1 CONTENTS TOPIC PAGE 1 Evolution of commodity exchanges 3 Evolution of Commodity Exchanges Leading Commodity Exchanges Commodity exchanges in Developing Economies 3 4 5 2 Commodity exchanges in India 6 Evolution of Commodity Markets in India List of Commodity Exchanges in India List of commodities in which futures trading is permitted 6 6 9 3 Introduction to Derivatives 11 Traditional markets Emergence and growth of derivatives markets What are derivatives? Forward and Future contracts Forwards v/s Futures in a nutshell Swaps Options Options Glossary 11 12 12 13 17 18 19 22 4 Futures market functioning 24 Trading Placing the Order Methods of Trading Kinds of Orders Kinds of Margins Pricing of Futures Closing out the positions Clearing and Settlement Clearing House Functions of a clearing house Processes of a clearing house Proposed Systems and Regulations at NCDEX – Clearing house Settlement Methods Proposed Systems and Regulations at NCDEX – Accredited Warehouse, R&T Agents, Assayers Clearing and Settlement at NCDEX in a nutshell 24 24 24 25 27 28 30 31 31 31 32 33 34 37 41 5 Characteristics of commodity trading 44 Hedging Hedging Strategies Hedge Ratio 44 45 45
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1
CONTENTS
TOPIC PAGE
1 Evolution of commodity exchanges 3
Evolution of Commodity Exchanges
Leading Commodity Exchanges
Commodity exchanges in Developing Economies
3
4
5
2 Commodity exchanges in India 6
Evolution of Commodity Markets in India
List of Commodity Exchanges in India
List of commodities in which futures trading is permitted
6
6
9
3 Introduction to Derivatives 11
Traditional markets
Emergence and growth of derivatives markets
What are derivatives?
Forward and Future contracts
Forwards v/s Futures in a nutshell
Swaps
Options
Options Glossary
11
12
12
13
17
18
19
22
4 Futures market functioning 24
Trading
Placing the Order
Methods of Trading
Kinds of Orders
Kinds of Margins
Pricing of Futures
Closing out the positions
Clearing and Settlement
Clearing House
Functions of a clearing house
Processes of a clearing house
Proposed Systems and Regulations at NCDEX – Clearing
house
Settlement Methods
Proposed Systems and Regulations at NCDEX –
Accredited Warehouse, R&T Agents, Assayers
Clearing and Settlement at NCDEX in a nutshell
24
24
24
25
27
28
30
31
31
31
32
33
34
37
41
5 Characteristics of commodity trading 44
Hedging
Hedging Strategies
Hedge Ratio
44
45
45
2
Advantages of Hedging
Limitations of Hedging
Basis Risk
Speculation
Arbitrage
Cash and Carry Arbitrage
47
47
48
49
49
50
6 NCDEX and its functioning 51
Objectives
Promoters
Governance
Membership
Commodities Traded
Institutional Tie-Up
51
51
51
52
52
52
7 Regulatory provisions 54
Forward Contract (Regulation) Act
Forward Markets Commission (FMC)
Functions of FMC
Powers of The Commission
Regulatory measures of FMC
Securities Contracts (Regulation) Act
Agricultural Markets
Proposed rules and regulations of NCDEX
54
54
54
55
55
55
56
57
8 Sample Problems and Answers 64
Multiple Choices
Fill in the blanks
Problems
Answers
64
71
72
79
9 Frequently Asked Questions 81
10 Economic Benefits of Futures trading 93
11 Glossary of Futures Terms 94
3
1. EVOLUTION OF COMMODITY EXCHANGES
Most of the commodity exchanges, which exist today, have their origin in the late 19th and
earlier 20th century. The first central exchange was established in 1848 in Chicago under
the name Chicago Board Of Trade. The emergence of the derivatives markets as the
effective risk management tools in 1970s and 1980s has resulted in the rapid creation of
new commodity exchanges and expansion of the existing ones. At present, there are major
commodity exchanges all over the world dealing in different types of commodities.
Commodity Exchange
Commodity exchanges are defined as centers where futures trade is organized In a wider
sense, it is taken to include any organized market place where trade is routed through one
mechanism, allowing effective competition among buyers and among sellers - this would
include auction-type exchanges, but not wholesale markets, where trade is localized, but
effectively takes place through many non-related individual transactions between different
permutations of buyers and sellers.
Role of Commodity Exchanges
Exchanges can concentrate on the trade in futures and options contracts, or they could
primarily function as centers for facilitating physical trade. They act as a focal point for trade
transactions, and increase the security of these transactions.
Well-organized commodity exchanges form natural reference points for physical trade, and
in this way, they help the price discovery process. If a commodity exchange manages to link
different warehouses in the country, this allows trade to take place more efficiently.
Evolution of Commodity Exchanges
The creation of exchanges goes back to the late 19th century with the development of
national and international market places. The main rationale, was the reduction of transaction
costs, the major potential for it lying in organizing a physical market place, where buyers and
sellers could be sure of finding a ready market .
One of the factors that led to the creation of the Chicago Board of Trade, over a century old
and still one of the world's largest commodity exchanges, was that farmers coming to Chicago
at times found no buyers, and had to dump their cereals unsold in Lake Michigan, adjoining the
city. These ―old‖ exchanges are located mainly in developed countries. However, a few were
created in developing countries, too. The Buenos Aires Grain Exchange in Argentina, founded in
1854, is one of the oldest in the world.
We're now seeing the onset of a new phase in the evolution of commodity exchanges, driven
by technology. Established traditional exchanges seem convinced that the Internet is
providing them with unprecedented opportunities. This is equally true for commodity
exchanges in developing countries - Technology has made it possible for them to offer new
products at a lower cost. They now need to grasp these possibilities.
4
Some of the leading commodity exchanges across the globe are:
North and South America
United States Of America Chicago Board of Trade (CBOT)
Chicago Mercantile Exchange
Minneapolis Grain Exchange
New York Cotton Exchange
New York Mercantile Exchange
Kansas Board of Trade
New York Board of Trade
Canada
The Winnipeg Commodity Exchange
Brazil
Brazilian Futures Exchange
Commodities and Futures Exchange
Asia/Pacific
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
Kansai Agricultural Commodities Exchange
Tokyo Grain Exchange
Malaysia Kuala Lumpur commodity Exchange
New Zealand New Zealand Futures & Options Exchange
Ltd.
Singapore Singapore Commodity Exchange Ltd.
Europe
France
Le Nouveau Marche
MATIF
Italy Italian Derivatives Market
Netherlands
Amsterdam Exchanges
Option Traders Combination
Russia
The Russian Exchange
MICEX/Relis Online
St. Petersburg Futures Exchange
Spain
The Spanish Options Exchange
Citrus Fruit and Commodity Futures Market
of Valencia
United Kingdom
The London International Financial Futures
and Options Exchange
The London Metal Exchange
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Commodity Exchanges in Developing Economies
Africa
Africa`s most active and important commodity exchange is the South African Futures
Exchange (SAFEX). It was informally launched in 1987. SAFEX only traded financial
futures and gold futures for a long time, but the creation of the Agricultural Markets
Division (as of 2002, the Agricultural Derivatives Division) led to the introduction of a range
of agricultural futures contracts for commodities, in which trade was liberalized, namely,
white and yellow maize, bread milling wheat and sunflower seeds.
Maize contracts are also traded on new exchanges in Zambia and Zimbabwe. Farmers
established the Zimbabwe Agricultural Commodity Exchange (ZIMACE) in 1994, in response
to the gradual liberalization of state-controlled agricultural marketing.
Asia
China’s first commodity exchange was established in 1990 and at least forty had appeared
by 1993. The main commodities traded were agricultural staples such as wheat, corn and in
particularly soybeans.
In late 1994, more than half of China's exchanges were closed down or reverted to being
wholesale markets, while only 15 restructured exchanges received formal government
approval. At the beginning of 1999, the China Securities Regulatory Committee began a
nationwide consolidation process which resulted in three commodity exchanges emerging;
the Dalian Commodity Exchange (DCE), the Zhengzhou Commodity Exchange and the
Shanghai futures Exchange, formed in 1999 after the merger of three exchanges: Shanghai
Metal, Commodity, Cereals & Oils Exchanges.
The Taiwan Futures Exchange was launched in 1998
Malaysia and Singapore have active commodity futures exchanges. Malaysia hosts one
futures and options exchange. Singapore is home to the Singapore Exchange (SGX), which
was formed in 1999 by the merger of two well-established exchanges, the Stock Exchange
of Singapore (SES) and Singapore International Monetary Exchange (SIMEX).
Latin America
Latin America’s largest commodity exchange is the Bolsa de Mercadorias & Futuros, (BM&F)
in Brazil. Although this exchange was only created in 1985, it was the 8th largest exchange
by 2001, with 98 million contracts traded.
