SALMAN.doc

7/29/2019 SALMAN.doc

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1

A

PROJECT REPORT

ON

STUDY OF COMMODITY MARKET

For

Marwadi Shares & Finance Ltd.

SUBMITTED TO PUNE UNIVERSITY

IN PARTIAL FULFILLMENT OF 2 YEARS FULL TIME COURSE

MANAGEMENT OF BUSINESS ADMINISTRATION

(MBA)

Submitted By:

ROHIT PARMAR

(Batch 2006-08)

Guided By:-

Prof. MAHESH HALALE

BRACTs

Vishwakarma Institute of Management,

Kondhwa Pune- 411014 2

ACKNOWLEDGEMENT

It is great pleasure for me to acknowledge the kind of help and guidance

received to

me during my project work. I was fortunate enough to get support from a large

number of

people to whom I shall always remain grateful.

I would like to express my sincere gratitude to Mr. Pratik Tanna and Mr. Ravi

Tandon

for giving me this opportunity to undergo this lucrative project with Marvadi

Finance Pvt.


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Ltd. and also for their great guidance and advice on this project, without which I

will not be

able to complete this project.

I am very thankful to our Director Sir Dr. Sharad Joshi for giving me valuablesuggestion and encouragement to bring out good project.

I am very thankful to my mentor Prof. Mr. Mahesh Halale for him inspiration and

for

initiating diligent efforts and expert guidance in course of my study and

completion of the

project and I am very thankful to my project guide for giving me timely and

concrete

guidance for making this project successful.

I would like to thankful to customers and staff members of Marwadi Shares &

Finance Pvt. Ltd. For helped me during the project report and providing me more

and more

valuable information for my project report.

I would thank to God for their blessing and my Parents also for their valuable

suggestion and support in my project report.

I would also like to thank our friends and those who have helped us during this

project

directly or indirectly.

Rohit Parmar

. 3

CONTENT

Sr. No. Particulars Page No.

1 EXECUTIVE SUMMARY

4

2 OBJECTIVE AND SCOPE OF THE PROJECT 5

3 INTRODUCTION 6

4 COMPANY PROFILE 8

5 ABOUT THE COMMODITY 16


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6 RESEARCH METHODOLOGY 62

7 DATA ANALYSIS 64

8 RESEARCH FINDING AND CONCLUSION 75

9 QUESTIONNAIRE 77

10 SUGGESTION AND RECOMMENDATION 79

11 BIBLIOGRAPHY 80 4

1. EXECUTIVE SUMMARY

One of the interesting developments in financial market over the last 15 to 20

years

has been the growing popularity of derivatives. In many situations, both hedgers

and

speculators find it more attractive to trade a derivative on an asset, commodity

than to trade

asset and commodity itself. Some commodity derivatives are traded on

exchanges.

In this report I have included history of commodity market. Than I have included

commodity market in India. And after that I have discussed the mechanism of

trading in

commodity market in India.

In this report I have taken a first look at forward, futures and options contract

and

other risk management instruments. Than after I have discuss the main

components of future

commodity trading like contract size, what actual margin is and delivery system

etc. There

are mainly three types of traders: hedgers, speculators and arbitrageurs.

In the next section I discuss about the two major commodity exchanges in India

that is

MCX AND NCDEX. How they are worked for developing this commodity market in

India.

And I have also given the list of other commodity exchanges in India. Put / call

ratio (P/C


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Ratio) is a market sentiment indicator that shows the relationship between the

numbers of put

to calls traded. One can use put/call ratio as market indicator .Then after I have

discussed

about the present scenario of commodity market in India.

In the next I have tried to analyze the trading pattern and investment pattern of

commodity traders and other investors. This I have done through the help of

QUESTIONER,

which contains 15 questions.

On the basis of different charts prepared, I have at the end given the research

findings

and conclusion. And on the basis of my findings I have given suggestion and

recommendation5

2. OBJECTIVE AND SCOPE OF THE PROJECT

2.1 OBJECTIVE OF THE PROJECT REPORT

To analyze the view of commodity traders.

To make understand the process of future commodity trading in India.

To know the investment pattern of commodity traders and people.

2.2 SCOPE OF THE PROJECT REPORT

For analyze the trading pattern and investment pattern of commodity traders

and

government servants, I have taken data from the local area of the Rajkot city. 6

3. INTRODUCTION

Instability of commodity prices has always been a major concern of theproducers as well as

the consumers in an agriculture dominated country like India. Farmers direct

exposure to

price fluctuations, for instance, makes it too risky for many farmers to invest in

otherwise

profitable activities. There are various ways to cope with this problem.

Apart from increasing the stability of the market, various factors in the farmsector


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can better manage their activities in an environment of unstable prices through

derivative

markets. These markets serve a risk -shifting function, and can be used to lock

-in prices

instead of relying on uncertain price developments.

There are a number of commodity-linked financial risk management

instruments,

which are used to hedge prices through formal commodity exchanges, over -the-

counter

(OTC) market and through intermediation by financial and specialized institutions

who

extend risk management services. (See UNCTAD, 1998 for a comprehensivesurvey of

instruments) These instruments are forward, futures and option contracts, swaps

and

commodity linked -bonds. While formal exchanges facilitate trade in

standardized contracts

like futures and options, other instruments like forwards and swaps are tailor

made contracts

to suit to the requirement of buyers and sellers and are available over-the

counter.

In general, these instruments are classified based on the purpose for which they

are

primarily used for price hedging, as part of a wider marketing strategy, or for

price hedging in

combination with other financial deals. While forward contracts and OTC options

are trade

related instruments, futures, exchange traded options and swaps between banks

and

customers are primarily price hedging instruments. In the case of swaps

between

intermediaries and producers, and commodity linked loans and bonds (CL&BS)

price

hedging are combined with financial deals.


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Forwards contracts are mostly OTC agreements to purchase or sell a specific

amount

of a commodity on a predetermined future date at a predetermined price. The

terms and

conditions of a forward contract are rigid and both the parties are obligated to

give and take

physical delivery of the commodity on the expiry of contract. The holders of

forward

contracts face spot (ready) price risk. When the prevailing spot price of the

underlying

commodity is higher than the agreed price on expiry of the contract, the buyer

gains and the

seller looses. The futures contracts are refined version of forwards by which the

parties are

insulated from bearing spot risk and are traded in organize exchanges. A

detailed discussion

on the futures contracts is presented in the next chapter. 7

Both forwards and futures contracts have specific utility to commodity

producers,

merchandisers and consumers. Apart from being a vehicle for risk transfer

among hedgers

and from hedgers to speculators, futures markets also play a major role in price

discovery.

Typology of risk management instruments

The price risk refers to the probability of adverse movements in prices of

commodities, services or assets. Agricultural products, unlike others, have an

added risk.

Many of them being typically seasonal would attract only lower price during the

harvest

season.

The forward and futures contracts are efficient risk management tools, which

insulate

buyers, and sellers from unexpected changes in future price movements. These

contracts


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enable them to lock-in the prices of the products well in advance. Moreover,

futures prices

give necessary indications to producers and consumer s about the likely future

ready price

and demand and supply conditions of the commodity traded. The cash market or

ready

delivery market on the other hand is a time-tested market system, which is used

in all forms

of business to transfer title of goods. 8

4. COMPANY PROFILE

4.1 NAME OF THE COMPANY

MARWADI SHARES & FINANCE LTD.

4.2 LOGO OF THE COMPANY

4.3 VISION OF THE COMPANY

To be a world class financial services provider by arranging all conceivable

financial services under one roof at affordable price through cost-effective

delivery

systems and achieve organic growth in business by adding newer lines of

business.

4.4 COMPANY PROFILE:

Marwadi Sales and Finance P. Ltd. started in the year 1994 when acquired

membership of National Stock Exchange of India Ltd. That was the time when

Govt. had just

started liberalization. Capital market being at the base of every thing else was

among the first

few sectors taken up for liberalization and alignment with global benchmarks.

NSE was

therefore a result of Governments policy to modernize stock market and give

our investors a

cost - effective trading and settlement system.

