Commodities by Money Market, BNG

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Study Material for Commodities

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Contents
1 Introduction to derivatives 9
1.1 Derivatives dened ..........................................................................................................................9
1.2 Products, participants and functions ............................................................................................10
1.3 Derivatives markets .....................................................................................................................11
1.3.1 Spot versus forward transaction .....................................................................................12
1.3.2 Exchange traded versus OTC derivatives .......................................................................12
1.3.3 Some commonly used derivatives ...................................................................................14
2 Commodity derivatives........................................................................................................17
2.1 Difference between commodity and nancial derivatives ..............................................................17
2.1.1 Physical settlement ..........................................................................................................17
2.1.2 Warehousing ....................................................................................................................19
2.1.3 Quality of underlying assets .............................................................................................20
2.2 Global commodities derivatives exchanges ..................................................................................20
2.2.1 Africa ...............................................................................................................................22
2.2.2 Asia ..................................................................................................................................22
2.2.3 Latin America ..................................................................................................................22
2.3 Evolution of the commodity market in India ................................................................................22
2.3.1 The Kabra committee report ..........................................................................................23
2.3.2 Latest developments .......................................................................................................25
3 The NCDEX platform ..........................................................................................................29

3.1 Structure of NCDEX ....................................................................................................................29
3.1.1 Promoters .......................................................................................................................30
3.1.2 Governance .....................................................................................................................30
3.2 Exchange membership ..................................................................................................................30
3.2.1 Trading cum clearing members (TCMs) ..........................................................................30
3.2.2 Professional clearing members (PCMs) ...........................................................................31
3.3 Capital requirements ....................................................................................................................31
3.4 The NCDEX system .....................................................................................................................32
3.4.1 Trading .............................................................................................................................32
3.4.2 Clearing ...........................................................................................................................33
3.4.3 Settlement .......................................................................................................................33
4 Commodities traded on the NCDEX platform...........................................................35

4.1 Agricultural commodities .............................................................................................................35
4.1.1 Cotton .............................................................................................................................36
4.1.2 Crude palm oil ................................................................................................................38
4.1.3 RBD Palmolein ................................................................................................................40
4.1.4 Soy oil ..............................................................................................................................41
4.1.5 Rapeseed oil ....................................................................................................................43
4.1.6 Soybean ...........................................................................................................................44
4.1.7 Rapeseed .........................................................................................................................45
4.2 Precious metals ...............................................................................................................47

4.2.1 Gold ....................................................................................................................48
4.2.2 Silver ...................................................................................................................52
5 Instruments available for trading .............................................................57

5.1 Forward contracts ..............................................................................................57
5.1.1 Limitations of forward markets ...............................................................58
5.2 Introduction to futures ........................................................................................58
5.2.1 Distinction between futures and forwards contracts ..............................59
5.2.2 Futures terminology ...............................................................................60
5.3 Introduction to options .......................................................................................60
5.3.1 Option terminology .................................................................................61
5.4 Basic payoffs .....................................................................................................62
5.4.1 Payoff for buyer of asset: Long asset ....................................................63
5.4.2 Payoff for seller of asset: Short asset ....................................................63
5.5 Pay off for futures ..............................................................................................63
5.5.1 Payoff for buyer of futures: Long futures ...............................................63
5.5.2 Payoff for seller of futures: Short futures ...............................................65
5.6 Payoff for options ...............................................................................................66
5.6.1 Payoff for buyer of call options: Long call ..............................................66
5.6.2 Payoff for writer of call options: Short call ..............................................67
5.6.3 Payoff for buyer of put options: Long put ...............................................67
5.6.4 Payoff for writer of put options: Short put ..............................................68
5.7 Using futures versus using options ...................................................................69
6 Pricing commodity futures ..................................................................................75

6.1 Investment assets versus consumption assets .................................................75
6.2 The cost of carry model .....................................................................................76
6.2.1 Pricing futures contracts on investment commodities ............................78
6.2.2 Pricing futures contracts on consumption commodities .........................80
6.3 The futures basis ...............................................................................................81
7 Using commodity futures ................................................................................85
7.1 Hedging .............................................................................................................85
7.1.1 Basic principles of hedging ....................................................................85
7.1.2 Short hedge ...........................................................................................86
7.1.3 Long hedge ............................................................................................87
7.1.4 Hedge ratio ............................................................................................89
7.1.5 Advantages of hedging ..........................................................................90
7.1.6 Limitation of hedging: basis Risk ...........................................................91
7.2 Speculation ......................................................................................................................92