There are also many other commodity exchanges operating in Brazil, spread throughout the
country. They trade largely in commodities for immediate or forward delivery, but through
an electronic network (which links most of the country’s exchanges) they also make it
possible to trade in futures contracts.
Argentina’s futures market Mercado a Termino de Buenos Aires, founded in 1909, ranks as
the world’s 51st largest exchange.
Mexico has only recently introduced a futures exchange to its markets. The Mercado
Mexicano de Derivados (Mexder) was launched in 1998.
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2. COMMODITY EXCHANGES IN INDIA
EVOLUTION OF COMMODITY DERIVATIVE MARKETS IN INDIA
First organized futures market evolved in India by setting up of Bombay Cotton Trade
Association Ltd. in 1875.
Bombay Cotton Exchange Ltd. was established in 1893 following the widespread
discontent amongst leading cotton mill owners and merchants over the functioning of
Bombay Cotton Trade Association.
The Futures trading in oilseeds started in 1900 with the establishment of the Gujarati
Vyapari Mandali which carried on futures trading in groundnut, castor seed and cotton.
Futures trading in wheat was existent at several places in Punjab and Uttar Pradesh. But
out of all the most notable futures exchange for wheat was chamber of commerce at
Hapur set up in 1913.
Futures trading in bullion began in Mumbai in 1920.
Calcutta Hessian Exchange Ltd. was established in 1919 for Futures trading in rawjute
and jute goods. But organized futures trading in raw jute began only in 1927 with the
establishment of East Indian Jute Association Ltd. These two associations amalgamated
in 1945 to form the East India Jute & Hessian Ltd. to conduct organized trading in both
Raw Jute and Jute goods.
Enactment of Forward Contracts (Regulation) Act, 1952
Establishment of the Forwards Markets Commission (FMC) in 1953 under the Ministry
of Consumer Affairs and Public Distribution.
In due course several other exchanges were created in the country to trade in diverse
commodities.
COMMODITY EXCHANGES IN INDIA
A comprehensive list of the registered commodity exchanges in India is given below:
S.No. EXCHANGE PRODUCTS TRADED
1 Bhatinda Om & Oil Exchange Ltd. Bhatinda. Gur
2 The Bombay Commodity Exchange Ltd.
Mumbai
Sunflower Oil
cotton (seed and oil)
Safflower (Seed, Oil and Oil cake)
Groundnut (Nuts and Oil)
Castor oil-Int'l
Castorseed
Sesamum (oil and Oilcake)
Rice Bran, Rice Bran Oil and Oilcake
Crude Palm Oil
3 The Rajkot Seeds oil & Bullion Merchants
Association Ltd.
Groundnut Oil
Castorseed
8
Rajkot
4 The Kanpur Commodity Exchange Ltd, Kanpur
Rapeseed/Mustardseed
Rapeseed/Mustardseed Oil
Rapeseed/Mustardseed oil-Cake
5 The Meerut Agro Commodities Exchange Co.
Ltd., Meerut.
Gur
6 The Spices and Oilseeds Exchange Ltd.
Sangli, Maharashtra.
Turmeric
7 Ahmedabad Commodity Exchange Ltd. cottonseed
Castorseed
8 Vijay Beopar Chamber Ltd., Muzaffarnagar Gur
9 India Pepper & Spice Trade Association.
Kochi
Pepper
10 Rajdhani Oils and Oilseeds Exchange Ltd.
Delhi
Gur
Rapeseed/Mustardseed
Sugar Grade - M
11 National Board of Trade.
Indore.
Rapeseed/Mustard seed/Oil/Cake
Soybean/Meal/Oil
Crude Palm Oil
12 The Chamber Of Commerce.
Hapur
Gur
Rapeseed/Mustardseed
13 The East India Cotton Association Mumbai Indian Cotton
14 The Central India Commercial Exchange Ltd.
Gwaliar
Gur
15 The East India Jute & Hessian Exchange
Ltd.,
Kolkata.
Hessian
Sacking
16 First Commodity Exchange of India Ltd.
Kochi
Copra
Coconut oil
Copra cake
17 Bikaner Commodity Exchange Ltd.
Bikaner
No commodity is traded at present
18 The Coffee Futures Exchange India Ltd.
Bangalore.
Coffee
9
19 E sugarindia Limited.
Mumbai
Sugar
20 National Multi Commodity Exchange of India
Limited.
Ahmedabad
Gur
RBD Pamolein
Crude Palm Oil
Sunflower (Seed and Oil)
Rapeseed/Mustardseed (seed, oil and
oilcake)
Soy bean (Beans, oil and oilcake)
Copra
Cotton (Seed, oil and oilcake)
Safflower (seed, oil and oilcake)
Groundnut (Nuts, oil and oilcake)
Sugar
Sacking
Coconut (oil and oilcake)
Castor (seed, oil and oilcake)
Sesamum (Seed, Oil and oilcake)
Linseed (seed, oil and oilcake)
Rice Bran Oil
Pepper
Guarseed
Gram
Aluminium Ingots
Nickel
Vanaspati
Rubber
Copper
Zinc
Lead
Tin
10
COMMODITIES IN WHICH FUTURES TRADING IS PERMITTED
Govt. of India has the ultimate powers to decide the commodities in which futures trading
can be allowed. At present forward trading is allowed in the following commodities in India.
Commodity Group Products
Fibers and Manufacturers Kapas,
Hessian
Indian Cotton
Staple Fiber Yarn
Sacking
Gram
Spices Pepper
Turmeric
Edible Oilseeds and Oil RBD Pamolein
Rapeseed/Mustard (seed, oil and cake)
Soy bean (beans, meal, oil and cake)
Copra
Cotton (seed, oil and cake)
Groundnut (nuts, oil and cake)
Castor oil-Int'l
Coconut (oil and cake)
Copra cake
Cottonseed oil
Sesamum (seeds, oil and cake)
Safflower (seed, oil and cake)
Rice Bran, Rice Bran Oil and cake
Sunflower (Seed, oil)
Crude Palm Oil
Vanaspati
Linseed (seed, oil and cake)
Others Gur
Potato
Sugar
Sugar Grade – M
Sugar Grade - S
Coffee-Robusta Cherry AB
Raw Coffee Arabica Parchment
Raw Coffee Robusta Cherry
Coffee
Coffee-Plantation A.
Coffee-Robusta Cherry AB.
Raw Coffee Robusta Cherry.
Raw Coffee Arabica parchment
Rubber
Metals Aluminium Ingots
11
Nickel
Copper
Zinc
Lead
Tin
Gold
Silver
12
3. INTRODUCTION TO DERIVATIVES
TRADITIONAL MARKETS
Traditional markets are the Cash and Carry markets. They are also called Spot markets. The
contract is called a Spot contract. A spot contract is an agreement where the seller agrees
to deliver an asset and a buyer agrees to pay for that asset ―on the spot‖. They are used in
all forms of business to transfer title to goods.
The advantage with the traditional markets is that the buyer can find the precise
commodity that suits him, pay the money and become the owner of the merchandise
immediately. However, transactions in traditional markets are inherently high-risk. The
following example is illustrative of this drawback of traditional markets.
Example: Company X has Poultry feed business and sells the feed in the retail market under
their own brand name.
The prices in the retail market fluctuate less and vary according to the competitor prices.
The raw material for the poultry feed consists of Soy meal, Maize, wheat bran and brokens,
oilcakes, etc. The prices of the raw materials vary according to the supply-demand situation
of the commodities like Soybean, Maize, Wheat etc. The production of these commodities is
in turn largely dependent on the vagaries of the monsoon.
The raw materials approximately constitute 70% of the cost of manufacturing the feed.
The profit margins at current price levels are 10% of the sales of the feed
The Company, in June (for example) needs to plan the buying of raw materials in the month
of December to manufacture the feed. In June the company anticipates the raw material
prices in December to be more or less similar as in the previous year.
However, in the month of December it finds that the cost of the raw materials have
increased by 20% from the previous year because of a bad monsoon resulting in fall in
production and the consequent supply shortage. The increase in raw material prices resulted
in increased cost of manufacturing of the feed and decreased profit margins for the
company.
This above example illustrates the need for a system, which can minimize the risk in the
traditional markets and protect the buyers and sellers from the unexpected price
fluctuations.
The Disadvantages of the traditional markets can thus be summed as follows:
Price uncertainty which makes it difficult to predict the market accurately
Lack of effective mechanism to eliminate the price risk which arises due to demand and
supply variations and uncertainties in the economic and market conditions
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EMERGENCE AND GROWTH OF DERIVATIVES MARKETS
Derivatives have emerged out of spot contracts as an effective risk management tool.
