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Introduction
Derivatives as a tool for managing risk first originated in the commodities
markets. They were then found useful as a hedging tool in financial markets as well. In
India, trading in commodity futures has been in existence from the nineteenth century
with organised trading in cotton through the establishment of Cotton Trade Association in
1875. Over a period of time, other commodities were permitted to be traded in futures
exchanges. Regulatory constraints in 1960s resulted in virtual dismantling of the
commodities future markets. It is only in the last decade that commodity future
exchanges have been actively encouraged. However, the markets have been thin with
poor liquidity and have not grown to any significant level.
Although India has a long history of trade in commodity derivatives, this segment
remained underdeveloped due to government intervention in many commodity markets to
control prices. The production, supply and distribution of many agricultural commodities
are still governed by the state and forwards and futures trading are selectively introduced
with stringent controls. While free trade in many commodity items is restricted under the
Essential Commodities Act (ECA), 1955, forward and futures contracts are limited to
certain commodity items under the Forward Contracts (Regulation) Act (FCRA), 1952.
The first commodity exchange was set up in India by Bombay Cotton Trade
Association Ltd., and formal organized futures trading started in cotton in 1875.
Subsequently, many exchanges came up in different parts of the country for futures trade
in various commodities. The Gujrati Vyapari Mandali came into existence in 1900 which
has undertaken futures trade in oilseeds first time in the country. The Calcutta Hessian
Exchange Ltd and East India Jute Association Ltd were set up in 1919 and 1927
respectively for futures trade in raw jute. In 1921, futures in cotton were organized in
Mumbai under the auspices of East India Cotton Association (EICA). Many exchanges
were set up in major agricultural centres in north India before world war broke out and
they were mostly engaged in wheat futures until it was prohibited. The existing
exchanges in Hapur, Muzaffarnagar, Meerut, Bhatinda, etc were established during this
period. The futures trade in spices was first organized by India Pepper and Spices Trade
Association (IPSTA) in Cochin in 1957. Futures in gold and silver began in Mumbai in
1920 and continued until it was prohibited by the government by mid-1950s. Options are
though permitted now in stock market, they are not allowed in commodities. The
commodity options were traded during the pre-independence period. Options on cotton
were traded until they along with futures were banned in 1939 (Ministry of Food and
Consumer Affairs, 1999). However, the government withdrew the ban on futures with
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passage of FCRA in 1952. The Act has provided for the establishment and constitution of
Forward Markets Commission (FMC) for the purpose of exercising the regulatory powers
assigned to it by the Act. Later, futures trade was altogether banned by the government in
1966 in order to have control on the movement of prices of many agricultural and
essential commodities.
After the ban of futures trade all the exchanges went out of business and many
traders started resorting to unofficial and informal trade in futures. On recommendation
of the Khusro Committee in 1980 government reintroduced futures on some selected
commodities including cotton, jute, potatoes, etc. As part of economic liberalization of
1990s an expert committee on forward markets under the chairmanship of Prof. K.N.
Kabra was appointed by the government of India in 1993. Its report submitted in 1994
recommended the reintroduction of futures which were banned in 1966 and also to widen
its coverage to many more agricultural commodities and silver. In order to give more
thrust on agricultural sector, the National Agricultural Policy 2000 has envisaged external
and domestic market reforms and dismantling of all controls and regulations in
agricultural commodity markets. It has also proposed to enlarge the coverage of futures
markets to minimize the wide fluctuations in commodity prices and for hedging the risk
arising from price fluctuations. In line with the proposal many more agricultural
commodities are being brought under futures trading.