They enter into the stock market coincided with Government's initiative to givea


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modern Stock exchange. Marwadi had then very presciently felt that this

development would

change the very structure and content of the market. Then, when Depository

system was

introduced to automate the settlement system, we became the first Corporate

DP in 1998 to

bring this concept to investor's doorstep in Saurashtra. Marwadi had very early

on seen that

the future lay in the ability to network and use technology to its fullest possible

extent. 9

Relying on your judgment, we used technology extensively which resulted in

efficient client

servicing.

It also saw the synergy that lay in providing a bouquet of services under one

roof. It is

this realization that led us in the year 2003 to go for membership of National

Level

Commodity Exchanges, which were set up as part of Govt's policy to bring

commodity

market on par with the capital market in terms of integrity and practices.

They bold initiatives starting with our journey from capital market up to

commodities

market has given us synergies in operations, enabling us to pass on the

advantage to

customers.

As an organization, have achieved a leader's position by ensuring total

satisfaction of

customers through world class services.

Utilize ultra modern technology for timely, seamless and accurate data

processing.

Proactively seek customers feedback in improving upon our service delivery

modes.

Promptly respond to customer issues in order to maximize clients satisfaction.

Products & Services offers:


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Equity & Derivatives:

Can look for an easy and convenient way to invest in equity and take positions in

the

futures and options market using their research and tools. To start trading inEquity, all you

need to do is open an online trading account. You can call them and they will

have their

representative meet you. You can get help opening the account and get

guidance on how to

trade in Equity.

Commodity:

You can enter the whole new world of commodity futures. Investors looking for a

fast-paced dynamic market with excellent liquidity can NOW trade in Commodity

Futures

Market. The Commodity Exchange is a Public Market forum and anyone can play

in these

vital Commodity Markets. Marwadi Commodity Broker (P) Ltd can certainly be

your point

of entry to the Commodity Markets. Marwadi is a registered trading-cum-clearing

member of

NCDEX and MCX.

Internet Trading:

Making the right trade at the right time! E-Broking service, which brings you

experience of online buying and selling of shares with just a click. 10

A detail resource like live quotes, charts, research and advice helps you takeproper decisions.

Their robust risk management system and 128 bit encryption gives you a

complete security

about money, shares, and transaction documents.

IPO:

An active player in the primary market with waste customer base and reaching

distribution network spread through out the lands. Then breathe Saurashtrapeninsula.


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Marwadi offer bidding for all booked bills IPOs being floated through NSE

network.

Marwadi offer services to customer such as advises on the minimum lot to

applied in

case of refer and details and data to be furnished into IPO form.

Marwadi scripts even fill up the form for related clients.

Marwadi offer bidding services at all major location in Saurashtra and Kutch

there by

enabled the interline investors to subscribes qualitative IPOs.

Mutual Funds:

Transact in a wide range of Mutual Funds. Mutual Funds are an attractive meansof

saving taxes and diversifying your investment portfolio. So if you are looking to

invest in

mutual funds, Marwadi offers you a host of mutual fund choices under one roof;

backed by

in-depth information and research to help you invest smartly.

PMS:

Can you analyze the prices of 1,500 shares every morning? Can you afford to

gamble

only on the recommendations from your friends and the information overload

from

magazines and financial dailies? And, of course, more importantly, if you happen

to be a

High Net worth Individual, do you have the time to judge which advice is reliable,

authentic

and has the least chance of failure? With Marwadi PMS, you can be assured that

your

investments are in safe hands! Give your portfolio the expert edge to smoothly

steer towards

wealth creation.

Cash Market Services:

Marwadi also F & O market to all clients in to entire Saurashtra and Kutch region,


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which they cover through, distributed cover.

Marwadi offer cash market trading services for the both retail and in station

clients at

all the certain Saurashtra and Kutch where placed either a branch or franchise orsub broker11

4.5 HIRARCHY STRUCTURE

4.6 COMPANY INFORMATION:

Name: Marwadi Shares & Finance Ltd.

Head Office : Marwadi Financial Center

Nr. Kathiawad Gymkhana

Dr. Radhakrishnana Road

Rajkot 360 001

C.E.O.: Mr. Jeyakumar A. S.

Directors: Mr. Ketan Marwadi

Mr. Deven Marwadi

Mr. Sandeep Marwadi

General Manager: Mr. Hareshbhai Maniar

E-Mail: [email protected]

Web Site: www.marwadionline.com

Board of Director

General Manager

DP Front Trading Account Technology

DP Back Audit

(Compliance)

Software 12


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4.7 COMPANYS MILESTONE:

1992: Marwadi Shares And Finance Pvt. Ltd. was incorporated

1996: Became a corporate member of national Stock Exchange of India.

1998: Became a member of Saurashtra Kutch Stock Exchange.

1999: Launched Depository services of Depository Participant under National

Securities

Depository Ltd.

2000: Commenced Derivative Trading after obtaining registration as a Clearing

and Trading

Member in NSE

2003: (MCBPL) became a corporate member of The National Commodity and

Derivatives

Exchange of India Ltd.

2004: Became a corporate member of The Stock Exchange, Mumbai.

2004: Launched Depository Services of Depository Participant under Central

Depository

Services (India) Ltd.

2006: MSFPL converted to Public Limited (Marwadi Shares And Finance Limited)

4.8 MEMBERSHIP:

Capital Market:

National Stock Exchange of India Ltd.

Bombay Stock Exchange Ltd.

Saurashtra-Kutch Stock Exchange Ltd.

Over-the-Counter Exchange of India Ltd.

Commodities Derivatives:

National Commodity & Derivatives Exchange Ltd.

Multi Commodity Exchange of India Ltd.

Depository Operations:

National Securities Depositories Ltd. (NSDL)

Central Depository Services (India) Ltd. 13


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4.9 SERVICES OF MARWADI:

Stock broking:

Cash Market

Derivatives Trading

Margin Trading

Internet Trading

Commodities Broking:

Commodities Futures

Financing Against Commodities

Depository Service:

NSDL

CDSL

IPO Subscription Services

Mutual Fund Products

Portfolio management

Insurance Services

Qualitative Research in Stock & Commodities

FUTURE SERVICES:

Private Banking Sector

Forex Market

Commodities Demat Service

Product Enhancement in commodity market

4.10 THE COMPLETE INVESTMENT DESTINATION:

It provides comprehensive range of investment services. Thats advantage of

having

all the services investor need under one roof.

Stock broking:

It offers complete range of pre-trade and post-trade services on the BSE and the

NSE.


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Whether an investor come into its conveniently environment, or issue instruction

over the 14

phone, its highly trained team and sophisticated equipment ensure smooth

transactions and

prompt services.

E-Broking and Web-Based Services:

It is one of the offers online trading on site www.marwadionline.com, high

bandwidth

leased lines, secure services and a customs-built user interface give you an

international

standards trading experience. It also gives regular trading hours, and access to

information,

analysis of information, and a range of monitoring tools.

Trading Terminals-Money pore Express:

It offer its sub-broker and approved/authorized user fully equipped trading

terminalsMoney pore Express, at the location of investors choice. It is fully

functional terminal, with a

variety of helpful features like market watch, order entry, order confirmation,

charts, and

trading calls, all available in resizable windows. And it can be operated through

the keyboard

using F1 for buy, F2 for sell.

Depository Participant Services:

It offers DP services mean hassle-free, speedy settlements. It is depository

participants with NSDL and CDSL.

Premium Research Services:

Its research team offers a package of fee-based services, including daily

technical

analysis, research reports, and advice on clients existing investments. It is

research beyond

desk and company-provider reports. If you have an equity portfolio, you know

that the pace

of life in the world of stocks and shares is frantic. Managing your portfolio means

you have


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to take firm, informed decisions, and quickly!

4.11 BRANCHES:

Marwadi has spread throughout Gujarat state with our 28 branches and now

taking onPan - India mantle with branches, now having come up in Hyderabad, Chennai

Bangalore,

Pune, Nasik, Kolhapur and Delhi. More out-of-Gujarat branches are on the anvil in

order to

be a conspicuous player at national level. As on today they are serving about

75,000 clients

spread out over 554 pin code locations through a network of about 300

intermediaries such as

sub-brokers, franchisees and authorized persons. 15

Also other branches of Marwadi in different cities like..