There are evidences indicating that futures trading existed in Japan and China even in the
17th century.
In the mid 1800’s Chicago was developing as a commercial center. Wheat farmers and
traders across the country used to assemble in Chicago to sell and buy wheat. There was a
heavy supply of wheat, but poor methods of grading and weighing almost left the farmers at
the mercy of the traders. As a result of this a central exchange was established in 1848 for
farmers and traders to deal in spot markets. Soon after this with the increase in trade,
farmers and traders started entering into forward contracts at a predetermined price to
minimize the risk. The first forward contract was recorded at CBOT (Chicago Board Of
Trade) in March 1851 for Maize corn to be delivered in June of that year. At that time the
forward contracts created confusion for the users as they were traded privately and were
not standardized. As a result of this, CBOT formalized grain trading by developing
standardized agreements called futures contracts in 1865.
For the next hundred years the derivatives segment grew steadily, but were still small
compared to spot markets. During the post 1970’s derivatives started growing exponentially
in the USA. The key economic and technological factors that drove this growth were:
Breakdown of the Bretton woods system of fixed exchange rates in 1971 (Bretton
woods System- US dollar is the anchor of this system and the dollar was pegged to
gold. It was convertible to gold at the rate of $35 to an ounce. The currencies of all
other nations were pegged to US dollar, which could be revalued or devalued when
necessary. With the breakdown of this system, dollar was no longer convertible to
gold, which resulted in inflation and currency turmoil).
Oil price shocks in 1973
Excess government spending and high inflation in USA in 1970’s
Exponential increase in the magnitude of world trade, capital flows and progressive
dismantling of tariff barriers.
Technological innovations like advancements in communication and information
technologies enabled effective implementation of derivatives
Implementation of financial innovations including 24 hours global trading and online
risk management systems.
WHAT ARE DERIVATIVES?
A derivative is a financial instrument whose value depends on the value of the underlying
variables. There are broadly 4 types of derivatives:
Forwards: A forward contract is a bilateral agreement in which the buyer and the seller
agree upon the delivery of a specified quality and quantity of an asset on a specified
future date at a price agreed today. These are not traded on the exchanges.
14
Futures: Future contracts are exchange-traded contracts to sell or buy financial
instruments or physical commodities for future delivery at an agreed upon price.
MEANING :WHICH PRICE EITHER SPOT OR……
Swaps: The word ―Swap‖ literally means an exchange. A Swap may be defined as a
contract whereby two parties (known as counter parties), exchange two different
streams of cash flows over a definite period of time, usually through an intermediary
like a financial institution. The nature of the exchange flows to be exchanged is defined
in the contract.
Options: An option is an agreement between two parties-one of whom is the buyer and
the other is the seller. An option gives the holder or buyer of the option the right but
not the obligation, to buy or sell an asset at a known fixed price at a given point in the
future. The seller in turn has the obligation (and not the right) to sell the asset to the
buyer. For assuming this obligation the seller charges a premium called Option premium
from the buyer.
In less than three decades of their coming into vogue, derivatives markets have become
part of the day-to-day life in trading for ordinary people in most parts of the world.
FORWARD AND FUTURE CONTRACTS
Forward Contracts
A forward contract is traded in the Over the Counter Market, usually between two financial
institutions or between a financial institution and client. One of the parties assumes a long
position and agrees to buy the underlying asset on a certain specified future date for a
certain specified price. The other party assumes a short position and agrees to sell the
asset on the same date for the same price. The price in a forward contract is known as the
delivery price.
Future Contracts
Future contracts have evolved out of forward contracts and are exchange-traded versions
of forward contracts. In futures contract there is an agreement to buy or sell a specified
quantity of financial instrument/ commodity in a designated future month at a price agreed
upon by the buyer and seller. The contracts have certain standardized specifications with
the date and time of expiry of the contract.
Types of Future Contracts:
The common underlying for which the futures are construed, are:
Commodity Futures: Futures in which the underlying asset is a commodity. It can be
agricultural commodity like wheat, corn, soybeans, perishable commodities like pork or
even precious assets like gold, silver etc.
Financial futures: Futures in which the underlying assets are financial instruments like
money market paper, notes, bonds. Currency futures on major convertible currencies
like the US Dollar, Pound, Euro or Yen. Security futures such as single stock futures and
stock index futures.
15
Index Futures: The underlying asset is an Index. Most, of these contracts are for stock
indices. The more famous indices on which futures are traded are Standard and Poor
Composite 500,The New York Stock Exchange Index.
Long and Short Positions in a Forward/ Futures contract
Long Position
The party, who buys the contract, is considered, as assuming a long position in the
market with the expectation that price will go up. If the market goes down the party
with the long position tends to lose money.
The payoff from a long position in a forward contract for one unit of an asset is St – K.
(Where, St is the spot price of the asset at the time of the maturity of the contract
and K is the delivery price)
Short Position
The party, who sells the contract, assumes a short position. Going short is selling off
expecting the price to go down. At the time of the maturity if the delivery price is
higher than the spot price the seller makes profit. If the delivery price is less than the
spot price at the time of maturity of the contract the seller incurs a loss.
The payoff from a short position in a forward contract for one unit of an asset is K – St.
K is the delivery price and St is the spot price of the asset at the time of the maturity
of the contract.
Figure: Pay-off in Forward contracts
Forward contracts have linear/symmetric pay-off profiles, highlighting the fact that both
the buyer and the seller of these products have equal rights and obligations. Consequently,
the buyer pays no compensation to the seller, upfront. The pay-offs to the buyer and seller
are a linear function of the price of the underlying.
Profit
Loss
Seller’s Pay-
off
Buyer’s Pay
-off
Spot price (St)
of the
commodity at
the time of
the maturity
Delivery
Price (k)
16
K is the delivery price of the contract (the price at which the underlying commodity or
security moves from the seller to the buyer) and St is the spot price of the commodity at
the maturity of the contract. This is because the holder of the contract is obligated to buy
an asset worth St for K.
17
Forward and Futures contract
i) Characteristics
Forward Contracts Future Contracts
Forward contracts are OTC (Over the
Counter) contracts.
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 has to be settled by
delivery of the asset on expiration date.
In case, the party wishes to reverse the
contract, it has to compulsorily go to the
same counter party.
Futures are essentially exchange traded.
Futures contracts are standardized in
terms of its various characteristics like
quantity, quality, settlement dates and
market conventions etc., for the easy and
convenient access by a large number of
market participants.
It is a price fixing contract. The
buyer/seller is obligated to take/give
delivery or closeout the positions at the
pre agreed price for the purpose of
settlement.
In futures market actual delivery of goods
takes place only in a very few cases.
Transactions are mostly squared up before
the due date and are settled by payment
of differences without any physical
delivery of goods taking place.
ii) Determining Prices
Forward Contracts Future Contracts
In principle the forward price for an asset would
be equal to the spot or the cash price at the time
of the transaction and the cost of carry. The cost
of carry includes all the costs incurred for
carrying the asset forward in time. Depending
upon the type of asset or commodity the cost of
carry takes into account factors including
payments and receipts for storage, transport
costs, interest payments, dividend receipts,
capital appreciation etc.
Forward Price = Spot or the cash price + Cost of
Carry
Price discovery mechanism is similar.
18
iii) Functions of the markets
Forward Markets Future Markets
Forward contract is a simple agreement to buy
or sell an asset at a certain future time for a
certain price. Since, the forward contract is
traded in over the counter market and not in
an exchange the market/exchange has no role
to play in a forward transaction.
Futures markets perform certain important
economic functions. They meet the needs of
three groups of future market users.
1.Those who wish to discover information
about the future prices of commodities.
2.Those who wish to speculate
3.Those who wish to hedge
iv) Advantages
Forward Markets Future Markets
Forward contract has no
margin system. This means
the cost of entering into a
transaction for both the
buyer and the seller is zero.
Absence of credit risk. At any point of time the maximum
credit risk is limited to one-day movement in futures
prices.
High Liquidity: Futures market gives the participants the
option to come out of their positions at any time they
want.
High leverage: Futures are highly leveraged instruments,
which attracts large number of market participants who
ensure high liquidity at all times.
Price stabilization: In times of violent price fluctuations,
the futures mechanism enables to reduce the price
fluctuations
v) Limitations
Forward Markets Future Markets
The contracts are private and are negotiated
bilaterally between the parties. Therefore,
there are no exchange guarantees.
The prices are not transparent, as there is no
reporting requirement.
The profit or loss is realized only on the
maturity date.
Settlement is only through actual delivery or
offsetting by cash delivery. Closing out is not
possible.
Futures are not versatile for
hedging strategies due to
standardization of commodities.
This limitation is overcome by
―options‖
Exact hedge is not possible.