Futures trading perform two important functions of price discovery and price risk
management with reference to the given commodity. It is useful to all segments of the
economy. It is useful to the producer because he can get an idea of the price likely to
prevail at a future point of time and therefore can decide between various competing
commodities, the best that suits him. It enables the consumer, in that he gets an idea of
the price at which the commodity would be available at a future point of time. He can do
proper costing and also cover his purchases by making forward contracts. Futures trading
is very useful to the exporters as it provides an advance indication of the price likely to
prevail and thereby help the exporter in quoting a realistic price and thereby secure export
contract in a competitive market. Having entered into an export contract, it enables him to
hedge his risk by operating in futures market.
National Exchanges
In enhancing the institutional capabilities for futures trading the idea of setting up
of National Commodity Exchange(s) has been pursued since 1999. Three such
Exchanges, viz, National Multi-Commodity Exchange of India Ltd., (NMCE),
Ahmedabad, National Commodity & Derivatives Exchange (NCDEX), Mumbai, and
Multi Commodity Exchange (MCX), Mumbai have become operational. “National
Status” implies that these exchanges would be automatically permitted to conduct futures
trading in all commodities subject to clearance of byelaws and contract specifications by
the FMC. While the NMCE, Ahmedabad commenced futures trading in November 2002,
MCX and NCDEX, Mumbai commenced operations in October/ December 2003
respectively.
MCX
MCX (Multi Commodity Exchange of India Ltd.) an independent and de-
mutulised multi commodity exchange has permanent recognition from Government of
India for facilitating online trading, clearing and settlement operations for commodity
futures markets across the country. Key shareholders of MCX are Financial Technologies
(India) Ltd., State Bank of India, HDFC Bank, State Bank of Indore, State Bank of
Hyderabad, State Bank of Saurashtra, SBI Life Insurance Co. Ltd., Union Bank of India,
Bank Of India, Bank Of Baroda, Canara Bank, Corporation Bank.
NMCE
National Multi Commodity Exchange of India Ltd. (NMCE) was promoted by Central
Warehousing Corporation (CWC), National Agricultural Cooperative Marketing
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Federation of India (NAFED), Gujarat Agro-Industries Corporation Limited (GAICL),
Gujarat State Agricultural Marketing Board (GSAMB), National Institute of Agricultural
Marketing (NIAM), and Neptune Overseas Limited (NOL). While various integral
aspects of commodity economy, viz., warehousing, cooperatives, private and public
sector marketing of agricultural commodities, research and training were adequately
addressed in structuring the Exchange, finance was still a vital missing link. Punjab
National Bank (PNB) took equity of the Exchange to establish that linkage. Even today,
NMCE is the only Exchange in India to have such investment and technical support from
the commodity relevant institutions.
NMCE facilitates electronic derivatives trading through robust and tested trading
platform, Derivative Trading Settlement System (DTSS), provided by CMC. It has robust
delivery mechanism making it the most suitable for the participants in the physical
commodity markets. It has also established fair and transparent rule-based procedures and
demonstrated total commitment towards eliminating any conflicts of interest. It is the
only Commodity Exchange in the world to have received ISO 9001:2000 certification
from British Standard Institutions (BSI). NMCE was the first commodity exchange to
provide trading facility through internet, through Virtual Private Network (VPN).
NMCE follows best international risk management practices. The contracts are marked to
market on daily basis. The system of upfront margining based on Value at Risk is
followed to ensure financial security of the market. In the event of high volatility in the
prices, special intra-day clearing and settlement is held. NMCE was the first to initiate
process of dematerialization and electronic transfer of warehoused commodity stocks.
The unique strength of NMCE is its settlements via a Delivery Backed System, an
imperative in the commodity trading business. These deliveries are executed through a
sound and reliable Warehouse Receipt System, leading to guaranteed clearing and
settlement.
NCDEX
The current profile of futures trading in India with respect to the various exchanges in
India:-
Commodity derivatives
The basic concept of a derivative contract remains the same whether the
underlying happens to be a commodity or a financial asset. However there are some
features which are very peculiar to commodity derivative markets. In the case of financial
derivatives, most of these contracts are cash settled. Even in the case of physical
settlement, financial assets are not bulky and do not need special facility for storage. Due
to the bulky nature of the underlying assets, physical settlement in commodity derivatives
creates the need for warehousing. Similarly, the concept of varying quality of asset does
not really exist as far as financial underlying assets are concerned. However in the case of
commodities, the quality of the asset underlying a contract can vary largely. This
becomes an important issue to be managed. A brief look at these issues.