7.2.1 Speculation: Bullish commodity, buy futures ......................................................92
7.2.2 Speculation: Bearish commodity, sell futures .....................................................93
7.3 Arbitrage .........................................................................................................................93
7.3.1 Overpriced commodity futures: buy spot, sell futures .......................................94
7.3.2 Underpriced commodity futures: buy futures, sell spot .....................................95
8 Trading 99
8.1 Futures trading system .................................................................................................................99
8.2 Entities in the trading system ........................................................................................................99
8.2.1 Guidelines for allotment of client code .........................................................................100
8.3 Contract specications for commodity futures ............................................................................101
8.4 Commodity futures trading cycle ...............................................................................................101
8.5 Order types and trading parameters ..........................................................................................102
8.5.1 Permitted lot size ..........................................................................................................106
8.5.2 Tick size for contracts ...................................................................................................106
8.5.3 Quantity freeze .............................................................................................................107
8.5.4 Base price ......................................................................................................................107
8.5.5 Price ranges of contracts ...............................................................................................107
8.5.6 Order entry on the trading system ...............................................................................108
8.6 Margins for trading in futures .....................................................................................................110
8.7 Charges ......................................................................................................................................111
9 Clearing and settlement....................................................................................................115

9.1 Clearing ......................................................................................................................................115
9.1.1 Clearing mechanism ......................................................................................................116
9.1.2 Clearing banks ...............................................................................................................116
9.1.3 Depository participants .................................................................................................117
9.2 Settlement ..................................................................................................................................117
9.2.1 Settlement mechanism ..................................................................................................117
9.2.2 Settlement methods ......................................................................................................120
9.2.3 Entities involved in physical settlement .........................................................................122
9.3 Risk management ........................................................................................................................123
9.4 Margining at NCDEX .................................................................................................................124
9.4.1 SPAN .............................................................................................................................124
9.4.2 Initial margin .................................................................................................................124

9.4.3 Computation of initial margin .......................................................................................124
9.4.4 Implementation aspects of margining and risk management ........................................126
9.4.5 Effect of violation ..........................................................................................................128
10 Regulatory framework ....................................................................................................133

10.1 Rules governing commodity derivatives exchanges .................................................................133
10.2 Rules governing intermediaries ................................................................................................134
10.2.1 Trading ............................................................................................................134