Ahmedabad Jamnagar

Amreli Junagadh

Anand Keshod

Baroda Manavadar

Bhavnagar Mithapur

Bhuj Mumbai

Delhi Okha

Dhoraji Porbandar

Dhangadhra Surat

Gondal Surendranagar

Gandhidham Veraval 16

5. ABOUT THE COMMODITY

5.1 INTRODUCTION

Keeping in view the experience of even strong and developed economies of the

world,

it is no denying the fact that financial market is extremely volatile by nature.

Indian financial


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market is not an exception to this phenomenon. The attendant risk arising out of

the volatility

and complexity of the financial market is an important concern for financial

analysts. As a

result, the logical need is for those financial instruments which allow fund

managers to better

manage or reduce these risks.

The emergence of the market for derivative products, most notably forwards,

futures

and options, can be traced back to the willingness of risk-averse economic

agents to guard

themselves against uncertainties arising out of fluctuations in asset prices. Bytheir very

nature, the financial markets are marked by a very high degree of volatility.

Through the use

of derivative products, it is possible to partially or fully transfer price risks by

lockingin

asset prices. As instruments of risk management, these generally do not

influence the

fluctuations in the underlying asset prices. However, by locking-in asset prices,

derivative

products minimize the impact of fluctuations in asset prices on the profitability

and cash flow

situation of risk-averse investors.

5.2 COMMODITIES

Organized futures market evolved in India by the setting up of "Bombay Cotton

Trade

Association Ltd." in 1875. In 1893, following widespread discontent amongst

leading cotton

mill owners and merchants over the functioning of the Bombay Cotton Trade

Association, a

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

constituted. Futures

trading in oilseeds was organized in India for the first time with the setting up ofGujarati


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Vyapari Mandali in 1900, which carried on futures trading in groundnut, castor

seed and

cotton. Before the Second World War broke out in 1939 several futures markets

in oilseeds

were functioning in Gujarat and Punjab.

A three-pronged approach has been adopted to revive and revitalize the market.

Firstly, on policy front many legal and administrative hurdles in the functioning of

the market

have been removed. Forward trading was permitted in cotton and jute goods in

1998,

followed by some oilseeds and their derivatives, such as groundnut, mustard

seed, sesame,

cottonseed etc. in 1999. A statement in the first ever National Agriculture Policy,

issued in

July, 2000 by the government that futures trading will be encouraged in

increasing number of

agricultural commodities was indicative of welcome change in the government

policy

towards forward trading. 17

Secondly, strengthening of infrastructure and institutional capabilities of the

regulator

and the existing exchanges received priority. Thirdly, as the existing exchanges

are slow to

adopt reforms due to legacy or lack of resources, new promoters with resources

and

professional approach were being attracted with a clear mandate to set up

dematerialized,

technology driven exchanges with nationwide reach and adopting best

international practices.

The year 2003 marked the real turning point in the policy framework for

commodity

market when the government issued notifications for withdrawing all prohibitions

and

opening up forward trading in all the commodities. This period also witnessedother reforms,


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such as, amendments to the Essential Commodities Act, Securities (Contract)

Rules, which

have reduced bottlenecks in the development and growth of commodity

markets. Of the

country's total GDP, commodities related (and dependent) industries constitute

about roughly

50-60 %, which itself cannot be ignored.

Most of the existing Indian commodity exchanges are single commodity

platforms;

are regional in nature, run mainly by entities which trade on them resulting in

substantial

conflict of interests, opaque in their functioning and have not used technology toscale up

their operations and reach to bring down their costs. But with the strong

emergence of:

National Multi-commodity Exchange Ltd., Ahmedabad (NMCE), Multi Commodity

Exchange Ltd., Mumbai (MCX), National Commodities and Derivatives Exchange,

Mumbai

(NCDEX), and National Board of Trade, Indore (NBOT), all these shortcomings willbe

addressed rapidly. These exchanges are expected to be role model to other

exchanges and are

likely to compete for trade not only among themselves but also with the existing

exchanges.

The current mindset of the people in India is that the Commodity exchanges are

speculative (due to non delivery) and are not meant for actual users. One major

reason being

that the awareness is lacking amongst actual users. In India, Interest rate risks,

exchange rate

risks are actively managed, but the same does not hold true for the commodity

risks. Some

additional impediments are centered on the safety, transparency and taxation

issues.

5.3 WHY COMMODITIES MARKET?


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India has very large agriculture production in number of agri-commodities,

which

needs use of futures and derivatives as price-risk management system.

Fundamentally price you pay for goods and services depend greatly on how wellbusiness handle risk. By using effectively futures and derivatives, businesses

can minimize

risks, thus lowering cost of doing business. 18

Commodity players use it as a hedge mechanism as well as a means of making

money. For e.g. in the bullion markets, players hedge their risks by using futures

Euro-Dollar

fluctuations and the international prices affecting it.

For an agricultural country like India, with plethora of mandis, trading in over

100

crops, the issues in price dissemination, standards, certification and warehousing

are bound to

occur. Commodity Market will serve as a suitable alternative to tackle all these

problems

efficiently.

5.4 COMMODITY FUTURES:

Commodity futures are simply the standard futures contracts traded through

exchange. These contracts have their respective commodity as underlying asset

and derive

the dynamics from it. Such contracts allow the participant to buy and sell certain

commodity

at a certain price for future delivery. Futures trading is a natural outgrowth of theproblem of

maintaining a year-round supply of seasonal products like agriculture crops. The

best thing

about a commodity futures contract is that it is generally leveraged giving

opportunity to all

types of investors to participate. Characteristically, such a contract has an expiry

and delivery

attached with it.


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5.5 WHY TRADE IN COMMODITIES?

1. Big market-diverse opportunities

India, a country with a population of over one billion, has an economy based on

agriculture, precious metals and base metals.

Thus, trading in commodities provides lucrative market opportunities for a wider

section of participants of diverse interests like investors, arbitragers, hedgers,

traders,

manufacturers, planters, exporters and importers.

2. Get to the sore

Commodity trading has been a breakthrough in expanding the investment from

investing in a metal company to trading in metal itself.

3. Huge potential

Commodity exchanges see a tremendous daily turnover of more than Rs.15,000

cores.

This gives a lunge potential to market participant to make profits.

4. Exploitable fundamental

The fundamental for commodity trading is simple price is a function of demand

and

supply so is hedging, by taking appropriate contract. This makes things really

easy to

understand and exploit. 19

5. Portfolio diversifier

Commodity futures derive their prices from the underlying commodity and

commodity prices cannot become zero. Commodity has a global presence and

their prices

move with global economics and hence, its a good portfolio diversifier.

5.6 ADVANTAGE OF FUTURES TRADING

Futures trading remove the hassles and costs of settlement and storage for

traders who

do not want custody.


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Though, the most lucrative element of futures trading is that it allows investors

to

participate and trade at nominal costs at a much lesser amount:

No longer need to put the whole amount for trading; only the margin is required.No sales tax is applicable if the trade is required off. Sales tax is applicable only

if a

trade results in delivery.

Traders can short sell. If a trader buys an equivalent contract back before the

contract

expires, he will be able to profit from a falling price. This is difficult in spot

marketers

because it requires the seller to borrow the commodity. It is next to impossible

for retail

investors in case of something like gold.

All participants trade exactly the same notional right i.e. those defined on the

standard

contract, so the market grows deeper and more liquid in the standard futures

contract than in

spot bullion where different qualities of bullion exit, each of which has different

prices.

Greater liquidity provides a reliable real-time price something which is absolutely

not

available in the OTC bullion market.

5.7 CHARACTERISTICS OF FUTURES TRADING

A "Futures Contract" is a highly standardized contract with certain distinct

features. Some of

the important features are as under:

Futures trading is necessarily organized under the auspices of a market

association so

that such trading is confined to or conducted through members of the

association in

accordance with the procedure laid down in the Rules & Bye-laws of the

association.