Physical settlement
Physical settlement involves the physical delivery of the underlying commodity,
typically at an accredited warehouse. The seller intending to make delivery would have to
take the commodities to the designated warehouse and the buyer intending to take
delivery would have to go to the designated warehouse and pick up the commodity. This
may sound simple, but the physical settlement of commodities is a complex process. The
issues faced in physical settlement are enormous. They are:-
? Limits on storage facilities in different states.
? Restrictions on interstate movement of commodities.
? State level octroi and duties have an impact on the cost of movement of goods
across locations.
The process of taking physical delivery in commodities is quite different from the
process of taking physical delivery in financial assets. We take a general overview at the
process flow of physical settlement of commodities.
Assignment
Whenever delivery notices are given by the seller, the clearing house of the
exchange identifies the buyer to whom this notice may be assigned. Exchanges follow
different practices for the assignment process. One approach is to display the delivery
notice and allow buyers wishing to take delivery to bid for taking delivery. Among the
international exchanges, BMF, CBOT and CME display delivery notices. Alternatively,
the clearing houses may assign deliveries to buyers on some basis. Exchanges such as
COMMEX and the Indian commodities exchanges have adopted this method.
Any seller/ buyer who has given intention to deliver/ been assigned a delivery has
an option to square off positions till the market close of the day of delivery notice. After
the close of trading, exchanges assign the delivery intentions to open long positions.
Assignment is done typically either on random basis or first-in-first out basis. In some
exchanges, the buyer has the option to give his preference for delivery location. The
clearing house decides on the daily delivery order rate at which delivery will be settled.
Delivery rate depends on the spot rate of the underlying adjusted for discount/ premium
for quality and freight costs. The discount/ premium for quality and freight costs are
published by the clearing house before introduction of the contract. The most active spot
market is normally taken as the benchmark for deciding spot prices. Alternatively, the
delivery rate is determined based on the previous day closing rate for the contract or the
closing rate for the day.
Delivery
After the assignment process, clearing house/ exchange issues a delivery order to
the buyer. The exchange also informs the respective warehouse about the identity of the
buyer. The buyer is required to deposit a certain percentage of the contract amount with
the clearing house as margin against the warehouse receipt. The period available for the
buyer to take physical delivery is stipulated by the exchange. Buyer or his authorised
representative in the presence of seller or his representative takes the physical stocks
against the delivery order. Proof of physical delivery having been effected is forwarded
by the seller to the clearing house and the invoice amount is credited to the seller's
account. In India if a seller does not give notice of delivery then at the expiry of the
contract the positions are cash settled by price difference exactly as in cash settled equity
futures contracts.
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Warehousing
One of the main differences between financial and commodity derivatives is the
need for warehousing. In case of most exchange-traded financial derivatives, all the
positions are cash settled. Cash settlement involves paying up the difference in prices
between the time the contract was entered into and the time the contract was closed. In
case of commodity derivatives however, there is a possibility of physical settlement.
Which means that if the seller chooses to hand over the commodity instead of the
difference in cash, the buyer must take physical delivery of the underlying asset. This
requires the exchange to make an arrangement with warehouses to handle the settlements.
The efficacy of the commodities settlements depends on the warehousing system
available. Most international commodity exchanges used certified warehouses (CWH) for
the purpose of handling physical settlements. Such CWH are required to provide storage
facilities for participants in the commodities markets and to certify the quantity and
quality of the underlying commodity. In India, the warehousing system is not as efficient
as it is in some of the other developed markets.
