UNDERSTANDING

COMMODITY
MARKETS
Learning Outcomes ............................................................................... 2
1. Physical Commodity Markets ............................................................ 2
1.1 Characteristics of Physical Commodity Markets .............................. 2
Definition of a Commodity ......................................................... 2
The Physical Market ................................................................ 3
Value Chain ............................................................................ 4
Key Features of Physical Commodity Markets in India ................... 5
Regulation .............................................................................. 7
Problems of the Physical Market ................................................ 9
Electronic Spot Exchange ......................................................... 9
1.2 Factors affecting Price, Demand and Supply of Commodities .......... 10
Factors Affecting the Price of Commodities ............................... 10
Factors Affecting the Demand of Commodities ........................... 11
Factors Affecting the Supply of Commodities ............................ 13
Law of Demand and Supply ..................................................... 15
Market Equilibrium ................................................................. 19
2. Need for an Organised Exchange ..................................................... 21
2.1 Cash Forward Transactions ....................................................... 21
2.2 The Need for and Benefits of an Organised Exchange ................... 23
2.3 Differences between Forwards and Futures ................................. 25
Summary ................................................................................... 28
Key Questions ................................................................................... 30

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 Understanding Commodity Markets

Learning Outcomes

On completing this module, you will be able to:

• Define commodities
• Know the working of the physical markets and value chain
• List key features of the physical markets
• Understand the regulations related to physical markets
• List the problems of the physical markets
• Describe the need and objectives of Electronic Spot Exchange
• Explain the factors affecting the price, demand and supply of
commodities
• Understand the effects of demand and supply on market price
• Understand the features and list the limitations of Cash
Forward transactions
• Understand the need for an Organised Exchange for Futures
Trading
• Know the difference between Forward and Futures

1. Physical Commodity Markets

1.1 Characteristics of Physical Commodity Markets

Organised commodity markets have existed in India for centuries. The more easily
understood markets are those that trade in agricultural commodities. For example,
grains such as wheat, paddy and maize; or oilseeds such as mustard, groundnut
and soybean. Other markets that trade in non-agricultural commodities include
markets for metals such as iron ore, and markets for energy products such as
crude oil and natural gas.

Definition of a Commodity

A commodity refers to any good, merchandise or produce of land that can be

bought and sold. A “commodity” is an article or product that:

• is used for commerce

• is movable
• has value

The Chicago Board of Trade (CBOT) defines a commodity as: “An article of
KEYWORDS

commerce or a product that can be used for commerce. In a narrow sense, products
traded on an authorised commodity exchange. Types of commodities include
agriculture products, metals, petroleum, foreign currency and financial instruments, to
name a few.”

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Understanding Commodity Markets

• can be bought and sold

• is produced or used as a subject in a barter or sale.

Goods or products have economic value. Producers produce goods and sell them
to processors who in turn process them into different goods or products to sell
them further. Sometimes, traders buy the goods, store and sell them later. In this
process, the goods or products pass through many hands before they reach the
end consumer.

For example, a farmer produces cotton and sells the produce to a yarn manufacturer.
The yarn manufacturer sells the finished yarn to a cloth manufacturer, who again
sells the finished cloth to a cloth merchant. Ultimately, consumers buy clothes for
their use from the cloth merchant. From cotton to cloth, all intermediary products
are commodities that are bought or held with the intention of sale. When the
commodity reaches the final consumer and is not held for further sale, it ceases to
be a commodity. It is important to note that the term “commodity” relates to the
intention of the person who produces or holds them for further sale.

The Physical Market

The physical market is the traditional market and is usually referred to as the “cash
and carry market” or the “spot market”. In this market, the seller agrees to deliver
the commodity and the buyer agrees to make the payment “on the spot”. This
agreement between the buyer and the seller is termed as “spot contract”. Purchases
are settled in cash at mutually agreed prices. In other words, in the physical
market, trades are executed through party-to-party contracts. The advantage of
this market is that the buyer can select and buy the specific commodity required.

Inherent Limitation of the Physical Market

The inherent characteristic of the physical market is that the transactions in this
market are subject to price risk. For example, consider a biscuit manufacturing
company. The basic raw materials required by this company are wheat and sugar.
The price of these basic raw materials depends on the demand-supply situation.
Demand and supply are a function of prices, and several other factors. The company
needs continuous supply of wheat and therefore needs to plan procurement and
storage of wheat in such a manner that the production of biscuits does not face
any problem. For this, the company could enter into a contract with a farmer to
purchase wheat. However, if the wheat production falls, then the company may
have to pay a higher price for the wheat to keep up its biscuit production.

The farmer, who is the other party to the contract, faces price uncertainty from
the time wheat is sown till it is harvested. The farmer may get attractive prices for
the wheat in times of scarcity. However, when there is a very good yield and
consequently over supply of wheat, he would have to sell off his perishable harvest
at a low price. Thus, both sellers and buyers face price risk in the physical market.

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 Understanding Commodity Markets

Value Chain

A value chain comprises all activities and services undertaken along a commodity
chain - from the primary producer to the final consumer. As products move from
one stage of the value chain to another, value gets added. A typical value chain
includes producers, assemblers, traders, processors, distributors, retailers and of
course, consumers. Producers use inputs such as seeds, fertilisers, labour, and
implements to produce raw materials. Assemblers and traders purchase these
materials in bulk. Processors or manufacturers, then convert these raw materials
into finished goods. These goods are procured by distributors who are generally
wholesalers. From them, the goods reach consumers through retailers.

We can analyse the value chain by examining all activities and observing where
further value is added to the product and also by examining business needs. This
analysis of the value chain helps players at various stages of the chain to increase
their profitability.

Intermediaries
The major participants of this market are producers, traders and brokers, processors,
distributors, packagers, wholesalers and retailers. The relationship between various
participants and the structure of the market is illustrated below. Traders, brokers
and commission agents act as “intermediaries” connecting the other participants
and the various segments of the value chain.

MARKET YARD

Primary Sellers Auction Buyers Wholesaler Sub

purchaser
Aggre- Commi- as the Commission Processor Raw/ Wholesaler
FARMERS produce
gator ssion was required Agent Finished
Agent AUCTION
Product

Retailer

Figure: 1.1: Physical Agricultural Commodity Market Structure

Example 1: The value chain for petrochemicals, starting from the refinery to the
end user is given below.

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Understanding Commodity Markets

Table 1.1: Value Chain for Petrochemicals

Value Chain Products

Refinery Crude Oil/Natural Gas
Naphtha/Ethane
Petrochemical Ethylene/Propylene/Ethylene Dichloride/Vinyl
Producer Chloride Monomer
Processor Poly Propylene, Poly Ethylene, Poly Vinyl Chloride
End User Furniture makers, Households,
Automotives, Films, Pipes

Example 2: The multi-layered value chain for castor seeds is shown below.

This illustration shows a value chain with different layers in the market structure
for castor seeds. The diagram clearly indicates that the value chain is long and
involves many intermediaries, commonly known as Arthiyas. These intermediaries
prevent efficient price discovery and price dissemination.

PRODUCER

Kacchha Arthiyas Pakka Arthiyas

(Commission Agent) (Commission Agent)

GOVT PVT
AGENCY AGENCY STOCKIST

PROCESSOR

OIL
WHOLESALER

OTHER INDUSTRIAL
EXPORTERS CONSUMERS USERS

Figure 1.2: Value chain for castor seeds

Key Features of Physical Commodity Markets in India

In India agricultural commodities are traded in wholesale markets called mandis,

which set the price of a commodity. The physical markets that trade in agriculture
commodities function under the control of the respective State Governments.

Setting up Mandis
Mandis can be set up only with the permission of the respective State Government.
Each state has a State Agriculture Marketing Board, which sets up Mandi Boards
downstream at the district level. Mandi Boards give permission to set up mandis.
After the mandi is set up, every mandi builds one or more yards with platforms.

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 Understanding Commodity Markets

Farmers sell their produce at these yards to licensed traders who in turn sell it to
the wholesale dealers.

Products
Every mandi trades in a set of primary commodities specific to the region and also
in a set of non-primary commodities. The farmers’ produce is first weighed and
certified by the Mandi Inspector in terms of type and quantity. Generally, once the
produce is certified and recorded at a particular mandi, sometimes for a fee, it has
free access to other mandis in the district. A farmer’s ability to access more than
one mandi to get the best price depends on various factors such as transportation
cost, packaging cost and the cost of storage during transportation.

Participants
Key market participants are farmers, licensed traders, brokers and wholesale dealers.
Traders and brokers are the intermediaries between the farmers, wholesale dealers
and mill owners. Only licensed traders are allowed to be the intermediaries.

Arthiyas are important intermediaries in the agricultural commodities market. An

Arthiya acts as both a commission agent and as a financier to the farmers. The
Mandi Board Committee allots specific yards to each of the Arthiyas and the
farmers unload their grains in these yards. The Arthiyas get the grains weighed
and packed and help to organise the auction. For these services, they are paid
“dami”, or a commission fee.

Traders have to pay Mandi Fees, which include:

• Basic transaction fee, varying from 4% to 12% of the monetary value of

the trader’s volume
• Other fees such as taxes, also linked to the volume.

Trading
There are two types of trading.

In the first type, the farmer approaches the trader for a price quote. When they
mutually agree on a price, the produce is considered to be sold to the trader.

The second type is an “outcry auction” for which there is a designated time at
each mandi. The auction is done in sequence, typically going from a lot with a fixed
grade to the next.

Price
There is no real-time price dissemination at mandis. A new price is set at each
auction. Prices are collected only at the time of clearing. There is also a wide gap
between the farm gate price and the consumer price at the retail end. This is
because the farmers sell the produce at low prices to the traders.

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Understanding Commodity Markets

Clearing, Delivery and Settlement

Physical markets for commodities deal in either cash (spot contract) or in forwards.
Traders have to do the clearing immediately for cash contracts. Disputes, if any
are settled by the Mandi Inspector. Traders have to report both price and volumes
on a daily basis. For spot contracts, delivery and payment has to be made within
11 days. However for forwards, delivery and payment can take place even after 11
days.

In the physical market, contracts have to be settled with physical delivery of the
commodities. However, under unforeseen circumstances when either party cannot
give or take delivery of the commodities, the contract maybe settled otherwise by
mutual agreement.

Regulation

The physical market in India is regulated through the State Agricultural Marketing
Boards. As on 31st March 2007, agricultural production in the country was serviced
through, 27,131 rural primary/periodic agricultural markets of which 7465 functioned
under the ambit of regulation. The regulatory framework is provided by the Agricultural
Produce Marketing Acts [APMC Acts] of various States. Agricultural Produce Market
Committees [APMCs] are set up to implement the provisions of the Act for regulating
the marketing of agricultural produce for designated market areas within a state.
These APMCs are responsible for the development and maintenance of market
yards and for enhancing trading facilities.

Currently, in most states, the APMC Acts place restrictions on the farmer from
entering into direct marketing or contract with any processor/manufacturer/bulk
purchaser. The Act specifies that the produce must be channelised only through
the regulated market. Several states including Maharashtra, Punjab, Andhra Pradesh
and Rajasthan have recently amended their APMC acts along the lines of the Model
APMC Act, 2002 of the Central government. This model Act permits farmers to sell
their produce directly to buyers offering them the best price. Several State
governments have also enacted legislation to permit contract farming. The
Karnataka Government has taken the initiative in facilitating the establishment of
an “Integrated Produce Market” owned and managed by the National Diary
Development Board (NDDB) for marketing of fruits, vegetables and flowers in the
State.

Settlement is the satisfying of a claim or demand. It is the transfer of the

KEYWORDS

commodity ( for the seller) or cash ( for the buyer) in order to complete a
transaction

APMC Act is a state act constituted by each state to establish and regulate
agricultural markets. The whole geographical area in the State is divided and
declared as a market area wherein the markets are managed by the Market
Committees constituted by the State Governments.

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 Understanding Commodity Markets

Status of Market Reforms in Agriculture (APMC Act amendments) as on 31st

January, 2007
Several States and Union Territories (UTs) have initiated reforms and amended
their APMC Acts keeping in view the model Act circulated to them. Table 1.2
summarizes the stage of reforms in the States and Union Territories.

Table 1.2: Status of market reforms in agriculture

Stage of Reforms in States /

Name of States / Union Territories
Union Territories (UTs)
Madhya Pradesh, Himachal Pradesh, Punjab,
Reforms to APMC Act have been Sikkim, Nagaland, Andhra Pradesh, Chattisgarh,
done as suggested Rajasthan, Orissa, Arunachal Pradesh,
Maharashtra and Chandigarh
Reforms to APMC Act have been
done partially by amending APMC Haryana, Karnataka, Gujarat, NCR of Delhi, U.P
Act / resolution by Executive Order
Bihar, Kerala, Manipur, Andaman & Nicobar
No APMC Act and hence do not
Islands, Dadra & Nagar Haveli, Daman & Diu and
require any reforms to the Act
Lakshadweep
APMC Act already provides for the
Tamil Nadu
reforms
Assam, Mizoram, Tripura, Meghalaya, Jammu
Administrative action is initiated for
Kashmir, Uttaranchal, Goa, West Bengal,
the reforms
Essential Commodities Act, 1955Pondicherry and Jharkhand

While trade in agricultural commodities at the State level is regulated by the APMC
Acts, the Essential Commodities Act provides the legislative framework for regulation
at the Central level. The Essential Commodities Act, 1955 is a central act that
provides for the control of production, supply and distribution of, and trade and
commerce in commodities. The Central government determines the commodities
that are regulated by the Essential Commodities Act. These commodities are those
where “it is felt necessary or expedient by the Central Government to do so for
maintaining or increasing supplies of any essential commodity, or for securing their
equitable distribution and availability at fair prices.”

The number of commodities designated as essential commodities, which stood at

70 in the year 1989 has been brought down to 15 during the 10th Plan period,
facilitating free trade and commerce. The licensing requirements, stock limits and
KEYWORDS

The Essential Commodities Act, 1955 was enacted to ensure easy availability
of essential commodities to the consumers and to protect them from exploitation
by unscrupulous traders.

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Understanding Commodity Markets

movement restrictions on specified food items under the Essential Commodities

Act have also been diluted. This dilution has enabled dealers to freely buy essential
commodities, stock them, sell, transport, distribute, or dispose any quantity.

Problems of the Physical Market

The main problems of the physical market are:

• Lack of proper price dissemination and transparency in price discovery

process
• Very fragmented, isolated and unorganised markets
• Restrictions on interstate movement of goods
• Lack of proper certification and standardisation of commodities
• Lack of proper warehousing and transportation facilities
• Long chain of intermediaries
• Cartelisation of intermediaries with multiple levels of intermediation
• Processors not allowed to buy directly from cultivators in most states
• Excessive dependence on and consequent exploitation by money lenders
• Distress sales by farmers
• Stock limits in essential commodities
• High volatility of spot market prices
• States having different tax and tariff structures

Electronic Spot Exchange

To overcome the problems of the physical market, an electronic spot exchange

has been established by the National Commodity & Derivatives Exchange Ltd.
(NCDEX) and is called the NCDEX Spot Exchange Ltd. (NCDEX Spot). This is a
national level, institutionalised and transparent electronic exchange. This exchange
is expected to help solve the various problems faced by farmers, traders, processors
and other players in the physical market.

Need for an Electronic Spot Exchange

It has been found that in a physical market a wide gap exists between the prices
paid by end-consumers and the prices received by the farmers. This is mainly due
to the following reasons:

1. Very high costs of intermediation.

2. The farmers’ ignorance about the spot prices of the commodity in a
mandi before they reach the mandi to sell their produce. This leads to
distress sales.
3. Price uncertainty making it difficult to predict the market accurately.
4. Lack of an effective mechanism to eliminate price risk. The risk arises
due to variations in demand and supply and also due to uncertainties in
the economic and market conditions.

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 Understanding Commodity Markets

The electronic exchange, with its high level of sophistication and connectivity with
local panchayats, has the potential to overcome the current problems of the
mandi trading system. This exchange provides real-time price information to farmers
thus, enabling them to take informed decisions.

Objectives
The objectives of setting up NCDEX Spot are to:

• Develop a Common Indian Market by setting up a national-level electronic

spot market with state-of-the-art trading, delivery and settlement
facilities that are accessible across the country.
• Provide an effective, transparent method of discovering nationwide spot
prices in various commodities.
• Create a market where farmers can get the best prices and receive
prompt payments.
• Facilitate better efficiency in procurement and bring down the levels
and costs of intermediation.
• Create a market where traders, processors and end users can procure
agricultural produces at a competitive price without any quality and
counter party risk.
• Provide quality certification, warehousing facilities and other services.
• Create a structured, organised and standardised spot market to help
the futures exchanges in facilitating physical delivery in agricultural
commodities.

1. 2 Factors Affecting Price, Demand and Supply of Commodities

Factors Affecting the Price of Commodities

The demand and the supply of goods constitute two sides of the commodities
market. We shall understand how the confluence of demand and supply factors
determines the prices of goods. The price of a product is determined by changes in
these two sides.

Demand
Demand is the relationship between a commodity’s price and the quantity of that
product that consumers are willing to buy at that price. In economics, demand is a
function of its price, prices of related commodities, income level, tastes and
preferences, and other factors like population, weather conditions, and quality.

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Understanding Commodity Markets

Mathematically, the demand function is:

Qd = f (P, Pr I, T, O)

Where

Qd The quantity demanded

P The price of the commodity
Pr The price of the related commodity
I The income of the household or income of the consumer
T The tastes and preferences of the consumer
O Other factors

As demand is a function of several factors, the relationship of demand with each

factor can be studied one at a time by keeping other factors constant.

Supply
Supply is the relationship between the price of a commodity and the amount of the
commodity that sellers of the commodity are willing to supply at that price at that
time. It refers to what producers offer for sale at that price. Like in the case of
demand, supply is also a function of its price and several other factors like production
technology, cost of production, prices of related commodities, weather and
seasonality, government policies, carry over stock etc.

Mathematically, the supply function is:

Qs = f ( P, Te, C, Pr, W, G, S, O)

Where

Qs The quantity supplied

P The price of the commodity
Te The technology used
C The cost of production
Pr Prices of related commodities
W Weather and seasonality
G Government policies
S Carry over stock
O Other factors

Factors Affecting the Demand of Commodities

Price of the Commodity

Other factors remaining the same, the demand for a commodity varies inversely
with its own price. When the price of a commodity goes up, its demand comes

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 Understanding Commodity Markets

down and vice versa. This inverse relationship may not remain constant if there is
a change in the price of related commodities, change in income level and change in
tastes and preferences. This relationship is also called The Law of Demand and is
explained in detail, later in this Chapter.

Price of Related Goods

Two products are said to be related to each other when one substitutes or
complements the other.

a) Substitute goods: Two commodities are said to be substitutes if the

consumption of either of them would satisfy the same need. Tea and
coffee are examples of substitutes. There is a positive relationship
between the price of a commodity and the demand for its substitute. If
two commodities x and y are substitutes, an increase, say, in the price
of y would induce consumers to shift from y to x, increasing the demand
for x.

When other factors remain constant, if the price of tea increases, its
demand will fall and the demand for coffee will increase. If the price of
coffee increases, its demand will fall and the demand for tea will increase.

b) Complementary goods: Two commodities are said to be complementary

when the consumption of one commodity requires the consumption of
the other commodity as well. Tea and sugar, car and petrol are examples
of complementary products. If the price of a product, say, petrol, goes
up, the demand for its complementary product, say, car, goes down.
The level of decrease, of course, depends on the degree of complement
between the two commodities.

Both in the case of substitute as well as complementary goods, a product

could have more than one substitute or complementary goods. The
price of each of the substitutes or complementary product is a vector
of prices rather than a single price.

Disposable Income
The ability to pay for a commodity is directly determined by the level of disposable
income of households. The exact relationship between income and demand depends
upon the nature of the commodity. Economists classify goods into inferior goods,
necessaries, comforts and luxuries.

Table 1.3 depicts the relationship between the disposable income and the demand
for goods, based on the nature of the goods.

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Understanding Commodity Markets

Table 1.3: Relationship between the disposable income and the demand
for goods

Type of commodity Disposable Demand for the commodity

income
Inferior goods (poor quality grains, Increase Decrease
soiled goods, unbranded goods etc.)
Necessaries ( food, clothing, shelter) Increase Increase up to a certain limit
and thereafter no change
Comforts and luxuries (branded Increase Increase
clothes, cars, TVs, etc.)

Consumer Taste and Preferences

Consumer taste and preferences are important factors for the demand of a commodity.
For example, if a person is a vegetarian, his demand for meat and meat products
will be zero, no matter what the price is. Health, fashion, changes in technology,
consumption patterns abroad - all these factors have an impact on consumer
taste and preferences and, therefore, on the demand of commodities.

Other Factors Influencing Demand

Population size
The aggregate demand for a commodity also depends on the number of
consumers. The demand for all commodities world over is on an increasing
trend because of the growth in population.

Supply
Usually, the lesser the supply of a commodity, the higher is its demand.
This in turn leads to an increase in price of the commodity.
For instance, if the supply of a particular variety of wheat falls, its
demand increases as some merchants may want to hoard it. For this,
they may be also willing to pay a higher price.

Factors Affecting the Supply of Commodities

Price
Other things remaining constant, the supply of a commodity varies directly with its
own price; that is, when prices go up, sellers are willing to supply more of the
commodity and vice versa. This relationship is called the Law of Supply and is
explained later in this module.

Techniques and Cost of Inputs

Improvements in production techniques and decrease in the cost of inputs will
bring down the cost of production of a commodity. When the price of a commodity
remains the same, any decrease in the cost of production will increase the

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 Understanding Commodity Markets

profitability and induce producers to produce more of the commodity. Hence, there
will be an increase in its supply.

Prices of Related Commodities

The supply of a commodity and the price of its substitute product are inversely
related. For example, tea and coffee are substitute products. When other things
remain the same, increase in the price of coffee will induce producers to divert
more resources on coffee production instead of tea and thus reduce the supply of tea.

The supply of a commodity and price of its complementary product are directly
related. For example, car and petrol are complementary products. When the price
of the car increases, supply of cars will increase and supply of petrol will also
increase.