Futures contracts cannot be
tailored to the particular needs of
firms and financial institutions.
19
FORWARDS VS FUTURES IN A NUTSHELL
Particulars Forward Contracts Future Contracts
Trading Traded on a private basis
and bilaterally negotiated
Traded on the floor of an
exchange through open
outcry or electronically
Nature Forward contracts are
customized by the two
counter parties as per their
requirements.
Future contracts are
exchange traded
standardized contracts.
Process Private and negotiated
bilaterally between the
parties with no exchange
guarantees
Transaction takes place
through a clearing house
which provides protection
for both the parties
Margin Requirements Involves no margin Requires a margin to be
paid
Liquidity Less liquid as the contract
prices are not transparent
and there is no reporting
requirement
More liquid as their prices
are transparent due to
standardization and market
reporting of volumes and
price
Settlement By actual delivery or offset
with cash settlement. A
forward contract can be
reversed only
Usually by closing out
through offsetting of
positions.
Credit risk Credit risk is substantial as
the contracts are not bound
by strict rules and
regulations
Credit risk is largely
eliminated by the use of
margins (initial, additional,
mark to market margins
etc.)
A typical futures price quotation will look like: (example taken from National Stock
The first line of the table: Corn (CBT) 5,000 bu; cents per bu This indicates that the
table applies to the Chicago Board of Trade (CBT) corn contract, the contract size is
5,000 bushels, and the prices shown in the table are in units of cents per bushel.
Opening Price: The open or opening price is the price or range of prices for the day’s
first trades, registered during the period designated as the opening of the market or
the opening call.
Closing price: The closing price is the price or range of prices at which the commodity
futures contracts are traded during the brief period designated as the market close or
on the closing call (i.e. last minute of the trading day).
Highest price: The word high refers to the highest price at which a commodity futures
contract is traded during the day.
Lowest price: Low refers to the lowest price at which a commodity futures contract is
traded during the day.
Settlement Price: This is abbreviated as settle in most of the pricing tables. There will
be many trades occurring in the last few minutes. Settlement price is computed from
the range of closing prices. Settlement price is important to calculate the daily gains,
losses and margin requirements. It is used by the clearing house to calculate the market
value of outstanding positions held by its members.
Change: The change refers to the change in settlement prices from the previous day’s
close to the current day’s close.
Lifetime high and low: They refer to the highest and lowest prices recorded for each
contract from the first day it traded to the present.
Open interest: It refers to the number of outstanding contracts for each maturity
month.
In the line at the bottom of the table, Est. vol. indicates the estimated volume of
trading for that day. Vol. Wed. indicates the trading volume for the previous day. Open
Int. refers to the total open interest for all contract months combined at the end of
the day’s trading session. Then the figure +987 indicates an increase of 987 contracts
from the open interest of the previous day.
Price Charts:
The price movements on any particular day can be shown in Bar charts, in the following
manner.
CLOSE
HIGH
OPEN
LOW
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Closing price is considered as the most important price for that day’s transaction as it
indicates the trend in the market i.e. either bullish (bulls expects the prices to go up) or
bearish (bears expect the prices to go down)
Patterns of Futures Prices:
As the maturity date approaches the futures prices show different patterns. Based on
these patterns the markets can be predicted
Normal Markets: Markets where the prices increase as the time to maturity increases.
Inverted markets: Markets where the price is a decreasing function of the time to
maturity.
Convergence of futures price to spot price:
As the delivery month of a future contract approaches the futures prices converges to the
spot price of the underlying asset. When the delivery period is reached the futures price
equals or is very close to the spot price. This happens because if the futures price is above
the spot price during the delivery period it gives rise to a clear arbitrage opportunity for
traders. In case of such arbitrage the trader can short his futures contract, buy the asset
from the spot market and make the delivery. This will lead to a profit equal to the
difference between the futures price and spot price. As traders start exploiting this
arbitrage opportunity the demand for the contract will increase and futures prices will fall
leading to the convergence of the future price with the spot price. If the futures price is
below the spot price during the delivery period all parties interested in buying the asset will
take a long position. The trader would buy the contract and sell the asset in the spot market
making a profit equal to the difference between the future price and the spot price. As
more traders take a long position the demand for the particular asset would increase and
the futures price would rise nullifying the arbitrage opportunity
f) Closing out the Positions
The futures contracts are squared-off before the delivery date. Most of the traders
choose to closeout their positions prior to the delivery period specified in the contract.
Closing out means taking opposite positions of trade from the original one.
Continuing from Example 1: The Mumbai investor who bought the December soybean futures
on September 2, 2003 can close out the position by selling (i.e. going short) one December
futures contract on any date before the agreed upon delivery date. The Indore investor
who sold the Soybean futures can closeout by buying one December contract at any time
before the Delivery date. The investor’s total gain or loss is determined by the change in
the futures prices between the date of entering in to the contract and date of closing out
the contract.
33
CLEARING AND SETTLEMENT
INTRODUCTION
Most of the futures contracts do not lead to the actual physical delivery of the underlying
asset. The settlement is by closing out, physical delivery or cash settlement. All these
settlement functions are taken care of by an exchange-clearing house, called clearing
house/ corporation, in futures transactions.
Clearing House
A clearing house is a system by which exchanges guarantee the faithful compliance of all
trade commitments undertaken on the trading floor or electronically over the electronic
trading systems. The main task of the clearing house is to keep track of all the transactions
that take place during a day so that the net position of each of its members can be
calculated. It guarantees the performance of the parties to each transaction. It is
responsible for
Effecting timely settlement
Trade registration and follow up
Control of the evolution of open interest
Financial clearing of the payment flow
Physical settlement (by delivery) or financial settlement (by price difference) of
contracts
Administration of financial guarantees demanded by the participants.
Functions of clearing house
Clearing house has a number of members, who are mostly financial institutions responsible
for the clearing and settlement of commodities traded on the exchanges. The margin
accounts for the clearing house members are adjusted for gains and losses at the end of
each day (in the same way as the individual traders keep margin accounts with the broker).
In the case of clearing house members only the original margin is required (and not
maintenance margin). Everyday the account balance for each contract must be maintained at
an amount equal to the original margin times the number of contracts outstanding. Thus
depending on a day’s transactions and price movement the members either need to add
funds or can withdraw funds from their margin accounts at the end of the day. The brokers
who are not the clearing members need to maintain a margin account with the clearing house
member through whom they trade in the clearing house.
34
Checking Members
Trading Report-
Statement of
commitments
Trading Room
Price information-
Commitments information
Computer Processing
Clearing Section-Report on
Margins In-out
Output
Input
Statement of Margins
Margin Required-
Margin Deposited
Statement of Account for
Daily Settlement
Daily clearing account (Mark
to Market)
• Exchange Trading
fee
• Exchange Tax
• Liability Reserve
• Special Security
Fund
Payment Margin required
or refundable
Amount to be paid or received
Margin required is to be paid by cash or
substitutable securities. Margin Refundable is
to be returned on request
To be made through account
transfer at the contracted bank by
noon of 2 business days after the
date of the statement
Processes of a clearing house
(The narrative above describes the general functions of a clearing house. NCDEX has only trading cum clearing members and Professional Clearing members. The specific differences are highlighted in NCDEX manual on rules and regulations)
35
Proposed Systems and Regulations at NCDEX
CLEARING AND SETTLEMENT PROCESS
CLEARING HOUSE
REGULATION OF CLEARING HOUSE
NCDEX shall prescribe the process from time to time for the functioning and operations of
the Clearing House and to regulate the functioning and operations of the Clearing House for
the settlement of non-depository deals.
EXCHANGE TO MAINTAIN CLEARING HOUSE
The Exchange shall maintain a Clearing House, which shall function as per the instructions,
and supervision of the Exchange. The Clearing House shall act as the common agent of the
members for clearing contracts between members and for delivering commodities to and
receiving commodities from members in connection with any of the contracts and to do all
things necessary or proper for carrying out the foregoing purposes.
CLEARING HOUSE TO DELIVER COMMODITIES AT DISCRETION
The Clearing House is entitled at its discretion to deliver commodities, which it has received
from a member under these Regulations to another member who is entitled under these
Regulations to receive delivery of commodities of a like kind or to instruct a member to give
direct delivery of commodities which he has to deliver.
NO LIEN ON CONSTITUENT’S COMMODITIES
When a member is declared a defaulter neither the Exchange nor the creditors of the
defaulter shall be entitled to any lien on the commodities delivered by him to the Clearing
House on account of his Constituents.
CLEARING CODE AND FORMS
A member shall be allotted a Clearing Code, which must appear on all forms used by the
member connected with the operation of the Clearing House. The Clearing Forms and
Formats to be used by the members shall be as prescribed by the Clearing House.