10.2.2 Clearing ..........................................................................................................138
10.3 Rules governing investor grievances, arbitration .........................................................142
10.3.1 Procedure for arbitration ...............................................................................143
10.3.2 Hearings and arbitral award ...........................................................................144
11 Implications of sales tax ..................................................................................................147
List of Table
2.1 The global derivatives industry ............................................................................................21
2.2 Volume on existing exchanges .............................................................................................25
2.3 Registered commodity exchanges in India ...........................................................................26
3.1 Fee/ deposit structure and networth requirement: TCM ....................................................31
3.2 Fee/ deposit structure and networth requirement: PCM ....................................................31
4.1 Countrywise share in gold production, 1968 and 1999 .......................................................49
5.1 Distinction between futures and forwards ..........................................................................59
5.2 Distinction between futures and options .............................................................................70
6.1 NCDEX indicative warehouse charges ................................................................................80
7.1 Rened soy oil futures contract specication ...........................................................................87
7.2 Silver futures contract specication .......................................................................................88
7.3 Gold futures contract specication ........................................................................................92
8.1 Commodity futures contract and their symbols ..................................................................101
8.2 Gold futures contract specication ........................................................................................102
8.3 Long staple cotton futures contract specication ..................................................................103
8.4 Commodity futures: Quantity freeze unit ............................................................................107
8.5 Commodity futures: Lot size and other parameters ...........................................................109
9.1 MTM on a long position in cotton futures ...........................................................................118
9.2 MTM on a short position in cotton futures ..........................................................................119
9.3 Calculating outstanding position at TCM level .....................................................................125
9.4 Minimum margin percentage on commodity futures contracts ...........................................125
9.5 Exposure limit as a multiple of liquid net worth ..................................................................128
9.6 Number of days for physical settlement on various commodities .......................................129
List of Figures
5.1 Payoff for a buyer of gold .....................................................................................................64
5.2 Payoff for a seller of gold ......................................................................................................64
5.3 Payoff for a buyer of gold futures .........................................................................................65
5.4 Payoff for a seller of cotton futures ......................................................................................66
5.5 Payoff for buyer of call option on gold .................................................................................67
5.6 Payoff for writer of call option on gold .................................................................................68
5.7 Payoff for buyer of put option on long staple cotton ...........................................................69
5.8 Payoff for writer of put option on long staple cotton ...........................................................70
6.1 Variation of basis over time ..................................................................................................82
7.1 Payoff for buyer of a short hedge .........................................................................................86
7.2 Payoff for buyer of a long hedge ...........................................................................................88
8.1 Contract cycle ....................................................................................................................104
Chapter 1
Introduction to derivatives
The origin of derivatives can be traced back to the need of farmers to protect themselves against
uctuations in the price of their crop. From the the time it was sown to the time it was ready for
harvest, farmers would face price uncertainty. Through the use of simple derivative products, it was
possible for the farmer to partially or fully transfer price risks by lockingin asset prices. These were
simple contracts developed to meet the needs of farmers and were basically a means of reducing
risk.
A farmer who sowed his crop in June faced uncertainty over the price he would receive for his
harvest in September. In years of scarcity, he would probably obtain attractive prices. However,
during times of oversupply, he would have to dispose off his harvest at a very low price. Clearly this
meant that the farmer and his family were exposed to a high risk of price uncertainty.
On the other hand, a merchant with an ongoing requirement of grains too would face a price risk
that of having to pay exorbitant prices during dearth, although favourable prices could be obtained
during periods of oversupply. Under such circumstances, it clearly made sense for the farmer and
the merchant to come together and enter into a contract whereby the price of the grain to be
delivered in September could be decided earlier. What they would then negotiate happened to be a
futurestype contract, which would enable both parties to eliminate the price risk.
In 1848, the Chicago Board of Trade, or CBOT, was established to bring farmers and merchants
together. A group of traders got together and created the toarrivecontract that permitted farmers
to lock in to price upfront and deliver the grain later. These to-arrive contracts proved useful as a
device for hedging and speculation on price changes. These were eventually standardised, and in
1925 the rst futures clearing house came into existence.
Today, derivative contracts exist on a variety of commodities such as corn, pepper, cotton,
wheat, silver, etc. Besides commodities, derivatives contracts also exist on a lot of nancial
underlyings like stocks, interest rate, exchange rate, etc.
1.1 Derivatives denied
A derivative is a product whose value is derived from the value of one or more underlying
variables or assets in a contractual manner. The underlying asset can be equity, forex,
commodity or any other asset. In our earlier discussion, we saw that wheat farmers may wish
to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such
a transaction is an example of a derivative. The price of this derivative is driven by the spot
price of wheat which is the underlyingin this case.
The Forwards Contracts (Regulation) Act, 1952, regulates the forward/ futures contracts in
commodities all over India. As per this the Forward Markets Commission (FMC) continues to
have jurisdiction over commodity forward/ futures contracts. However when derivatives
trading in securities was introduced in 2001, the term securityin the Securities Contracts
(Regulation) Act, 1956 (SCRA), was amended to include derivative contracts in securities.
Consequently, regulation of derivatives came under the perview of Securities Exchange Board
of India (SEBI). We thus have separate regulatory authorities for securities and commodity
derivative markets.
Derivatives are securities under the SCRA and hence the trading of derivatives is governed by
the regulatory framework under the SCRA. The Securities Contracts (Regulation) Act, 1956
(SC(R)A) denes derivativeto include
1. A security derived from a debt instrument, share, loan whether secured or unsecured, risk
instrument or contract for differences or any other form of security.
2. A contract which derives its value from the prices, or index of prices, of underlying
securities.
1.2 Products, participants and functions
Derivative contracts are of different types. The most common ones are forwards, futures,
options and swaps. Participants who trade in the derivatives market can be classied under the
following three broad categories hedgers, speculators, and arbitragers.
1. Hedgers: The farmers example that we discussed about was a case of hedging. Hedgers
face risk associated with the price of an asset. They use the futures or options markets to
reduce or eliminate this risk.
2. Speculators: Speculators are participants who wish to bet on future movements in the
price of an asset. Futures and options contracts can give them leverage; that is, by putting in
small amounts of money upfront, they can take large positions on the market. As a result of
this leveraged speculative position, they increase the potential for large gains as well as large
losses.
3. Arbitragers: Arbitragers work at making prots by taking advantage of discrepancy between