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It is invariably entered into for a standard variety known as the "basis variety"

with

permission to deliver other identified varieties known as "tenderable varieties".

The units of price quotation and trading are fixed in these contracts, parties tothe

contracts not being capable of altering these units. 20

The delivery periods are specified.

The seller in a futures market has the choice to decide whether to deliver goods

against outstanding sale contracts. In case he decides to deliver goods, he can

do so not only

at the location of the Association through which trading is organized but also at anumber of

other pre-specified delivery centers.

In futures market actual delivery of goods takes place only in a very few cases.

Transactions are mostly squared up before the due date of the contract and

contracts are

settled by payment of differences without any physical delivery of goods taking

place.

5.8 COMMODITY DERIVATIVES IN INDIA

Commodity derivatives have a crucial role to play in the price risk management

process especially in any agriculture dominated economy. Derivatives like

forwards, futures,

options, swaps etc are extensively used in many developed and developing

countries in the

world. The Chicago Mercantile Exchange; Chicago Board of Trade; New YorkMercantile

Exchange; International Petroleum Exchange, London; London Metal Exchange;

London

Futures and Options Exchange; Marche a Terme International de France;

Sidney Futures

Exchange; Singapore International Monetary Exchange; The Singapore

Commodity

Exchange; Kuala Lumpur Commodity Exchange ; Bolsa de Mercadorias &

Futuros (in


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Brazil), the Buenos Aires Grain Exchange; Shanghai Metals Exchange; China

Commodity

Futures Exchange; Beijing Commodity Exchange, etc are some of the leading

commodity

exchanges in the world engaged in trading of derivatives in commodities.

However, they have been utilized in a very limited scale in India Although India

has a

long history of trade in commodity derivatives, this segment remained

underdeveloped due to

government intervention in many commodity markets to control prices. The

government

controls the production, supply and distribution of many agriculturalcommodities and only

forwards and futures trading are permitted in certain commodity items. Free

trade in many

commodity items is restricted under the Essential Commodities Ac, 195, and

forward and

futures contracts are limited to certain commodity items under the Forward

Contracts

(Regulation) Act, 1952.

The first commodity exchange was set up in India by Bombay Cotton Trade

Association Ltd., and formal organized futures trading started in cotton in 1875.

Subsequently, many exchanges came up in different parts of the country for

futures trade in

various commodities. The Gujarati Vyapari Mandali came into existence in 1900,

which has

undertaken futures trade in oilseeds first time in the country. The Calcutta

Hessian Exchange

Ltd and East India Jute Association Ltd were set up in 1919 and 1927 respectively

for futures 21

trade in raw jute. In 1921, futures in cotton were organized in Mumbai under the

auspices of

East India Cotton Association. Many exchanges came up in the agricultural

centers in north


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India before world war broke out and engaged in wheat futures until it was

prohibited. The

exchanges in Hapur, Muzaffarnagar, Meerut, Bhatinda, etc were established

during this

period. The futures trade in spices was firs organized by IPSTA in Cochin in 1957.

Futures in gold and silver began in Mumbai in 1920 and continued until the

government prohibited it by mid-1950s. Later, futures trade was altogether

banned by the

government in 1966 in order to have control on the movement of prices of many

agricultural

and essential commodities. Options are though permitted now in stock market,

they are not

allowed in commodities. The commodity options were traded during the pre-

independence

period. Options on cotton were traded until the along with futures were banned

in 1939.

However, the government withdrew the ban on futures with passage of Forward

Contract

(Regulation) Act in 1952.

After the ban of futures trade many exchanges went out of business and many

traders

started resorting to unofficial and informal trade in futures. On recommendation

of the

Khusro Committee in 1980 government reintroduced futures on some selected

commodities

including cotton, jute, potatoes, etc.

Further in 1993 the government of India appointed an expert committee on

forward

markets under the chairmanship of Prof. K.N. Kabra and the report of the

committee was

submitted in 1994 which recommended the reintroduction of futures already

banned and to

introduce futures on many more commodities including silver. In tune with the

ongoing


25/95

economic liberalization, the National Agricultural Policy 2000 has envisaged

external and

domestic market reforms and dismantling of all controls and regulations in

agricultural

commodity markets. It has also proposed to enlarge the coverage of futures

markets to

minimize the wide fluctuations in commodity prices and for hedging the risk

emerging from

price fluctuations. In line with the proposal many more agricultural commodities

are being

brought under futures trading.

In India, currently there are 15 commodity exchanges actively undertakingtrading in

domestic futures contracts, while two of them, viz., India Pepper and Spice Trade

Association

(IPST), Cochin and the Bombay Commodity Exchange (BCE) Ltd. have been

recently

upgraded to international exchanges to deal in international contracts in pepper

and castor oil

respectively. Another 8 exchanges are proposed and some of them are

expected to start

operation shortly. There are 4 exchanges, which are specifically approved for

undertaking

forward deals in cotton. More detailed account of these exchanges has been

presented. 22

The proposed study is primarily based on the visit of seven leading exchanges

viz.,

IPST Cochin, which deal in domestic and international contracts in pepper; BCE

Ltd., a

multy-commodity international exchange where futures in castor oil, castor seed,

sunflower

oil, RBD Palmolein etc are traded; The East India Cotton Association (EICA) Ltd.,

Bombay,

which is a specialized exchange dealing in forwards and futures in cotton; South

India Cotton


26/95

Association (SICA , Coimbatore which deals in forward contracts in cotton; Coffee

Futures

Exchange India Ltd., (COFEI) Bangalore which undertakes coffee futures trading;

Kanpur

Commodity Exchange (KCE) which deals with futures contracts in mustard oil and

gur; and

The Chamber of Commerce, Hapur which undertakes futures trading in gur and

potatoes.

5.9 MECHANICS OF FUTURES TRADING

Futures are a segment of derivative markets. The value of a futures contract is

derived

from the spot (ready) price of the commodity underlying the contract. Therefore,they are

called derivatives of spot market. The buying and selling of futures contracts

take place in

organized exchanges. The members of exchanges are authorized to carryout

trading in

futures. The trading members buy and sell futures contract for their own account

and for the

account of non-trading members and other clients. All other persons interested

to trade in

futures contracts, as clients must get themselves registered with the exchange

as registered

non-members.

5.10 WHAT IS A COMMODITY FUTURE EXCHANGE?

Exchange is an association of members, which provides all organizational

support for

carrying out futures trading in a formal environment. These exchanges are

managed by the

Board of Directors, which is composed primarily of the members of the

association. There

are also representatives of the government and public nominated by the Forward

Markets

Commission. The majority of members of the Board have been chosen fromamong the


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members of the Association who have trading and business interest in the

exchange. The

chief executive officer and his team in day-to-day administration assist the

Board. There are

different classes of members who capitalize the exchange by way of participation

in the form

of equity, admission fee, security deposits, registration fee etc.

a. Ordinary Members: They are the promoters who have the right to have own

account

transactions without having the right to execute transactions in the trading ring.

They have to

place orders with trading members or others who have the right to trade in theexchange. 23

b. Trading Members: These members execute buy and sell orders in the trading

ring of the

exchange on their account, on account of ordinary members and other clients.

c. Trading-cum-Clearing Members: They have the right to trade and also to

participate in

clearing and settlement in respect of transactions carried out on their accountand on account

of their clients.

d. Institutional Clearing Members: They have the right to participate in clearing

and

settlement on behalf of other members but do not have the trading rights.

e. Designated Clearing Bank: It provides banking facilities in respect of pay-in,

payout and

other monetary settlements.

The composition of the members in an exchange however varies. In so me

exchanges there

are exclusive clearing members, broker members and registered non -members

in addition to

the above category of members.