SIGNING OF CLEARING FORMS
The member or his Clearing Assistant shall sign all Clearing Forms.
SPECIMEN SIGNATURES
A member shall file with the Clearing House specimens of his own signature and of the
signatures of his Clearing Assistants. The member and his Authorized Representative in the
presence of an officer of the Exchange or of the Clearing House shall sign the specimen
signature card.
PROVISIONS REGARDING MEMBERS OF THE CLEARING HOUSE
CLEARANCE BY MEMBERS ONLY
Clearing Members including Professional Clearing Members only shall be entitled to clear and
settle contracts through the Clearing House.
CHARGES FOR CLEARING
36
The Exchange shall from time to time prescribe the scale of clearing charges for the
clearance and settlement of transactions through the Clearing House.
CLEARING HOUSE BILLS
The Clearing House shall periodically render bills for the charges, fees, fines and other
dues payable by members to the Exchange which would also include the charges for the use
of the property as well as the charges, fines and other dues payable on account of the
business cleared and settled through the Clearing House and debit the amount payable by
members to their accounts. All such bills shall be paid within a week of the date on which
they are rendered.
LIABILITY OF THE CLEARING HOUSE
The only obligation of the Clearing House shall be to facilitate the delivery and payment in
respect of commodities, transfer deed and any other documents between members.
Settlement Methods
A contract can be settled in three ways
By physical delivery of the underlying asset
Closing out by offsetting positions
Cash settlement.
Closing out
Most of the contracts are settled by closing out. In closing out, the opposite transaction is
effected to close out the original futures position. A buy contract is closed out by a sale
and a sale contract is closed out by a buy.
Cash settlement
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.
At NCDEX
After the trading hours on the expiry date, based on the available information, the
matching for deliveries would take place firstly, on the basis of locations and then randomly
keeping in view the factors such as available capacity of the vault/warehouse, commodities
already deposited and dematerialized and offered for delivery and any other factor as may
be specified by the Exchange from time to time. Matching done by aforesaid process shall
be binding on the Clearing Members. After completion of the matching process, Clearing
Members would be informed of the deliverable / receivable positions and the unmatched
positions. Unmatched positions shall have to be settled in cash. The cash settlement would
be only for the incremental gain / loss as determined on the basis of Final Settlement Price.
Physical Delivery
When a contract comes to settlement, the exchange provides alternatives like delivery
place, month and quality specifications.
37
Trading period, Delivery date etc. are all defined as per settlement calendar
Member is bound to give Delivery information. If he fails to give information, it is
Closed out with Penalty as decided by the Exchange
Member can choose for an alternative mode of Settlement by providing Counter
party Clearing Member and Constituent. The Exchange will not be responsible for or
guarantee settlement for such deals.
Settlement Price is calculated and notified by the Exchange
The delivery place is very important for commodities with significant transportation costs.
The exchange also specifies the precise period (date and time) during which the delivery
can be made. For many commodities the delivery period may be an entire month. The party
in the short position (seller) gets the chance to make choices from these alternatives. The
Exchange collects ―delivery information‖. The price paid is normally the most recent
settlement price (with a possible adjustment for the quality of the asset and the delivery
location). Then the exchange selects a party with an outstanding long position to accept
delivery.
At NCDEX
As and when the Buyers intend to take physical delivery of the commodities, held by them
in their respective Demat accounts, they would make such requests to their respective
depository participant (DP) with whom they hold the Demat account. The DP will upload
such requests to the specified Depository who will in turn forward the same to the R&T
Agent concerned. After due verification of the authenticity, the R&T Agent will forward
delivery details to the warehouse who in turn will arrange to release the commodities after
due verification of the identity of recipient.
NCDEX contracts provide a standardized description for each commodity. The description
is given in terms of quality parameters specific to the commodities. At the same time, it is
realized that with commodities, there could be some amount of variances in quality/ weight
etc, due to natural causes, which are beyond the control of any person. Hence, NCDEX
contracts also provide tolerance limits for variances.
A delivery will be treated as good delivery and accepted if the delivery comes within the
tolerance limits. However, to allow for the difference, the concept of premium and discount
has been introduced. The goods that come to the authorized warehouse for delivery would
be tested and graded as per the prescribed parameters. The premium and discount rates
would apply depending on the level of variation. The price payable by the party taking
delivery would then be adjusted as per the premium/ discount rates fixed by the Exchange.
This ensures that some amount of leeway is given for delivery, but at the same time, the
buyer taking delivery does not face windfall loss/ gain due to the quantity/ quality variation
at the time of taking delivery. This, to some extent, mitigates the difficulty in delivering
and receiving exact quality/ quantity of commodity.
An example of a contract specification at NCDEX is provided below:
Contracts: Soyabean
Trading system NCDEX Trading System
Trading hours Monday to Friday 10:00 am to 4:00 pm
Unit of trading 10 Quintal (=1 MT)
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Quotation/Base Value Rs per Quintal
Tick size Re 0.05
Delivery unit 100 Quintal (=10 MT)
Quantity variation +/- 2%
Quality specification
Moisture: 10% Max
Sand/Silica: 2% Max
Damaged: 2% Max
Green Seed: 7% Max
Delivery center Indore
No. of active contracts 3 concurrent month contracts
Opening of contracts
Trading in any contract month will open on the 21st
day of the month, 3 months prior to the contract
month i.e. December 2003 contract opens on 21st
September 2003
Due date 20th day of the delivery month, if 20th happens to
be a holiday then previous working day
Closing of contract All open positions will be settled as per general and
product specific regulations
Price band
Limit 10% or as specified by Exchange from time to
time. Limits will not apply if the limit is reached
during final 30 minutes of trading
Position limits
Member-wise: Max (Rs. 40 crore, 15% of open
interest)
Client-wise: Max (Rs. 20 crore, 10% of open
interest)
39
Proposed Systems and Regulations at NCDEX pertaining to Accredited
warehouse, Registrar and Transfer Agent and Assayer
ACCREDITED WAREHOUSE
The Exchange shall specify accredited warehouse(s) through which delivery of a specific
commodity shall be effected and which shall facilitate for storage of commodities.
PROCESS AND PROCEDURES FOR ACCREDITED WAREHOUSE
The Exchange shall specify from time to time the processes, procedures, and operations
that every accredited Warehouse, Constituents, Depository Participants and R & T Agents
shall be required to follow for the participation, functioning and operations of the
accredited warehouse.
FUNCTIONS OF ACCREDITED WAREHOUSE
(a) Earmark separate storage area as specified by the Exchange for the purpose of storing
commodities to be delivered against deals made on the Exchange. The Warehouse(s)
shall also meet the specifications prescribed by the Exchange for storage of
commodities.
(b) Ensure and co-ordinate for grading of the commodities received at the Warehouse
before they are being stored.
(c) Store commodities in line with their grade specifications and validity period and shall
facilitate maintenance of identity. On expiry of such validity period of the grade for
such commodities, the Warehouse(s) shall segregate such commodities and store them
in a separate area so that the same are not mixed with commodities which are within
the validity period as per the grade certificate issued by the approved Assayers
DUTIES OF ACCREDITED WAREHOUSE
(a) Shall use uniform and standard description of commodities and units of measurement in
respect of the commodities stored pertaining to the Constituent of the Exchange.
(b) Shall strictly adhere to the Warehousing norms stipulated for a commodity in particular
or group of commodities in general by the Exchange.
(c) Shall ensure that necessary steps and precautions are taken to ensure that the quantity
and the grade of the commodity are maintained during the storage period.
(d) Shall maintain the records for the commodities deposited with it by the Constituents, in
electronic form in the manner and in the system as prescribed by specified Depository.
Warehouse(s) shall avail the services of a Registrar & Transfer (R&T) agent approved
and appointed by the Exchange for the above purpose. The Warehouse shall facilitate
the uploading of instructions by the R&T agent using the system connected to the
depository for the creation of electronic records of the Commodities received by the
Warehouse in the Depository Clearing System. The Warehouse shall execute and
complete necessary documentation with the R&T agent and the Depository in this
regard.
40
(e) Unless and until expressly consented by the Exchange, the Warehouse shall not assign,
shift, transfer and relocate the commodities held by it pertaining to the Constituents
of the Exchange. The Warehouse(s), however, is/are entitled to move the commodities
within the area earmarked in the warehouse for storing the commodities pertaining to
the Constituents of the Exchange.
VERIFICATION OF COMMODITIES STORED IN WAREHOUSE
The Exchange will verify itself or through any agencies / experts, at any time, the
commodities deposited by the Constituents and/or warehouse facilities in general or for
compliance of the warehousing norms stipulated by the Exchange for the specific
commodities.