Weather, Seasonality and Production Cycle

In the case of agricultural commodities, weather is one of the key factors determining
the quantity of a commodity produced. Both excess and shortage of rains affect
the supply of these commodities. Weather forecasts are an important source of
information. These forecasts help in determining the expected supply of a commodity
and, therefore, its price. Supply of a commodity will be higher during certain
periods of the year. For example, supply of fans and coolers will be high during
summer.

Most commodity prices tend to be higher at the beginning of a production cycle.

For example, paddy prices will be strong during the time of field preparation and
planting. The risk is very high at this stage including the fear of poor or too much
rains leading to lower yields and supply. As harvesting nears and risk lessens,
prices weaken, especially if the harvest is expected to be good. Similarly, prices of
seasonally produced commodities will be higher during off-seasons. The advantage
of agricultural commodities is that seasonality is a known phenomenon, which
helps in predicting trends of supply and prices.

Government Policy
The government’s economic policies, such as the industrial policy, fiscal policy and
tariff policy influence supply. For example, high custom duties reduce the supply of
imported commodities and increase the supply of domestic commodities. An increase
in excise duties for any commodity will reduce its supply. Increase in the Minimum
Support Prices of agricultural commodities by the Government sends positive signals
to the farming community to increase the acreage under cultivation of the crops,
which increases the supply.

Carry Over Stock

Carry over stocks when added to the annual production of a commodity, gives its
supply for the year. When the carry over stock of a commodity is a high proportion
of the total commodity usage in a year, that is, when the stock-to-use ratio is

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Understanding Commodity Markets

high, prices are expected to be low, as this is an indication of a good supply

position. For example, high carry over stocks of sugar in 2006-07 led to a decline in
sugar prices in the open market.

Laws of Demand and Supply

The law of demand explains the functional relationship between the demand of a
commodity and its price. Similarly, the law of supply explains the functional
relationship between the supply of a commodity and its price.

The Law of Demand

Other things remaining the same, the demand for a commodity varies inversely
with its own price, that is, when the price of a commodity goes up, its demand
comes down and vice versa. The above relationship can be represented in the
form of a table called the demand schedule or can be represented graphically in
the form of a figure called the demand curve.

A market demand schedule is a table that shows the quantity of a commodity

that consumers are willing to and are able to purchase over a given period of time
at each price of the commodity. All other relevant variables on which the demand
depends are kept unchanged.

Table 1.4 depicts a typical demand schedule.

Table 1.4: Demand schedule

Price for potatoes Quantity demanded

Point (Rs. per kg.) per month (000 kgs.)

A 20 700
B 40 500
C 60 350
D 80 200
E 100 100

Demand Curve
The demand curve is drawn by plotting the various price-quantity combinations
indicated in the demand schedule. Generally, the price per unit is measured along
the vertical axis (y-axis) while the quantity demanded per unit of time is measured
KEYWORDS

Law of demand: The law depicting the inverse relationship between demand
and price.

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 Understanding Commodity Markets

along the horizontal axis (x-axis). The demand curve has a negative slope, sloping
downwards from left to right. This negative slope reflects the inverse relationship
between price and quantity demanded. The points on the demand curve represent
various price-quantity combinations.

Figure 1.3 depicts the demand curve for the above demand schedule.
E
100

D
80
Price (Rupees per kg)

C
60

B
40

A
20
Demand

0
0 100 200 300 400 500 600 700 800
Quantity (Kgs: 000s)

Figure 1.3: Demand Curve

Shift in Demand
The demand curve for a commodity is drawn on the assumption that the income of
the consumer, his tastes, the price level of related commodities, and other non
price factors remain unchanged. If there is a change in any of the factors, there
will be a ‘shift’ in the demand curve. Whenever there is any change in any of the
determinants of demand the demand curve shifts either right (upward) or left
(downward). A rightward shift indicates that more of the commodity is demanded
at each price level. For example, increase in income, or a fall in the price of
complementary product will lead to an increase in the quantity demanded and
cause an upward shift the demand curve. A downward (leftward) shift takes place
when less of the commodity is demanded due to fall in the price of substitute,
increase in the price of compliments, or a change in the taste or fashion against
the commodity. Figure 1.3(A) and 1.3(B) depicts the upward and downward shift
in demand respectively.
E
100

D
80
Price (Rupees per kg)

C
60

B
40

A
20
Demand

0
0 100 200 300 400 500 600 700 800
Quantity (Kgs: 000s)

Figure 1.3(A): Upward Shift in Demand

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Understanding Commodity Markets

E
100

D
80
Price (Rupees per kg)

C
60

B
40

A
20
Demand

0
0 100 200 300 400 500 600 700 800
Quantity (Kgs: 000s)

Figure 1.3(B): Downward Shift in Demand

The Law of Supply

The supply of a commodity varies directly with its own price. When prices go up
sellers are willing to supply more of the commodity and vice versa, other things
remaining the same. The above relationship can be presented in the form of a table
called the supply schedule or can be represented graphically in the form of a
chart called the supply curve.

A market supply schedule is a table that shows the quantity of a commodity

supplied at specific prices, the other factors, which affect the supply of the
commodity, being constant.

Table 1.5 depicts a typical supply schedule.

Table: 1.5 Supply Schedule

Point Price Quantity Supplied

(Rupees per kg) Monthly
for potatoes (Kgs 000s)
A 20 100
B 40 200
C 60 350
D 80 530
E 100 700
KEYWORDS

Law of supply: The law of supply is that, other things remaining the same, the
quantity supplied will increase as the price increases.

17
 Understanding Commodity Markets

Supply Curve
When the various price-quantity combinations of a supply schedule are plotted as
a graph, the supply curve is obtained. The supply curve has a positive slope, going
upwards from left to right, indicating the direct relationship between price and
quantity supplied.

Figure 1.4 depicts the supply curve for the above supply schedule.
e

100 d
Price (Rupees per kg)

80
c

60
b

40

a
20

0
0 100 200 300 400 500 600 700 800
Quantity (Kgs: 000s)

Figure 1.4: Supply Curve

Shift in Supply Curve

When the supply of a commodity changes due to changes in factors of supply, the
supply curve shifts either upwards (right) or downwards (left). For example, if the
supply increases due to better technology, decrease in cost of production etc.,
the supply curve shifts upward, meaning more is supplied for the same price. On
the other hand, the supply curve shifts left when the cost of production increases
or there is a fall in the price of its complements. Figure 1.4(A) and 1.4 (B) depicts
the upward and downward shift in supply.

Figure 1.4(A): Upward Shift in Supply

KEYWORDS

Supply curve is a curve that depicts the relationship between price and quantity
supplied.

18
Understanding Commodity Markets

Figure 1.4 (B): Downward Shift in Supply

Market Equilibrium

The interaction of the forces of demand and supply determines the equilibrium
price and the quantity of a commodity. A market is said to be in equilibrium when
buyers and sellers buy and sell at the given price without trying to change the
quantity or the price. The equilibrium price of a commodity is the price at which
the quantity demanded equals the quantity supplied.

E e
Supply

100 D d
P rice (R upe e s pe r kg)

80
c C

60
b B
40
a
A
20 Demand

0
0 100 200 300 400 500 600 700 800

Quantity of potatos : Monthly (Kgs: 000s)

Figure 1.5: Equilibrium Price

Figure 1.5 depicts the market equilibrium in potatoes. The chart indicates that
when the price of the potatoes is Rs. 60 per kg, both the quantity demanded as
well as the quantity supplied is 350,000 kg per month.

At prices above the equilibrium price, the quantity supplied will exceed the quantity
demanded, leading to a surplus of the commodity, which would drive the price
down. For example, as shown in the chart below, at a price of Rs. 80 per kg, the
quantity of potato supplied is 530,000 kg, while the quantity demanded is only
200,000 kg, leading to a surplus of 330,000 kg.

19
 Understanding Commodity Markets

Figure 1.6: Surplus of Commodity

Sellers of potatoes would reduce prices to reduce the accumulated stock of unsold
potatoes. At lower prices, suppliers will supply lesser quantity of potatoes, while
buyers will demand more. This process will continue until the equilibrium price of
Rs. 60 per kg is reached, as indicated in Figure 1.6.

On the other hand, at prices below the equilibrium price, the quantity supplied to
the market will come down, while demand will increase, thus leading to a shortage
of the commodity. For example, at a price of Rs. 40 per kg, only 200,000 kg of
potatoes will be supplied in a month. At this price, 500,000 kg of potatoes will be
demanded, leading to a shortage of 300,000 kg. This is shown in Figure 1.7.

E e
Supply
100
D d
Price (Rupees per kg)

80

c C
60

b SHORTAGE B
40
(330 000)

a
20 A
Demand
0
0 100 200 300 400 500 600 700 800

Quantity of potatos : Monthly (Kgs: 000s)

Figure: 1.7: Shortage of Commodity

The shortage will push up the price and more quantity of potatoes will get supplied
to the market till prices reach the equilibrium once more as indicated in Figure 1.8.

20
Understanding Commodity Markets

E e
Supply
100
D d
Price (Rupees per kg)

80

c C
60

b B
40

a
20 A
Demand
0
0 100 200 300 400 500 600 700 800

Quantity of potatos : Monthly (Kgs: 000s)

Figure: 1.8: Market Equilibrium

At any particular point in time, the observed market price may or may not be the
equilibrium price. However, as explained earlier, the market forces will push the
market price towards equilibrium. This process may happen rapidly or slowly. It can
generally be stated that the market price reflects the equilibrium price fairly closely
in the absence of

• any shift in demand

• any shift in supply
• price controls

2. Need for an Organised Exchange

2.1 Cash Forward Transactions

Cash transactions in the physical market involve two types of contracts that
require:

1. Immediate delivery in the spot market

2. Delivery of a specific commodity to the buyer sometime in the future

The second type of contract that specifies delivery of a commodity to the buyer
at a future date is called a “cash forward contract”. For example, suppose a farmer
enters into a forward contract with a flourmill in December 2007 to deliver 15,000
tonnes of wheat during June 2008. While entering the contract, both partners
agree upon the quality, quantity, delivery time, location and price. At the time of
delivery, price adjustments are made depending on whether the stipulated factors
have been met or not.

21
 Understanding Commodity Markets

Forward Contract
A forward contract is a bilateral agreement in which a buyer and seller agree upon
the delivery of a specified quality and quantity of an asset on a specified future
date at a pre-determined price. One of the parties to the forward contract assumes
a long position and agrees to buy the underlying asset on a certain specified future
date for a specified price. The other party assumes a short position and agrees to
sell the asset on the same date at the same specified price. In simple terms, long
and short positions indicate whether the party to the contract has a buy position
(long) or sell position (short). Other contract details like delivery date, delivery
price and quantity are negotiated bilaterally by the parties to the contract. Forward
contracts are customised contracts normally traded outside the exchanges.

Features of Forward Contracts

The salient features of forward contracts are:

• Forward contracts are over the counter (OTC) contracts. They are
bilateral contracts and hence are exposed to counter–party risk.
• Each contract is custom designed and hence unique in terms of contract
size, expiration date and the asset type and quality.
• Generally, only parties to the contract know the contract price.
• On the expiration date, the contract has to be settled by delivery of
the asset. If the party wishes to reverse the contract, it has to
compulsorily go to the same counter party, which often results in high
prices being charged.

Difference Between a Spot and a Forward Transaction

There are three processes involved in any market transaction:

1. Trading

2. Clearing

3. Settlement.

In a trading process, the buyer with the demand for the product interacts with the
seller supplying the product. The buyer and the seller negotiate and arrive at an
agreement regarding quantity, quality and price.

In the clearing process, the buyer and the seller decide on the quantum of goods
and the amount of cash that would be exchanged among them.

The actual exchange happens in the settlement process.

KEYWORDS

OTC Derivatives: OTC derivatives are bilateral contracts negotiated privately

between two parties and not traded on any exchange.

22
Understanding Commodity Markets

In a spot transaction, trading, clearing and settlement happen simultaneously

and instantaneously - that is, “on the spot”. For example, consider a mill owner
interested in buying cotton. He approaches a farmer on 1st July 2007 who quotes
Rs. 4,500 per quintal. They agree upon this price and the mill owner buys 1,000
quintals. He pays the farmer Rs. 45 lakh and leaves with the cotton. This is a spot
transaction. However, if the mill owner is interested in buying the cotton only two
months later, he can contact the farmer, who quotes Rs. 4,520 per quintal for
1,000 quintals for delivery after two months. Two months later, the mill owner will
pay the farmer Rs. 45.20 lakh and take delivery of the cotton. This is a forward
contract.

In a forward transaction, cash does not change hands on the date of entering into
the contract. While the trading happens on the current day, clearing and settlement
happen at the end of the specified period. Hence, in a forward contract, the
trading, clearing and settlement do not happen simultaneously as in a spot contract.

2.2 The Need for and Benefits of an Organised Exchange

While the cash forward transactions have the advantage of being customised,
they have the following limitations:

• The contracts are private and negotiated bilaterally between two parties.
Therefore, there are no exchange guarantees.
• The prices are not transparent as there is no reporting requirement.
• There are no regulations for establishing market stability and protection
of market players.
• Lack of standardisation leads to illiquidity in the absence of a secondary
market.
• The profit or loss is realised only on the maturity date.
• Settlement is only through actual delivery or offsetting by cash delivery.

Compared to the forward market for commodities, which is highly customized,

other forward markets, say the Foreign Exchange market, can be highly standardised.
This process of standardization reaches its limit in the organised futures market, in
which the above limitations get addressed.

Future contracts have evolved out of forward contracts. These contracts are
exchange-traded versions of forward contracts. These contracts are an agreement
to buy or sell a specified quantity of a commodity during a designated month in the
future, at a price agreed upon by the buyer and seller at the time of entering into
the contract. Future contracts contain standard specifications of the underlying
asset, its quality and quantity and the date and time of expiry of the contract. A
futures contract need not be settled through physical delivery. It can be closed by
entering into an equal and opposite contract.

23
 Understanding Commodity Markets

Benefits of Futures Trading

Futures contracts provide several benefits to market participants. These are:

• Price discovery and price dissemination

Futures markets enable various players to discover the price of
commodities and make informed decisions. Prices get disseminated
instantaneously to everybody as the contract prices are available on
the centralised trading screen of the exchange. The producer can access
the prices and get an idea of what the future prices are likely to be.
This information helps the producer to decide among various commodities.
The consumer gets an idea of prices that would be charged to him at
points in the future. Exporters also find it easier to quote realistic prices
and face competition better.
• Price risk management
The larger, more frequent and more unforeseen price variability in a
commodity, the greater is its price risk. The risk mitigation or “hedging”
mechanism provided by the futures market provides an efficient and
effective mechanism for management of price risks. For example, an
exporter can “hedge” his price risk on the export contract by using the
futures market. Or, a manufacturer can hedge the risk inherent in the
cash market.
• Price stability
The futures market mechanism helps prevent rampant fluctuations in
prices leading to price stabilisation. Efficient price discovery helps in
preventing seasonal price volatility.
• Common platform for all traders
A centralised trading platform gives access to all players, unlike the
bilateral forward market, which has only restricted access.
• Low transaction costs
Low brokerage costs and a smaller bid-ask spread lead to low impact
costs. In addition, there is no need to get into any time-consuming
negotiations as in the forward markets. These factors help to reduce
the transaction costs.
• Absence of counter party credit risk
In a futures contract, the ‘clearing house’ becomes a counter party to
each transaction. This act of the clearinghouse is called ‘novation’ and
this removes the counter party risk. This is possible because of the
standardised and centralised nature of all transactions.
• Lower credit risk
The use of various types of margins helps in guaranteeing the
performance of future contracts, thereby bringing down the credit risk.
• Liquidity
The standardisation of contracts enables participants to come out of
their positions easily. Liquidity is further enhanced by the large number
of market participants trading on an exchange.

24
Understanding Commodity Markets

The futures market also helps in several other ways:

• Makes possible spaced out purchases of commodities – this precludes

the need for large cash purchases and the problem of storage.
• Provides greater flexibility, certainty and transparency in procuring
commodities - this helps to procure bank finance easily.
• Facilitates informed lending to lending agencies, especially for the
agricultural sector.
• Hedging techniques reduce the risk of default of participants to the
lenders.

2.3 Differences Between Forwards and Futures

Given below are the differences between forward and futures contracts in terms
of:

1. Characteristics
2. Price determination
3. Functions of the market
4. Advantages
5. Limitations.

25
 Understanding Commodity Markets

Criteria Forward Contracts Future Contracts

Characteristics • Forward contracts are OTC • Futures are exchange
(Over-the-Counter) contracts. traded.
• These contracts are bilateral • There are a large number
contracts and hence exposed of market participants.
to counter-party risk. The exchange takes care
• Each contract is custom of the risk management.
designed and hence is • Futures contracts are
unique in terms of contract standardised in terms of
size, expiration date and the their various
asset type and quality. characteristics such as
• The contract has to be quantity, quality,
settled by delivery of the settlement dates and
asset on the expiration date. market conventions. This
If the party wishes to reverse standardisation enables
the contract, it has to easy and convenient
compulsorily go to the same access by a large
counter party. number of market
participants.
• Futures contract is a
price fixing contract. The
buyer or seller is
obligated to take or
deliver or close out the
positions at the pre-
agreed price for
settlement.
• In the 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.
Price determination • In principle, the forward price • Futures markets have a
for an asset would be equal large number of market
to the spot or the cash price participants. Price
at the time of transaction and discovery takes place
the cost of carry. The cost of based on the
carry includes all the costs fundamentals affecting
incurred for carrying the the demand and supply
asset forward in time. of the commodity and the
Depending on the type of market perception of this
asset or commodity, the cost demand-supply situation.
of carry takes into account
various factors such as
payments and receipts for
storage, transport costs,
interest payments, dividend
receipts and capital
appreciation. The buyer and
the seller decide the price
amongst themselves. There
is neither a market
mechanism nor price
discovery.
cont'd…
26
Understanding Commodity Markets

Functions of the • Forward contract is a simple • Futures markets perform

agreement to buy or sell an various important economic
market
asset at a certain future time functions. These markets
for a certain price. The meet the needs of three
forward contract is traded in groups of futures market
over-the-counter market and users:
not in an exchange. o Those who wish to
Therefore neither the market discover information
nor the exchange has a role about the future
to play in a forward prices of
commodities.
transaction.
o Those who wish to
speculate or exploit
any arbitrage
opportunity.
o Those who wish to
hedge their price
risk.

Advantages • A forward contract has no • Future contracts contain

margin system. This means standard specifications of
that there is no cost for both the underlying asset, its
the buyer and the seller, for quality and quantity and the
entering into a transaction. date and time of expiry of
• Forward contracts are the contract.
customised and the contract • Absence of credit risk. At
terms can include any point of time, the
specifications regarding maximum credit risk is
quality, location of delivery, limited to one-day
etc. as agreed upon between movement in futures prices.
the buyer and the seller. • High liquidity: Futures
market allows participants to
come out of their positions
at any point in time.
• High leverage: Futures are
highly leveraged
instruments, which attract a
large number of market
participants; these
participants ensure high
liquidity at all times.
• Price stabilisation: the
futures mechanism enables
reduction in price
fluctuations whenever there
is a violent fluctuation in
price.
• Standardisation in futures
contracts enables easy and
convenient access to all
market participants.

cont'd…
27
 Understanding Commodity Markets

Lim itations • The contracts are private • Perfect hedge is not

and negotiated bilaterally possible due to
between the parties. standardisation of
Therefore, there are no contracts. Futures
exchange guarantees. contracts cannot be
• Prices are not transparent as tailored to the specific
there is no reporting needs of firms and
requirement. financial institutions.
• The profit or loss is realised
only on the m aturity date.
• Settlement is only through
actual delivery or offsetting
by cash delivery. Closing out
is not possible.
• Lack of standardisation
exists and hence there is no
secondary market.

Summary

In this module, we have identified:

• The characteristics of commodities

• The factors that affect their demand and supply
• How commodity prices are determined
• The limitations of the physical markets
• The need for organised exchanges for trading in various commodities.

A commodity is an article or product that is used for commerce, is movable, has a

value, can be bought and sold and that is produced or used as a subject in a
barter or sale. Commodities are traded in the physical markets and in futures
markets. The physical market is the traditional market and is usually referred to as
the “cash and carry market” or the “spot market”, where, the seller agrees to
deliver the commodity and the buyer agrees to make the payment on the “spot”.

Value chains incorporate all the activities and services undertaken along a commodity
chain - from the primary producer to the final consumer. Analysis of the value
chain by examining all activities and observing where we can add further value to
the product and also by examining the business needs help players in various
stages of the chain to increase profitability.
KEYWORDS

Closing Out is the opposite transaction 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.

28
Understanding Commodity Markets

The major participants of the commodity market are producers, traders and brokers,
processors, distributors, packagers, wholesalers and retailers.

In India agricultural commodities are traded in wholesale markets called mandis,

which also set the price of a commodity. There is no real-time price dissemination
at mandis. In India, the physical markets in agriculture are under the control of the
respective State Governments under the aegis of the state’s Agricultural Produce
Marketing Act (APMC). These markets are also governed by the provisions of The
Essential Commodities Act, 1955 (ECA). The physical market has a lot of limitations,
price risk being a major factor. To overcome the problems of physical market,
electronic spot exchanges are being established.

The demand and the supply of goods constitute the two sides of the commodities
market. The price of a product is determined by changes in these two sides.
Demand is the relationship between a commodity’s price and the quantity of that
product that consumers are willing to buy at that price. In economics, demand is a
function of its price, prices of related commodities, income level, tastes and
preferences, and other factors like population, weather conditions and quality. The
various factors that affect the demand of commodities include its price, the price
of related goods, demand for substitutes and complementary goods and disposable
income. Factors affecting supply include price, production techniques and cost of
inputs, prices of related goods, weather, seasonality, production cycle, government
policies and existence of carry over stocks.

The Law of Demand states that, other things remaining the same, when the price
of a commodity goes up, its demand comes down and vice versa. The Law of
Supply states that, the supply of a commodity varies directly with its price. The
equilibrium price is the point of intersection between the demand and supply curves.