prices of the same product across different markets. If, for example, they see the futures price
of an asset getting out of line with the cash price, they would take offsetting positions in the
two markets to lock in the prot.
Whether the underlying asset is a commodity or a nancial asset, derivative markets

performs a number of economic functions.
~ Prices in an organised derivatives market reect the perception of market participants about
the future and lead the prices of underlying to the perceived future level. The prices of
derivatives converge with the prices of the underlying at the expiration of the derivative
contract. Thus derivatives help in discovery of future as well as current prices.
Derivative products initially emerged as hedging devices against uctuations in commodity

prices, and commodity-linked derivatives remained the sole form of such products for almost
three hundred years. Financial derivatives came into spotlight in the post-1970 period due to
growing instability in the nancial markets. However, since their emergence, these products
have become very popular and by 1990s, they accounted for about two-thirds of total
transactions in derivative products. In recent years, the market for nancial derivatives has
grown tremendously in terms of variety of instruments available, their complexity and also
turnover. In the class of equity derivatives the world over, futures and options on stock indices
have gained more popularity than on individual stocks, especially among institutional
investors, who are major users of index-linked derivatives. Even small investors nd these
useful due to high correlation of the popular indexes with various portfolios and ease of use.
The lower costs associated with index derivatives visavis derivative products based on
individual securities is another reason for their growing us
Box 1.1: Emergence of nancial derivative products
The derivatives market helps to transfer risks from those who have them but may not like
them to those who have an appetite for them.
Derivatives, due to their inherent nature, are linked to the underlying cash markets. With the
introduction of derivatives, the underlying market witnesses higher trading volumes because
of participation by more players who would not otherwise participate for lack of an
arrangement to transfer risk.
Speculative traders shift to a more controlled environment of the derivatives market. In the
absence of an organised derivatives market, speculators trade in the underlying cash markets.
Margining, monitoring and surveillance of the activities of various participants become
extremely difcult in these kind of mixed markets.
An important incidental benet thato ws from derivatives trading is that it acts as a catalyst for
new entrepreneurial activity. Derivatives have a history of attracting many bright, creative,
welleducated people with an entrepreneurial attitude. They often energize others to create
new businesses, new products and new employment opportunities, the benet of which are
immense.
Derivatives markets help increase savings and investment in the long run. The transfer of risk
enables market participants to expand their volume of activity.
1.3 Derivatives markets
Derivative markets can broadly be classied as commodity derivative market and nancial
derivatives markets. As the name suggest, commodity derivatives markets trade contracts for
which the underlying asset is a commodity. It can be an agricultural commodity like wheat,
soybeans, rapeseed, cotton, etc or precious metals like gold, silver, etc. Financial derivatives
markets trade contracts that have a nancial asset or variable as the underlying. The more
popular nancial derivatives are those which have equity, interest rates and exchange rates
asthe underlying. The most commonly used derivatives contracts are forwards, futures and
options which we shall discuss in detail later.
1.3.1 Spot versus forward transaction
Using the example of a forward contract, let us try to understand the difference between a
spot and derivatives contract. Every transaction has three components trading, clearing and
settlement. A buyer and seller come together, negotiate and arrive at a price. This is trading.
Clearing involves nding out the net outstanding, that is exactly how much of goods and money
the two should exchange. For instance A buys goods worth Rs.100 from B and sells goods
worth Rs.50 to B. On a net basis A has to pay Rs.50 to B. Settlement is the actual process of