RELEASE OF COMMODITIES STORED IN WAREHOUSE
As and when the Buyers intend to take physical delivery of the commodities, held by them
in their respective Demat accounts, they would make such requests to their respective
depository participant (DP) with whom they hold the Demat account. The DP will upload
such requests to the specified Depository who will in turn forward the same to the R&T
Agent concerned. After due verification of the authenticity, the R&T Agent will forward
delivery details to the warehouse who in turn will arrange to release the commodities after
due verification of the identity of recipient.
CHARGES FOR WAREHOUSE SERVICES
Warehouse(s) shall charge from the Constituents of the Exchange, storage and other
charges as may be mutually agreed in advance between the Exchange and Warehouse(s)
from time to time. For the purpose of operational convenience, the DPs who will be opening
the Demat account for the Constituents will arrange to collect the storage charges from
them and pay the same to the Warehouse at agreed periodic intervals. The Warehouse(s) is
entitled to levy all incidental charges such as insurance; assaying, handling charges or any
such charges directly from the Constituent depositing the commodities as may be
applicable. The Exchange shall not be responsible in any manner for payment of any of the
charges of Warehouse.
The Exchange may also explore the possibility of availing the services of Collateral
Management Agent (CMA), who can offer the warehousing facilities for the Constituents of
the Exchange. In such a case the Constituents shall be required to shift their holdings in
the warehouses approved / identified by such CMA.
REGISTRAR AND TRANSFER AGENT(R&T AGENT)
APPROVED R&T AGENT
The Exchange shall specify Approved R&T Agent(s) through which commodities shall be
dematerialized and which shall facilitate for dematerialization / re-materialization of
commodities in the manner as prescribed by the Exchange from time to time.
PROCESS AND PROCEDURES FOR R&T AGENT
The Exchange shall specify from time to time the processes, procedures, and operations
that every accredited warehouse, Depository Participants and Constituents shall be
required to follow for the participation, functioning and operations of the R&T Agent. The
41
Regulations relating to the R&T Agent shall be deemed to form a part of any settlement
process so provided.
FUNCTIONS OF R&T AGENT
(a) Establish connectivity with approved warehouse(s) and support them with physical
infrastructure.
(b) Verify the information regarding the commodities accepted by the accredited
warehouse and assign the identification number (ISIN) allotted by the Depository in
line with the grade/validity period.
(c) Further process the information, and ensure the credit of commodity holding to the
Demat account of the Constituent.
(d) Ensure that the credit of commodities goes only to the Demat account of the
Constituents held with the Exchange empanelled DPs
(e) On receiving request for Re-materialization (physical delivery) through the depository,
R&T Agent(s) shall arrange for issuance of authorization to the relevant warehouse for
the delivery of commodities.
MAINTENANCE OF RECORDS AND CO-ORDINATION ACTIVITIES
R&T Agent(s) shall maintain proper records of beneficiary position of Constituents holding
dematerialized commodities in Warehouse(s) and in the Depository for a period and also as
on a particular date. R&T Agent(s) shall furnish the same to the Exchange as and when
demanded by the Exchange.
R&T Agent(s) shall also co-ordinate with DPs and Warehouse(s) for billing of charges for
services rendered on periodic intervals.
R&T Agent(s) shall also reconcile Dematerialized commodities in the Depository and Physical
commodities at the Warehouse(s) on periodic basis and co-ordinate with all parties
concerned for the same.
ASSAYER
APPROVED ASSAYER
The Exchange shall specify Approved Assayer(s) through which grading of commodities
received at approved warehouse(s) for delivery against deals made on the Exchange can be
availed by the Constituents of Clearing Members.
PROCESS AND PROCEDURES FOR ASSAYER
The Exchange shall specify from time to time the processes, procedures, and operations
that every Warehouse, Constituents and R&T Agent shall be required to follow for the
participation, functioning and operations of the Assayer. The Regulations relating to the
approved Assayer shall be deemed to form a part of any settlement process so provided.
FUNCTIONS OF ASSAYERS
(a) Inspect the Warehouse(s) identified by the Exchange on periodic basis to verify the
compliance of technical / safety parameters detailed in the Warehousing Accreditation
42
norms of the Exchange by the Warehouse(s). The compliance certificate so given by the
Assayer would form the basis of Warehouse accreditation by the Exchange.
(b) Make available grading facilities to the Constituents in respect of the specific
commodities traded on the Exchange at specified warehouse. The Assayer shall ensure
that the grading to be done, in a certificate format prescribed by the Exchange from
time to time, in respect of specific commodity shall be as per the norms specified by
the Exchange in the respective Contract specifications
(c) Grading certificate so issued by the Assayer would specify the grade as well as the
validity period up to which the commodities would retain the original grade, and the time
up to which the commodities are fit for trading subject to environment changes at the
warehouses.
DUTIES OF ASSAYER(S)
(a) The issuance of the certificate of compliance by the Assayer would imply that in the
event of deterioration of quality of the commodity before the expiry of the validity
period assigned by the Assayer, the Assayer would make good the losses that may be
incurred. However, the Exchange shall not liable for any losses arising out of such cases.
(b) Assayer(s) shall not allow to store any commodity that does not meet the grading norms
and parameters specified by the Exchange and that the Assayer(s) shall make available
to the Constituents the grading certificate when the commodities are allowed to be
stored in the warehouses.
(c) Assayer(s) shall ensure that it shall at all given times maintain properly records in
respect of grading of specific commodities and validity period of the commodity in
electronic form along with the details with regard to the certificate issued by them
from time to time.
INSPECTION OF GRADING FACILITIES
The Exchange reserves the right to physically verify / inspect itself or through any
agencies / experts, at any time, the grading facilities and processes of the approved
Assayers as and when felt necessary.
43
CLEARING AND SETTLEMENT AT NCDEX IN A NUTSHELL
NCDEX has tied-up with NSCCL for clearing the trades
Settlement guarantee fund would be maintained and managed by NCDEX.
Contracts settlement
All open contracts not intended for delivery and non-deliverable positions at client level
would be cash settled.
Settlement period
All contracts settling in cash would be settled on the following day after the contract
expiry date. All contracts materializing into deliveries would settle in a period of 2-7 days
after the expiry. The exact settlement day would be specified for each commodity.
Are deliveries compulsory?
No. The buyer and the seller have to give delivery information. Deliveries would be matched
randomly at client level. Contracts not assigned delivery would be settled in cash
Would additional margins be levied for deliverable positions?
Yes
Settlement in commodity futures market
For open positions on the expiry day of the contract, the buyer and the seller can give
intentions for delivery. Deliveries would take place in electronic form. All other positions
would be settled in cash.
Taking physical delivery
Any buyer intending to take physicals would have to put a request to its Depository
Participant, who would pass on the same to the registrar and the warehouse. On a specified
day, the buyer would go to the warehouse and pick up the physicals.
Getting the electronic balance for the physical holdings
The seller intending to make delivery would have to take the commodities to the designated
warehouse. These commodities would have to be assayed by the Exchange specified assayer.
The commodities would have to meet the contract specifications with allowed variances. If
the commodities meet the specifications, the warehouse would accept them. Warehouses
would then ensure updating the receipt in the depository system giving a credit in the
depositor's electronic account.
Seller giving an invoice to the buyer
The seller would give the invoice to its clearing member, who would courier, the same to the
buyer's clearing member.
Accrediting warehouses
NCDEX would prescribe the accreditation norms, comprising of financial and technical
parameters, which would have to be met by the warehouses. NCDEX would take
assayer's/Structural Engineer's certificate confirming the compliance of the technical
norms by the warehouses.
Whether the accredited warehouses would be dedicated warehouses?
In case of grains/seeds, warehouses would earmark a definite storage capacity within the
warehouse premises for members of NCDEX, while in case of oils, specified tankers would
be earmarked for NCDEX participants.
Warehousing charges
The warehouse concerned would decide the warehousing charges. However, the warehouse
charges would be made available on NCDEX website
Health checks and inventory verification
44
The assayers and or other experts on behalf of NCDEX would carry out surprise health
checks and inventory verification.
Sales tax
Prices quoted for the futures contracts would be basis warehouse and exclusive of sales tax
applicable at the delivery center. For contracts materializing into deliveries, sales tax would
be added to the settlement amount. The sales tax would be settled on the specified day
after the payout.
How would the buyer give a declaration for re-sale in case of last point collection of
tax?
The buyer intending to take delivery would give declaration for re-sale at the time of giving
intention for delivery. Accordingly the seller would issue the invoice, exclusive of sales tax.
The declaration form duly signed by the buyer would be forwarded through the buyer's
clearing member to the seller's clearing member within a specified time after pay-in and
payout.
Uniformity in delivered grades / varieties
The exchange will specify, in its contract description, the particular grade / variety of a
commodity that is being offered for trade. A range will be specified for all the properties
and only those grades / varieties, which fall within the range, will be accepted for delivery.