5.11 WHAT IS COMMODITY FUTURES CONTRACT?


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Futures contracts are an improved variant of forward contracts. They are

agreements

to purchase or sell a given quantity of a commodity at a predetermined price,

with settlement

expected to take place at a future date. While forward contracts are mainly over-

the-counter

and tailor-made which physical delivery futures settlement standardized

contracts whose

transactions are made in formal exchanges through clearing houses and

generally closed out

before delivery. The closing out involves buying a different times of two identical

contracts

for the purchase and sale o the commodity in question, with each canceling the

other out. The

futures contracts are standardized in terms of quality and quantity, and place

and date of

delivery of the commodity. The commodity futures contracts in India as defined

by the FMC

has the following features:

(a) Trading in futures is necessarily organized under the auspices of a recognized

association

so that such trading is confined to or conducted through members of the

association in

accordance with the procedure laid down in the Rules and Bye-laws of the

association.

(b) It is invariably entered into for a standard variety known as the basis

variety with

permission to deliver other identified varieties known as tender able varieties.

(c) The units of price quotation and trading are fixed in these contracts, parties

to the

contracts not being capable of altering these units.

(d) The delivery periods are specified. 24

(e) The seller in a futures market has the choice to decide whether to deliver

goods against


29/95

outstanding sale contracts. In case he decides to deliver goods, he can do so not

only at the

location of the Association through which trading is organized but also at a

number of other

pre-specified delivery centers.

(f) In futures market actual delivery of goods takes place only in a very few

cases.

Transactions are mostly squared up before the due date of the contract and

contracts are

settled by payment of differences without any physical delivery of goods taking

place. The

terms and specifications of futures contracts vary depending on the commodityand the

exchange in which it is traded.

The major terms and conditions of contracts traded in six sample exchanges in

India. These

terms are standardized and applicable across the trading community in the

respective

exchanges and are framed to promote trade in the respective commodity Forexample, the

contract size is important for better management of risk by the customer. It has

implications

for the amount of money that can be gained or lost relative to a given change in

price levels. I

also affect the margins required and the commission charged. Similarly, the

margin to be

deposited with the clearing house has implications for the cash position of

customers because

it blocks cash for the period of the contract to which he is a party the strength

and weaknesses

of contract specifications are discussed under constraints and policy options.

5.12 WHO ARE THE PARTICIPANTS IN FUTURES MARKET?

Broadly, speculators who take positions in the market in an attempt to benefit

from a


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correct anticipation of future price movements, and hedgers who transact in

futures market

with an objective of offsetting a price risk on the physical market for a particular

commodity

make the futures market in that commodity. Although it is difficult to draw a line

of

distinction between hedgers and speculators, the former category consists of

manufacturing

companies, merchandisers, and farmers. Manufacturing companies who use the

commodity

as a raw material buy futures to ensure its uninterrupted supply of guaranteed

quality at a

predetermined price, which facilitates immunity against price fluctuations. While

exporters in

addition to using the price discovery mechanism for getting better prices for

their

commodities seek to hedge against their overseas exposure by way of locking-in

the price by

way of buying futures contracts, the importers utilize the liquid futures market

for the

purpose of hedging their outstanding position by way of selling futures contracts.

Futures

market helps farmers taking informed decisions about their crop pattern on the

basis of the

futures prices and reduces the risk associated with variations in their sales

revenue due to 25

unpredictable future supply demand conditions. Above all, there are a largenumber of

brokers who intermediate between hedgers and speculators create the market

for futures

contracts.

5.13 COMMODITY ORDERS

The buy and sell orders for commodity futures are executed on the trading floor

where floor


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brokers congregate during the trading hours stipulated by the exchange. The

floor

brokers/trading members on receipt of orders from clients or from their office

transmits the

same to others on the trading floor by hand signal and by calling out the orders

(in an open

outcry system they would like to place and price. After trade is made with

another floor

broker who takes the opposite side of the transaction for another customer or for

his own

account, the details of transactions are passed on to the clearing house through

a transaction

slip on the basis o which the clearinghouse verifies the match and adds to its

records.

Following the experiences of stock exchanges with electronic screen based

trading

commodity exchanges are also moving from outdated open outcry system to

automated

trading system. Many leading commodity exchanges in the world including

Chicago

Mercantile Exchange (CME), Chicago Board of Trade (CBOT), International

Petroleum

Exchange (IPE), London, have already computerized the trading activities. In

India, coffee

futures exchange, Bangalore has already put in

place the screen based trading and many others are in the process of

computerization. To add

to modernization efforts, the Bombay Commodity Exchange (BCE) has initiated

for a

common electronic trading platform connecting all commodity exchanges to

conduct screen

based trading. In electronic trading, trading takes place through a centralized

computer

network system to which all buy and sell orders and their respective prices are

keyed in from


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various terminals of trading members. The deal takes place when the central

computer finds

matching price quotes for buy and sell. The entire procedural steps involved in

electronic

trading beginning from placing the buy/sell order to the confirmation of the

transaction have

been shown in figure -2.1 below. 26

Order and Execution flows in electronic future trade

Confirmation Comfirmation

Order Output Order Input

Verifaction of

Verifaction of Order Order

Legitimitate Order Legitimate

Are Trasferred Order are

Transferred

Orders are matched

Transfer of Position

Position

and margin settlement

5.14 ROLE OF CLEARING HOUSE

Clearinghouse is the organizational set up adjunct to the futures exchangewhich

handles all back-office operations including matching up of each buy and sell

transactions,

execution, clearing and reporting of all transactions, settlement of all

transactions on maturity

by paying the price difference or by arranging physical delivery, etc., and

assumes all


33/95

counterparty risk on behalf of buyer and seller. It is important to understand that

the futures

market is designed to provide a proxy for the ready (spot) market and thereby

acts as a

pricing mechanism and not as part of, or as a substitute for, the ready market.

The buyer or seller of futures contracts has two options before the maturity of

the

contract. First, the buyer (seller) may take (give) physical delivery of the

commodity at the

delivery point approved by the exchange after the contract matures. The second

option, which

distinguishes futures from forward contracts is that, the buyer (seller) can offsetthe contract

SELLER

COMPUTER COMPUTER

CREDIT RISK CREDIT RISK

ELECTRONIC

TRADING

BUYER

EXECUTION

CLEARING HOUSE

CLEARING MEMBER CLEARING MEMBER 27

by selling (buying) the same amount of commodity and squaring off his position.

For

squaring of a position, the buyer (seller) is not obligated to sell (buy) the original

contract.

Instead, the clearinghouse may substitute any contract of the same

specifications in the

process of daily matching. As delivery time approaches, virtually all contracts are

settled by

offset as those who have bought (long) sell to those who have sold (short). This

offsetting


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reduces the open position in the account of all traders as they approach the

maturity date of

the contract. The contracts, if any, which remain unsettled by offset until

maturity date are

settled by physical delivery.

The clearinghouse plays a major role in the process explained above by

intermediating between the buyer and seller. There is no clearinghouse in a

forward market

due to which buyers and sellers face counterparty risk. In a futures exchange all

transactions

are routed through and guaranteed by the clearinghouse which automatically

becomes a

counterpart to each transaction. It assumes the position of counterpart to both

sides of the

transaction. It sells contract to the buyer and buys the identical contract from the

seller.

Therefore, traders obtain a position vis --vis the clearing house. It ensures

default risk-free

transactions and provides financial guarantee on the strength of fundscontributed by its

members and through collection of margins (discussed in section 2.3), marking-

to-market all

outstanding contracts, position limits imposed on traders, fixing the daily price

limits and

settlement guarantee fund.

The organizational structure and membership requirements of clearinghouses

vary

from one exchange to the other. The Bombay Commodity Exchange and Cochin

pepper

exchange have set up separate independent corporations (namely, Prime

Commodities

Clearing Corporation of India Ltd, and First Commodities Clearing Corporation of

India Ltd.,

respectively) for handling clearing and guarantee of all futures transactions inthe respective


35/95

exchanges. While coffee exchange has clearing house as a separate division of

the exchange,

many other exchanges like Chamber of Commerce, Hapur; Kanpur Commodity

Exchange

and cotton exchange in Bombay run in-house clearinghouse as part of the

respective

exchanges. The clearing and guaranty are managed in these exchanges by a

separate

committee (normally called the Clearing House Committee).