Cash forward transactions in the physical market involve delivery of a specific

commodity to the buyer sometime in the future and are called forward contracts.
A forward contract is a bilateral agreement in which a buyer and seller agree upon
the delivery of a specified quality and quantity of an asset on a specified future
date at a pre determined agreed price. Generally, only parties to the contract
know the contract price. On the expiration date, the contract has to be settled by
delivery of the asset. If the party wishes to reverse the contract, it has to
compulsorily go to the same counter party, which often results in high prices being
charged. Future contracts have evolved out of the limitations of forward contracts.
Future contracts are standardized, exchange-traded versions of forward contracts.
Benefits of futures trading include price discovery and price dissemination, price
risk management, price stability, common trading platform, low transaction costs,
liquidity and absence of counter party credit risk.

29
 Key Questions

1. A bilateral agreement in which a buyer and seller agree upon the delivery
of a specified quality and quantity of a commodity on a specified future
date at a pre-determined price is known as:

A) Cash Contract
B) Forward Contract
C) Spot Contract
D) Bilateral Contract

2. In India, wholesale agricultural commodity markets are known as:

A) Bazaar
B) Hyper Mart
C) Mandis
D) Super Markets

3. Chains that comprise all activities and services from primary producer to
final consumers are known as:

A) Trade Chains
B) Trade Cycles
C) Manufacturing Cycle
D) Value Chains

4. The __________ price of a commodity is the price where the quantity

demanded equals quantity supplied.

A) Market
B) Selling
C) Equilibrium
D) Supply

5. A commission agent as well as financier to the farmers is known as:

A) Arthiya
B) Broker
C) Shaukar
D) Munshi

30
Key Questions

6. Physical markets either trade in cash (spot contract) or ______.

A) Future Contracts
B) Forward Contracts
C) Rollover Contracts
D) Swaps

7. In case of spot contracts, delivery and payments have to be made within

____ days.

A) 7
B) 9
C) 10
D) 11

8. In case of substitute goods, the fall of demand for one product would
result in ______ in demand for the other.

A) No change
B) Decrease
C) Increase

9. In case of complementary goods, the fall of demand for one product would
result in ______ in demand for the other.

A) No change
B) Decrease
C) Increase

10. The __________ price of a commodity is the price where the quantity
demanded equals quantity supplied.

A) Market
B) Selling
C) Equilibrium
D) Supply
ANSWER KEY

Qustion No. 1 2 3 4 5 6 7 8 9 10
Answers B C D C A B D C B C

31
32
 UNDERSTANDING
DERIVATIVES
Learning Outcomes ............................................................................. 34
1. Types of Derivatives ....................................................................... 34
1.1 OTC Derivatives ...................................................................... 35
Forwards ............................................................................. 36
Swaps ................................................................................. 36
Types of Swaps .................................................................... 37
1.2 Exchange–Traded Derivatives .................................................... 40
Futures ............................................................................... 40
Options ............................................................................... 42
Indices ................................................................................ 46
1.3 Other Derivatives .................................................................... 47
Credit Derivatives ................................................................. 47
Weather Derivatives .............................................................. 48
Energy Derivatives ................................................................ 49
Insurance Derivatives ............................................................ 50
Interest Rate Derivatives ....................................................... 50
2. Payoff for Derivative Positions ........................................................ 51
2.1 The Payoffs for Forwards ......................................................... 52
2.2 The Payoffs for Futures ........................................................... 53
2.3 The Payoff for Options ............................................................. 53
3. Commodity Derivatives vs. Financial Derivatives ............................ 58
3.1 Physical Settlement ................................................................. 58
3.2 Warehousing ........................................................................... 60
3.3 Quality of Underlying Assets ..................................................... 60
4. Derivative Market Participants ........................................................ 61
4.1 Various Market Participants and their Roles ................................. 61
4.2 Types of Traders ..................................................................... 64
Summary ................................................................................... 65
Key Questions ................................................................................... 68

33
 Understanding Derivatives

Learning Outcomes

On completing this module, you will be able to:

• Understand the meaning of derivatives

• Appreciate the uses of derivatives
• Understand the meaning of OTC Derivatives
• Understand the various types of swaps
• Describe commodity swaps and its payoffs
• Explain the determination of swap prices
• List the exchange traded derivatives
• Understand various terminologies used in relation to futures and options
• Get introduced to various kinds of margins
• Understand the concepts of Agricultural Options and Options based on
commodity futures
• Describe derivatives based on indices
• Have a basic understanding of derivatives based on weather, credit,
insurance, energy, interest rates and currency
• Understand the payoffs of long and short positions in forwards and
futures
• Understand the payoffs for buyers and writers of long and short positions
in options
• Explain the differences between commodity and financial derivatives
• Describe the meaning and role of various market participants
• Identify the various types of traders

1. Types of Derivatives

Derivatives
A derivative is a financial instrument whose value depends on or is “derived” from
the value of an underlying asset. This underlying asset could be a commodity,
foreign exchange, equity, interest rate or an index among others.

In India, the Securities Contract Regulation Act (SCRA) 1956 has included derivatives
as securities. Therefore, this law governs the trading of financial derivatives in our
country.

The SCRA has defined derivatives to include:

• A security derived from a debt instrument, share, loan whether secured

or unsecured, risk investment or contract for differences or any other
form of security

34
Understanding Derivatives

• A contract that derives its value from the prices, or index of prices, of
underlying securities

Derivatives are mainly of four types:

1. Forwards
2. Futures
3. Swaps
4. Options

Derivatives are traded in two different markets:

• Over-the-Counter (OTC) markets

• Exchanges

Derivatives traded on the OTC markets are simply called OTC derivatives and the
ones traded on exchange are exchange-traded derivatives.

1.1 OTC Derivatives

OTC derivatives are bilateral contracts negotiated privately between two parties
and not traded on any exchange. It is a telephone and computer-linked network of
dealers who do not physically meet. The dealers perform the economic functions
of “market making” by offering two-way quotes to the participants. The brokered
OTC trading process may be automated and electronic, but it still remains bilateral
because only the two parties to the transaction get to know the quotes or details
of execution.

A key advantage of the OTC market is that the terms of a contract do not have to
be those that are specified by an exchange. Market participants are free to negotiate
any mutually attractive deal. However, the disadvantage is that there is usually
some credit risk, of the contract not being honoured. The major OTC derivatives
are forwards and swaps.

Over-The-Counter (OTC): A market conducted directly between dealers and

KEYWORDS

principals via a telephone and computer network rather than an exchange trading
floor. Unlike an exchange, there is no automatic disclosure of the price of deals to
other market participants, and the deals and traded instruments are not
standardized.

35
 Understanding Derivatives

Forwards

As we have seen in the earlier unit, forwards are bilateral contracts in which the
buyer and seller agree upon the price and terms of delivery. These contracts are
highly customised and not traded on exchanges.

A commodity forward is an agreement to buy or sell an asset or a commodity, at a

certain time in the future, for a certain price (called the delivery price). The party
that agrees to buy is said to have taken a long position. And the party that
agrees to sell is said to have taken a short position.

Assume, for example that on February 21, the treasurer of a corporation enters
into a long forward contract to buy 1 million MT of wheat in three months at an
exchange rate of Rs. 680/quintal. This obligates the corporation to pay Rs. 6.8
billion on May 20 for delivery of 1 million MT of wheat.

Swaps

Literally, ‘swap’ means an exchange. A swap derivative is an agreement between

two parties (known as counterparties) to exchange two different streams of cash
flows (known as the legs of the swap) over a definite period of time, usually
through an intermediary such as a financial institution. The agreement defines the
dates when the cash flows are to be paid and how they are to be calculated.
Usually the calculation of the cash flows involves the future values of one or more
market variables.

The nature of the cash flows to be exchanged is defined in the contract. A swap is
thus an agreement entered into between two counterparties to exchange cash
flows at some point or points in the future. Therefore, a forward itself can be
thought of as a swap, where cash flows get exchanged on a single date in the
future.

For example, suppose that on 1st January a company enters into a six-month
forward contract to buy 100 kgs of silver at Rs.17,600 per kg. The company can
sell the silver in the market as soon as it receives the same on 30th June. Further
assume that on 30th June the spot rate for silver is “S”. The swap here is that, at
the end of 6 months, the company pays a fixed amount and receives a variable
KEYWORDS

Swap: A derivative contract, where two counterparties exchange one stream of

cash flows against another stream.

36
Understanding Derivatives

amount on the transaction, linked to “S”.

Forwards are single period price-fixing contracts, which involve exchange of cash
flows on a single future date, whereas swaps are multi-period price fixing contracts,
where cash flow exchanges occur on several future dates.

A swap is made up of three components:

• The initial exchange (called opening/near-leg)

• A set of cash flows
• The final exchange (called closing/far-leg)

Types of Swaps

There are four different types of swaps:

• Interest rate swaps

• Currency swaps
• Equity swaps
• Commodity swaps

Interest Rate Swaps

Interest rate swap is the most common of all swaps and refers to the exchange of
two sets of cash flows between two counterparties over an agreed time frame.
Often, an interest rate swap involves exchanging a fixed amount per payment
period for a payment that is not fixed (the floating side of the swap would usually
be linked to another interest rate, say the LIBOR). While the notional principal
amount is the same, the intermittent payments are based on two interest rates.
The objective of this swap is to facilitate the counterparties to cover their
exposures, say fixed to floating and vice-versa, by exchanging the interest cash
flows. Generally, the principal is not exchanged.

Interest rate swaps are used to get a better interest rate for both parties. Consider
this example.

LIBOR: London Inter Bank Offer Rate (LIBOR) is a daily reference rate based on the
KEYWORDS

interest rate that the banks charge each other for unsecured funds in the London
wholesale money market (or interbank market).

Interest Rate Swap is a derivative in which one party exchanges a stream of

interest payments for another party’s stream of cash flows. Interest rate swaps can
be used by hedgers to manage their fixed or floating assets and liabilities.

37
 Understanding Derivatives

• Suppose that X Ltd. wants to borrow at fixed rate of 6%. It has a good
credit rating in floating rate market but not in fixed rate market.
• Another company, Y Ltd. wants to borrow at floating rate, say at LIBOR.
It has good credit rating in floating rate market and not in fixed rate
market.
• It makes sense for them to borrow in the markets where they can get
better terms and then swap.

Borrows at LIBOR from market

X Pays fixed at 6% to Y

Borrows at 6% from market

Y Pays at LIBOR to X

Figure 2.1: An interest rate swap

So X can issue a floating rate note on a $1 million principal, while Y can issue a
fixed rate bond at, say 6% on the same principal amount with the same maturity of
five years. On swapping the cash flows, X agrees to pay Y 6% for five years, while
Y agrees to pay X a six-month LIBOR on the same principal as shown in Figure 2.1.
The notional amount of the principal of $1 million is not transferred. Cash flows are
normally settled so that only the difference is paid by a counter party.

Currency Swaps
A currency swap refers to the exchange of a fixed amount of a currency per
annum for a fixed amount of another currency per annum. On maturity of the
swap, the principals are exchanged.

All three components of a typical swap are identifiable in a currency swap. The
exchange rate is agreed upon at the beginning itself. In a cross-currency swap, at
least one of the cash flows will be based on a floating rate. Currency swaps help to
hedge exposures in foreign currency.

Currency Swap refers to the exchange of a fixed amount of a currency per annum
KEYWORDS

for a fixed amount of another currency per annum. On maturity of the swap, the
principals are exchanged.

Equity Swap: A swap where payments on one or both sides are linked to the
performance of equities or an equity index.

38
Understanding Derivatives

Equity Swaps
In an equity swap, one set of payments is based on the returns of a stock or a
stock index, whereas the other counterparty’s payments are either a fixed amount
or based on a stock or a stock index. Equity swaps can sometimes give negative
returns.

Commodity Swaps
In a commodity swap, the cash flows exchanged depend on the value of the
underlying commodity. They are used to hedge against price risks. Like in any
other swap transaction, a bank or a financial institution arranges the commodity
swaps.

Commodity swaps are commonly used in the oil industry by heavy users such as
airlines. For example, an airline can agree to make a series of fixed payments to a
bank or an intermediary, say every six months for two years. In turn, it can receive
variable payments (based on market rate for oil) on the same days as shown in
Figure 2.2. The airline will buy oil it needs from the spot market and pay from the
variable amounts it receives from the bank. However, the actual outflow for the
airlines is fixed.

Pay variable Pay fixed

Oil company Airlines Bank

Pay Variable

Figure 2.2: Commodity Swap in an Airline Industry

Commodity swaps are also gaining popularity in the agricultural and energy sectors
where demand and supply of the underlying commodity are subject to high levels
of uncertainty. To remove the impact of high levels of volatility in commodity
swaps say in oil swaps, the variable payments are based on the average value of
an oil index over a period of time whereas in interest rate, currency, and equity
swaps, variable payments are based on the price/rate on a particular day.
KEYWORDS

Commodity Swaps: A swap where exchanged cash flows are dependent on the price
of an underlying commodity

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 Understanding Derivatives

1.2 Exchange–Traded Derivatives

Exchange-traded derivatives are standard derivatives like futures and options

traded on exchanges. Traditionally, exchanges used the open-outcry system on
trading floors for trading of these derivatives. In recent years, however, open-
outcry is increasingly being replaced by electronic trading. Compared to OTC
derivatives, the exchange-traded derivatives carry virtually no counterparty credit
risk.

Futures

As we have understood earlier, a futures contract is an agreement between two

parties to buy or sell the underlying asset at a future date at today’s future price.
A futures contract is different from a forward contract, as it is standardised and
exchange-traded. It has a standard underlying, standard quality and quantity of
the underlying, and a standard timing for settlement of the contract. The underlying
can be delivered, or its value can be used as a reference for settlement.

Examples of Future Contract

• Agreement to buy 10 kg of gold at Rs. 9,470/10 gms in March
• Agreement to sell 1,000 MT of wheat at Rs. 680 per quintal in May

Commodity Futures Contracts may be up to one year into the future. A futures
contract mandates physical delivery. But in most of the cases, it may be offset by
entering into another contract, which is exactly opposite in nature, at any time
before the maturity date.

Futures traded on the NCDEX include commodities like gold, silver, soy bean, rapeseed,
mustard seed, crude palm oil, rubber, pepper, jute, guar, chana and wheat. Maize
futures traded on NCDEX use 10 MTs as the unit of trading. Quotations are given in
Rs. per quintal. Quality is specified in terms of the percentage of damages, infections,
foreign matter allowed, moisture and test weight. Quantity variations of + or – 5%
is allowed. Nizamabad, Andhra Pradesh is the main delivery centre.

Common Terminology Used in Futures Contract

• Spot price
This refers to the price at which an underlying asset trades in the spot
market.

• Futures price
This refers to the price at which a futures contract trades in the futures
market.

40
Understanding Derivatives

• Contract cycle
This refers to the period over which the futures contract trades in the
exchange. In NCDEX, commodity futures contracts that expire every
one month, two months and three months are available. For example,
observe the future quotes for maize in Table 2.1
Table 2.1: Futures quote for maize on NCDEX
Closing Price
(Rs./Quintal)
as on 1 March, 2008

Spot 752.10

One month future (expiry in March 2008) 823.00

Two month future (expiry in April 2008) 869.50

Three month future (expiry in May 2008) 902.50

• Expiry Date
This refers to the last day on which the contract would be traded. After
this date, the contract ceases to exist. In NCDEX, this expiry date is
the 20th day of the delivery month. If this happens to be a holiday, a
Saturday, or a Sunday, the expiry date will be the immediately preceding
trading day, other than a Saturday.

• Delivery Unit
This refers to the amount of a commodity that has to be delivered
under a single contract. In NCDEX, for example, it is 10 MTs for maize,
55 bales for long staple cotton and 1 kg for gold.

• Basis
This refers to the difference between the futures price and the spot
price. For commodities, basis is calculated using the formula [Spot Price
- Future Price] while for financial assets, the formula [Futures Price -
Spot Price] is more commonly used. Normally, futures prices exceed
spot prices.

The basis is determined by comparing the costs of actually holding the

commodity versus contracting to buy it for a later delivery (that is a
futures contract). The basis is affected by factors such as changing
situations in supply or demand. Unless otherwise specified, the price of
the nearby futures contract month is generally used to calculate the
basis.

• Margin
This refers to the deposit money that needs to be paid to buy or sell
each contract. The margin required for a futures contract is better
described as a performance bond or “good faith” money. The margin

41
 Understanding Derivatives

levels are set by the exchanges based on the price volatility of the
commodity and can be changed at any time. The margin requirements
for most futures contracts range from 2% to 15% of the value of the
ontract.

Options

An option is an agreement between two parties - one of whom is the buyer and
the other 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 (called the
exercise 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 the “option premium”
from the buyer. Unlike forwards and futures, the holder of the option is not obliged
to exercise the contract. While no upfront costs are incurred in entering into a
forward or a future, an option requires the upfront payment of the option premium.

There are two types of options:

1. Call option: A call option is a contract that gives the buyer the right
(option) to buy the underlying asset by a certain date for a certain
price. He can choose not to exercise the option. The seller of the call
option has an obligation to sell the asset, if the option is exercised by
the buyer.

2. Put option: A put option is a contract that gives the holder the right
(option) to sell the underlying asset by a certain date for a certain
price. He can choose not to exercise the option. The seller of the put
option has an obligation to buy the asset, if the option is exercised.
There are several terms used in the context of options. They are:

• Buyer/Holder/Owner
This refers to the person who buys the option. As a result, he gets the
right (option) to buy or sell the underlying asset without the obligation
to do so.
KEYWORDS

Options are financial instruments that convey the right, but not the obligation, to
engage in a future transaction on some underlying security, or in a futures contract.

42
Understanding Derivatives

• Seller/Writer
This refers to the person who sells the option. As a result, he acquires
the obligation to buy or sell the underlying asset. He receives the option
premium for accepting the obligation.
• Long position
This refers to the buying of a security such as a stock, commodity or
currency, with the expectation that the asset will rise in value. In the
context of options, it refers to the buying of an options contract.

• Short position
This refers to the sale of a borrowed security, commodity or currency
with the expectation that the asset will fall in value. In the context of
options, it is the sale (also known as “writing”) of an options contract.

• American option
In this type of option, the buyer can exercise the right (buy/sell) at any
time until the expiry of the option contract.

• European option
In this type of option, the right can be exercised by the buyer only at
the end of the life of the option contract.

• Spot rate
This refers to the rate at which an underlying asset quotes in the spot
market.

• Exchange rate
This refers to the forward exchange rate that is to be used if the strike
price is expressed in a foreign currency.

• Exercise price
The price at which the option holder may buy or sell the underlying
security, as defined in the terms of contract. A “call” holder may exercise
to buy the underlying asset or the “put” holder may exercise to sell the
underlying asset.

• Option price (or option premium)

This is the amount paid by a buyer to the seller for acquiring the right to
buy or sell an underlying asset. Alternatively, it is the price received by

43
 Understanding Derivatives

the seller for surrendering his rights in an option contract. It is usually

paid upfront - at the time of entering into the option contract.

• In–the-money option
This option is one that would give its holder a positive cash flow, if
exercised immediately. In a call option if the market price (spot price) is
above the exercise price, it is in-the-money.
In a put option, if the market price (spot price) is below the strike price,
it is in-the-money.

• Out-of-the-money option
This option is one that would give its holder a negative cash flow, if
exercised immediately. In a call option if the market price (spot price) is
below the exercise price, it is out-of-the-money. In a put option, if the
market price (spot price) is above the strike price, it is out-of-the-
money.

• At–the–money option
This option is one which leads to nil or zero cash flow to its holder. This
would be the situation where the price of the underlying asset equals
the option’s exercise price.

• Intrinsic value
The option premium is the sum of two parts - intrinsic value and time
value. The amount by which an option is in-the-money is the intrinsic
value. An option will have intrinsic value if it is in-the-money option.

• Time value
This is the amount of money that buyers are willing to pay for an option
in the anticipation that, over time, a change in the underlying futures
price will cause the option to increase in value. The time value of an
option depends on the “length of time to expiration” of the option. The
option premium will decrease when the time to expire decreases. The
option with a longer “time to expire” has higher probability of moving ‘in-
the-money” than the option with less time to expire. The time value is

Intrinsic value for a call option is the difference between the underlying stock’s
price and the strike price. For put options, it is the difference between the strike price
KEYWORDS

and the underlying stock’s price. An option will have intrinsic value if it is in-the-
money option.

Time Value is the difference between the premium paid for an option and the
intrinsic value. As an option approaches expiration, the time value erodes, eventually
to zero. An option will have only time value if it is at-the-money or out-of-the-money.

44
Understanding Derivatives

the difference between the option premium and its intrinsic value. Other
things remaining the same, the greater the time left for expiration, the
greater is the option’s time value. At expiration, the option has no time
value. An option that is at-the-money or out-of-the-money has no
intrinsic value. It has only time value.

Option terminologies for this example are given below:

Example: In January, the spot price of corn is $4.00 per bushel. John buys from
Haneef a call option on 1st January at $ 4.50 per bushel for delivery on 30th
June the same year, and pays premium of $0.20 per bushel.Chandy buys from
Haneef a put option on 1st January at $ 4.30 per bushel, for delivery on 30th
June the same year and pays premium of $0.10.