In case the properties fall within the range, but differ from the benchmark specifications,
the Exchange will specify a premium / rebate
Premium / rebates for the difference in quality
These would be pre-defined and made available on the website. The settlement obligation
would be impacted on account of the premium / rebates in case of deliverable positions. The
parameters which would be considered for premium / rebate computation as well as the
methodology would be specified by NCDEX
Certifying / assaying agencies.
NCDEX is looking at following assayers: SGS India Pvt. Limited, Geo-Chem Laboratories, Dr.
Amin Superintendents & Surveyors Pvt Ltd., Calib Brett and Stewart. Only certificates
given by specified assayers by NCDEX will be accepted. All the certificates issued will have
time validity
What happens when the commodities reach the validity date?
Those commodities will not be available for delivery on the clearing corporation. Hence the
deliverable electronic balance would be automatically reduced. Warehouse would place the
commodities in a separate area, indicating that they are not available for electronic trading.
Would commodities be accepted without assayer's certificate?
No
Can commodities be re-deposited in the warehouse after the validity period of the
assayer's certificate?
Yes, provided they are re-validated by the assayer.
Transaction charges
Rs.6/- per Rs100,000/-, i.e. 0.006% of the trade value.
Procedure for handling bad delivery / part delivery?
Partial delivery as well as bad delivery would be considered as default. Penalties would be
levied.
How would disputes be resolved?
Any disputes in regard to the quality / quantity will be referred to the Arbitration
45
committee set up for the purpose.
Clearing bankers
Following banks have agreed to act as clearing bankers:
Canara Bank
HDFC Bank
ICICI Bank
UTI Bank
Depository participants
NCDEX has approached
Bank of Baroda
Canara Bank
Global Trust Bank
HDFC Bank
ICICI Bank
IDBI Bank
Indusind Bank
UTI Bank
46
5. CHARACTERISTICS OF COMMODITY TRADING
Commodity trading gives opportunity to the traders for investment and risk management
through different strategies like hedging, speculation and arbitrage. In this section these
aspects have been discussed for a futures market. Most of those who participate in the
futures or options markets can be categorized broadly into one of two groups — hedgers
and speculators — depending on whether they are trying to transfer or accept risk. Brokers
are intermediaries who carry out buying and selling instructions from hedgers or
speculators.
Hedgers
Hedgers are market participants who want to transfer risk. They can be producers or
consumers. A producer hedger wants to transfer the risk that prices will decline by the
time a sale is made. A consumer hedger wants to transfer the risk that prices will increase
before a purchase is made.
Speculators
Speculators include investors and traders who want to profit from price changes. They
accept the price risks and rewards that hedgers wish to avoid. Speculators try to make
money by buying futures contracts at a low price and selling back at a higher price or selling
high and buying back lower. They take on the risk of an adverse price direction and its
effect on their account. Speculators provide risk capital and depth to the market place and
make it possible for hedgers to use the futures market to reduce risk (They don’t do this,
intentionally. They are in the market for profits, but the nature of the market is such that
they become de-facto risk capital providers).
Buyers and sellers of the actual commodities use the futures market as a form of risk management. They use futures to protect themselves against adverse price changes. Speculators accept the price risks and rewards that hedgers wish to avoid. Speculators include investors and traders who want to profit from price changes.
A. HEDGING
Commodity trading involves sizable price risks (due to volatile prices in the cash markets),
which may affect the value of the underlying commodity. Hedging is a strategy used in the
futures markets to protect one’s asset from adverse price changes and minimize risks.
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.
Example:
A company orders a commodity at a price of USD 300 per tonne. The commodity will be
delivered after 8 weeks to the receiving port. If the price, during the period, increases to
USD 310 per tonne, the company would have made a gain. However, if the price falls to USD
280 per tonne, the company would incur a loss. The company hedges its position by taking a
put option on the same commodity at say, USD 300 per tonne for the same date. If the
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price indeed falls to USD 280, the company exercises its option and offsets its losses (The
company buys an equivalent amount in the spot market and gains USD 20 per tonne. This
offsets the losses due to fall in price during the delivery period). If the prices, on the
other hand go up to say, USD 310 per tonne, the company will choose not to exercise the
option and will lose only the premium. The option premium is thus an insurance against losses.
A company that wants to sell an asset at a particular time in the future can hedge by taking
short futures position. This is known as futures hedge. If the price of the asset goes down,
the company does not fare well on the sale of the asset but makes a gain on the short
futures position. If the price of the asset goes up, the company gains from the sale of the
asset but takes a loss on the futures position. Similarly, a company that knows that it is due
to buy an asset in the futures can hedge by taking long futures position. This is known as
long hedge
Example:
A poultry farmer’s objective is to raise and sell broiler birds at a price that would give him
the most profit. His risk is declining broiler prices. To offset (minimize) this risk, he could
sell futures contracts. If broiler prices fall, he could then buy back the futures contracts
at a price lower than he previously sold them. The subsequent gain on this futures
transaction would help offset his cash loss, thus minimizing his risk. (In this case, if he sold
futures and prices rose, he would lose money on the futures transaction, but gain on the
spot transaction).
Whereas the broiler farmer is the futures seller in this example, the futures buyer could
be a risk taker — a speculator who thinks that broiler prices are going to rise, or a
commercial user — such as a poultry processor, who needs broiler birds and would be
adversely affected by higher prices. A speculator is willing to accept risk in hopes of
generating a profit. The commercial user is using futures to offset the risk of possible
higher bird prices.
Hedging strategies
The hedging strategies are short and long. A hedger takes a closed position where he has an
asset and liability on the same maturity date.
Selling Hedge (Short) – Selling futures contracts to protect against possible declining
prices of commodities that will be sold in the future. At the time the cash commodities are
sold, the open futures position is closed by purchasing an ―equal number and type‖ of
futures contracts as those that were initially sold.
Example. If a company knows that it is due to sell an asset at a particular time in the
future, it hedges by taking a short futures position. If the price of the asset goes down the
sale results in a loss to the company but it makes a gain on the short futures market. If the
price of the asset goes up the company gains from the sale of the asset but makes a loss on
the short futures position.
Purchasing (Long) Hedge – Buying futures contracts to protect against a possible increase in
the price of cash commodities that will be purchased in the future. At the time the physical
commodities are bought, the open futures position is closed by selling an ―equal number and
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type‖ of futures contracts as those that were initially purchased. This is also referred to as
a buying hedge.
Hedge Ratio
The Hedge Ratio is defined as the ratio of the size of the position taken in futures contract
to the size of the exposure.
Let,
S be the change in spot price, S during the life of the hedge
F be the change in futures price, P during the life of the hedge
S be the standard deviation of S
F be the standard deviation of F
be the coefficient of correlation between S and F
h be the hedge ratio
When the hedger is long on the assets and short on futures (short hedge), the change in
value of the hedger’s position during the life of the hedge is
S - h F
For a long hedge, it is h F - S
The variance, V, of the change in the value of hedged position is given by
V = (S)2 + (h)2 (F)2 - 2 h S) (F)
The variance is minimized when
h = (S/ F)
If these two are perfectly correlated, ie., = 1, h = (S/ F)
When the futures price mirrors the spot price perfectly, S = F and h = 1.0
Example:
A company will buy 100,000 tons of soy-bean in three months. The standard deviation of the
change in price per ton over a three- month period has been calculated as 0.072. The
company hedges by buying futures contracts. The standard deviation of the change in
futures price is 0.08 over a three-month period. The coefficient of correlation between the
three month change in spot prices and futures prices is 0.9. The optimal hedge ratio will be
h = 0.9 x 0.072/ 0.08 = 0.81
If one futures contract is for 1000 tons, the company needs to buy
0.81 x 100,000/ 1000 = 81 contracts
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Advantages of hedging
Hedging stretches the marketing period.
Example: A livestock feeder does not have to wait until his cattle are ready to market
before he can sell them. The futures market permits him to sell futures contracts to
establish the approximate sale price at any time between the time he buys his calves for
feeding and the time the fed cattle are ready to market, some four to six months later.
He can take advantage of good prices even though the cattle are not ready for market.
Hedging protects inventory values.
Example.: A merchandiser with a large, unsold inventory can sell futures contracts that
will protect the value of the inventory, even if the price of the commodity drops.
Hedging permits forward pricing of products.
Example.: A jewelry manufacturer can determine the cost for gold, silver or platinum by
buying a futures contract, translate that to a price for the finished products, and make
forward sales to stores at firm prices. Having made the forward sales, the
manufacturer can use its capital to acquire only as much gold, silver, or platinum as may
be needed to make the products that will fill its orders.