exchanging money and goods.
In a spot transaction, the trading, clearing and settlement happens instantaneously, i.e. on the
spot. Consider this example. On 1st January 2004, Aditya wants to buy some gold. The
goldsmith quotes Rs.6,000 per 10 grams. They agree upon this price and Aditya buys 20 grams
of gold. He pays Rs.12,000, takes the gold and leaves. This is a spot transaction.
Now suppose Aditya does not want to buy the gold on the 1st January, but wants to buy it a
month later. The goldsmith quotes Rs.6,015 per 10 grams. They agree upon the forward price
for 20 grams of gold that Aditya wants to buy and Aditya leaves. A month later, he pays the
goldsmith Rs. 12,030 and collects his gold. This is a forward contract, a contract by which two
parties irrevocably agree to settle a trade at a future date, for a stated price and quantity. No
money changes hands when the contract is signed. The exchange of money and the underlying
goods only happens at the future date as specied in the contract. In a forward contract the
process of trading, clearing and settlement does not happen instantaneously. The trading
happens today, but the clearing and settlement happens at the end of the specied period.
A forward is the most basic derivative contract. We call it a derivative because it derives value
from the price of the asset underlying the contract, in this case gold. If on the 1st of February,
gold trades for Rs.6,050 in the spot market, the contract becomes more valuable to Aditya
because it now enables him to buy gold at Rs.6,015. If however, the price of gold drops down
to Rs.5,990, he is worse off because as per the terms of the contract, he is bound to pay
Rs.6,015 for the same gold. The contract has now lost value from Adityas point of view. Note
that the value of the forward contract to the goldsmith varies exactly in an opposite manner to
its value for Aditya.
1.3.2 Exchange traded versus OTC derivatives
Derivatives have probably been around for as long as people have been trading with one
another. Forward contracting dates back at least to the 12th century, and may well have been
around before then. These contracts were typically OTC kind of contracts. Over the
counter(OTC) derivatives are privately negotiated contracts. Merchants entered into
contracts with one another for future delivery of specied amount of commodities at specied
price. A primary motivation for pre
arranging a buyer or seller for a stock of commodities in early forward contracts was to lessen
the possibility that large swings would inhibit marketing the commodity after a harvest. Later
Early forward contracts in the US addressed merchantsconcerns about ensuring that there
were buyers and sellers for commodities. However credit riskremained a serious problem. To
deal with this problem, a group of Chicago businessmen formed the Chicago Board of Trade
(CBOT) in 1848. The primary intention of the CBOT was to provide a centralised location
known in advance for buyers and sellers to negotiate forward contracts. In 1865, the CBOT
went one step further and listed the rst
exchange tradedderivatives contract in the US, these contracts were called futures contracts.
In 1919, Chicago Butter and Egg Board, a spin-off of CBOT, was reorganised to allow futures
trading. Its name was changed to Chicago Mercantile Exchange (CME). The CBOT and the
CME remain the two largest organised futures exchanges, indeed the two largest
nancialexchanges of any kind in the world today.
The rst stock index futures contract was traded at Kansas City Board of Trade. Currently the
most popular stock index futures contract in the world is based on S&P 500 index, traded on
Chicago Mercantile Exchange. During the mid eighties, nancial futures became the most
active derivative instruments generating volumes many times more than the commodity
futures. Index futures, futures on T-bills and Euro-Dollar futures are the three most popular
futures contracts traded today. Other popular international exchanges that trade derivatives
are LIFFE in England, DTB in Germany, SGX in Singapore, TIFFE in Japan, MATIF in France,
Eurex etc.
Box 1.2: History of commodity derivatives markets
many of these contracts were standardised in terms of quantity and delivery dates and began
to trade on an exchange.
The OTC derivatives markets have the following features compared to exchange-traded
derivatives:
1. The management of counter-party (credit) risk is decentralised and located within