Governance
NCDEX is run by an independent Board of Directors. Promoters do not
participate in the day-to-day activities of the exchange. The directors are appointed in
accordance with the provisions of the Articles of Association of the company. The board
is responsible for managing and regulating all the operations of the exchange and
commodities transactions. It formulates the rules and regulations related to the operations
of the exchange. Board appoints an executive committee and other committees for the
purpose of managing activities of the exchange. The executive committee consists of
Managing Director of the exchange who would be acting as the Chief Executive of the
exchange, and also other members appointed by the board. Apart from the executive
committee the board has constitute committee like Membership committee, Audit
Committee, Risk Committee, Nomination Committee, Compensation Committee and
Business Strategy Committee, which, help the Board in policy formulation.
Exchange membership
Membership of NCDEX is open to any person, association of persons,
partnerships, co-operative societies, companies etc. that fulfills the eligibility criteria set
by the exchange. All the members of the exchange have to register themselves with the
competent authority before commencing their operations. The members of NCDEX fall
into two categories.
Hedgers
Many participants in the commodity futures market are hedgers. They use the
futures market to reduce a particular risk that they face. This risk might relate to the price
of any commodity that the person deals in. The classic hedging example is that of wheat
farmer who wants to hedge the risk of fluctuations in the price of wheat around the time
that his crop is ready for harvesting. By selling his crop forward, he obtains a hedge by
locking in to a predetermined price. Hedging does not necessarily improve the financial
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outcome; indeed, it could make the outcome worse. What it does however is, that it
makes the outcome more certain. Hedgers could be government institutions, private
corporations like financial institutions, trading companies and even other participants in
the value chain, for instance farmers, extractors, ginners, processors etc., who are
influenced by the commodity prices.
There are basically two kinds of hedges that can be taken. A company that wants
to sell an asset at a particular time in the future can hedge by taking short futures position.
This is called a short hedge. A short hedge is a hedge that requires a short position in
futures contracts. As we said, a short hedge is appropriate when the hedger already owns
the asset, or is likely to own the asset and expects to sell it at some time in the future.
Similarly, a company that knows that it is due to buy an asset in the future can
hedge by taking long futures position. This is known as long hedge. A long hedge is
appropriate when a company knows it will have to purchase a certain asset in the future
and wants to lock in a price now.
Speculators
If hedgers are the people who wish to avoid price risk, speculators are those who
are willing to take such risk. These are the people who takes positions in the market &
assume risks to profit from price fluctuations in fact the speculators consume market
information make forecasts about the prices & put money in these forecasts. An entity
having an opinion on the price movements of a given commodity can speculate using the
commodity market. While the basics of speculation apply to any market, speculating in
commodities is not as simple as speculating on stocks in the financial market. For a
speculator who thinks the shares of a given company will rise, it is easy to buy the shares
and hold them for whatever duration he wants to. However, commodities are bulky
products and come with all the costs and procedures of handling these products. The
commodities futures markets provide speculators with an easy mechanism to speculate on
the price of underlying commodities. To trade commodity futures on the NCDEX, a
customer must open a futures trading account with a commodity derivatives broker.
Buying futures simply involves putting in the margin money. This enables futures traders
to take a position in the underlying commodity without having to actually hold that
commodity. With the purchase of futures contract on a commodity, the holder essentially
makes a legally binding promise or obligation to buy the underlying security at some
point in the future (the expiration date of the contract).
Arbitrage
A central idea in modern economics is the law of one price. This states that in a
competitive market, if two assets are equivalent from the point of view of risk and return,
they should sell at the same price. If the price of the same asset is different in two
markets, there will be operators who will buy in the market where the asset sells cheap
and sell in the market where it is costly. This activity termed as arbitrage. The buying
cheap and selling expensive continues till prices in the two markets reach equilibrium.
Hence, arbitrage helps to equalise prices and restore market efficiency.