Limitations of hedging
Hedging-using futures does not work perfectly in practice. The limitations are
Hedging can only minimize the risk but cannot fully eliminate it. For Example. The
loss made during selling of an asset is not equal to the profits made by going short.
This is because the underlying value of the asset and the future contract vary
The hedge may require the futures contract to be closed out well before its
expiration date
Hedge ratio, h
h*
Variance of
position
Dependence of variance of hedger’s position on hedge ratio
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Limitation also exists that the underlying hedged product and the contract
specification might not be exactly the same grade
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Roll Over
Hedges can be rolled forward. When the expiration date of the hedge is later than the
delivery dates of the future contracts, the hedger closes out the futures contracts
entered into and takes the same position in futures contracts with a later delivery date.
Hedges can be rolled forward many times. However, multiple rollovers could lead to short-
term cash flow problems.
Basis Risk
The limitations of hedging give rise to basis risk. The basis in a hedging situation is defined
as the difference between the current cash price and the futures price of the same
commodity. Unless otherwise specified, the price of the nearby futures contract month is
used to calculate the basis.
Basis = Spot price of asset to be hedged less futures price of contract
When the spot price increases by more than the futures price, the basis increases which is
referred to as strengthening of the basis. When the futures price increases by more than
the spot price the basis declines. This is referred as weakening of the basis.
Example of Hedging
A farmer intends to plant 10 acres of Soybean in June and is willing to forward sell 50 per
cent of his anticipated production before planting (expected yield is 400 kgs/acre and
estimated total production is 4 tons). Only a portion of the expected crop is hedged due to
production uncertainty. Delivery is expected in mid-September. The farmer estimates basis
to be Rs. 25/tonne under the November contract price in mid-September. The farmer
places an order to sell 2 November futures contracts (2 tonnes) on June 15. This is
referred to as a forward pricing hedge.
The farmer delivers and sells the harvested soybean crop on September 15. Also on
September 15, the farmer buys back the 2 November soybean futures contracts at the
current price of Rs.14,250/tonne, offsetting his/her position in the futures market.
Date Market Price November Futures Basis
June 15 implied Rs.14,000/t Rs. 14,025/t anticipated Rs.25/tonne
Forward Price Hedge: Soybean seed
Date Action Cash Position Futures Position Basis
June 15 Plant Soybean
Sell 50% of
expected
Production on
Nov. futures
Expect 4 tons
production.
Hedge 2 tons at
expected
price of Rs. 14,000/t
(Rs.14,025-basis
Rs.25/t)
Sell 2 November
Futures contract @
Rs. 14,025/t
anticipated
Rs.25/t
September Sell cash
Soybean seed
Sell 2 tons Buy 2 November
soybean
Rs. 25/t
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15 Offset
futures
position
@Rs.13,700/t @ Rs.13,725/t
Gains/losses Loss: Rs.300/t
(relative to
expectation)
Gain: Rs.300/t no change
Final Outcome:
The net price received on the 4 tonnes of Soybean hedged is Rs.14,000/t. (Rs.13,700/ton
from the cash sale plus a Rs. 300/ton gain on the futures position).
If all 4 tonnes of production are sold on September 15, the average price for the total crop
is Rs.13,850/t. (average of Rs.14,000/t for the hedged portion and Rs.13,700/t for the un-
hedged portion).
B. SPECULATION
The price of any commodity in the market is a function of the demand and supply. If
supplies fall short prices tend to increase and vice versa. Often the estimation of demand
and supply is the major challenge faced by the market. The traders who speculate are called
Speculators. Speculation is the process of buying or selling something now based on
anticipations of future price changes. Speculators buy (or sell) futures at a time when its
price is low (or high) and sell later (or buy) when the price is higher (or lower). Speculators
are risk takers and they add liquidity and capital to the futures markets. If the price
changes are temporary, speculation reduces fluctuations, reduces risk and enhances
efficiency. The main objective of speculators is to make profit in the trade and not to
minimize risk unlike Hedgers
Positions
Speculators take open positions- i.e. they will have either an asset or liability.
Long position: Buy futures, expecting higher futures price at later date
Short Position: Sell futures, expecting lower futures price at later date.
C. ARBITRAGE
Arbitrage is the process of buying something at a place where its price is low and selling it
where its price is high. Arbitragers try to profit from differencein prices of identical goods
in different locations.
Example: The shares of a particular stock are trading at Rs.410 and Rs 420 in Ahmedabad
and Mumbai stock exchanges simultaneously. An arbitrager will purchase the scrip in
Ahmedabad and sell it in Mumbai to generate a riskless profit of Rs 10 per share.
In arbitrage as both the trades are done simultaneously there is no investment. But in an
efficient market, arbitrage opportunities would not exist. Even though they exist they
cannot last long as arbitrage itself reduces the price differentials. As arbitrageurs start
buying goods from the low price locations it raises the prices of goods and as they sell the
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scrip in a high price location it lowers the price of goods thereby nullifying any arbitrage
opportunities.
In reality, if such arbitrage opportunities do exist (at first glance), the prospective
arbitrageur would do well to check the hidden transaction costs. In most cases he would
find that such hidden costs nullify the apparent arbitrage opportunity.
Cost-of-carry
This is the cost to carry a storable good forward in time. The carrying charges are of four
basic kinds
Cost of warehousing
Cost of insurance
Transportation costs (moving the goods from origin to the appropriate destination
for delivery).
Financing cost
Cash and carry arbitrage
A trader can buy goods for cash and carry it through to the expiration of the futures
contract. Let us see an example to understand this:
Example
Spot price of gold per 10 gms – Rs 5,100/-
Future price of gold per 10 gms (for delivery in one year) – Rs 5,500/-
Interest rate per annum – 6.5%
The trader borrows Rs 5,100 for 1 year at 6.5%. He buys 10 gms of gold in the spot market
for Rs 5,100 and sells a futures contract for delivery one year hence.
At the end of 1 year, he delivers 10 gms of gold against the futures and realizes Rs 5,500/-.
He also repays the loan of Rs 5,100/- and the interest amount of Rs 331/- (total Rs 5431/-).
Thus, he gets a total profit of Rs 69/-
In the above example, we have assumed that there is only financing charge applicable. When
attempting arbitrage at significant volumes of goods, the trader would have to worry about
storage costs and insurance. The arbitrage opportunity may still exist. However, as
discussed earlier, the market would react to changes in interest rates, insurance premiums
and storage costs and the gaps would close very quickly.
Reverse cash and carry arbitrage
This happens when the spot price is too high. In the above example, let us suppose that the
spot price was Rs 5,200/- instead of Rs 5,100/-.
The trader would now sell 10 gms of gold short, lend Rs 5,200/- for 1 year and buy one gold
future for delivery of 10 gms one year hence.
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At the end of 1 year, he collects the proceeds from the loan (Rs 5,200/- + interest Rs
338/-), accepts delivery on the futures contract of 10 gms gold (pays out Rs 5,500/-) and
uses the gold from futures delivery to repay the short sale. He thus profits by Rs 38/-
In the end the market ensures that the future price equals the spot price and the cost of
carry to close out the arbitrage opportunities.
6. NCDEX AND ITS FUNCTIONING
National Commodity and Derivatives Exchange Ltd. (NCDEX) is a public limited company
registered under the Companies Act, 1956 with the Registrar of Companies, Maharashtra in
Mumbai on April 23,2003.
A. OBJECTIVES OF NCDEX
To create a world class commodity exchange platform for the market participants.
To bring professionalism and transparency in to the commodity trading.
To inculcate international best practices like demutualisation, technology platforms, low
cost solutions and information dissemination without noise etc. into our trade.
To provide nation wide reach and consistent offering.
To bring together the names that market can trust.
B. PROMOTERS
NCDEX is promoted by a consortium of Institutions. They are
ICICI Limited
Life Insurance Corporation of India (LIC)
National Bank for agriculture and Rural Development (NABARD)
National Stock Exchange of India Ltd. (NSE)
The consortium brings to the table:
Institution building expertise
Commitment to the Agricultural sector
Nationwide reach
Ability to bring in capital
Technology and risk management skills.
C. GOVERNANCE
Board of Directors
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NCDEX is run by an independent Board of Directors. Promoters do not participate in the
day to day activities of the Exchange.
The directors are appointed in accordance with the provisions of the Articles ofAssociation
of the company.
The board is responsible for managing and regulating all the operations of the exchange and
commodities transactions.
It formulates the rules and regulations related to the operations of the exchange.
Board appoints Executive committee and other committees for the purpose of managing
activities of the exchange.
Executive Committee
The executive committee consists of Managing Director of the exchange who would be
acting as the Chief Executive of the Exchange, and also other members appointed by the
board.
Other Committees
Apart from the executive committee the board has constitute committee like Membership