driven by
the need to facilitate trading. It creates basis risk in commodity derivatives.
3. Cost of production – commodity prices frequently gravitate towards
the cost of production. This is because the market will adjust over time. If prices
are significantly above or below the cost of production (including a "normal" profit
component), then supply will adjust in the longer term.
4. Price behavior – commodity prices display seasonality and may
change over different phases of the commodity life. Seasonal patterns in
consumption and production are manifested in recurring behavior of prices and
volatility. Forward prices of commodities will generally change as time to maturity
changes.
Commodity Markets – Participants
The structure of commodity markets dictates that there are several types
of participants active in the trading of commodities and commodity derivatives.
The structure of the participants and the nature of their activities/motivations are
more complex than in other asset classes.
The major participants in commodity markets include:
Commodity Producers/Consumers: These participants have natural
underlying outright long (producers) and short (consumers) positions in the
relevant commodity. The inherent risk-exposure drives the use of commodity
derivatives by producers and users.
The application of commodity derivatives in frequently driven by the
pattern of cash flows. Producers must generally make significant capital
investments (sometime significant in scale) to undertake the production of the
commodity. This investment must generally be made in advance of production
and sale of the commodity. This means that the producer is exposed to the price
fluctuations in the commodity.
If prices decline sharply, then revenues may be insufficient to cover the
cost of servicing the capital investment (including debt service). This means that
there is a natural tendency for producers to hedge at levels that ensure adequate
returns without seeking to optimize the potential returns from higher returns. This
may also be necessitated by the need to secure financing for the project.
Consumer hedging behavior is more complex. Consumer desire to
undertake hedges is influenced by availability of substitute products and the
ability to pass on higher input costs in its own product market. In many
commodities, producer and consumer deal directly with each other. The form of
arrangement may include negotiated bilateral long term supply or purchase
contracts between the producers and consumers. The contracts may include
fixed. Price arrangements to reduce the price risk for both parties.
These arrangements create a number of difficulties. These include lack of
transparency, low liquidity and exposure to counterparty credit risk. The bilateral
structure also creates potential adverse performance incentives. This reflects the
fact that the contracts combine supply/purchase obligations and price risk
elements in a single contract.
2. Commodity Processors: These participants have limited outright price
exposure. This reflects the fact the processors have a spread exposure to the
price differential between the cost of the input and the cost of the output. For
example, oil refiners are exposed to the differential between the price of the
crude oil and the price of the refined oil products (diesel, gasoline, heating oil,
aviation fuel, etc.). The nature of the exposure drives the types of hedging activity
and the instruments used.
3. Commodity Traders: Commodity markets have complex trading
arrangements. This may. include the involvement of trading companies (such as
the Japanese trading companies and specialized commodity traders). Where
involved, the traders act as an agent or principal to secure the sale/purchase of
the commodity. Traders increasingly seek to add value to pure trading
relationship by providing derivative/risk management expertise. Traders also
occasionally provide financing and other services. Commodity traders have
complex hedging requirements, depending on the nature of their activities.
A trader as a pure agent will generally have no price exposure. Where a
trader acts as a principal, it will generally have outright commodity price risk that
requires hedging. Where traders provide ancillary services such as commodity
derivatives as the principal, the market risk assumed will need to be hedged or
managed.
4. Financial Institution/Dealers: Dealer participation in commodity
markets is primarily as a provider of finance or provider of risk management
products. The dealers' role is similar to that in the derivative market in other asset
classes. The dealers provide credit enhancement, speed, immediacy of
execution and structural flexibility. Dealers frequently bundle risk management
products with other financial services such as provision of finance.
5. Investors: This covers financial investors seeking to invest in
commodities as a distinct and a separate asset class of financial investment. The
gradual recognition of commodities as a specific class of investment assets is an
important factor that has influenced the structure of commodity derivatives
markets.
Commodity Exchange Definition
A commodities exchange is an exchange where various commodities and derivatives
products are traded. Most commodity markets across the world trade in agricultural
products and other raw materials (like wheat, barley, sugar, maize, cotton, cocoa,
coffee, milk products, pork bellies, oil, metals, etc.) and contracts based on them. These
contracts can include spots, forwards, futures and options on futures. Other
sophisticated products may include interest rates, environmental instruments, swaps, or
ocean freight contracts.
C o m m o d i t y e x c h a n g e s a r e i n s t i t u t i o n s w h i c h p r o v i d e a p l a t f o r m f o r t r a d i n g i n
‘commodity futures’ just as how stock markets provide space for trading in equities and
their derivatives. They thus play a critical role in robust price discovery where several
buyers and sellers interact and determine the most efficient price for the product.
In India there are 21 regional exchanges and three national level multi-
commodity exchanges.
STRUCTURE OF COMMODITY MARKET IN INDIA
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:
(1) National Commodities & Derivatives Exchange Limited (NCDEX)
National Commodities & Derivatives Exchange Limited (NCDEX) promoted
by ICICI Bank Limited (ICICI Bank), Life Insurance Corporation of India (LIC), National
Bank of Agriculture and Rural Development (NABARD) and National Stock Exchange of
India Limited (NSC). Punjab National Bank (PNB), Credit Ratting Information Service of
India Limited (CRISIL), Indian Farmers Fertilizer Cooperative Limited (IFFCO), Canara
Bank and Goldman Sachs by subscribing to the equity shares have joined the
promoters as a share holder of exchange. NCDEX is the only Commodity Exchange in
the country promoted by national level institutions.
NCDEX is a public limited company incorporated on 23 April 2003.
NCDEX is a national level technology driven on line Commodity Exchange with an
independent Board of Directors and professionals not having any vested interest in
Commodity Markets.
It is committed to provide a world class commodity exchange platform for
market participants to trade in a wide spectrum of commodity derivatives driven by best
global practices, professionalism and transparency.
NCDEX is regulated by Forward Markets Commission (FMC). NCDEX is
also subjected to the various laws of land like the Companies Act, Stamp Act, Contracts
Act, Forward Contracts Regulation Act and various other legislations.
NCDEX is located in Mumbai and offers facilities to its members in more
than 550 centers through out India. NCDEX currently facilitates trading of 57
commodities.
Commodities Traded at NCDEX:- Bullion:- Gold KG, Silver, Brent