F = (S + U)erT
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The cost-of-carry ensures that futures prices stay in tune with the spot prices of
the underlying assets. The above equation gives the fair value of a futures contract on an
investment commodity. Whenever the futures price deviates substantially from its fair
value, arbitrage opportunities arise. To capture mispricings that result in overpriced
futures, the arbitrager must sell futures and buy spot, whereas to capture mispricings that
result in underpriced futures, the arbitrager must sell spot and buy futures. In the case of
investment commodities, mispricing would result in both, buying the spot and holding it
or selling the spot and investing the proceeds. However, in the case of consumption assets
which are held primarily for reasons of usage, even if there exists a mispricing, a person
who holds the underlying may not want to sell it to profit from the arbitrage.
Trading
The trading system on the NCDEX provides a fully automated screen-based
trading for futures on commodities on a nationwide basis as well as an online monitoring
and surveillance mechanism. It supports an order driven market and provides complete
transparency of trading operations. The trade timings of the NCDEX are 10.00 a.m. to
4.00 p.m. After hours trading has also been proposed for implementation at a later stage.
The NCDEX system supports an order driven market, where orders match automatically.
Order matching is essentially on the basis of commodity, its price, time and quantity. The
exchange specifies the unit of trading and the delivery unit for futures contracts on
various commodities. The exchange notifies the regular lot size and tick size for each of
the contracts traded from time to time. When any order enters the trading system, it is an
active order. It tries to find a match on the other side of the book. If it finds a match, a
trade is generated. If it does not find a match, the order becomes passive and gets queued
in the respective outstanding order book in the system.
The figure shows the contract cycle for futures contracts on NCDEX. As can be seen, at
any given point of time, three contracts are available for trading - a near-month, a middle-
month and a far-month. As the January contract expires on the 20th of the month, a new
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three-month contract starts trading from the following day, once more making available
three index futures contracts for trading.
Types of Order
An electronic trading system allows the trading members to enter orders with
various conditions attached to them as per their requirements. These conditions are
broadly divided into the following categories:
? Time conditions
? Price conditions
? Other conditions
Time conditions
Good till day order: A day order, as the name suggests is an order which is valid for the
day on which it is entered. If the order is not executed during the day, the system cancels
the order automatically at the end of the day.
Good till cancelled (GTC): A GTC order remains in the system until the user cancels it.
Consequently, it spans trading days, if not traded on the day the order is entered. The
maximum number of days an order can remain in the system is notified by the exchange
from time to time after which the order is automatically cancelled by the system. The
GTC order on the NCDEX is cancelled at the end of a period of seven calendar days from
the date of entering an order or when the contract expires, whichever is earlier.
Good till date (GTD): A GTD order allows the user to specify the date till which the
order should remain in the system if not executed. The maximum days allowed by the
system are the same as in GTC order. At the end of this day/ date, the order is cancelled
from the system.
Immediate or Cancel (IOC): An IOC order allows the user to buy or sell a contract as
soon as the order is released into the system, failing which the order is cancelled from the
system. Partial match is possible for the order, and the unmatched portion of the order is
cancelled immediately.
All or none order: All or none order (AON) is a limit order, which is to be executed in its
entirety, or not at all.
Fill or kill order: This order is a limit order that is placed to be executed immediately and
if the order is unable to be filled immediately, it gets cancelled.
Price conditions
Limit order: An order to buy or sell a stated amount of a commodity at a specified price,
or at a better price, if obtainable at the time of execution. The disadvantage is that the
order may not get filled at all if the price for that day does not reach the specified price.
Stop-loss: A stop-loss order is an order, placed with the broker, to buy or sell a particular
futures contract at the market price if and when the price reaches a specified level.
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Futures traders often use stop orders in an effort to limit the amount of loss if the futures
price moves against their position. Stop orders are not executed until the price reaches the
specified point. When the price reaches that point the stop order becomes a market order.