T yp e Type
S. S.
D e s c rip tio n of T e rm D e s c rip tio n of T e rm
No. No.
o p tio n o p tio n
If M a rk e t
st st
P ric e o n 1 C a ll va lu e o n 1 O u t-o f-
S p o t p ric e
1 J a n u a ry and 9 M a rc h is C a ll th e -
$ 4 .0 0 P ut $ 4 .4 0 p e r m oney
bushel
If M a rk e t
st
B u ye r / va lu e o n 1 A t-th e -
2 John C a ll 10 C a ll
h o ld e r M a rc h is m oney
$ 4 .5 0
C a ll
3 H aneef and W rite r 11 C handy P ut B u ye r
P ut
E x e rc is e
E x e rc is e
4 $ 4 .5 0 C a ll p ric e /S trik e 12 $ 4 .3 0 P ut
p ric e
p ric e

5 $ 0 .2 0 C a ll P re m iu m 13 $ 0 .1 0 P ut P re m iu m

If M a rk e t
E x e rc is e
A n y tim e C a ll va lu e o n 1 s t O u t-o f-
d a te –
6 b e fo re and 14 M a rc h is P ut th e -
A m e ric a n
June 30 P ut $ 4 .6 0 p e r m oney
o p tio n
bushel
If M a rk e t
E x e rc is e
C al va lu e o n 1 s t
d a te – In -th e -
7 3 0 th J u n e and 15 M a rc h is P ut
E u ro p e a n m oney
P ut $ 4 .1 0 p e r
o p tio n
bushel
If M a rk e t If M a rk e t
va lu e o n 1 s t va lu e o n 1 s t
In -th e - A t-th e -
8 M a rc h is C a ll 16 M a rc h is P ut
m oney m oney
$ 4 .6 0 p e r $ 4 .3 0 p e r
bushel bushel

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 Understanding Derivatives

Commodity options are yet to be permitted to be traded in India, though it is to be

expected that commodity option contracts would be permitted soon.

Options Based on Commodity Futures

Also called futures options, these options provide holders an opportunity to avoid
the potential losses associated with a futures contract. The underlying asset in
this case is the futures contract and not the physical commodity represented by
the futures contract. For example, a June corn option contract is an option for a
June delivery corn futures contract. In this way, the options are on futures and
not on the corn itself.

The underlying futures contract generally matures immediately after the expiration
of the option. On exercise of a call option, the holder acquires from the seller a
long position in the underlying futures contract. In addition, there is a cash amount
equal to the excess of the futures price over the exercise price. The opposite
happens in the case of a put option. In both the cases, the futures contracts are
closed out, as they have no value on maturity.

The advantage of futures options is that unlike the physical market, which could
be controlled by a few parties and hence possible to manipulate, the futures
market is more organised. It has a large number of participants along with speedy
assimilation of information. While these options have not yet been introduced in
Indian markets, commodity options are traded in international exchanges like CBOT
and LIFFE. In CBOT, all commodity options are American options and the final
Settlement price is the Daily Settlement Price of the underlying futures contract
on the expiration day.

Indices

Stock Index Futures Contracts

Futures contracts can be traded with an index as the underlying. The movement
of the stock index future will be similar to that of the underlying index. Stock index
futures contracts are cash settled. The profit to the holder of a long position is the
difference between the value of the stock index on the maturity date and the
futures price.

Generally, stock market indices are value-weighted or price-weighted. In a value-

weighted index, the weight of each stock in the index is in proportion to the
market value of all outstanding shares. A price-weighted index is one that gives a
weight to each stock that is proportionate to the stock price itself.

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Understanding Derivatives

Stock Index Options

Index options have an index as the underlying asset. Trading in index options gives
the benefit of index movements without having to invest in the component stocks
of the index. Index options are settled in cash. A holder of an index option, that is
in-the-money, receives the difference between the exercise price and the value of
the index at the close of the exercise day. Stock index options trading commenced
on the NSE and the BSE in June 2001, with the Nifty and the Sensex as the
underlying asset.

Derivatives Trading on the National Stock Exchange (NSE)

Derivatives trading on the National Stock Exchange (NSE) commenced on June 12,
2000 with futures trading on S&P CNX Nifty Index. Subsequently the product base
has been increased to include trading in futures and options on S&P CNX Nifty
Index, futures and options on CNX IT index, Bank Nifty index and single securities
(118 stocks as stipulated by SEBI) and futures on interest rate. The interest rate
future contracts are available on Notional 91 day T-bill and Notional 10 year bonds
(6% coupon bearing and zero coupon bonds), while the index options are European
style and stock options are American style.

At any point of time, only three contract months are available for trading, with 1
month, 2 months and 3 months to expiry. These contracts expire on the last
Thursday of the expiry month and have a maximum of 3 month expiration cycle. A
new contract is introduced on the next trading day following the expiry of the near
month contract. All the derivatives contracts are presently cash settled.

The turnover in the derivatives segment has witnessed considerable growth since
inception. The total settlement value in the derivatives segment of the NSE is
estimated to be over Rs. 95,000 crore in the fiscal year 2007-08. NSE has
established itself as the country’s sole market leader in this segment in the country
with more than 99.5% market share

1.3 Other Derivatives

Credit Derivatives

A credit derivative is designed to assume or transfer credit risk from one party to
another in exchange for a fee.

Credit Risk: In simple words, credit risk is the risk that a borrower will default on his
obligations under a credit arrangement. Put simply, credit risk is the risk that a
KEYWORDS

borrower will not pay back the lender. The borrower may either default on interest
and/or principal payments. The reason for default can be bankruptcy, though the
actual default normally occurs well before becoming bankrupt. In either case, the
lender/investor stands to lose part or all of the investment. Sometimes credit risk is
also called default risk.

47
 Understanding Derivatives

Weather Derivatives

Companies whose performance will be adversely affected by weather changes

need protection against weather risk. This risk can be hedged by using weather
derivatives that potentially reduces the risk associated with inclement weather
conditions. Unlike other derivatives, in weather derivatives the underlying asset
(weather) cannot be valued directly. Hence, pricing becomes an issue. Weather
derivatives can be used by farmers, leisure and entertainment companies, food
and drink manufacturers, and oil and power companies to reduce risks related to
weather.

Weather derivatives use two variables:

1. Heating Degree Days (HDD)

2. Cooling Degree Days (CDD)

A day’s HDD is computed as: HDD = Max (0, 65 - A)

A day’s CDD is computed as: CDD = Max (0, A - 65)

“A” refers to the average of the day’s highest and lowest temperature at a specified
weather station. The temperature is measured in degrees Fahrenheit.

For example, if the maximum temperature during a day (12 p.m. to 12 p.m.) was 70
degrees Fahrenheit and the minimum temperature for the same period was 46
degrees Fahrenheit, A will be 58. The daily HDD = Max (0, 65-58) = 7 and the daily
CDD = Max (0, 58-65) = 0.

A typical weather derivative could be a forward or an option contract with the pay
off related to the cumulative HDD or CDD during a period. For example, in February
2007, an investment dealer sells a call option to a client. This could be on the
cumulative HDD during March 2007 at a particular weather station with a strike
price of 800 and a payment rate of $1,000 per degree per day. If the actual
cumulative HDD is found to be 900, the payoff is $100,000.
KEYWORDS

Heating Degree Days (HDD) The number of degrees that a day’s average
temperature is below 65 Fahrenheit (18o Celsius), the temperature below which
o

buildings need to be heated. The price of weather derivatives traded in the winter is
based on an index made up of monthly HDD values

Cooling Degree Days (CDD) The number of degrees that a day’s average
temperature is above 65o Fahrenheit, the temperature at which people will start to
use air conditioning to cool their buildings. The price of weather derivatives traded
in the summer are based on an index made up of monthly CDD values

48
Understanding Derivatives

Note: As weather derivatives are not yet introduced in Indian Exchanges, the
above example relates to USA.

Energy Derivatives

Energy derivatives are very active in the derivatives market, both in OTC and
exchange-traded derivatives. The underlying are mostly in crude oil, natural gas
and electricity.

Crude Oil
Crude oil is one of the important commodities in the world with very high levels of
demand. For many years, 10-year fixed-price supply contracts are popular in the
OTC markets. These are swaps where oil at a fixed price is exchanged for oil at
floating price. The highly volatile nature of oil prices has led to both OTC and
exchange-traded derivatives for managing price risk. During the 1970s, oil price
was highly volatile, which led oil producers to seek more sophisticated instruments
to manage price risk. During the 1980s, many products were developed. Products
like swaps, forward contracts and options are actively traded in the OTC markets.
Exchanges like New York Mercantile Exchange (NYMEX) and the International
Petroleum Exchange (IPE) trade a large number of oil options and futures. The
futures can be settled either in cash or delivery.

Natural Gas
Globally, as well as in our country, the natural gas industry is witnessing deregulation
and private participation. Nowadays, the supplier of natural gas and the producer
of gas are not necessarily the same entity. Suppliers are faced with the problem of
meeting daily requirements of demand. And the seller of gas has to take responsibility
for the distribution of gas through pipelines.

Both OTC and exchange-traded contracts are available (NYMEX and IPE) for the
delivery of natural gas. Forward contracts, options and swaps are available in the
OTC market, where the contract specifies the quantity of gas, the rate, the
delivery period etc. In NYMEX, contracts for the delivery of 10,000 million British
Thermal units of natural gas are traded.

Electricity
The peculiarity of electricity as a commodity is that it cannot be stored easily. The
maximum capacity of all electricity producing stations in a region determines the
maximum electricity supply for that region. Generally, the demand for electricity is
higher in the summer months with the increased need for air-conditioning. Heat
waves, combined with the lack of ability to store electricity, cause spot prices of
electricity to become highly volatile for short intervals. This volatility, accompanied
by deregulation in the industry has led to the growth of a market in electricity

49
 Understanding Derivatives

derivatives. In this market, both OTC and exchange-traded derivatives are available
and option contracts are normally exercised on a daily or on a monthly basis.

An energy producer faces two kinds of risks.

• Price risk
• Volume risk

While price risk is hedged by trading in energy derivatives, volume risk is taken
care of by weather derivatives.

Insurance Derivatives

Both insurance contracts and derivatives contracts are tools for risk management.
These contracts exhibit a lot of common features. The insurance industry has
been hedging its exposure to catastrophic risks through the process of reinsurance
over the years. Natural forces like earthquakes and hurricanes, among others are
the main causes.

In recent years, the industry feels that its reinsurance needs are more than what
could be provided by the traditional method. This has led to the development of a
new derivative in the OTC market called the CAT Bond or Catastrophe Bond. These
are issued by insurance subsidiaries and pay a high interest rate. In exchange for
this higher than normal interest rate, the holder of the bond agrees to provide an
excess cost reinsurance contract.

Interest Rate Derivatives

Interest rate derivatives are futures contracts based on fixed income securities or
instruments. These instruments, based on their time-period, can be categorized
into the following:

• Short-term instruments with a maturity of up to one year. Treasury bills

(T-bills), commercial paper and company deposits are examples of short-
term instruments.
• Long-term instruments with an initial maturity of more than one year.
Corporate bonds and debentures, government loans and Public Sector
Undertaking (PSU) bonds are examples of long-term instruments.
KEYWORDS

An interest rate derivative is a derivative where the underlying asset is the right
to pay or receive a (usually notional) amount of money at a given interest rate .
Interest rate options, futures, swaps , forward rate agreements are some of the
interest rate derivatives.

50
Understanding Derivatives

A holder of such securities faces two types of risks:

• Default risk: This is the risk of losing all or part of the principal amount
due to the borrower becoming bankrupt. The more the risk of default,
the higher is the interest rate charged by the lender. Government loans
and T-bills are default risk free and therefore, they carry the lowest
interest rates for any given maturity.

• Interest rate risk: This is the risk that the price or the market value of
a security will change as a result of changes in macroeconomic factors
like inflation rate, money supply, economic growth rate, RBI policy, etc.
For example, the news that future inflation would be higher than earlier
expectations will lead to the demand for a higher yield on all fixed
income securities. Yields on outstanding fixed-income securities are
adjusted through changes in the prices of these securities.

Exchange-Traded Interest Rate Futures in India

Interest rate futures were launched on the National Stock Exchange (NSE) on 24th
June 2003. They are based on a list of underlying assets specified by the exchange
and approved by the Securities & Exchange Board of India (SEBI) from time to
time. Currently, interest rate futures contracts are on the following underlying
assets:

• Notional T-bills
• Notional 10 year bonds (coupon bearing)
• Notional 10 year bonds (non-coupon bearing)

Currency Derivatives
A currency derivative is a contract or financial agreement to exchange two currencies
at a predetermined rate or a contract or financial agreement whose value is derived
from the rate of exchange of the two currencies in the spot market. Firms exposed
to foreign exchange rate risk have turned both to the forex market and to currency
futures markets to manage exchange rate risks. In customized forex market
transactions, both parties negotiate and agree on the rate of exchange and other
terms in what is essentially a forward contract. Market participation is limited to
very large customers. On the other hand, currency futures contracts are, like all
futures contracts, standardized and remain open to anyone who needs a vehicle
to hedge currency risk. Futures also provide a formal clearing process in which
accounts are settled daily.

2. Payoff for Derivative Positions

A payoff is the likely profit or loss to be made by market participants due to a

Payoff: A payoff is the profit or loss that is likely to be faced by the market
KEYWORDS

participants with changes in the price of the underlying asset. Payoff diagrams are
used to graphically represent these, with the price of the underlying being plotted on
the X axis and the Profit or Loss on the Y axis.

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 Understanding Derivatives

change in the price of an underlying asset. Usually, the profit or loss is graphically
represented by payoff diagrams. In the payoff diagram, the price of the underlying
asset is plotted on the X-axis and profit or loss on the Y-axis.

2.1 The Payoffs for Forwards

Usually, forward contracts have linear payoffs. The buyer of a forward contract
makes a profit if the price of the underlying asset increases and vice versa.

Payoffs for Long Forward Positions

In a long forward contract, the party who buys the contract is considered to
assume a long position in the market with the expectation that the price will go up.
At the time of maturity, if the delivery price is lower than the spot price, the buyer
makes a profit and vice versa. The payoff from a long position in a forward contract
for one unit of an asset is calculated using the formula:

St – K
where,

S t is the spot price of the asset at the time of maturity of the

contract, and,

K is the delivery price.

This is illustrated in Figure 2.3.

Profit from a
Long Forward Position

Profit

Price of underlying
K-delivery price
at maturity, St

Figure 2.3: Profit from a long forward position

Payoffs for Short Forward Positions

In a short forward contract, the party who sells the contract is considered to
assume a short position in the market with the expectation that the price will go
down. At the time of maturity, if the delivery price is higher than the spot price,
the seller makes a profit and vice versa.

The payoff from a short position in a forward contract for one unit of an asset is
calculated using the formula:

K – St

This is illustrated in the Figure 2.2.

52
Understanding Derivatives

Profit from a
Short Forward Position

t Profit

Price of underlying
O at maturity
K

Figure 2.4: Profit from a short forward position

2.2 The Payoffs for Futures

Like forward contracts, futures contracts also have a linear payoff, leading to
unlimited profits or losses for buyers and sellers. The linearity ensures the same
magnitude of profits or losses for a given upward or downward movement of the
underlying asset.

Payoffs for Futures Positions

Forwards and futures have the same payoff characteristics as shown in Figures
2.3 and 2.4.

2.3 The Payoff for Options

In contrast to the linear nature of payoffs from forwards and futures, option
payoffs are non-linear. The non-linearity arises from the fact that in options, the
holder’s (buyer’s) losses are limited, whereas gains are potentially unlimited. In
forwards and futures, both the losses and the gains are unlimited. The writer
(seller) of an option gets the premium, making his profits limited to the option
premium, and losses potentially unlimited. The payoffs of the option buyer and the
option seller are exactly opposite in nature. Additionally, options entail an upfront
cost in the form of the option premium, unlike forwards and futures.

Payoff on a Long Call Option

This is essentially the payoff to the buyer of a call option. In such an option, the
buyer has the right but not the obligation to buy the underlying asset at the
specified price. On the expiry of the option, if the spot price (St) exceeds the
exercise price (K), the buyer makes a profit. The greater the excess of spot price
over the exercise price, greater is the profit. On expiration, if the spot price (St) of
the option is less than the exercise price, the holder will choose not to exercise
the option. In this case, the loss will be the option premium that the holder has to
pay to the seller.

Figure 2.5 shows the payoff from buying a 2-month call option on Essar Oil stock
at an exercise price of Rs. 60 and an option premium of Rs. 5.

53
 Understanding Derivatives

Profit
30
(Rs)
20

10 Terminal
30 40 50 60 Stock Price (Rs)
0
-5 70 80 90

Figure 2.5: Long call on Essar Oil

Let us consider the example of an investor who buys 100 call options on Essar Oil
stock. At an option premium of Rs. 5, his initial investment will be Rs. 500. If the
stock price on the exercise date is above Rs. 60, he will choose to exercise the
option.

Let us assume that the stock price on the exercise date is Rs. 70. The holder can
buy 100 shares of Essar Oil at Rs. 60 per share and sell it immediately for Rs. 70 per
share, thereby gaining Rs. 10 per share or Rs. 1,000 in total (ignoring transaction
costs).

Considering the option premium, the holder makes a net gain of Rs. 500. If the
stock price (St) on expiration is lesser than Rs. 60, he will choose not to exercise
the option. The option premium of Rs. 500 paid upfront then becomes his loss.
Suppose the price on the exercise date is Rs. 63, the holder exercises the option
but makes a loss of Rs. 200. Overall, this is better than a loss of Rs. 500 if the
option is not exercised, as can be seen from a summary of the payoff given in
Table 2.2.

Table 2.2: Summary of Payoff on a long call option

(Price in Rs.)
Type of Exercise Premium Spot Price Profit / loss
Call Price (St)on including
(K) exercise date premium paid
Long call 60 5 70 500
60 -500
63 -200

Payoff on a Short Call Option

This is essentially the payoff to the seller (writer) of a call option. In such an
option, the seller (or writer) receives the premium upfront. The seller is obliged to
take on certain potential liabilities if the buyer chooses to exercise the option. The

54
Understanding Derivatives

seller’s profit or loss is exactly the reverse of that of the buyer. If on expiration,
the spot price exceeds the exercise price, the buyer will choose to exercise the
option. The seller has to oblige, and in the process will incur a loss.

The higher the spot price (St), the greater is the loss made by the seller. If on
expiration, the spot price is less than the exercise price, the buyer will choose to
let the contract expire. In this case, the premium retained by the seller becomes
his profit.

Figure 2.6 gives the payoff for writing a call option on Essar Oil at an option price
of Rs. 5 and a strike price of Rs. 60.

Profit (Rs)
5 70 80 90
0
30 40 50 60 Terminal
-10 Stock Price(Rs)

-20

-30

Figure 2.6: Short Call on Essar Oil

As may be seen, the payoff is exactly the reverse of that of the option buyer.

Let us assume the seller has written 100 call options on Essar Oil. If on expiration,
the strike price is Rs. 70, he loses Rs. 1000 but gets a premium of Rs. 500, making
a net loss of Rs. 500. If the strike price is lesser than Rs. 60, the buyer will not
exercise the option. The entire Rs. 500 is then a profit for the seller, as can be
seen from a summary in Table 2.3

Table 2.3: Payoff on a short call option

(Price in Rs.)
Type of Exercise Premium Spot Price (St) on Profit / loss
Option Price exercise date (Including
(K) premium
paid)
Short call 60 5 70 - 500
60 500
63 200

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 Understanding Derivatives

Payoff on a Long Put Option

This is the payoff to the buyer of a put option. In such an option, the buyer has
the right but not the obligation to sell the underlying asset at the specified exercise
price.

If on the expiry date, the spot price (St) of the asset is less than the exercise price
(K) of the option, the buyer will choose to exercise it and make a profit. The profit
will be to the extent that the exercise price is higher than the spot price. If on the
expiry date, the spot price (St) of the asset is more than the exercise price (K) of
the option, the buyer will choose to let the option expire. In this case, his loss will
be the option premium that he has to pay to the writer of the option.

Figure 2.7 gives the payoff from buying a put option on Petronet LNG’s stock at an
exercise price of Rs. 90 and an option premium of Rs. 7.
Profit(Rs)
30

20

10 Terminal
Stock Price(Rs)
0
-7

Figure 2.7: Long Put on Petronet NG

Let us consider the example of an investor who buys 100 put options on Petronet
LNG’s stock. At an option premium of Rs. 7, his initial investment will be Rs. 700. If
the spot price on the exercise date is lesser than Rs. 90, he will choose to exercise
the option. This is because he will get a lower price if he sells in the spot market.

Let us assume the spot price on the exercise date is Rs. 70. The investor’s net
return works out to

Rs. 1,300 [100*(Rs. 90 - Rs. 70) minus the premium of Rs. 700]. The higher the
exercise price over the spot price, the more he gains. If on expiration date, the
exercise price is lower than the spot price, he will choose not to exercise the
option. But he still has to pay the premium of Rs. 700. All this is summarised in
Table 2.4.

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Understanding Derivatives

Table 2.4: Payoff on a long put option

(Price in Rs.)
Type Exercise Premium Spot Price Profit / loss
of Price (St) on (Including premium
Option (K) exercise paid)
date
Long 90 7 70 1300
Put
90 -700
80 300

Payoff on a Short Put

This is the payoff to the seller of a put option. As figure 2.8 reveals, using the
same example of Petronet LNG, the payoff is exactly the opposite as that of a
buyer of the put option.

Profit (Rs) Terminal

7 60 70 80 Stock Price (Rs.)
0

-10

-20

-30

Figure: 2.8: Short Put on Petronet LNG

When the spot price is higher than the exercise price of Rs. 90, the buyer will not
exercise the option. The seller can retain the premium of Rs. 7 per put. However, if
the opposite happens and the buyer exercises the option, then, the seller is
obliged to execute the contract at the higher exercise price. But, his losses will be
offset to the extent of premium amount he has received from the buyer. This is
summarised in Table 2.5.

Table 2.5: Payoff on a short put

(Price in Rs.)
Type of Exercise Premiu Spot Price (St) Profit / loss
Option Price (K) m on exercise (Including
date premium paid)

Short Put 90 7 70 -1300

90 700
80 -300

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 Understanding Derivatives

3. Commodity Derivatives vs. Financial Derivatives

Derivatives as a risk management tool were first used in commodity markets. Later,
it was found that they can be used as a hedging mechanism for financial assets in
the financial markets as well. Regardless of the underlying asset, the basic concepts
of a derivative contract remain the same. However, a few differences between the
nature of commodities and the financial assets have led to some differences in
market practices. These differences are mainly in terms of:

1. Physical settlement
2. Warehousing
3. Quality of underlying assets

3.1 Physical Settlement

Financial derivatives are settled only in cash. Commodity derivatives, especially

forwards, are also settled through physical delivery. Physical settlement involves
the actual delivery of the underlying commodity, typically at an accredited
warehouse. Both the seller and the buyer have to go to the designated warehouse
to give or take delivery. Physical settlement in India is, however, rife with numerous
issues, including:

• Limits on storage facilities in various states,

• Restriction on inter-state movement of commodities, and
• State-level taxes and duties adding to the cost of transportation.