The membership in the clearinghouse requires capital contribution in the form of

equity, security deposit, admission fee, registration fee, guarantee fund

contribution in

addition to net worth requirement depending on its organizational structure. For

example, in

the Bombay Commodity Exchange the minimum capital requirement for

membership in its

clearinghouse as applicable to trading-cum-clearing members is Rs.50,000 each

toward

equity and security deposit, Rs. 500 as annual subscription, and additionally,members are 28

required to have net worth of Rs.3 lakhs. Similarly, coffee exchange prescribed

Rs.5 lakh

each towards equity and guarantee fund contribution and Rs.40,000 towards

admission fee

for a trading-cum-clearing member. However, in exchanges where clearing

house is a part of

the exchange the payment requirements are lower. For example, Kanpur

Commodity

Exchange prescribed only Rs.25,00,000 Rs.1000 and Rs.500 respectively towards

security

deposit, registration fee and annual fee for a clearing cum-trading member.

For ensuring financial integrity of the exchange and for counterparty risk -free

trade

position (exposure) limits have been imposed on clearing members. These limitswhich are


36/95

stringent in some cases and are liberal in other cases are normally linked to the

members

contribution towards equity capital or security deposit or a combination of both

and

settlement guarantee fund.

In Bombay Commodity Exchange the exposure limit of a clearing member is the

sum

of 50 times the face value of contribution to equity capital of the clearinghouse

and 30 times

the security deposit the member has maintained with the clearinghouse. While

coffee

exchange prescribes the limit of 80 times the sum of members equityinvestment and the

contribution to the guarantee fund, the cotton exchange, Bombay, has stipulated

a liberal

exposure limit on open positions. It has a limit of 200 and 1500 units (recall that

one contract

unit is equivalent to 93.5 quintals respectively for composite and institutional

members. The

Cochin pepper exchange has fixed a net exposure limit of 60 units (equivalent to

1500

quintals) for domestic contract and 90 units (equivalent to 2250 quintals) for

international

contract. Moreover, setting up of settlement guarantee fund ensures enough

financial strength

in case the clearinghouse faces default.

The Kanpur Commodity Exchange maintains a trade guarantee fund with a

corpus of

Rs.100 lakhs while the coffee exchange in addition to a guarantee fund the

exchange has

substituted itself as party to clear all transactions.

Yet another check on the possible default is through prescribing maximum price

fluctuation on any trading day, which helps limit the probable profit/loss from

each unit of


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transaction. The relevant data on permitted price limit has been presented. Its

clear from the

table that the maximum profit/loss potential from trade in each contract unit

varies from as

low as Rs. 800 for potato futures in Chamber of Commerce, Hapur to as high as

Rs. 15,000 in

pepper exchange, Cochin. Similarly, given the permissible open position of 200

units for a

trading-cum-clearing member and maximum price fluctuation of Rs. 150 per 100

kg for

cotton futures in the cotton exchange, Bombay, the maximum potential

loss/profit in a trading

day works out to be Rs.28.05 lakhs! 29

Margins

Margins (also called clearing margins) are good -faith deposits kept with a

clearinghouse usually in the form of cash. There are two types of margins to be

maintained

by the trader with the clearinghouse: initial margin and maintenance or variation

margins.

Initial margin is a fixed amount per contract and does not vary with the current

value of the

commodity traded. Margins are deposited with the clearing house in advance

against the

expected exposure of the trading member on his account and on account of the

clients. The

member who executes trade for them in turn collects this amount from the

clients. Generally,

the margin is payable on the net exposure of the member.

Net exposure is the sum of gross exposure (buy quantity or sale quantity,

whichever is

higher, multiplied by the current price of the contract) on account of trades

executed through

him for each of his clients and gross exposure of trades carried out on his own

account.


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However, for squaring-off transactions carried out only at the clients level, fresh

margins are

not required. The margin is refundable after the client liquidates his position or

after the

maturity of the contract.

Maintenance margin which usually ranges from 60 to 80 per cent of initial

margin is

also required by the exchange. Variation margin is to compensate the risk borne

by the

clearinghouse on account of price volatility of the commodity underlying the

contract to

which it is a counterparty. A debit in the margin account due to adverse marketconditions

and consequent change in the value of contract would lead to initial margin

falling below the

maintenance level. The clearinghouse restores initial margin through margin

calls to the

client for collecting variation margin. In case of an increase in value of the

contract, markingto-market ensures that the holder gets the payment equivalent

to the difference between the

initial contract value and its change over the lifetime of the contract on the basis

of its daily

price movements. If the member is not able to pay the variation margin, he is

bound to square

off his position or else the clearinghouse will be liquidating the position.

The margins have important bearing on the success of futures. As they are

noninterest bearing deposits payable to the clearinghouse up-front workingcapital of any trading

entity gets blocked to that extent. While a higher margin requirement prevents

traders from

participating in trading, a lower margin makes the clearinghouse vulnerable to

any default

due to its weak financial strength otherwise. Internationally, many developed

exchanges

maintain a low margin on positions due to their better financial strength along

with massive


39/95

volume of trade resulting in large income accruing to them.

However, this has not been the case with many exchanges in India. For

example, as

shown in table 2.2 the initial margin liability for transacting the minimum lot sizein pepper is 30

Rs.30, 000 for domestic contracts and US$ 312.50 for international contracts

.Similarly, the

volume of transactions. These clearinghouses deal in many exchanges in India is

abysmally

low making their existence financially unviable.

Most of the exchanges in additions to keeping mandatory margins maintain a

settlement

guarantee fund. The fund set up with the contribution from members of clearing

house is used

for guaranteeing financial performance of all members. This fund absorbs losses

not covered

by margin deposits of the defaulted member. The clearinghouse ensures this by

settling the

default transactions by properly compensating the traders paying the amount ofdifference at

the closing out rate.

How does futures contract facilitate hedging against price risk?

The futures contracts are designed to deal directly with the credit risk involved

in

locking-in prices and obtaining forward cover. These contracts can be used for

hedging price

risk and discovering future prices. For commodities that compete in world or

national

markets, such as coffee, there are many relatively small producers scattered

over a wide

geographic area. These widely dispersed producers find it difficult to know what

prices are

available, and the opportunity for producer, processor, and merchandiser to

ascertain their


40/95

likely cost for coffee and develop long range plans is limited. Futures trading,

used in the

Midwest for grains and similar farm commodities since 1859, and adapted for

coffee in 1955,

provides the industry with a guide to what coffee is worth now as well as todays

best

estimate for the future. Moreover, since all transactions are guaranteed through

a central

body, clearing house, which is the counter party to each buyer and seller

ensuring zero

default risk, market participants need not worry about their counterparts

creditworthiness.

Hedge is a purchase or sale on a futures market intended to offset a price risk

on the

physical (ready) market. It involves establishing a position in the futures market

again ones

position or firm commitments in the physical market. The producers who seek to

protect

themselves from an expected decline in prices of their commodity in future go

for short

hedge (also called sell hedge). He undertakes the following operations in the

market to lockin the price in advance which he is going to receive after the

product. I ready for physical

sale. We assume that the producer anticipates a harvest of 5 metric tones

(equivalent to 2

units of contracts in Cochin pepper exchange) of pepper in March, the futures

price for March

delivery of the specific variety of pepper is Rs.8400 per quintal (Rs.2.10lakh per

unit, and the

prevailing (say, October) ready market price is Rs.8100 per quintal.

a) In October, the producer goes short (sells) in the futures market selling 2

March futures

contracts at Rs.8400 per quintal. This is called price fixing. 31

b) In the delivery month, futures prices dropped to Rs.8200 per quintal and the

producer sells


41/95

pepper in the ready market for Rs.8200.

c) Simultaneously, he closes out his short position in futures by buying (long

position) 2

March futures contracts at Rs.8200 per quintal. The result is that the producersold futures

contract at Rs.8400 and bought the same futures contract at Rs.8200 per quintal

making a net

gain of Rs.200 per quintal or Rs.5000 per contract.