A buy stop order is initiated when one wants to buy a contract or go long and a sell stop
order when one wants to sell or go short. For the stop-loss sell order, the trigger price has
to be greater than the limit price.
Other conditions
Market price: Market orders are orders for which no price is specified at the time the
order is entered (i.e. price is market price). For such orders, the system determines the
price. Only the position to be taken long/ short is stated.
Market on open: The order will be executed on the market open within the opening range.
This trade is used to enter a new trade, or exit an open trade.
Market on close: The order will be executed on the market close. The fill price will be
within the closing range, which may, in some markets, be substantially different from the
settlement price. This trade is also used to enter a new trade, or exit an open trade.
Trigger price: Price at which an order gets triggered from the stop-loss book.
Limit price: Price of the orders after triggering from stop-loss book.
Spread order: A simple spread order involves two positions, one long and one short. They
are taken in the same commodity with different months or in closely related commodities.
Prices of the two futures contract therefore tend to go up and down together, and gains on
one side of the spread are offset by losses on the other. The spreaders goal is to profit
from a change in the difference between the two futures prices.
One cancels the other order: An order placed so as to take advantage of price movement,
which consists of both a stop and a limit price. Once one level is reached, one half of the
order will be executed (either stop or limit) and the remaining order cancelled (either
limit or stop). This type of order would close the position if the market moved to either
the stop rate or the limit rate, thereby closing the trade and at the same time, cancelling
the other entry order.
Trading parameters
Permitted lot size
The permitted trading lot size for the futures contracts on individual commodities
is stipulated by the exchange from time to time. The lot size currently applicable on
individual commodity contracts is given as follows :
Quantity freeze
Orders placed have to be within the quantity specified by the exchange regard.
Any order exceeding this specified quantity will not be executed but will lie pending with
the exchange as a quantity freeze. In respect of orders which have come under quantity
freeze, the member is required to confirm to the exchange that there is no inadvertent
error in the order entry and that the order is genuine. On such confirmation, the exchange
can approve such order. However, in exceptional cases, the exchange may, at its
discretion, not allow the orders that have come under quantity freeze for execution.
Charges
Members are liable to pay transaction charges for the trade done through the
exchange during the previous month. The transaction charges are payable at the rate of
Rs.6 per Rs.one Lakh trade done. This rate is subject to change from time to time. The
transaction charges are payable on the 7th day from the date of the bill every month in
respect of the trade done in the previous month.
Clearing
National Securities Clearing Corporation Limited (NSCCL) undertakes clearing
of trades executed on the NCDEX. The settlement guarantee fund is maintained and
managed by NCDEX. Only clearing members including professional clearing members
(PCMs) are entitled to clear and settle contracts through the clearing house. At NCDEX,
after the trading hours on the expiry date, based on the available information, the
matching for deliveries takes place firstly, on the basis of locations and then randomly,
keeping in view the factors such as available capacity of the vault/ warehouse,
commodities already deposited and dematerialized and offered for delivery etc. Matching
done by this process is binding on the clearing members. After completion of the
matching process, clearing members are informed of the deliverable/ receivable positions
and the unmatched positions. Unmatched positions have to be settled in cash. The cash
settlement is only for the incremental gain/ loss as determined on the basis of final
settlement price.
Settlement
Futures contracts have two types of settlements, the MTM settlement which
happens on a continuous basis at the end of each day, and the final settlement which
happens on the last trading day of the futures contract. On the NCDEX, daily MTM
settlement and final MTM settlement in respect of admitted deals in futures contracts are
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cash settled by debiting/ crediting the clearing accounts of CMs with the respective
clearing bank. All positions of a CM, either brought forward, created during the day or
closed out during the day, are market to market at the daily settlement price or the final
settlement price at the close of trading hours on a day.
On the date of expiry, the final settlement price is the spot price on the expiry day.