The process of taking physical delivery of a commodity, unlike that of a financial

instrument, involves three different steps.

1. Delivery notice period

2. Assignment
3. Delivery

Delivery Notice Period

Unlike the sellers of equity futures contracts, sellers of commodity futures have
the option to give a notice of delivery. This option is given during a period called
“Delivery Notice Period”. Such contracts are then assigned to a buyer as in the
case of options. Unlike in the options market, here, both positions can be closed
out at any time, before the expiry of the contract.

The notice of delivery helps the seller and the buyer make preparations to give or
take delivery. This also allows the seller to completely verify the delivery. A delivery
notice must be supported by a warehouse receipt, which is a documentary evidence

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Understanding Derivatives

for the quantity and quality of the commodity being delivered. In the case of
exchanges that have laboratories for quality verification, the seller must produce a
laboratory verification report along with the delivery notice.

Assignment
On receipt of the seller’s delivery notice, the clearing house identifies the buyer to
whom the notice can be assigned. Different exchanges do this in different ways.
For example, the Chicago Board of Trade (CBOT) and the Chicago Mercantile
Exchange (CME) display the delivery notice, letting interested buyers bid to take
delivery, while Indian exchanges like NCDEX assign the delivery notices on a random
basis. Sellers who have given the delivery notice and buyers who have been
assigned a delivery have the option to square off their positions. They can do so
at any time before the market closes on the last day of the delivery notice period.
After the close of trading on the last day, exchanges then assign the delivery
intentions to parties with open long positions, either on a first in first out basis or
on a random basis.

Some exchanges give buyers an option to decide on the delivery location. The
delivery is settled at the delivery order rate, which is decided on a daily basis by
the clearing house. The delivery rate can be based on:

i) The spot rate (calculated on the basis of the prevailing prices in the
most active spot market) for the underlying, adjusted for discount or
premium for quality and freight cost. These are published by the clearing
house before the introduction of the contract.
ii) The closing rate of the previous day.

Delivery
After the process of assignment, the exchange or clearing house issues a delivery
order to buyers. It also informs the identity of the buyer to the respective
warehouse. The buyer in turn has to deposit a certain percentage of the value of
the contract in the clearing house. This is the margin against the warehouse
receipt. The exchange stipulates the period within which the buyer must take
physical delivery. The period could be as much as a month for some commodities.

Once the buyer or the authorised representative takes physical delivery against
the delivery order, the seller or the authorised representative gives the invoice to
its clearing member. The seller’s clearing member then couriers the same to the
buyer’s clearing member. Once the clearing house receives the proof of physical
delivery, the invoice amount is credited to the seller’s amount.

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 Understanding Derivatives

In India, a seller has to give a notice of delivery, failing which the positions are
cash settled on the date of expiry of the contract. The settlement price on that
day is set equal to the closing spot price of the commodity. Cash settlement takes
place for the price difference as in equity future contracts. For example, a trader
buys futures on a stock at Rs. 100. On the contract expiration day, the stock
closes at Rs.110. The trader then does not have to buy the underlying stock. But,
he still gets the difference of Rs. 10 in cash.

3.2 Warehousing

In commodity derivatives, in case the seller chooses to physically deliver the

commodity over settlement in cash, the buyer must take delivery. This requires
commodity exchanges to designate accredited warehouses through which storage
and delivery of commodities can be facilitated. Such warehouses have to perform
the following functions:

• Earmark separate storage areas as specified by the exchange for storing

commodities;
• ensure proper grading of commodities before they are stored;
• Store commodities according to their grade specifications and validity
period; and
• Ensure that necessary steps and precautions are taken to ensure that
the quantity and grade of commodity, as certified in the warehouse
receipt, are maintained during the storage period. This receipt can also
be used as collateral for financing.

3.3 Quality of Underlying Assets

In financial derivatives, variations in quality of underlying assets are minimal. In

commodities however, the quality of the underlying can vary significantly and
hence is given utmost importance. Commodity exchanges therefore specify the
grade(s) of a commodity that are acceptable to it.

Trading in commodity derivatives also requires quality assurance and certifications

from specialised agencies. In India, for example, the Bureau of Indian Standards
(BIS) under the Department of Consumer Affairs specifies standards for processed
agricultural commodities. AGMARK, another certifying body under the Department
of Agriculture and Cooperation, specifies standards for basic agricultural commodities.

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Understanding Derivatives

Summary

The major differences between commodity derivatives and financial derivatives are
summarised in the following table:

Table 2.6: Commodity Derivatives Vs. Financial Derivatives.

COMMODITY DERIVATIVES FINANCIAL DERIVATIVES

Commodity derivatives may be settled by Financial derivatives are only cash
actual deliveries settled on the given day
Quantity and quality differences exist No quantity and quality differences exist

Holding cost includes assaying, Holding cost normally consists of only

warehousing and insurance costs interest costs
Physical markets are seasonal in nature Financial markets are active throughout
the year
Factors impacting: Factors impacting:
• Demand and supply • Global and local economic
• Import-export regulations conditions
• Government intervention • Performance of the entity
• Taxation structure

4. Derivative Market Participants

4.1 Various Market Participants and their Roles

The commodity derivatives market features a variety of participants with a variety

of roles. The three main participants are hedgers, speculators and arbitragers.

Hedgers
Hedgers are people or companies who wish to protect themselves or “hedge”
against adverse price movements using futures. Hedgers do this by buying and
selling futures contracts to offset the risks of changing prices in the spot market.
They participate in the derivative market, hoping that they can transfer their
price risk. In commodity markets, hedgers could be producers (such as farmers),
processors, or consumers.

To understand how producers hedge, let us look at an example where a farmer

uses the futures market to hedge and locks into a sales price and profits from his
soybean crop. Let us assume that the soybean farmer’s planting time is in April
and the harvesting is in September. A price fall in September could affect his
profits. Therefore, he decides to hedge his price risk in the soybean market by

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 Understanding Derivatives

entering into a “short” soybean futures position. Let us assume that the spot
price of soybean in April is Rs. 9,400 per MT while the futures price at that time is
Rs. 9,900 per MT. At harvest time in September, the soybean spot prices reduce
to Rs. 7,900 per MT while the futures price falls to Rs. 8,400 per MT. He offsets his
futures position by buying back soybean futures contract at Rs. 8,400 per MT and
gaining Rs. 1,500 per MT. He will also sell his produce in the market at Rs. 7,900
per MT. So, his total return is Rs. 9,400 per MT, which is equal to the spot price in
April. This way, the farmer was able to protect himself against price risk even
when the price of soybean fell.

Table 2.7 depicts the total return per MT received by the farmer at harvest time in
September when he has sold future contract at sowing time in April. In April, the
farmer sells the futures contract at Rs. 9,900 per MT.
Table 2.7: Total return to farmer by selling future contract

Market Transaction Am ount Am ount Paid Net am ount

Received (Rs.) (Rs.) received/paid
(Rs.)
Spot Sells soybean after 7,900 7,900
harvesting in
Septem ber
Future (a) Buys future at 9,900 8,400 1500
Rs.8400 i.e.
the current
price and
(b) Sells future at
Rs. 9900 i.e.
price fixed
earlier
Total 17,800 8,400 9,400

Therefore, producers or farmers can hedge themselves against a fall in commodity

prices by selling a future or taking a short futures position. In the same manner,
buyers of a commodity can hedge themselves against a potential rise in the cost
of inputs by buying futures or taking a long futures position.

Speculators
Speculation refers to buying or selling something, anticipating future price changes.
Market participants engaged in such buying or selling are called speculators. While
the objective of hedgers is to avoid risks, speculators are more willing to accept
risks. For example, speculators buy futures at a time when its price is low and sell
it later when the price is higher.

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Understanding Derivatives

Speculators provide the much-needed liquidity to markets and are an integral part
of the growing futures markets. Speculators do not belong to the industry in
which they trade. As a result, they prefer speculating using forwards or futures in
which transactions can be initiated with a small investment, unlike in the cash
market. Speculators are rarely interested in giving or taking delivery.

Apart from forwards and futures, speculators sometimes use options owing to
their unlimited upside potential.

Let us look at an example to understand how a speculator works.

Suppose, in February, a physical trader buys a quintal of wheat for Rs. 1,200 per
quintal, anticipating that the price will rise to Rs. 1,450 per quintal in May. Compare
the trader with a speculator who has decided to buy wheat futures in NCDEX at
the futures price of Rs. 1,300 per quintal. The contract is available by paying an
initial margin of 10%, which is Rs. 130 whereas the investment of the physical
trader is Rs. 1,200.

Let us assume that in May, the price of a quintal of wheat is Rs. 1,450 per quintal.
The physical trader sells his wheat for Rs. 1,450 and makes a profit of Rs. 250.
This means, a return of 20.8% on an investment of Rs. 1,200. The speculator
offsets his open long position by selling his futures position at Rs. 1,450 and
makes a profit of Rs. 150. This means a return of a whopping 115%, considering
his initial investment of just Rs. 130.

Table 2.8 depicts the rate of return received by the speculator vis-à-vis the
physical trader.

Table 2.8: Computation of rate of return to physical trader and speculator

M ark e t T r a n s a c t io n Am ount Am ount Am oun R ate
P a r t ic ip a In ve sted r e c e iv e d t of of
nt per back per p r o f it re tu rn
q u in t a l q u in t a l per
( R s .) ( R s .) q u in t a l
(2) (4) ( R s .)
(1) (3) (5 = 4 - (6 = 5 /
3) 3)
P h y s ic a l B u y s d u r in g 1 ,2 0 0 1 ,4 5 0 250 2 0 .8 %
tr a d e r F e b ru a ry , &
s e lls d u rin g M a y , in
sp o t m a rk ets
S p e c u la t o r B u y s M a y fu tu r e in 130 280 150 1 1 5 .4
F e b r u a r y @ R s .1 ,3 0 0 (10 % of (1 5 0 + %
a t 1 0 % m a r g in , 1 ,3 0 0 ) 130)
and
s e lls th e fu t u r e in
M a y @ R s .1 ,4 5 0 a n d
r e c e iv e s m a rg in b a c k

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 Understanding Derivatives

However, if markets move in the wrong direction, the physical trader can sell the
wheat and get some return. It is not so with the speculator who faces the risk of
running into huge losses.

Arbitragers
In simple terms, arbitrage is the process of buying something at a place where its
price is low and selling it in a place where its price is high. The same asset can
thus be bought and sold simultaneously in two or more markets to take advantage
of the price difference. Market participants looking to capitalise on arbitrage
opportunities are called arbitragers. Such opportunities are not easy to spot.

The very existence of profit-seeking arbitrages ensures that parity is automatically

restored between different markets. Therefore, we can say that arbitragers help
in restoring market equilibrium and market efficiency. Practically, this means that
very limited arbitrage opportunities can be observed in prices quoted in most
markets.

Let us see how an arbitrager operates.

The spot price of 10 gm of gold in Delhi is Rs. 9,560. The futures contract in
NCDEX is being traded at Rs. 9,624 per 10 gm. The arbitrager buys 1 Kg of gold in
the cash market. Simultaneously, he takes a short position in the futures market.
On the expiry of the futures contract he opts to physically deliver the gold and
gains Rs. 64 per gm.

4.2 Types of Traders

Within the category of traders (hedgers, speculators and arbitragers), there are
several types of market participants - proprietary traders, market makers, scalpers,
day traders and position traders.

Proprietary Traders
Proprietary traders are employees who work for investment firms, commercial
banks and trading houses. These traders have different trading objectives. Some
traders engage in speculative trading activity and profit when the market moves
in their direction. Others manage risk by hedging or spreading between different
markets to insulate their business from the risk of price fluctuation.

Market Makers
Market makers give liquidity to the market by a constant bid to buy and an offer
to sell. They often profit from the ‘spread’ or the small difference between the bid
and ask prices. The profit of market makers is calculated using the simple formula:

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Understanding Derivatives

Profit = (Average offer price – Average bid price) * Number of units traded

Scalpers
Scalpers trade in and out of the market several times during a day, hoping to
make a small profit from a large volume of trades. They generally attempt to buy
at the bid price and sell at the ask price and offset their trades within seconds of
making the original trade. Usually, scalpers do not make any predictions on the
future direction of the market.

Day Traders
Day traders, like scalpers, trade actively. However, day traders engage in fewer
trades than scalpers and take trading decisions based on predictions of the future
direction of the market.

Position Traders
Position traders typically take one trading position and hold on to that position.
Minor fluctuations in the market do not concern them much, as these traders are
more focussed on long-term trends and market forces.

Summary

A derivative is a financial instrument whose value depends on or is “derived” from

the value of an underlying asset. This underlying asset could be a commodity,
foreign exchange, equity, interest rate or an index among others. The different
types of derivatives are Forwards, Futures, Swaps and Options. Derivatives are
traded in two different markets namely Over-the–Counter and at Exchanges.

Forwards are bilateral contracts in which the buyer and seller agree upon the
price and terms of delivery.

A swap derivative is an agreement between two parties to exchange two different

streams of cash flows. There are 4 types of swaps namely, Interest rate swaps,
Currency swaps, equity swaps and commodity swaps.

Exchange-traded derivatives are standard derivatives like futures and options

traded on exchanges.
KEYWORDS

Scalpers are floor traders, who trade for small, short-term profits during the course
of a trading session, rarely carrying a position overnight.

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 Understanding Derivatives

A futures contract is an agreement between two parties to buy or sell the underlying
asset at a future date at today’s future price.

An option is an agreement between two parties - one of whom is the buyer and
the other 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 (called the
exercise 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. There are two kinds of options:
Call option and put option.

A credit derivative is designed to assume or transfer credit risk from one party to
another in exchange for a fee.

Weather derivate is an instrument used by companies to hedge against the risk of

weather-related losses.

A payoff is the likely profit or loss to be made by market participants due to a

change in the price of an underlying asset. Usually, forward contracts have linear
payoffs.

In a long forward contract, the party that buys the contract is considered to
assume a long position in the market with the expectation that the price of the
commodity will go up. At the time of maturity of the contract, if the delivery price
is lower than the spot price, the buyer makes a profit and vice versa.

In a short forward contract, the party who sells the contract is considered to
assume a short position in the market with the expectation that the price will go
down. At the time of maturity of the contract, if the delivery price is higher than
the spot price, the seller makes a profit and vice versa.

Like forward contracts, futures contracts also have a linear payoff, leading to
unlimited profits or losses for buyer and sellers. The linearity ensures the same
magnitude of profits or losses for a given upward or downward movement of the
underlying asset. Forwards and futures have the same payoff characteristics.

Option payoffs are non-linear, unlike the payoffs from forwards and futures, which
is linear in nature. The non-linearity arises from the fact that the holder’s (buyer’s)
losses are limited, while gains are potentially unlimited.

The writer (seller) of an option gets the premium, making his profits limited to the
option premium, and losses potentially unlimited. The payoffs of the option buyer
and the option seller are exactly opposite in nature. Additionally, options entail an

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Understanding Derivatives

upfront cost in the form of the option premium unlike forwards and futures.

a
The buyer of a call option makes a profit to the extent of the spot price over the
exercise price on the expiry date. The payoff on a short call option, to the seller,
is just the opposite.

The buyer of a put option makes a profit to the extent that the exercise price is
greater than the spot price on expiration. The payoff on a short put option, to the
seller, is just the opposite.

Commodity derivatives differ from financial derivatives in terms of physical

settlement, need for warehousing and the importance of the quality of the underlying
commodities.

Derivative market participants include hedgers, speculators and arbitragers. Hedgers

protect themselves by buying and selling futures contracts to offset the risks of
changing prices in the spot market.

Market participants engaged in buying or selling to take advantage of price

movements are called speculators. While the objective of hedgers is to avoid
risks, speculators are more willing to accept risks. Arbitragers capitalise on price
differences between markets. Within the category of traders (hedgers, speculators
and arbitragers), there are several types of market participants - proprietary
traders, market makers, scalpers, day traders and position traders.

67
 Key Questions

a
1. For a person who has gone short on a futures contract, if at the time of
maturity of the contract, the delivery price is less than the spot price,

A) He makes a loss to the extent the delivery price is lesser than the
spot price
B) He makes a profit
C) He cannot make a loss as it is a futures contract
D) He need not physically deliver

2. CAT Bonds are:

A) Energy derivatives
B) Weather derivatives
C) Insurance derivatives
D) None of the above

3. Which of the following market participants accept risk willingly?

A) Hedgers
B) Speculators
C) Arbitragers
D) Jobbers

4. Which of the following players help in restoring market equilibrium?

A) Hedgers
B) Speculators
C) Arbitragers
D) Market makers

5. A R&T agent:

A) Ensures that the credit of commodities goes only to the Demat

account of the Constituents held with the Exchange empanelled DPs
B) Inspects the warehouse(s) identified by the Exchange
C) Ensures and co-ordinates for grading of the commodities
D) Makes available grading facilities

6. A futures contract can be settled by:

A) Only physical delivery

B) Closing out also
C) Cash settlement Only
D) Both 1 and 3

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Key Questions

7. An order given for trade specifying a certain maximum price, beyond which
the order (buy or sell) is not to be executed is a:

A) Day Order
B) Limit Order
C) Stop Loss Order
D) Fill Order

8. Which of the following is true with reference to a swap?

A) Swaps are traded on exchanges

B) The notional principal is to be exchanged
C) Swaps can only be cash settled
D) Clearing houses are not required for clearing swaps

9. A clearing member buys a long staple cotton futures contract on Day 1 at

Rs.6435 per quintal. If on Day 2, the price falls to Rs.6320. the marking to
marker will be for:

A) Rs. -70
B) Rs.115
C) Rs. -115
D) None of the above

10. A trading member went short on 3000 trading units of cotton futures at
Rs. 6020 per quintal. Subsequently he purchased 2500 units at Rs. 6000
per quintal. What is the outstanding position on which he would be
margined?

A) Long 3000 units

B) Short 3000 units
C) Long 500 units
D) Short 500 units
ANSWER KEY

Qustion No. 1 2 3 4 5 6 7 8 9 10
Answers A C B C A B B D C D

69
70
 GLOBAL
COMMODITY
EXCHANGES
Learning Outcomes ............................................................................. 72
1. Global Commodity Exchanges ......................................................... 72
1.1 Evolution of Global Exchanges ................................................... 72
1.2 Commodity Exchanges Outside India .......................................... 74
1.3 Commodity Exchanges in Developing Economies ........................... 75
1.4 Major Commodities Traded in Global Exchanges ............................ 77
2. Indian Commodity Exchanges ......................................................... 79
2.1 Evolution of Indian Commodity Exchanges ................................... 79
2.2 The Structure of Indian Commodity Exchanges ............................ 80
2.3 Major Commodity Exchanges of India .......................................... 83
2.4 Commodities Traded on Indian Commodity Exchanges ................... 88
2.5 Commodities Traded on the NCDEX ............................................ 88
2.6 Regulatory Framework .............................................................. 89
3. Functions and Roles of an Exchange ................................................ 95
3.1 Functions of an Exchange ........................................................ 95
Price Discovery ..................................................................... 96
Price Dissemination ................................................................ 97
Risk Management ................................................................. 100
Market Surveillance .............................................................. 102
Clearing and Settlement ........................................................ 102
3.2 The Roles of an Exchange ....................................................... 103
Standardisation ................................................................... 103
Guarantor of all Trades ......................................................... 104
Anonymous Auction Platform ................................................. 105
Neutrality ........................................................................... 105
Risk Transfer Platform ........................................................... 105
Provider of Long-Term Price Signals ........................................ 106
Market Linkages and Infrastructure ......................................... 106
Summary ................................................................................. 110
Key Questions ................................................................................. 110

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 Global Commodity Exchanges

Learning Outcomes

On completing this module, the learner should be able to:

• List out the major functions of an exchange

• Understand the meaning of price discovery
• Appreciate how speculators and arbitragers help in price discovery
• Know the need and methods of price dissemination
• Understand price risk and credit risk management in commodity
exchanges
• List types of members at NCDEX and their membership criteria
• Understand the need for a good margining system
• Explain how exchanges carry out market surveillance
• Know the role of a clearinghouse
• List of the roles of an exchange
• Understand the evolution of global exchanges
• Identify the various commodity exchanges outside India
• List the main commodities traded in these exchanges
• Understand the evolution of Indian commodity exchanges
• Understand the structure of Indian commodity exchanges
• Identify the major commodity exchanges in India
• List the main categories of commodities traded in these exchanges
• List all commodities traded on NCDEX
• Understand the regulatory framework

1. Global Commodity Exchange

1.1 Evolution of Global Exchanges

Several of the commodity exchanges that are functioning today originated in the
late 19th century. The evolution of the exchanges was fuelled by the needs of
businessmen and farmers. The need was to make the process of buying and selling
commodities easier by bringing the buyers and sellers together.

The development of modern futures trading began in the US in the early 1800s.
This development was tied closely to the development of commerce in Chicago,
which started developing as a grain terminal. At that time, supply and demand
imbalances were normal. There was a glut of commodities at harvest time in some
years and severe shortages during the years of crop failure. Difficulties in
transportation and lack of proper storage facilities aggravated the problem of
imbalance in demand and supply.

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Global Commodity Exchanges

The uncertain market conditions led farmers and merchants to contract for forward
delivery. Some of the first forward contracts were in corn. To reduce the price risk
of storing corn in winter, these merchants went to Chicago in spring and entered
into forward contracts with processors for the delivery of grain. The grain was
received from the farmers in late fall or early winter.

The earliest recorded forward contract was on March 13, 1851. As the grain trade
expanded, a group of 82 merchants gathered over a flour store in Chicago to form
the Chicago Board of Trade (CBOT). CBOT started the “to arrive” forward contract,
which permitted farmers to lock in the price and deliver the grain much later. The
exchange’s early years saw the dominance of forward contracts. However, certain
drawbacks of forwards such as lack of standardisation and non-fulfilment of
commitments made CBOT take steps in 1865 to formalise grain trading.