individual institutions.
2. There are no formal centralised limits on individual positions, leverage, or margining.
3. There are no formal rules for risk and burden sharing.

4. There are no formal rules or mechanisms for ensuring market stability and integrity, and for
safeguarding the collective interests of market participants.
5. The OTC contracts are generally not regulated by a regulatory authority and the exchanges
self regulatory organisation, although they are affected indirectly by national legal systems,
banking supervision and market surveillance.
The OTC derivatives markets have witnessed rather sharp growth over the last few years,
which has accompanied the modernisation of commercial and investment banking and
globalisation of nancial activities. The recent developments in information technology have
contributed to a great extent to these developments. While both exchange-traded and OTC
derivative contracts offer many benets, the former have rigid structures compared to the
latter.
The largest OTC derivative market is the interbank foreign exchange market. Commodity
derivatives the world over are typically exchangetraded and not OTC in nature.
1.3.3 Some commonly used derivatives
Here we dene some of the more popularly used derivative contracts. Some of these, namely
futures and options will be discussed in more details at a later stage.
Forwards: As we discussed, a forward contract is an agreement between two entities to buy

or sell the underlying asset at a future date, at todays pre-agreed price.
Futures: A futures contract is an agreement between two parties to buy or sell the underlying
asset at a future date at todays future price. Futures contracts differ from forward contracts in
the sense that they are standardised and exchange traded.
Options: There are two types of options - calls and puts. Calls give the buyer the right but not
the obligation to buy a given quantity of the underlying asset, at a given price on or before a
given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of
the underlying asset at a given price on or before a given date.
Warrants: Options generally have lives of upto one year, the majority of options traded on
options exchanges having a maximum maturity of nine months. Longerdated options are
called warrants and are generally traded overthecounter.
Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is
usually a weighted average of a basket of assets. Equity index options are a form of basket
options.
Swaps: Swaps are private agreements between two parties to exchange cash ows in the
future according to a prearranged formula. They can be regarded as portfolios of forward
contracts. The two commonly used swaps are:
Interest rate swaps: These entail swapping only the interest related cash ows between the parties
in the same currency.
Currency swaps: These entail swapping both principal and interest between the parties, with the
cashows in one direction being in a different currency than those in the opposite direction.
Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of
the options. Thus a swaption is an option on a forward swap.
Solved Problems
Q: Futures trading commenced rst on
1. Chicago Board of Trade 2. Chicago Mercantile Exchange
3. Chicago Board Options Exchange
4. London International Financial Futures and Options Exchange
Q: Derivatives rst emerged as products

1. Speculative 3. Volatility
2. Hedging 4. Risky
A: The correct answer is number 2.
Q: Which of the following exchanges offer commodity derivatives trading

1. National Commodity Derivatives Exchange 3. Over The Counter Exchange of India
2. Interconnected Stock Exchange 4. ICICI Securities Limited
Q: OTC derivatives are considered risky because
1. There is no formal margining system. 3. They are not settled on a clearing house.
2. They do not follow any formal rules or mechanisms. 4. All of the
above

Q: The rst exchange traded nancial derivative in India commenced with the trading of
1. Index futures 2. Index options

3. Stock Option 3. Interest rate Futures
Q: A is the simplest derivative contract
1. Option 3.Forward
2. Future 4. Swap
Q: In a transaction, trading involves
1. The buyer and seller agreeing upon a price.

2. The buyer and seller exchanging goods and money.
3. The buyer and seller calculating the net out-standing.
4. None of the above.
Q: In a transaction, clearing involves
1. The buyer and seller agreeing upon a price. 3. The buyer and seller calculating the net out-
standing.
2. The buyer and seller exchanging goods and money. 4. None of the above.
Q: In a transaction, settlement involves
1. The buyer and seller agreeing upon a price. 3. The buyer and seller calculating the net
out-
standing.
2. The buyer and seller exchanging goods and
money. 4. None of the above.

Chapter 2
Commodity derivatives
Derivatives as a tool for managing risk rst originated in the commodities markets. They were then
found useful as a hedging tool in nancial 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 signicant level. In this chapter we look at how commodity derivatives
differ from nancial derivatives. We also have a brief look at the global commodity markets and the
commodity markets that exist in India.
2.1 Difference between commodity and nancial derivatives

The basic concept of a derivative contract remains the same whether the underlying happens to be a
commodity or a nancial asset. However there are some features which are very peculiar to
commodity derivative markets. In the case of nancial derivatives, most of these contracts are cash
settled. Even in the case of physical settlement, nancial 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 nancial underlyings 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. We have a brief look at these issues.
2.1.1 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. There are limits on storage facilities in different states. There are restrictions on
interstate movement of commodities. Besides 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 nancial assets. We take a general
overview at the process ow of physical settlement of commodities. Later on we will look into details
of how physical settlement happens on the NCDEX.
Delivery notice period