The responsibility of settlement is on a trading cum clearing member for all trades done
on his own account and his client's trades. A professional clearing member is responsible
for settling all the participants’ trades which he has confirmed to the exchange. On the
expiry date of a futures contract, members submit delivery information through delivery
request window on the trader workstations provided by NCDEX for all open positions for
a commodity for all constituents individually. NCDEX on receipt of such information
matches the information and arrives at a delivery position for a member for a commodity.
The seller intending to make delivery takes the commodities to the designated
warehouse. These commodities have to be assayed by the exchange specified assayer.
The commodities have to meet the contract specifications with allowed variances. If the
commodities meet the specifications, the warehouse accepts them. Warehouse then
ensures that the receipts get updated in the depository system giving a credit in the
depositor's electronic account. The seller then gives the invoice to his clearing member,
who would courier the same to the buyer's clearing member. On an appointed date, the
buyer goes to the warehouse and takes physical possession of the commodities.
Risk management
NCDEX has developed a comprehensive risk containment mechanism for the
commodity futures market. The salient features of risk containment mechanism are:
1. The financial soundness of the members is the key to risk management. Therefore, the
requirements for membership in terms of capital adequacy (net worth, security deposits)
are quite stringent.
2. NCDEX charges an upfront initial margin for all the open positions of a member. It
specifies the initial margin requirements for each futures contract on a daily basis. It also
follows value-at-risk (VaR) based margining through SPAN. The PCMs and TCMs in
turn collect the initial margin from the TCMs and their clients respectively.
3. The open positions of the members are marked to market based on contract settlement
price for each contract. The difference is settled in cash on a T+1 basis.
4. A member is alerted of his position to enable him to adjust his exposure or bring in
additional capital. Position violations result in withdrawal of trading facility for all TCMs
of a PCM in case of a violation by the PCM.
5. A separate settlement guarantee fund for this segment has been created out of the
capital of members.
Investment assets
An investment asset is an asset that is held for investment purposes by most
investors. Stocks and bonds are examples of investment assets. Gold and silver are also
examples of investment assets. Note however that investment assets do not always have
to be held exclusively for investment. However, to classify as investment assets, these
assets do have to satisfy the requirement that they are held by a large number of investors
solely for investment. we can use arbitrage arguments to determine the futures prices of
an investment asset from its spot price and other observable market variables.
We saw that in the absence of storage costs, the futures price of a commodity that
is an investment asset is given by F = SerT. Storage costs add to the cost of carry. If U is
the present value of all the storage costs that will be incurred during the life of a futures
contract, it follows that the futures price will be equal to
F = (S + U)erT ? eq(4)
Where: r = Cost of financing (annualised)
T = Time till expiration
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U = Present value of all storage costs
Consumption assets
A consumption asset is an asset that is held primarily for consumption. It is not
usually held for investment. Examples of consumption assets are commodities such as
copper, oil, and pork bellies. For pricing consumption assets, we need to review the
arbitrage arguments a little differently. We consider the cost-of-carry model and the
pricing of futures contracts on investment assets to determine the price of consumption
assets.
The figure shows how basis changes over time. As the time to expiration of a contract
reduces, the basis reduces. Towards the close of trading on the day of settlement, the
futures price and the spot price converge. The closing price for the April gold futures
contract is the closing value of gold in the spot market on that day.
Global Scenario
The following table shows the position of Indian commodity market in the
International Commodity Market with respect to certain significant commodities.
Conclusion
Commodity derivatives have a crucial role to play in the price risk management
process for the commodities in which it deals. And it can be extremely beneficial in
agriculture-dominated economy, like India, as the commodity market also involves
agricultural produce. Derivatives like forwards, futures, options, swaps etc are
extensively used in the country. However, the commodity derivatives have been utilized
in a very limited scale. Only forwards and futures trading are permitted in certain
commodity items.
The project has discussed the recognized exchanges and their organizational,
trading and the regulatory set up for futures trading in commodities.