By the mid 19th century, futures markets had developed into effective mechanisms
for managing counterparty and price risks. The clearinghouse of the exchange
guaranteed the performance of contracts and started collecting margins to ensure
contract performance. Trading practices were further formalised as contracts started
getting more refined and rules of conduct and procedures for clearing and settlement
were established.

Trading became more efficient with the entry of speculators who provided liquidity
and helped minimise price fluctuations.

New exchanges were formed in the late 19th and early 20th centuries as trading
started in non-agricultural commodities such as precious metals and processed
products, among others. Financial innovations in the post-Bretton Woods period
led to trading in financial futures, the most successful contract in the futures
industry. Financial derivatives became important due to the rise in uncertainty in
the post-1970s period, when US announced an end to the Bretton Woods System
of fixed exchange rates. This led to the introduction of currency derivatives followed
by other innovations including stock index futures.

Commodities’ trading in some developing economies also has a long history. The
Buenos Aires Grain Exchange in Argentina (founded in 1854) is one of the oldest in
the world. In India, futures trading was introduced in 1875. Though developing
countries saw the early use of commodity risk-management instruments, increased
government intervention and policies impeded the development of futures markets.
Failure of government-led price-stabilisation schemes and the adoption of
liberalisation and globalisation policies since the 1980s has led to the resurgence of
commodity markets in these countries.
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 Global Commodity Exchanges

In recent years, there has been an onset of a new phase in the evolution of
commodity exchanges, driven by technology. Established traditional exchanges in
the developed and the developing economies are increasingly using Information
Technology (IT) to put in place more user friendly, modern and cost effective
electronic trading platforms.

1.2 Commodity Exchanges Outside India

Commodity markets across the world are experiencing exponential growth driven
by a positive growth rate and a rebounding global economy. A list of global commodity
exchanges is presented in Table 3.1. The oldest among them are the Chicago
Board of Trade (CBOT) and the Chicago Mercantile Exchange (CME).

Table 3.1: Leading commodity exchanges across the globe

Country Exchange
Chicago Board of Trade (CBOT)
Chicago Mercantile Exchange (CME)
Minneapolis Grain Exchange (MGEX)
United States of America New York Cotton Exchange (NYCE)
New York Mercantile Exchange (NYMEX)
Kansas City Board of Trade (KCBT)
New York Board of Trade (NYBOT)
Canada The W innipeg Commodity Exchange (W CE)
Brazil Brazilian Mercantile and Futures Exchange (BM&F)
Australia Sydney Futures Exchange Ltd.(SFE)
People’s Republic Of Beijing Commodity Exchange (BCE)
China Shanghai Metal Exchange (SHME)
Hong Kong Hong Kong Futures Exchange (HKFE)
Tokyo International Financial Futures Exchange (TIFFE)
Japan Kansai Agricultural Commodities Exchange (KACE)
Tokyo Grain Exchange (TGE)
Malaysia Kuala Lumpur Commodity Exchange (KLCE)
New Zealand New Zealand Futures & Options Exchange Ltd. (NZFOE)
Singapore Singapore Commodity Exchange Ltd. (SICOM)
France Le Nouveau Marche MATIF
Italy Italian Derivatives Exchange Market (IDEM)
Netherlands Amsterdam Exchanges Option Traders (AEOT)
MICEX/Relis Online, St. Petersburg Futures Exchange
Russia
(SPBFE)
The Spanish Options Exchange (SOE)
Spain Citrus Fruit and Commodity Futures Market of Valencia
(CFCFMV)
The London International Financial Futures Options
United Kingdom Exchange (LIFFE)
The London Metal Exchange (LME)

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Global Commodity Exchanges

Figure 3.1 displays the world’s major commodity exchanges.

Figure 3.1: World’s Major Commodity Exchanges

1.3 Commodity Exchanges in Developing Economies

Let us look at some commodity exchanges in developing economies other than

India.

Africa
Africa’s most active and important commodity exchange is the South African Futures
Exchange (SAFEX). Launched in 1987, SAFEX traded only in financial and gold
futures for a long time. However, the creation of the Agricultural Markets Division
(known as the Agricultural Derivatives Division since 2002) led to the introduction
of a range of agricultural futures contracts. Trade was liberalised in these commodities
including white and yellow maize, bread milling wheat and sunflower seeds.

Maize contracts are traded on new exchanges in Zambia and Zimbabwe. With the
gradual liberation of State-controlled agricultural marketing, the Zimbabwe Agricultural
Commodity Exchange (ZIMACE) was established in 1994.

Asia
• China: China’s first commodity exchange was established in 1990 and
by the year 1993, the number of exchanges grew to 40! The main
commodities traded were agricultural staples such as wheat, corn and
soybean. However, in late 1994, more than half the number of exchanges
were closed down or reconverted into wholesale markets. Only 15
restructured exchanges received formal government approval.
• In the beginning of 1999, the China Securities Regulatory Committee
began a nationwide consolidation process of the exchanges. The

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 Global Commodity Exchanges

consolidation resulted in three commodity exchanges - Dalian Commodity

Exchange (DCE), Zheng Zhou Commodity Exchange and the Shanghai
Futures Exchange.

• Malaysia: The Bursa Malaysia Derivatives Exchange (MDEX) was

established in 1980. MDEX is the world’s only exchange that trades in
futures contracts in crude palm oil. Trading is conducted the traditional
way - using open outcry system and trading pits. Though other
agricultural commodities like coco, rubber and palm oil were also
introduced, they failed due to the lack of interest and liquidity problems.

• Taiwan: The Taiwan Futures Exchange (TAIFEX) was established in

1998. It offers futures and options on major Taiwan stock indices,
government bond futures, equity options and 30-day CP interest rate
futures. TAIFEX also introduced three US$-denominated products during
2006 that includes Taiwan’s first commodity contract - Gold Futures.

• Indonesia: The Jakarta Futures Exchange (JFX) was launched in 1999

by a team of financial institutions, farm plantations, refineries, coffee
exporters, securities companies and traders. Though many commodities
like Robusta coffee, refined crude palm oil and olein were introduced,
olein futures remain the most active contract. JFX was established in
the midst of a financial crisis when the country was facing very high
levels of inflation.

• Singapore: The merger of two well-established exchanges in Singapore

- the Stock Exchange of Singapore (SES) and Singapore International
Monetary Exchange (SIMEX) led to the formation of the Singapore
Exchange (SGX) in 1999.

• Thailand: Efforts to launch an agricultural futures exchange in Thailand

started in 1979. The country’s Agricultural Futures Exchange of Thailand
(AFET) was launched much later in 2004. The exchange mainly trades
in rubber.

Latin America

• Brazil: Latin America’s largest commodity exchange is the Brazil based

Bolsa de Mercadorias & Futuros (BM&F). Established in 1985, the exchange
became the eighth largest exchange by 2001, trading 98 million contracts.
Several other commodity exchanges operate throughout Brazil.

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Global Commodity Exchanges

• The first agricultural commodity exchange was the Sao Paolo

Commodities Exchange established in 1917. It was later merged with
BM&F in 1991. The exchange mainly trades in financial derivatives. Some
of the agricultural commodities traded include coffee, soybean, corn,
sugar and feeder cattle. Futures contracts are also offered on gold.

• Argentina: Argentina’s futures market Mercado a Termino de Buenos

Aires (MATba), founded in 1909 ranks 51st among the largest exchanges
in the world. The Rosaria Future Exchange (ROFEX) is another active
exchange but trades in smaller volumes. At MATba, prices are quoted in
US dollar and both the open-outcry and electronic trading systems are
used. Futures and options on wheat, flaxseed, corn, soybean and meat
indices are also traded on the exchange.
• Mexico: Mercado Mexicano de Derivados (Mexder) – the futures
exchange of Mexico’s commodities market was established in 1998.

1.4 Major Commodities Traded in Global Exchanges

A summary of leading global derivative exchanges and the commodities traded on

them is presented in Table 3.2.

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 Global Commodity Exchanges

Table 3. 2: Global commodities derivatives exchanges

Name and Address Contracts Traded

Butter, m ilk, di-amm onium phosphate, feeder cattle,
Chicago Mercantile
frozen pork bellies, lean hogs, live cattle, non-fat dry
Exchange (CME)
milk, urea, urea ammonium nitrate among others
Light sweet crude oil, natural gas, heating oil, gasoline,
New York Mercantile
RBOB gasoline, electricity, propane, gold, silver,
Exchange (NYMEX)
copper, aluminium, platinum , palladium and the like
London International
Cocoa, Robusta coffee, corn, potato, rapeseed, white
Financial Futures and
sugar, feed wheat, milling wheat and the like
Options Exchange (LIFFE)
Chicago Board of Trade Corn, soybeans, soybean oil, soybean meal, wheat,
(CBOT) oats, ethanol, rough rice, gold, silver, among others
Alum inium , copper, nickel, lead, tin, zinc, aluminium
London Metal Exchange alloy, North American Special Alum inium Alloy
(LME) (NASAAC), polypropylene, linear, low-density
polyethylene and the like
New York Board of Trade Cocoa, coffee, cotton, ethanol, sugar, frozen
(NYBOT) concentrated orange juice, pulp and so on
Tokyo Commodity Gasoline, kerosene, crude oil, gold, silver, platinum ,
Exchange (TOCOM) palladium, aluminium and rubber am ong others
Sydney Futures Exchange
Greasy wool, fine wool, broad wool, cattle and the like
(SFE)
Dubai Gold and
Comm odities Exchange Gold, silver, fuel oil, steel, freight rates, cotton and so on
(DGCX)
Refined bleached deodorized palmolein, crude palm oil,
Bursa Malaysia Berhad
palm kernel oil, am ong others
W innipeg Comm odity
Canola, feed wheat, western barley and the like
Exchange
Dalian Commodity
Corn, soybean, soybean meal, soy oil and so on
Exchange
Zheng Zhou Comm odity
W heat, cotton, sugar, am ong others
Exchange (CZCE)
Central Japan Comm odity Gasoline, kerosene, gas oil, eggs, ferrous scrap and the
Exchange like
Shanghai Futures Exchange Copper, alum inium , natural rubber, plywood and long-
(SHFE) grained rice
Anhydrous fuel alcohol, Arabica coffee, Robusta-Conillon
Brazilian Mercantile and
coffee, corn, cotton, feeder cattle, live cattle, soybean,
Futures Exchange
crystal sugar, gold, am ong others
Kansai Comm odity Soybean, raw sugar, raw silk, shrim p (frozen), coffee,
Exchange corn, Azuki beans (red), am ong others
(Ribbed Sm oked Sheets) RSS3, (Technically Specified
Osaka Mercantile Exchange
Rubber) TSR20, nickel, aluminium , Rubber Index

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Global Commodity Exchanges

2. Indian Commodity Exchanges

2.1 Evolution of Indian Commodity Exchanges

In India, organised trading in commodity derivatives started in 1875 with the

setting up of the Bombay Cotton Trade Association Ltd. However, very soon leading
cotton mill owners and merchants expressed discontent over its functioning. This
led to the establishment of the Bombay Cotton Exchange Ltd. in 1893.

Following cotton, trading was introduced in other agricultural commodities. In 1900,

the Gujarati Vyapari Mandali was established to carry out futures trading in oilseeds,
groundnut, castor seed and cotton. The States of Punjab and Uttar Pradesh were
also trading futures on wheat. The Hapur Chamber of Commerce established the
futures exchange for wheat in 1913 at Hapur.

Futures trading in raw jute and other jute goods began at Kolkata with the setting
up of the Calcutta Hessian Exchange Ltd. in 1919. However, organised futures
trading in raw jute started only in 1927 with the establishment of the East Indian
Jute Association Ltd. These two associations merged in 1945 to form the East
India Jute and Hessian Ltd. to conduct organised trading in both raw jute and jute
goods.

Futures trading in bullion began in Mumbai in 1920 and was later introduced at
Rajkot, Jaipur, Jamnagar, Kanpur, Delhi and Kolkata.

The Second World War proved detrimental to futures trading, as the then Union
Government prohibited it. After independence, stock exchanges and futures markets
were brought under the Union List in the Constitution of India. The responsibility
for the regulation of commodity futures markets hence came under the Central
Government.

In December 1952, the Forward Contracts (Regulation) Act (FCRA) was enacted.
This Act continues to regulate forward contracts in commodities in the country.
The Forward Markets Commission (FMC) was set up in 1953 and functions under
the Ministry of Consumer Affairs, Food and Public Distribution. In due course,
several exchanges and registered associations were set up to trade in a range of
commodities. However, during the 1960s, most of these exchanges and associations
became inactive because trading in futures and forwards of commodities was
either suspended or totally prohibited.

In 1980, the Khusro Committee recommended the reintroduction of futures trading

in major commodities. As a result, the government initiated trading in potato in the
latter half of 1980 in Punjab and Uttar Pradesh.

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 Global Commodity Exchanges

Subsequent to the introduction of economic reforms in 1991, the government

appointed the Kabra Committee in 1993 under the Chairmanship of Prof K. N.
Kabra. The Committee’s task was to review the working of commodity exchanges
and their trading practices and the role of the Forward Markets Commission. The
Committee was also required to suggest measures to increase the effectiveness of
futures trading and recommend amendments to the FCRA for better enforcement.
The Committee submitted its report in September 1994. The Government accepted
most of these recommendations and futures trading have been permitted in all
recommended commodities except bullion and basmati rice. The Government
announced through its National Agricultural Policy, 1999, that it will expand the
coverage of futures market to minimize the wide fluctuations in commodity prices,
as also for hedging their risk. The expert committee on Agricultural Marketing
headed by Shri Shankerlal Guru recommended linkage of spot and forward markets,
introduction of electronic warehouse receipt system, inclusion of more commodities
under futures trading and promotion of national system of warehouse receipt. A
sub-group on forward and futures markets was formed under the Chairmanship of
Dr. Kalyan Raipuria to examine the feasibility of implementing the recommendations
made by the Expert Committee chaired by Shankerlal Guru. This sub-group
recommended that the commodity-specific approach to the grant of recognition
should be given up. The economic survey for the year 2000-2001 indicated the
intention of the Government to allow futures trading in bullion. In the Budget
speech made on 28th February 2002, the Finance Minister announced expansion of
futures and forward trading to cover all agricultural commodities. On April 1, 2003,
the Government issued notifications and permitted futures trading in commodities.
Due to mistaken apprehensions that futures trading contributes to inflation, futures
trading in rice, wheat, urad and tur has been temporarily suspended.

There is widespread consensus that the commodity derivatives market requires an

independent, effective and well functioning regulatory system. The Forward Markets
Commission (FMC) is broadly functioning in its traditional manner. Many of the
existing provisions of the Forward Contracts Regulation Act, 1952 (FCRA Act) have
become redundant in view of the rapid expansion of the commodity futures market.
This has necessitated changes in the organisational structure and institutional
capacity of the FMC. There is also a growing demand for allowing trading in options
for risk management. In response to this need, the Government of India has
introduced the FCRA Amendment Bill seeking major amendments. The key objective
of this comprehensive set of amendments is to restructure and strengthen FMC
broadly on the lines of the Securities and Exchange Board of India. The proposed
Amendment Act confers upon the FMC the status of a body corporate. Other
major amendments proposed include:

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Global Commodity Exchanges

• Amendment in the definition of the expression “forward contract” to

include “commodity derivative”
• Permission for trading in options;
• Provision for investigation, enforcement and penalty in case of
contravention
• Confer power upon the FMC to levy fees.

2.2 The Structure of Indian Commodity Exchanges

There are 24 recognised commodity futures exchanges in India, under the purview
of the Forward Markets Commission (FMC). The country’s commodity futures
exchanges are divided into two types:

• National exchanges
• Regional exchanges

The three exchanges operating at the national level are:

i) National Commodity and Derivatives Exchange of India Ltd. (NCDEX),

Mumbai
ii) National Multi Commodity Exchange of India Ltd. (NMCE), Ahmedabad
iii) Multi Commodity Exchange (MCX), Mumbai.

The leading regional exchange is the National Bond of Trade (NBOT), located at
Indore.

The structure of the Indian commodity futures exchanges is depicted graphically in

Figure 3.2.
Indian Commodity Futures
Exchanges

FMC

Commodity Exchanges

National Regional
exchanges exchanges

20 Other Regional
NCDEX NMCE MCX NBOT Exchanges

Figure 3.2: Indian commodity futures exchanges

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 Global Commodity Exchanges

The national level exchanges follow the best practices and offer better and more
transparent services in comparison to the regional exchanges. A brief comparison
of the two types of exchanges is presented in Table 3.3.

Table 3.3: National versus regional commodity exchanges

National Regional
Compulsory online trading Online trading not compulsory
Transparent trading Opaque trading
Exchanges to be de- De-mutualisation not mandatory
mutualised
Exchange recognised on Recognition given for fixed period after which it could be
permanent basis given for re-regulation
Multi commodity exchange Generally, these are single commodity exchanges.
Exchanges have to apply for trading each commodity.
Certain commodities like wheat, rice, and gold are not
permitted
Professionally run Driven by interest groups
Large expanding volumes Low volumes in niche markets

The market share of leading Indian commodity exchanges for FY 2006-07 is presented
in Figure 3.3
M arket Share

3% 2%
32%
NCDEX
MCX
NMCE
NBOT

63%

Figure 3.3: Market Share of Leading Indian Commodity Exchanges

Table 3.4 shows the turnover on commodity futures markets for the years 2004-
05, 2005-06 and 2006-07.

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Global Commodity Exchanges

Table 3.4: Turnover on Commodity Futures Markets

(in Rs. Crores)
Exchanges 2004-05 2005-06 2006-07
Multi Commodity Exchange (MCX) 165,147 961,633 2,293,434
National Commodity & Derivatives 266,338 1,066,686 1,167,279
Exchange (NCDEX)
National Multi Commodity Exchange 13,988 18,385 112,405
(NMCE)
National Board of Trade (NBOT) 58,463 53,683 73,377
Others 67,823 54,735 30,431
All Exchanges 571,759 2,155,122 3,676,926

While the market share in the total traded volume of NCDEX is 32% in over-all
terms it is over 80% in respect of agricultural commodities.

2.3 Major Commodity Exchanges of India

A comprehensive list of the registered commodity exchanges in India with the

commodities traded is presented in Table 3.5.

Table 3.5: Major Indian commodity exchanges and commodities traded on

them
EXCHANGE COMMODITIES TRADED
Barley, Cashew, Castor Seed, Chana, Chilli, Coffee
- Robusta, Crude Palm Oil, Cotton Seed Oil Cake -
Akola, Cotton Seed Oil Cake - Kadi, Expeller
Mustard Oil, Groundnut (In Shell), Groundnut
Expeller Oil, Guar Gum, Guar Seeds, Gur, Jeera,
Indian 28.5 mm Cotton, Indian 31 mm Cotton,
Masoor Grain Bold, Medium Staple Cotton, Mentha
Oil, Mustard Seed, Pepper, Potato, Raw Jute,
Rapeseed-Mustard Seed Oil Cake, RBD Palmolein,
National Commodity & Refined Soy Oil, Rubber, Sesame Seeds,
Derivatives Exchange, Mumbai Soyabean, Sugar (M Grade), Sugar (S Grade),
Yellow Soybean Meal (Domestic), Yellow Soybean
Meal (Export), Turmeric, V-797 Kapas, Shankar
Kapas, Yellow Peas, Yellow Red Maize, Aluminium
Ingot, Electrolytic Copper Cathode, Gold, Gold 100
gm, Mild Steel Ingots, Nickel Cathode, Silver, Silver
5 kg, Zinc Ingot, Crude Oil, Brent Crude Oil,
Furnace Oil, Polyethylene, Polypropylene and
Polyvinyl Chloride Rice, Wheat, Urad and Tur are
currently de-listed.
cont'd…
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 Global Commodity Exchanges

Gold, Gold HNI, Gold M, i-Gold, Silver, Silver HNI,

Silver M, Castor Oil, Castor Seeds, Coconut Cake,
Coconut Oil, Cotton Seed, Crude Palm Oil,
Groundnut Oil, Kapasia Khalli, Mustard Oil, Mustard
Seed (Jaipur), Mustard Seed (Sirsa), RBD
Palmolein, Refined Soy Oil, Refined Sunflower Oil,
Rice Bran DOC, Rice Bran Refined Oil, Sesame
Seed, Soymeal, Soy Bean, Soy Seeds, Cardamom,
Jeera, Pepper, Red Chilli, Turmeric, Aluminium,

Multi Commodity Exchange, Copper, Lead, Nickel, Sponge Iron, Steel Long

Mumbai (Bhavnagar), Steel Long (Govindgarh), Steel Flat,

Tin, Zinc, Cotton L Staple, Cotton M Staple, Cotton
S Staple, Cotton Yarn, Kapas, Raw Jute, Chana,
Masur, Yellow Peas, Maize, Brent Crude Oil, Crude
Oil, Furnace Oil, Natural Gas, M. E. Sour Crude Oil,
Arecanut, Cashew Kernel, Coffee (Robusta),
Rubber, HDPE, Polypropylene, PVC, Carbon Credit,
Guargum, Guar Seed, Gurchaku, Mentha Oil,
Potato (Agra), Potato (Tarkeshwar), Sugar M-30,
Sugar S-30

Castor Seed, Copra, Cotton Seed, Groundnut,

Linseed, Rape/Mustard Seed, Rape Seed-42,
Sesame Seed, Soybean, Castor Oil, Coconut Oil,
Cotton Seed Oil, Groundnut Oil, Linseed Oil,
Rape/Mustard Seed Oil, Sesame Seed Oil,
Soybean Oil, Crude Palm Oil, RBD Palmolein, Rice
Bran Oil, Vanaspati, Castor Oilcake, Coconut
National Multi Commodity Oilcake, Cotton Seed Oilcake, Groundnut Oilcake,
Exchange of India Ltd., Linseed Oilcake, Rape/Mustard Seed Oilcake,
Ahmedabad Sesame Oilcake, Soybean Oilcake, Aluminium,
Copper, Gold (100 grams), Kilo Gold, Lead, Nickel,
Silver, Tin, Zinc, Pepper, Ungarbled Pepper,
Cadamom, Cumin Seed, Turmeric, Tur/Arhar, Urad,
Moong, Masur, Chana, Rubber, Sacking, Sugar,
Sugar S-30, Gur, Guarseed, Guar Gum, W heat,
Rice, Raw Jute, Coffee Robusta, Coffee Arabica,
Menthol, Isabgul Seed.
Soybean, Soy Meal, Soy Oil, Mustard/Rape Expeller
National Board of Trade
Oil, Mustard/ Rape Seed, Crude Palm Oil

cont'd…

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Global Commodity Exchanges

Bhatinda Om & Oil Exchange

Gur
Ltd., Bhatinda
Sunflower oil, Cotton (seed and oil), Safflower
(seed, oil and oil cake), Groundnut (nuts and oil),
The Bombay Commodity
Castor oil-Int’l , Castor seed, Sesamum (oil and oil
Exchange Ltd., Mumbai
cake), Rice bran, rice bran oil and oil cake, Crude
palm oil
The Rajkot Seeds Oil & Bullion
Merchants Association Ltd., Groundnut oil, Castor seed
Rajkot
The Kanpur Commodity Rapeseed/mustard seed, Rapeseed/mustard seed,
Exchange Ltd., Kanpur Oil, Rapeseed/mustard seed, Oil cake
The Meerut Agro Commodities
Gur
Exchange Co. Ltd., Meerut
The Spices and Oilseeds
Exchange Ltd., Sangli, Turmeric
Maharashtra
Ahmedabad Commodity
Cotton seed, Castor seed
Exchange Ltd., Ahmedabad
Vijay Beopar Chamber Ltd.,
Gur
Muzaffarnagar
India Pepper & Spice Trade
Pepper
Association, Kochi
Rajdhani Oils and Oilseeds
Gur, Rapeseed/mustard seed, Sugar Grade – M
Exchange Ltd., Delhi
Rapeseed/mustard seed/oil/cake, Soybean/meal/oil,
National Board of Trade, Indore
Crude palm oil
The Chamber Of Commerce,
Gur, Rapeseed/mustard seed
Hapur
The East India Company
Indian cotton
Association, Mumbai
The Central India Commercial
Gur
Exchange Ltd., Gwalior
The East India Jute & Hessian
Hessian, Sacking
Exchange Ltd., Kolkata
First Commodity Exchange of
Copra, Coconut oil, Copra cake
India Ltd., Kochi
Bikaner Commodity Exchange
No commodity is traded at present
Ltd., Bikaner
The Coffee Futures Exchange
Coffee
India Ltd., Bangalore
E-sugarindia Limited. Mumbai Sugar

The Forward Market Commission (FMC) has reported that the total value of
trade that took place across all registered exchanges touched Rs. 21.55 lakh

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 Global Commodity Exchanges

crore during 2005-06 from Rs. 5.71 lakh crore during 2004-05, a growth of 277%.
The total turnover of all the 24 national and regional bourses stood at Rs 36.76
lakh crore during 2006-07.