For the physical sale, the producer received the market price of Rs.8200

prevailing on

the day of the sale and the gain of Rs.200 per quintal from closing-out of futures

contracts

makes him to realize Rs.8400 per quintal as initially locked -in by price-fixing. If

the price

realized in the ready market is lower than the price in future contract, the loss on

the physical

market is compensated by the higher price realized on the future contract. On

the other hand,

if the price in the ready market is higher than in futures contract, the gain in theready market

is offset by the loss on the repurchase of the futures contract.

Since futures market prices move in tandem with the ready market prices over

the

course of time tending to converge as the contract matures, a gain in the futures

market in a

developed commodity market under normal conditions, will be offset by a loss in

the ready

market, or vice versa. However, market imperfections will lead to the basis risk

emerging

from the mismatch between the gain/loss from the futures market not

compensated by

loss/gain in the ready market.

Meaning of Derivatives

The term "Derivative" indicates that it has no independent value, i.e. its value is


42/95

entirely "derived". A derivative is a financial instrument, which derives its value

from some

other financial price. This other financial price is called underlying. The most

common

underlying assets include stocks, bonds, commodities, currencies, livestock,

interest rates and

market indexes.

A wheat farmer may wish to contract to sell his harvest at a future date to

eliminate

the risk of a change in prices by that date. The price for such a contract would

obviously

depend upon the current spot price of wheat. Such a transaction could takeplace on a wheat

forward market. Here, the wheat forward is the derivative and wheat on the

spot market is

the underlying. The terms derivative contract, derivative product, or

derivative are

used interchangeably. 32

Examples of Derivatives

Consider how the value of mutual fund units changes on a day-to-day basis.

Dont

mutual fund units draw their value from the value of the portfolio of securities

under the

schemes?

A very simple example of derivatives is cloth, which is derivative of cotton. The

price

of cloth depends upon the price of cotton, which in turn depends upon the

demand, and

supply of cotton...

Arent these examples of derivatives? Yes, these are. And you know what, these

examples prove that derivatives are not so new to us.

There are two broad types of derivatives:

Financial derivatives: - Here the underlying includes treasuries, bonds, stocks,

stock index,


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foreign exchange etc.

Commodity derivatives: Here the underlying is a commodity such as wheat,

cotton,

peppers, turmeric, corn, soybeans, rice crude oil etc.5.15 HISTORY

The history of derivatives is surprisingly longer than what most people think.

Some

texts even find the existence of the characteristics of derivative contracts in

incidents of

Mahabharata. Traces of derivative contracts can even be found in incidents that

date back to

the ages before Jesus Christ.

The first organized commodity exchange came into existence in the early 1700s

in

Japan. The first formal commodities exchange, the Chicago board of trade

(CBOT), was

formed in 1848 in the US to deal with the problem of credit risk and to provide

centralized

location to negotiate forward contracts, where forward contracts on various

commodities

were standardized around 1865.The primary market intention of the CBOT was

to provide a

centralized location known in advance for buyers and sellers to negotiate forward

contracts.

In 1865, the CBOT went one step further and listed the first futures contracts.

In 1919,

Chicago Butter and Egg Board, a spin-off of CBOT, was recognized to allow

futures trading.

Its name was changed to Chicago Mercantile Exchange (CME). The CBOT and the

CME

remain the two largest organized futures exchanges, indeed the two largest

financial 33

exchanges of any kind in the world today. From then on, futures contracts have

remained


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more or less in the same form, as we know them today.

The first stock index futures contract was traded at Kansas City Board of Trade.

Currently the most popular stock index futures contract in the world is based on

S & P 500index, traded on Chicago Mercantile Exchange. During the mid eighties, financial

futures

became the most active derivative instruments generating volumes many times

more than the

commodity futures. Index futures, futures on T-bills and Euro-Dollar futures are

the three

most popular futures contracts traded today. Other popular international

exchanges that trade

derivatives are LIFFE in England, DTB in Germany, SGX in Singapore, TIFFE in

Japan,

MATIF in France etc.

However, the advent of modern day derivative contracts is attributed to the

need for

farmers to protect themselves from any decline in the price of their crops due to

delayed

monsoon, or overproduction. Although trading in agricultural and other

commodities has

been the driving force behind the development of derivatives exchanges, the

demand for

products based on financial instruments - such as bond, currencies, stocks and

stock

indiceshas now far outstripped that for the commodities contracts.

India has been trading derivatives contracts in silver, gold, spices, coffee, cotton

and

oil etc for decades in the gray market. Trading derivatives contracts in organized

market was

legal before Morarji Desais government banned forward contracts. Derivatives

on stocks

were traded in the form of Teji and Mandi in unorganized markets. Recently

futures contract


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in various commodities was allowed to trade on exchanges.

In June 2000, National Stock Exchange and Bombay Stock Exchange

started trading

in futures on Sensex and Nifty. Options trading on Sensex and Nifty commencedin June

2001. Very soon thereafter trading began on options and futures in 31 prominent

stocks in the

month of July and November respectively. The derivatives market in India has

grown

exponentially, especially at NSE. Stock Futures are the most highly traded

contracts on NSE

accounting for around 55% of the total turnover of derivatives at NSE, as on April13, 2005 34

5.16 TYPES OF DERIVATIVES

A derivative as a term conjures up visions of complex numeric calculations,

speculative

dealings and comes across as an instrument which is the prerogative of a few

smart finance

professionals. In reality it is not so. In fact, a derivative transaction helps tocover risk,

which would arise on the trading of securities on which the derivative is based

and a small

investor, can benefit immensely.

A derivative security can be defined as a security whose value depends on the

values of other

underlying variables. Very often, the variables underlying the derivative

securities are the

prices of traded securities.

An example of a simple derivative contract:

Rohan buys a futures contract.

He will make a profit of Rs. 1200 if the price of Infosys rises by Rs. 1200.

If the price is unchanged Ram will receive nothing.

If the stock price of Infosys falls by Rs. 1000 he will lose Rs. 1000.


46/95

As we can see, the above contract depends upon the price of the Infosys scrip,

which

is the underlying security. Similarly, futures trading has already started in

Sensex futures and

Nifty futures. The underlying security in this case is the BSE Sensex and NSE

Nifty.

There are basically of 3 types of Derivatives and Futures:

Forwards and Futures

Options

Swaps

DERIVATIVES

Options Swaps Futures Forwards

Interest Rate Currency

Commodity Securities

Put Call 35

FORWARD CONTRACT

A forward contract is an agreement to buy or sell an asset on a specified datefor a

specified price. One of the parties to the contract assumes a long position and

agrees to buy

the underlying assed on a certain specified future date for a certain specified

price. The other

party assumes a short position and agrees to dell the asset on the same date for

the same

price. Other contract details like delivery date, price and quantity are negotiated

bilaterally by

the parties to the contract. The forward contracts are normally traded outside

the exchanges.

The salient features of forward contracts are:

They are bilateral contracts hence exposed to counter-party risk.

Each contract is custom designed, and hence is unique in terms of contract

size,


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expiration date and the asset type and quality.

The contract price is generally not available in public domain.

On the expiration date, the contract has to be settled by delivery of the asset.

it has to compulsorily go to the same counter party, which often results in highprice

being charged.

Limitation of forward market:

Forward market world-wide are afflicted by several problems:

Lack of centralization

Illiquidity

Counterparty risk

In the first two of these, the basic problem is that of too much flexibility and

generality. The forward market is like a real estate market in that any two

consenting adults

can form contracts against each other. This often makes them design terms of

the deal which

are very convenient in that specific situation, but makes the contracts non-tradable.

Counterparty risk arises from the possibility of default by any one party to the

transaction. When one of the two sides to the transaction declares bankruptcy,

the other

suffers. Even when forward market trade standardized contracts, and hence

avoids the

problem of illiquidity, still the counterparty risk remains very serious issue.

Illustration

Sahil wants to buy a Laptop, which costs Rs 30,000 but he has no cash to buy it

outright. He can only buy it 3 months hence. He, however, fears that prices of

laptop will rise 36

3 months from now. So in order to protect himself from the rise in prices Sahil

enters into a

contract with the laptop dealer that 3 months from now he will buy the laptop forRs 30,000.