Let us take a brief look at the three major commodity exchanges in India.

National Commodity and Derivatives Exchange Limited (NCDEX)

India’s largest exchange for agricultural commodities, the National Commodity &
Derivatives Exchange Limited (NCDEX) is a technology-driven de-mutualised, on-
line commodity exchange with an independent Board of Directors and professional
management. The exchange is committed to providing world-class commodity
exchange platform for market participants to trade in a wide spectrum of commodity
derivatives. The exchange is driven by best global practices, professionalism and
transparency. NCDEX is located in Mumbai and offers facilities to its members from
about 550 centres throughout India. NCDEX currently facilitates trading of 55
commodities.

The shareholders of the exchange are:

Promoter shareholders:
Life Insurance Corporation of India (LIC)
National Bank for Agriculture and Rural Development (NABARD)
National Stock Exchange of India Limited (NSE)

Other shareholders
Canara Bank
CRISIL Ltd.
Goldman Sachs
Intercontinental Exchange (ICE)
Indian Farmers Fertiliser Cooperative Limited (IFFCO)
Punjab National Bank (PNB)

NCDEX is the only commodity exchange in the country that is promoted by national-
level institutions. This unique parentage enables the exchange to offer a bouquet
of benefits, which are currently lacking in the commodity markets. NCDEX is a
public limited company incorporated on April 23, 2003 under the Companies Act,
1956. It obtained its Certificate for Commencement of Business on May 9, 2003
and commenced operations on December 15, 2003. A snapshot of the exchange
and volume trends is presented in Table 3.6 and Table 3.7, respectively.

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Table 3.6: Exchange Profile

Number Remarks
Products 55 40 agro, 4 bullion, 3 energy, 5 metals, 3 polymers
Members 850 Spread across India
Terminals 17,000
Delivery Centers 660 All over the country
Depository 65
Participants
Clearing Banks 12
Weather Stations 223 By associate company NCMSL

Table 3.7: Leading five commodities traded on NCDEX

2004-05 2005-06 2006-07

Share
Commodity (%) Commodity Share Commodity Share
Guar seed 46 Guar seed 29 Guar seed 24
Silver 13 Chana 21 Chana 23
Refined Soya Urad
Oil 9 17 Gold 9
Chana 6 Silver 8 Silver 8
Guar gum 5 Gold 4 Pepper 6

National Multi Commodity Exchange of India Ltd. (NMCE)

Established in 2002, NMCE is a state-of-the-art, de-mutualised, multi-commodity
exchange. The promoters of the exchange are:

• Central Warehousing Corporation

• National Agricultural Cooperative Marketing Federation (NAFED)
• Gujarat Agro-Industries Corporation Ltd.
• Gujarat State Agricultural Marketing Board
• National Institute of Agriculture and Marketing
• Neptune Overseas Ltd.

The Bombay Stock Exchange has recently taken 26 per cent equity in NMCE. The
exchange commenced trading in November 2002 with 24 commodities. Now, the
exchange trades in several more commodities including cash crops, food grains,
plantations, spices, oil seeds, metals and bullion.

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Multi Commodity Exchange of India Ltd. (MCX)

Set up in 2003, MCX is an independent and de-mutualised commodity exchange. It
has been promoted by Financial Technologies (I) Ltd. The other shareholders of
the company include:

• FID Funds (Mauritius) Ltd.

• State Bank of India
• National Bank for Agriculture and Rural Development (NABARD)
• Citigroup Strategic Holdings Mauritius Limited
• Merrill Lynch Holdings (Mauritius) and
• IL & FS Trust Company Ltd.

Products traded include gold, silver, oil and oil seeds, spices, metals, fibre, pulses,
cereals, energy, plantations and petrochemicals.

About 60 commodities are traded on MCX of which three to four commodities, viz.
gold, energy and base metals alone account for more than 80% of the total trade
volume. As most of the commodities on the MCX are also traded in international
markets, prices on the MCX largely reflect international trends.

2.4 Commodities Traded on Indian Commodity Exchanges

The Government of India alone has the power to decide the commodities in which
futures trading can be allowed. Commodities have been defined by the Forward
Contracts (Regulation) Act 1952 as “Every kind of movable property other than
actionable claims, money and securities”. Indices and weather derivatives have so
far not been considered as commodities in the Indian context. Broadly, the
commodities tradable may be classified into eight categories.

1. Vegetable oil seeds, oils and meals

2. Pulses
3. Spices
4. Metals
5. Energy products
6. Vegetables
7. Fibres and manufactures - Cotton
Other – guar seed, guar gum, sugar, carbon credits, etc.

2.5 Commodities Traded on NCDEX

NCDEX gives priority to commodities that are most relevant to India, and where
the price discovery process takes place domestically. The products chosen are
based on certain economic criteria as indicated below:

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• Price volatility
• Share in GDP
• Correlation with global markets
• Share in external trade
• Government intervention
• Warehousing facilities
• Traders distribution
• Geographical spread
• Number of varieties

The list of commodities traded on NCDEX is presented earlier in Table 3.5.

The NCDEX market share in key agricultural commodities is given in Table 3.8

Table 3.8: NCDEX Market Share

NCDEX market share in total volumes of key

agri-commodities (April 2006 - Mar 2007)

Cereals & Pulses Spices

Chana\Gram 88% Pepper 84%
Wheat 98% Chilli 98%
Maize 99.5% Turmeric 100%
Guar Seeds 86% Jeera 97%
Urad 87%
Tur 91% Oil & OiI seed complex
Rape/Mustard Seed 99%
Processed agri-products Soyabeen Seeds 99%
Guar Gum 99% Refined Soya Oil 29%
Sugar 86% Soya_Meal 86%
Gur 76% Castor 89%
Mentha oil 16%

Fiber
Medium Staple Cotton 100%
Kapas 50%

2.6 Regulatory Framework

In India, the spot market and the forward markets are not governed by the same
regulatory system. As we have seen in Module 1, the spot markets are generally
controlled by the State governments through the APMC acts.

The responsibility for regulation of forward and futures contracts rests with the
Central government, as the subject “Stock Exchanges and Futures Markets” is in
the Union List. The Forward Contracts (Regulation) Act, 1952 presently regulates
forward contracts in commodities.

A comparison of the regulation of spot and forward markets is presented in Figure

3.5.

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State Governments Ministry of Consumer Affairs,

Food and public Distribution

Forward Markets
Spot Market Commission (FMC)

Futures Market/
Commodity Exchange

Figure 3.5: Regulatory Structure – Spot and Futures

The Forward Contracts (Regulation) Act 1952

The main provisions of this Act that govern futures trading are:

1. The Act applies to goods defined as commodities in the Act. Indices

and weather derivatives have recently been included as commodity
derivatives.
2. The recent FCRA Amendment Act permits option in goods. It should,
however, be noted that FMC has not yet permitted any options to be
traded.
3. Contracts under the Act are categorised into ready delivery contracts
and forward contracts. Ready delivery contracts are contracts where
the delivery of goods and full payment of price is to be made within a
period of 11 days. Forward contracts (by definition not ready delivery
contracts) can be of two types:

a) Specific Delivery Contracts, and

b) Non-specific Delivery Contracts or Standardised Contracts (that is
Futures Contract)

4. Non-transferable specific delivery contracts are normally outside the

preview of the Act. A specific delivery contract is a forward contract
that provides for actual delivery of specific qualities or types of goods.
KEYWORDS

FCRA, 1952: The Forward Contract (Regulation) Act, 1952, a Central Act, governs
commodity derivatives trading in India. The Act defines various forms of contract.

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It is for a specified future period, at a price fixed thereby agreed, or, to

be fixed in the manner thereby agreed. It mentions the names of both
the buyer and the seller.

5. Till the recent amendment, the Act envisaged a three-tier regulatory

structure as indicated in Figure 2.3.

The exchange, which organises futures trading in regulated commodities

can prepare its own rules (articles of association) and byelaws and
regulate trading on a day-to-day basis. The Forward Markets Commission
(FMC) approves those rules and byelaws and provides its suggestions.
The exchange also acquires concurrent powers of regulation, either
while approving the rules and byelaws or by making such rules and by-
laws under the delegated powers.

The Central government’s Ministry of Consumer Affairs, Food and Public

Distribution is the ultimate regulatory authority. Only those associations
granted recognition by the government are allowed to conduct futures
trading. Presently, the recognition is commodity-specific. The role of
FMC was recommendatory in nature until the recent amendment of the
FCRA Act, which has given FMC statutory status.

6. Forward contracts in goods notified under Section 15 of the Act are

illegal.

Forward Markets Commission (FMC)

The Forward Markets Commission (FMC) regulates commodity futures trading in
India. Set up in 1953 under the Ministry of Consumer Affairs and Public Distribution,
FMC is now a statutory body and comes under the purview of the Forward Contracts
(Regulation) Act, 1952.

Functions of FMC
Till the recent amendments to the Forward Contracts (Regulation) Act 1952, the

FMC: The Forward Markets Commission is a statutory body set up under Forward
KEYWORDS

Contracts (Regulation) Act, 1952 and functions under the administrative control of the
Ministry of Consumer Affairs, Food and Public Distribution. The Commission regulates
forward markets in commodities through the recognised associations, recommends to
the Government the grant/withdrawal of recognition to the associations organising
forward trading in commodities and makes recommendations for the general
improvement of the functioning of forward markets in the country.

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functions of the FMC were:

a. To advise the Central Government for the recognition of or the withdrawal

of recognition of any association, or any other matter arising out of the
administration of this Act. It is to keep forward markets under observation
and to take such action in relation to them, as it may consider necessary
in exercise of the powers assigned to it by or under this Act.
b. To collect and, whenever the Commission thinks it necessary, publish
information regarding the trading conditions in respect of goods to which
any of the provisions of this Act is made applicable, including information
regarding supply, demand and prices. It is also to submit to the Central
Government periodical reports on the operation of this Act and on the
working of forward markets relating to such goods.
c. To make recommendations on improving the organisation and the working
of forward markets.
d. To undertake the inspection of the accounts and other documents of
any recognised association or registered association or any member of
such association whenever it considers it necessary.
e. To perform such duties and exercise such other powers as maybe assigned
to the Commission by or under this Act or maybe prescribed.

Powers of the Commission

Till the recent amendments to the Forward Contracts (Regulation) Act 1952, the
powers of the FMC were:

1. The Commission shall, in the performance of its functions, have all the
powers of a civil court under the Code of Civil Procedure, 1908, (5 of
1908) while trying a suit in respect of the following matters:

• Summoning and enforcing the attendance of any person and examining

him on oath
• Requiring the discovery and production of any document
• Receiving evidence on affidavits
• Requisition of any public record or copy thereof from any office
• Any other matters which maybe prescribed

2. The Commission shall have the power to require any person, subject to
any privilege which maybe claimed by that person, under law for the
time being in force to furnish information on such points or matters as in
the opinion of the commission maybe useful for or relevant to any
matter under the consideration of the commission. Any person so required
shall be deemed to be legally bound to furnish such information within

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the meaning of Section 176 of the Indian Penal code, 1860 (45 of
1860). The commission shall be deemed to be a civil court. When any
offence described in Sections. 175, 178, 179, 180 or Sec. 228 of the
Indian Penal code, 1860 (45 of 1860), is committed in the view or
presence of the commission, the commission may, after recording the
facts constituting the offence and the statement of the accused as
provided for in the Code of Criminal Procedure, 1898 (5 of 1898), forward
the case to a magistrate having jurisdiction to try the same. The
magistrate to whom any such case is forwarded shall proceed to hear
the complaint against the accused as if the case had been forwarded
to him under Section 482 of the said code.

3. Any proceeding before the commission shall be deemed to be a judicial

proceeding within the meaning of Sections 193 and 228 of the India
Penal code, 1860 (45 of 1860).

To inculcate best practices and to promote financial integrity, market

integrity and transparency, the FMC has imposed certain regulations on
commodity exchanges such as:

• Daily mark to market margining

• Time stamping of trades
• Novation of contracts and creation of Trade/ Settlement Guarantee
Fund
• Back-office computerisation for single commodity exchanges and online
trading for the new exchanges
• De-mutualisation for the new exchanges
• Limit on net open position as on the close of the trading hours.
Sometimes, limit is also imposed on intra-day net open position. The
limit is imposed operator-wise and in some cases, also member-wise.
• Circuit filters or limit on price fluctuations to allow cooling of market in
the event of abrupt upswing or downswing in prices
• Special margin deposit to be collected on outstanding purchases or
sales, when price moves up or down sharply, above or below the previous
day closing price
• Circuit breakers or minimum or maximum prices are prescribed to prevent
futures prices from falling below or rising above figures not warranted
by prospective supply and demand factors.
• Skipping trading in certain derivatives of the contract, closing the market
for a specified period and even closing out the contract. These extreme
measures are taken only in emergency situations.

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Securities Contracts (Regulation) Act, 1956

The FCRA act has been recently amended by an Ordinance, transferring substantial
powers and responsibilities from the Central Government to the FMC. The amendments
made provide, inter-alia, for

• Allowing trading in options;

• Conferring power on FMC to levy fees;

• Providing for transfer of duties and functions of a clearing house to a clearing

corporation;

• Making provisions for registration of members and intermediaries;

• Providing for carrying out investigation, enforcement and penalty in case of

contravention of the provisions of the act;

• Making provisions for making of appeals; and

• Increasing the maximum number of members of FMC from four to nine out of
which three to be whole-time members and a Chairman.

The Securities Contracts (Regulation) Act governs and regulates transactions in

securities. The functions of the Securities and Exchange Board of India (SEBI) are
regulating the business in stock exchanges and other securities’ markets.

The role of FMC in the commodities markets is similar to the role of SEBI in stock
markets. The major area of difference is that, while the SEBI is required to conduct
research relating to stock exchanges and securities markets and disseminate these
findings, the FMC is prohibited from disseminating research information, which has
implications for market outlook. The FMC is required to collect and publish information
on supply, demand and prices of commodities.

The Finance Ministry has amended two main clauses in the Securities Contracts
(Regulation) Rules, 1957, which would substantially widen participation in commodity
futures market. Through a notification issued in August 2003, the Central
Government has amended rule 8 (1) (f) of the SCRA Rules, 1957 that permits
KEYWORDS

SCRA 1956: Securities Contracts Regulation Act is an act established in 1956 to

govern and regulate transactions in securities.

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stockbrokers to trade in commodity derivatives also. However, stockbrokers will be

permitted to trade in commodity derivatives only through a separate subsidiary
that meets all the requisite norms set out by the FMC. Further, rule 8(4) has been
amended to permit banks and other entities like the Export Import (EXIM) Bank of
India, National Bank for Agriculture and Rural Development (NABARD) and the National
Housing Bank (NHB) to trade in commodity futures. Their respective statutes, such
as the Banking Regulation Act, prevent these entities from trading in commodity
futures.

3. Functions and Roles of an Exchange

3.1 Functions of an Exchange

The need to manage a variety of risks in agriculture led to the evolution and
establishment of commodity exchanges across a large number of countries. The
various risks are mainly associated with the following:

• Production
• Storage
• Processing
• Trading
• Safeguarding against counterparty risks.

Derivative exchanges lower the transaction costs and offer the market participants,
a platform with different risk preferences to exchange risks. Additionally, exchanges
serve as an inexpensive, efficient and transparent mechanism for price discovery
and dissemination of price information.

Participation in these exchanges is not limited to those who are directly involved in
the physical market. In fact, other participants like speculators impart the much-
needed liquidity to these markets.

The major functions of an exchange are:

• Price discovery
• Price dissemination
• Risk management
• Market surveillance
• Clearing and settlement.

Let us briefly examine each of these functions.

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Price Discovery

In a futures contract, the price is predetermined. The buyer and the seller know
how much they should give and expect on a future date, respectively. As contracts
in futures are standardised according to quantity, quality and location, buyers and
sellers can bargain only on price. This price is determined through a process called
price discovery.

Price discovery is the process of arriving at the price at which the buyer buys and
a seller sells a futures contract on a specific expiration date. In an active futures
market, the process of price discovery starts from the moment the market opens
and continues until it closes. The prices are discovered competitively. Futures
prices are therefore considered superior than administered prices or prices that are
determined privately. Additionally, a handful of buyers and sellers cannot control
the market (including prices) as the futures market is characterised by low
transaction costs and frequent trading, encouraged by wider participation.

The futures price is a reflection of the market participants’ consensus on the

expected value of the commodity at the contract expiration. As demand and
supply change and new information comes into the market, the price of a contract
gets reassessed. This transparency in price discovery ensures that everyone has
access to the same information at all times. This improves market efficiency.

The process of price discovery happens in two phases.

Phase 1

In this phase, buyers and sellers evaluate the demand and supply conditions to
decide a general price band, around which specific transaction prices fluctuate.
The prices depend on a number of factors like geographic market location, time
horizon of the price assessment to be made, grading accuracy of the commodity,
and information availability among others.

Phase 2

In this phase, buyers and sellers determine the value and price of a specific lot of
the commodity traded. The actual price could be arrived through private negotiation
(forwards), auction or trading. Figure 3.6 illustrates the process of price discovery
and determination at NCDEX for a gold October month futures contract.

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Global Commodity Exchanges

ATP - Average Traded Price, LTP - Last Traded Price

Figure 3.6: Example of gold October month future price discovery

On the left-hand side of the diagram, you can see buyers with their quoted price
and quantity on the exchange. On the right, you can see sellers with their quoted
price and quantity on the exchange. You can also see that a buyer is ready to buy
2 kg of gold at a price of 9,457 Rs/10gms; and a seller is ready to sell 1 kg of gold
at a price of 9,458 Rs/10gms. The trade will take place the moment both the buyer
and seller arrive at a common price for the commodity. Note that last trade took
place at Rs. 9,458. This price must have emerged from the negotiation and
agreement between some buyer and seller on a certain price quote for that particular
time period.

Both speculators and arbitragers help to discover prices. If a speculator is of the

opinion that new information justifies higher valuation, he goes long on the commodity
and vice-versa. Such activities of speculators provide fresh information to the
markets leading to a revision in the prices. Arbitragers also help the process of
price discovery and restore market efficiency by trading on the discrepancies in
prices between different markets. As a result, they help in restoring market
equilibrium. For example, if castor is costly at NCDEX and cheap at MCX, they buy
in MCX and sell in NCDEX till prices equalise.

Price Dissemination

In active futures markets, free flow of information is vital. Futures exchanges act
as a focal point for collection and dissemination of statistics on supplies,
transportation, storage, purchases, exports, imports, currency values, interest
rates and other pertinent information. Any significant change in this data is
immediately reflected in the trading pits or on the trading screen. Traders use this
new information and adjust their bids and offers accordingly. Based on such free
flow of information, the market determines the best estimate of current and future
prices. This way, the market gives an accurate picture of the supply and demand
scenario for an underlying commodity.

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Exchanges also help in removing asymmetry of information in scattered farming

communities. Farmers with better knowledge of present and expected prices are
able to decide whether to sell in the spot or in the futures markets.

In commodity exchanges, price dissemination occurs through ticker bands, print,

audio and visual media.

The key input underlying derivative markets is reliable spot price information. Spot
prices serve as inputs to generate trading strategies and payoffs on settlement.
However, many spot markets are not transparent and spot prices cannot be regularly
observed. In India, the fragmented state of spot markets further compounds the
problem. Exchanges use polling of price data by using a panel of dealers and
various other sources to get reliable spot prices. Dealers can form cartels and
attempt to manipulate spot prices. The polling process has to get round the
problem of such manipulation as much as possible. The spot price polling process
and polling centres used are given later in Figure 3.6 and Table 3.9.

Price Dissemination Efforts at NCDEX

Price Dissemination efforts at NCDEX are carried out through the following:

1. Kisan call centers

2. Doordarshan, CNBC, NDTV Profit and All India Radio (AIR)
3. Tie-ups with Reuters, Telerate, Telequotes, Bloomberg, among others
4. Corporate tie-ups with ITC e-Chaupals, n-Lounge
5. Newspapers, Agricultural journals
6. AgmarkNet,
7. Extranet, Website
8. Other sites including
a. IFFCO, HAFED, NAFED, MP Warehousing Corp., NICR, NCDEX Spot
b. Bank branches: Bank of Baroda, Band of India, Punjab National Bank
c. Selected Central and State government offices
d. Commodity trader offices
e. Post offices
f. Bank branches
g. Railway stations and bus stands
h. APMC boards at mandis
i. Others
• Agri extension services: Mahindra Shubhlabh, Rallis
• TV channels such as Aaj Tak, Zee Business
• FMCG dealer points

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Spot Polling Process at NCDEX

Through a process known as polling, the exchange randomly calls up about 25
market participants from a panel of 40 market participants and asks them for the
spot prices thrice a day. After collecting the raw prices, the exchange carries out
a process called bootstrapping, a scientific procedure for removing the outliers of
raw prices (i.e. prices that are too far away) and averaging the remaining prices.

Figure 3.6 shows the spot polling process at NCDEX.

Mandi Exchange website

Traders
Trading terminals
Mill owners
Statistical Near real-time
Polled prices cleansing of nationwide prices
Refiner raw data
Info-vendor terminals
Commission
agents

Manufacturers Media-electronic and print

Figure 3.6: Spot Polling Process at NCDEX

Some polling centres used by NCDEX are presented in Table 3.9.

Table 3.9: Priority Centers used by NCDEX

Commodities Priority Center Non- priority Center

RM Seed Jaipur Alwar, Sriganganagar
RM Oil Jaipur
Soybean Indore Nagpur, Bhopal, Kota
Soybean Meal Indore
Refined Soya Oil Indore Mumbai, Nagpur
Crude Palm Oil Kandla
RBD Palmolein Kakinada
Medium Staple Cotton Abhor Sriganganagar, Sirsa
Long Staple Cotton Kadi Rajkot
Gold Mumbai
Silver Delhi

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Risk Management

A commodity exchange manages two types of risks

1. Price risk
2. Credit risk

Price Risk Management

Buyers and sellers of commodities use the futures market for risk management.
They use futures to protect themselves against adverse price changes. Commodity
exchanges provide a market for all participants to manage price risks by locking
prices of fixed delivery dates, in advance.

An earlier section has illustrated how traders, hedgers and speculators use various
derivative products to cover potential losses and make gains, if possible, through
the market mechanism.

Credit Risk Management

The objective of any exchange should also be to organise trading in such a way
that risk of default (counterparty credit risk) is almost eliminated.
To achieve this, exchanges adopt various measures as described below.

Capital adequacy (minimum net worth, security deposits)

requirements: Stringent requirements ensure financial soundness of
Members of the exchange. The members of NCDEX fall into two categories:
• Trading-cum-Clearing Members - carry out the transactions such as
trading, setting and clearing on their own account and also on their
clients’ account.
• Professional Clearing Members - Carry out settlement and clearing
for their clients who have traded through a Trading-cum-Clearing
Member.

The criteria adopted by NCDEX for selection of members is summarised in Table

3.10

Table 3.10: Membership criteria at NCDEX

Membership Criteria Trading Cum Clearing Professional Clearing

Members (TCMs) Members (PCMs)
Net Worth Rs. 50 lakh Rs. 50 crore
Interest free cash security deposit Rs. 15 lakh Rs. 25 lakh
Collateral security deposit Rs. 15 lakh Rs. 25 lakh
Annual membership fees Rs. 50 thousand Rs. 1 lakh
Advance minimum transaction Rs. 50 thousand Rs. 1 lakh
charges
Admission fees (one-time) Rs. 5 lakh -

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Membership of NCDEX as Trading cum Clearing Members (TCM) is open

to any person, association of persons, partnerships, cooperative societies
and companies, among others. They need to fulfil the eligibility criteria
set by the exchange. All members of the exchange have to register
themselves with the competent authority before commencing their
operations.

2. Margins: A good margining system also helps in ensuring financial

soundness. At NCDEX, a minimum initial margin is set for each commodity.
Initial margins help in covering the largest potential loss in any one day.
The process of marking to market the margin account of each trader
further helps in bringing down the default risk.

Exchanges charge additional or special margins when markets become

highly volatile, to prevent any payment crisis. Clearinghouses are also
required to maintain margins of their members to ensure that they are
able to guarantee trade commitments. For example, NCDEX uses Value
at Risk (VaR) through Standard Portfolio Analysis of Risk (SPAN) to help
it to identify the portfolio risk positions of members. Value at Risk is the
maximum loss not exceeded with a given probability defined as the
confidence level, over a given period of time which could be a day, ten
days or even a year. Commonly used confidence levels are 99% and
95%.

3. Mark to market (MTM): It is a mechanism devised by the exchanges

to minimize risk. All trades done on the exchange during the day and all
open positions for the day are marked to the closing price for the
respective series and the notional gain or loss is worked out. Such loss/
gain is debited/credited to the respective member’s account. NCDEX
uses Real Time Position Limit Monitoring (PRISM) for on-line position
monitoring. A member is alerted when he crosses his exposure limit. The
member can either choose to reduce his exposure, or can bring in
additional capital as net worth. Failure to furnish additional capital results
in withdrawal of trading facility of the member.

4. Price bands: Exchanges impose daily price fluctuation limits called price
bands on all commodities. This is to reduce extreme volatility and prevent
a handful of players from controlling the market.

5. Fund for Contingencies: In addition to margins, NCDEX collects money

to tide over contingencies and unforeseen situations. Both the investors

SPAN: SPAN is a registered trademark of the Chicago Mercantile Exchange. It is used

KEYWORDS

by NCDEX under a license obtained from CME. The objective of SPAN is to identify the
overall risk in a portfolio of all futures contracts for each member. Its over-riding
objective is to determine the largest loss that a portfolio might reasonably be
expected to suffer from one day to the next based on 99% VaR methodology.

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and the members are covered through two separate funds viz. the
Members Margin Fund and the Investor Protection Fund.

Market Surveillance

Proper market monitoring and surveillance results in

1. Confidence among participants

2. Increased market liquidity
3. High turnover.
Exchanges engage in market surveillance through:

• Monitoring price and volume movements

• Detecting potential market manipulation at the early stages
• Neutralising market participants’ ability to collude and influence prices.

Exchanges use online surveillance to monitor prices, volume and volatility of trades
done. Real-time surveillance is required on margining requirements, position
monitoring and exposure limits of members. Off-line surveillance is used for specific
investigations, cases requiring disciplinary action etc. Some exchanges use this
surveillance for margining requirements and position monitoring as well.

A good market monitoring and surveillance system has the following features:

• An adequate framework for regulation and compliance

• Proper controls over trading practices
• A well enforced regulation for brokers and other members of the exchange
• A well functioning clearing and delivery system
• Capacity for timely detection and prevention of attempts at market
manipulation.

At NCDEX, most of the surveillance is done online, especially in relation to margining

and monitoring of members’ positions. A team of professionals is engaged in monitoring
on an hourly basis. Teams regularly visit mandis.

Clearing and Settlement

Settlement in the commodities derivatives market can be done through closing

out, physical delivery or cash settlement. These settlements are carried out through
the exchange’s clearing house or clearing corporation.

A clearinghouse is a system by which exchanges guarantee faithful compliance of

all trade commitments undertaken on the trading floor or electronically over
electronic trading systems. The main task of the clearinghouse is to keep track of
all transactions that take place during a day. This facilitates calculation of the net
position of each member.

The clearinghouse is also involved in post-trade activities. These include confirming

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trades, computing gains or losses of members for the day, collecting losses from
losing members and paying out to members who have made gains.

A strong and reliable clearinghouse helps in instilling trust in an exchange as it not

only facilitates trade, but also provides safety. While the clearinghouse does not
deal directly with clients, its role in ensuring the financial integrity of market is
critical. The clearinghouse, through its margining and risk management procedures,
assures protection to clients and members. The clearinghouse also ensures that
members are able to manage their positions. Members are expected to daily notify
the exchange of large positions so that their financial exposure can be calculated.

3.2 The Roles of an Exchange

The roles of an exchange are manifold and include the following:

• Standardisation
• Guarantor of all trades
• Provider of an anonymous auction platform
• Neutrality
• Risk transfer platform
• Provider of long-term price signals
• Market linkages and infrastructure.

Standardisation

The contracts designed by specific exchanges can be traded only on those

exchanges. These contracts are standardised and cannot be modified by participants.
The contract specification document lays down product and trading standards
such as product quality, lot size, tick size, margins, delivery centres and settlement
date. This standardisation helps bring the much-needed liquidity to futures markets.

An example of a standard contract specification at NCDEX is presented in Table

3.11.

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Contracts: Soybean
Trading system NCDEX Trading System
Trading hours Monday to Friday 10:00 am to 5:00 pm
Unit of trading 10 MT
Quotation or Base Value Rs. per Quintal
Tick size Re. 0.05
Delivery unit Table 3.3:
100Standard
Quintal (= Contract
10 MT) Specifications

Quantity variation +/- 2%

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Opening of contracts Trading in any contract month will open on the 10th day of
the month. If the 10th day happens to be a non-trading day,
contracts would open on the next trading day
th th
Due date 20 day of the delivery month. If 20 happens to be a
holiday, the previous working day
Closing of contract All open positions will be settled as per general and product-
specific regulations
Price band Daily price fluctuation limit is (+/-) 3%. If the trade hits the
prescribed daily price limit there will be a cooling off period
for 15 minutes. Trade will be allowed during this cooling off
period within the price band. Thereafter the price band would
be raised by (+/-) 1% and trade will be resumed

If the price hits the revised price band (4%) again during the
day, trade will only be allowed within the revised price band.
No trade / order shall be permitted during the day beyond the
revised limit of (+ / -) 4%
Positions limits Member level (all contract months): 60,000 MT or 15% of
market open interest, whichever is higher
Client level (all contract months): 20,000 MT
Quality specification Moisture: 10% Max
Sand/Silica: 2% Max
Damaged: 2% Max
Green Seed: 7% Max
Delivery centre Indore

No. of active contracts Concurrent month contracts

Guarantor of all Trades

Futures contract orders are first received by brokers. They could be either members
or non-members of a clearinghouse. Non-members can make transactions only
through members for a fee. Member brokers report the net position - long or short
- to the clearinghouse. The clearinghouse balances its position with an equal

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number of long or short contracts. Therefore, the clearinghouse becomes the legal
counterparty to every contract made, regardless of its origin.

The clearinghouse also plays the role of guarantor of members’ financial obligation
in case they default. It acts as a legal counterparty to buyers and sellers through
the process of novation - minimising the counterparty risk. OTC markets do not
have any clearinghouses, making them more prone to counter party risk.

However, market participants do face a credit risk – default by the clearinghouse

itself! This risk is prevented by the Settlement/Trade Guarantee Fund. Clearinghouses
rarely default, though it happened in Hong Kong (1987) and France (1970s). The
London Metal Exchange almost went bankrupt in 1985 when it faced the “Tin
Crisis”. Similarly, the stock market crash of 1987 in the US also adversely affected
US clearinghouses.

Anonymous Auction Platform

Exchanges provide an anonymous auction platform, where bids and offers coming
from geographically dispersed locations converge. This creates competitive conditions
for trading. Prices are determined through an open and continuous auction on the
exchange, either through the open outcry system or through the electronic platform.
While each trader knows who the other trader is, customers remain anonymous.
The public yet anonymous auction ensures ready availability of a widely accepted
reference price through price discovery.

Neutrality

Exchanges maintain absolute neutrality toward market movements and price changes.
Their rules apply to both sides of a transaction. The exchange is just a neutral
repository of information on market statistics. The exchange itself does not trade,
but only provides a trading platform for members. It does not take positions in the
market, nor does it advise members on what positions to take. It provides a
mechanism whereby members, on behalf of their clients or themselves, trade in a
safe, efficient and orderly manner.

Risk Transfer Platform

One of the primary roles an exchange performs is to act as a platform that transfers
risk. The risk is transferred from risk-averse persons to those who feel they are
better at managing risks. This mechanism of risk transfer helps farmers, producers,
manufacturers and purchasers to focus on their core activities of cropping,
production and procurement. The risk is transferred from the hedgers to the
speculators and arbitragers who want to take various kinds of risks in the hope of
making profits.

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Provider of Long-Term Price Signals

Futures prices signal prices that are likely to prevail at particular times in the
future. Farmers can decide on the cropping pattern based on futures prices.
Agricultural financiers can prevent their loans from becoming non-performing assets.
They watch futures prices and sell futures contracts at the right time for the value
of credit exposure. Thus, commodity producers, merchants, stockists, processors,
importers and exporters can protect themselves from adverse price movements.
They watch the price signals in futures contracts and take appropriate actions.

Market Linkages and Infrastructure

Market linkages and infrastructure of an exchange help reduce operational risk.

Operational risk is the loss resulting from inadequate or failed internal processors in
the exchange, for example, breakdown of computers. NCDEX is an online commodity
exchange driven by technology. The network infrastructure is shown in Figure 3.7.

Figure 3.7: Network Infrastructure

Technology

Trading Link

Terrestrial Wireless

Leased Dial-up Mobile Others

Internet V-SAT
Lines ISDN Phones WiFi etc.

NCDEX terminals are connected through VSAT, leased lines and the Internet. The
network helps in the discovery of realistic commodity prices to buyers and sellers
in real time. The exchange provides trading services through leased lines, VSAT
and Internet. Fifty per cent of the trading is through leased lines and Internet and
the rest through VSAT.

Summary

The need to manage a variety of risks in agriculture led to the evolution and
establishment of commodity exchanges across a large number of countries. Derivative
exchanges lower transaction costs and offer a platform to market participants
with different risk preferences to exchange risks. The major functions of an exchange

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are price discovery, price dissemination, risk management, market surveillance,

clearing and settlement.

Price discovery is the process of arriving at the price at which the buyer buys and
a seller sells a futures contract on a specific expiration date. In active futures
markets, free flow of information is vital. In commodity exchanges, price
dissemination occurs through ticker bands, print, audio and visual media. The key
objective of an exchange is to organise trading in such a way that risk of default
(counter party credit risk) is almost eliminated. To achieve this, exchanges adopt
various measures such as capital adequacy for its members, margin requirements,
marking to market, setting price bands etc.

Exchanges use market surveillance to instil market confidence and increase liquidity
and turnover. Clearing and settlement is another important function for which
clearinghouses are used. A clearinghouse is a system by which exchanges guarantee
faithful compliance of all trade commitments undertaken on the trading floor or
electronically over electronic trading systems.

Settlement in the commodities derivatives market can be done through closing

out, physical delivery or cash settlement. These settlements are carried out through
the exchange’s clearinghouse or clearing corporation. The roles of an exchange
are manifold and include

• standardisation
• guarantor of all trades
• provider of an anonymous auction platform
• neutrality
• risk transfer platform
• provider of long-term price signals
• market linkages
• infrastructure.
The contracts designed by specific exchanges are standardised and cannot be
modified by participants. The clearinghouse becomes the legal counterparty to
every contract made, regardless of its origin. Exchanges provide an anonymous
auction platform, where bids and offers coming from geographically dispersed
locations converge. Exchanges maintain absolute neutrality toward market
movements and price changes. Their rules apply to both sides of a transaction.
One of the primary roles an exchange performs is to act as a platform that transfers
risk. Exchanges act as providers of long-term price signals.

The development of modern futures trading began in the US in the early 1800s.
The earliest recorded forward contract was on March 13, 1851. As the grain trade

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expanded, a group of 82 merchants gathered over a flour store in Chicago to form

the Chicago Board of Trade (CBOT). By the mid 19th century, futures markets had
developed into effective mechanisms for managing counterparty and price risks.
The clearinghouse of the exchange guaranteed the performance of contracts and
started collecting margins to ensure contract performance. New exchanges were
formed in the late 19th and early 20th centuries as trading started in non-agricultural
commodities like precious metals and processed products, among others.

Commodities’ trading in some developing economies also has a long history. The
Buenos Aires Grain Exchange in Argentina (founded in 1854) is one of the oldest in
the world. In India, futures trading was introduced in 1875. Africa’s most active
and important commodity exchange is the South African Futures Exchange (SAFEX).
China’s ûrst commodity exchange was established in 1990, followed soon after by
the setting up of as many as 40 exchanges. Subsequent consolidation has resulted
in three commodity exchanges - Dalian Commodity Exchange (DCE), Zheng Zhou
Commodity Exchange and the Shanghai Futures Exchange. The Bursa Malaysia
Derivatives Exchange (MDEX) was established in 1980. The Taiwan Futures Exchange
(TAIFEX) was established in 1998. The Jakarta Futures Exchange (JFX) was launched
in 1999. The merger of two well–established exchanges in Singapore - the Stock
Exchange of Singapore (SES) and Singapore International Monetary Exchange
(SIMEX) led to the formation of the Singapore Exchange (SGX) in 1999. Thailand’s
Agricultural Futures Exchange of Thailand (AFET) was launched much later in
2004. Latin America’s largest commodity exchange is the Brazil based Bolsa de
Mercadorias & Futuros (BM&F). Argentina’s futures market Mercado a Termino de
Buenos Aires (MATba), founded in 1909 ranks 51st among the largest exchanges in
the world. Mercado Mexicano de Derivados (Mexder) – the futures exchange of
Mexico’s commodities market was established recently in 1998.

In India, organised trading in commodity derivatives started in 1875 with the

setting up of the Bombay Cotton Trade Association Ltd. This led to the establishment
of the Bombay Cotton Exchange Ltd. in 1893.Following cotton, trading was
introduced in other agricultural commodities. In 1900, the Gujarati Vyapari Mandali
was established. Futures trading in raw jute and other jute goods began at Kolkata
with the setting up of the Calcutta Hessian Exchange Ltd. in 1919.

Futures trading in bullion began in Mumbai in 1920 and later in Rajkot, Jaipur,
Jamnagar, Kanpur, Delhi and Kolkata. In December 1952, the Forward Contracts
(Regulation) Act (FCRA) was enacted that currently regulates forward contracts
in commodities in the country. The Forward Markets Commission (FMC) was set up
in 1953 under the Ministry of Consumer Affairs and Public Distribution. In due
course, several exchanges and registered associations were set up to trade in a
range of commodities. During the 1970s however, most of these became inactive

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as trading in futures and forwards of commodities for which they were registered
was either suspended or totally prohibited.

The Government issued notifications on April 1, 2003 and permitted futures trading
in commodities. The country’s commodity futures exchanges are divided into two
types: National exchanges and Regional exchanges. The three exchanges operating
at the national level are: National Commodity and Derivatives Exchange of India
Ltd. (NCDEX), Mumbai, National Multi Commodity Exchange of India Ltd. (NMCE),
Ahmedabad, and Multi Commodity Exchange (MCX), Mumbai. The leading regional
exchange is the National Bond of Trade (NBOT), located at Indore.

The commodities tradable may be classified into vegetable oil seeds, oils and
meals, pulses, spices, metals, energy products, vegetables, fibres etc.

In India, the spot market and the forward markets are not governed by the same
regulatory system. The spot markets are controlled by the State governments and
regional agricultural produce marketing committees (APMC).

The responsibility for regulation of forward and futures contracts rests with the
Central government, as the subject “Stock Exchanges and Futures Markets” is in
the Union List. The Forward Contracts (Regulation) Act, 1952 (FCRA Act) presently
regulates forward contracts in commodities. The Forward Markets Commission (FMC)
regulates commodity futures trading in India. The FCRA Act has been amended
through an Ordinance recently which has given FMC statutory status. Options
trading and trading in other derivatives have also been permitted under the amended
Act.

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 Key Questions

a
1. Professional Clearing Members:

A) Cannot trade on their own accounts

B) Function on their own outside the exchanges
C) Do not have any new worth requirements
D) Both 2 and 3 above

2. Which of the following is not a national exchange?

A) NCDEX
B) NBOT
C) NMCE
D) MCX

3. According to the FCRA, settlement and delivery has to be done in the

physical market within how many days after completion of the contract?

A) 11days
B) 14 days
C) One month
D) No date is specified

4. “Novation”:

A) Means closing out of futures contracts by entering into new contracts

B) Reduces counter party risk
C) Can be done only on electronic exchanges
D) Is present only in commodity exchanges and not in financial exchanges

5. Which of the following is true about SPAN?

A) It has been licensed by NCDEX from CMIE

B) It is used for price dissemination
C) It uses Value at Risk
D) All are true

6. Agricultural commodities are an example of:

A) Consumption asset
B) Investment asset
C) Speculation asset
D) Fixed asset

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Key Questions

7. NCDEX does not provide:

A) Screen based trading

B) Nation wide trading
C) Open Outcry trading
D) Electronic trading

8. Which order has the maximum flexibility?

A) Market Order
B) Day Order
C) Fill Order
D) Good till Cancelled Order

9. In relation to the Clearing House Margin, which of the following is correct?

A) Is meant only for PCMs

B) Are not marked to market
C) Requires no maintenance margin
D) Cannot withdraw surplus funds in the margin account

10. The theoretical price of a forward contract consider is:

A) Spot price
B) Cost of carry
C) Time to expiration
D) All the above
ANSWER KEY

Qustion No. 1 2 3 4 5 6 7 8 9 10
Answers A B A B C A C A C D

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