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What Sahil is doing is that he is locking the current price of a LAPTOP for a

forward

contract. The forward contract is settled at maturity. The dealer will deliver the

asset to Sahil

at the end of three months and Sahil in turn will pay cash equivalent to the

LAPTOP price on

delivery.

FUTURES CONTRACT

Futures markets were designed to solve the problems that exist in forward

market. A

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

certain time in

the future at a certain price. But unlike forward contracts, the futures contracts

are

standardized and exchange traded. So, the counter party to a future contract is

the clearing

corporation of the appropriate exchange. To facilitate liquidity in the futures

contracts, the

exchange specifies certain standard features of the contract. It is a standardizedcontract with

standard underlying instrument, a standard quantity and quality of the

underlying instrument

that can be delivered, (or which can be used for reference purposes in

settlement) and a

standard timing of such settlement. Future contracts are often settled in cash or

cash

equivalents, rather than requiring physical delivery of the underlying asset. A

futures contract

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

transaction. More than

99% of futures transaction is offset this way.

The standardized items in a futures contract are:

Quantity of the Underlying.

Quality of the Underlying.


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The date and month of delivery.

The units of price quotation and minimum price change.

Location of settlement.

Distinction between futures and forwards contracts:

Forward contracts are often confused with futures contracts. The confusion is

primarily because both serve essentially the same economic functions of

allocating risk in the

presence of future price uncertainty. However futures are a significant

improvement over the

forward contracts as they eliminate counterparty risk and offer more liquidity.

The distinction

between futures and forwards are summarized below: 37

Futures Forwards

1.Trade on an organized exchange 1.OTC in nature

2.Standardized contract terms 2.Customized contract terms

3.Hence more liquid 3.Hence less liquid

4.Requires margin payments 4.No margin payment

5.follows daily settlement

5.Settlement happens at the end of

period.

OPTIONS CONTRACT

Option means several things to different people. It may refer to choice or

alternative

or privilege or opportunity or preference or right. To have option is normally

regarded good.

One is considered unfortunate without any options. Options are valuable since

they provide

protection against unwanted, uncertain happenings. They provide alternatives to

bail out from

a difficult situation. Options can be exercised on the happening of certain events.


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Options may be explicit or implicit. When you buy insurance on your house, it is

an

explicit option that will protect you in the event there is a fire or a theft in your

house. If you

own shares of a company, your liability is limited. Limited liability is an implicit

option to

default on the payment of debt.

Options have assumed considerable significance in finance. They can be written

on

any asset, including shares, bonds, portfolios, stock indices currencies, etc. They

are quite

useful in risk management. How are options defined in finance? What gives valueto options?

How are they valued?

An option is a contract that gives the buyer the right, but not the obligation, to

buy or

sell an underlying asset at a specific price on or before a certain date. An option,

just like a

stock or bond, is a security. It is also a binding contract with strictly definedterms and

properties.

For example, that Rohit discover a bungalow that Rohit love to purchase.

Unfortunately,

Rohit won't have the cash to buy it for another three months. Rohit talk to the

owner and

negotiate a deal that gives Rohit an option to buy the bunglow in three months

for a price of

Rs.20,00,000. The owner agrees, but for this option, Rohit pay a price of

Rs.50,000.

Now, consider two theoretical situations that might arise:

1. It is discovered that the bunglow is actually having a historical importance! As

a result, the


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market value of the bunglow increases to Rs. 50,00,000. Because the owner sold

Rohit the 38

option, he is obligated to sell Rohit the bunglow for Rs.20,00,000. In the end,

Rohit stand to

make a profit of Rs.29, 50,000.

(Rs.50,00,000Rs.20,00,000Rs.50,000).

2. While touring the bunglow, Rohit discover not only that the walls are chock-full

of

asbestos, but also that it is a home place of numerous rats. Though Rohit

originally thought

Rohit had found the bunglow of Rohit dreams, Rohit now consider it worthless.

On the

upside, because Rohit bought an option, Rohit are under no obligation to go

through with the

sale. Of course, Rohit still lose the Rs.50,000 price of the option.

This example demonstrates two very important points. First, when Rohit buy an

option, Rohit have a right but not an obligation to do something. Rohit can

always let the

expiration date go by, at which point the option becomes worthless. If this

happens, Rohit

lose 100% of Rohit investment, which is the money Rohit used to pay for the

option. Second,

an option is merely a contract that deals with an underlying asset. For this

reason, options are

called derivatives; means an option derives its value from something else. In our

example, the

bunglow is the underlying asset. Most of the time, the underlying asset is a stock

or an index.

Types of Options

There are two types of options:

Call Options: - It gives the holder the right to buy an asset at a certain price

within a specific


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period of time. Calls are similar to having a long position on a stock. Buyers of

calls hope

that the stock will increase substantially before the option expires.

Put Option: - It gives the holder the right to sell an asset at a certain price withina specific

period of time. Puts are very similar to having a short position on a stock. Buyers

of puts

hope that the price of the stock will fall before the option expires.

Participants in the Options Market

There are four types of participants in options markets depending on the position

they take:

1. Buyers of calls

2. Sellers of calls

3. Buyers of puts

4. Sellers of put 39

People who buy options are called holders and those who sell options are called

writers;

furthermore, buyers are said to have long positions, and sellers are said to haveshort

positions.

Here is the important distinction between buyers and sellers:

Call holders and put holders (buyers) are not obligated to buy or sell. They have

the

choice to exercise their rights if they choose.

Call writers and put writers (sellers), however, are obligated to buy or sell. This

means that a seller may be required to make good on a promise to buy or sell.

Terminology Associated With The Options Market.

Option Price: - Option price is the price, which the option buyer pays to the

option

seller. It is also referred to as the option premium.

Expiration Date: - The date specified in the options contract is known as the


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expiration date, the exercise date, the strike date or the maturity.

Strike Price: - The price specified in the options contract is known as the strike

price

or the exercise price.Listed Options: - An option that is traded on a national options exchange such

as

the National Stock Exchange is known as a listed option. These have fixed strike

prices and

expiration dates. Each listed option represents a predetermined number of

shares of company

stock (known as a contract).

In-the-money Option: - An in-the-money (ITM) option is an option that would lead

to a positive cashflow to the holder if it were exercised immediately. A call option

on the

index is said to be in-the-money when the current index stands at a level higher

than the

strike price (i.e. spot price > strike price). If the index is much higher than the

strike price, the

call is said to be deep ITM. In the case of a put, the put is ITM if the index is

below the strike

price.

At-the-money Option: - An at-the-money (ATM) option is an option that would

lead

to zero cashflow if it were exercised immediately. An option on the index is at-

the-money

when the current index equals the strike price (i.e. spot price = strike price).

Out-of-the-money Option:- An out-of-the-money (OTM) option is an option that

would lead to a negative cash flow when exercised immediately. A call option on

the index is

out-of-the-money when the current index stands at a level, which is less than the

strike price

(i.e. spot price < strike price). If the index is much lower than the strike price, the

call is said


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to be deep OTM. In the case of a put, the put is OTM if the index is above the

strike price.

Depending on when an option can be exercised, it is classified in on of the

following two

categories: 40

American Options: - American options are options that can be exercised at any

time

upto the expiration date. Most exchange-traded options are American.

European Options: - European options are options that can be exercised only on

the

expiration date itself. European options are easier to analyze than American

options, and

properties of an American option are frequently deduced from those of its

European

counterpart.

TRADING IN OPTIONS

If one buys an option contract he is buying the option, or "right" to trade a

particular

underlying instrument at a stated price.

An option that gives you the right to eventually make a purchase at a

predetermined

price is called a "call" option. If you buy that right it is called a long call; if you

sell that right

it is called a short call.

An option that gives you the right to eventually make a sale at a predetermined

price

is called a "put" option. If you buy that right it is called a long put; if you sell that

right it is

called a short put.

Trading in Call

Suppose a call option with an exercise/strike price equal to the price of the

underlying (100)

is bought today for premium Re.1.


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Profit/ Loss for a Long Call.

At expiry, if the securitys price has fallen below the strike price, the option will

be allowed

to expire worthless and the po

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