Unlike in the case of equity futures, typically a seller of commodity futures has the option to give
notice of delivery. This option is given during a period identied as delivery notice period. Such
contracts are then assigned to a buyer, in a manner similar to the assignments to a seller in an options
market. However what is interesting and different from a typical options exercise is that in the
commodities market, both positions can still be closed out before expiry of the contract. The
intention of this notice is to allow verication of delivery and to give adequate notice to the buyer of a
possible requirement to take delivery. These are required by virtue of the fact that the actual
physical settlement of commodities requires preparation from both delivering and receiving
members.
Typically, in all commodity exchanges, delivery notice is required to be supported by a warehouse

receipt. The warehouse receipt is the proof for the quantity and quality of commodities being
delivered. Some exchanges have certied laboratories for verifying the quality of goods. In these
exchanges the seller has to produce a verication report from these laboratories along with delivery
notice. Some exchanges like LIF FE, accept warehouse receipts as quality verication documents
while others like BMFBrazil have independent grading and classication agency to verify the quality.
In the case of BMF-Brazil a seller typically has to submit the following documents:
4A declaration verifying that the asset is free of any and all charges, includingscal debts related
to the stored goods.
4A provisional delivery order of the good to BM&F (Brazil), issued by the warehouse.
4A warehouse certicate showing that storage and regular insurance have been
paid. Assignment
Whenever delivery notices are given by the seller, the clearing house of the exchange identies 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 rstinrst out basis. In some exchanges (CME), 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 sellers 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.
2.1.2 Warehousing
One of the main differences between nancial and commodity derivatives is the need for
warehousing. In case of most exchangetraded nancial 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. For instance, if a trader buys futures on a stock at
Rs.100 and on the day of expiration, the futures on that stock close Rs.120, he does not really have to
buy the underlying stock. All he does is take the difference of Rs.20 in cash. Similarly the person who
sold this futures contract at Rs. 100, does not have to deliver the underlying stock. All he has to do is
pay up the loss of Rs.20 in cash.
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 efcacy of the commodities
settlements depends on the warehousing system available. Most international commodity
exchanges used certied warehouses (CWH) for the purpose of handling physical settlements. Such
CWH are required to provide storage facilities for participants in the commodities markets
The New York Cotton Exchange has specied the asset in its orange juice futures contract as U.S
Grade A, with Brix value of not less than 57 degrees, having a Brix value to acid ratio of not less than
13 to 1 nor more than 19 to 1, with factors of color and avour each scoring 37 points or higher and 19
for defects, with a minimum score 94.
The Chicago Mercantile Exchange in its random~ length lumber futures contract has specied that
Each delivery unit shall consist of nominal ~ ~ s of random lengths from 8 feet to 20 feet, grade-
stamped Construction Standard, Standard and Better, or #1 and #2; however, in no case may the
quantity of Standard grade or #2 exceed 50%. Each deliver unit shall be manufactured in California,
Idaho, Montana, Nevada, Oregon, Washington, Wyoming, or Alberta or British Columbia, Canada,
and contain lumber produced from grade-stamped Alpine r, Englemann spruce, hem-r, lodgepole
pine, and/ or spruce pine r.
Box 2.3: Specications of some commodities underlying derivatives contracts
and to certify the quantity and quality of the underlying commodity. The advantage of this system
is that a warehouse receipt becomes a good collateral, not just for settlement of exchange trades but
also for other purposes too. In India, the warehousing system is not as efcient as it is in some of the
other developed markets. Central and state government controlled warehouses are the major
providers of agriproduce storage facilities. Apart from these, there are a few private warehousing
being maintained. However there is no clear regulatory oversight of warehousing services.
2.1 .3 Quality of underlying assets
A derivatives contract is written on a given underlying. Variance in quality is not an issue in case of
nancial derivatives as the physical attribute is missing. When the underlying asset is a commodity, the
quality of the underlying asset is of prime importance. There may be quite some variation in the
quality of what is available in the marketplace. When the asset is specied, it is therefore important
that the exchange stipulate the grade or grades of the commodity that are acceptable. Commodity
derivatives demand good standards and quality assurance/ certication procedures. A good grading
system allows commodities to be traded by specication.
Currently there are various agencies that are responsible for specifying grades for commodities.
For example, the Bureau of Indian Standards (BIS) under Ministry of Consumer Affairs species
standards for processed agricultural commodities whereas AGMARK under the department of rural
development under Ministry of Agriculture is responsible for promulgating standards for basic
agricultural commodities. Apart from these, there are other agencies like EIA, which specify
standards for export oriented commodities.
2.2 Global commodities derivatives exchanges
Globally commodities derivatives exchanges have existed for a long time. Table 2.1 gives a list of
commodities exchanges across the world. The CBOT and CME are two of the oldest derivatives
2.2 Global commodities derivatives exchanges 23
Table 2.1 The global derivatives industry

Country Exchange
United States of America Chicago Board of Trade (CBOT)
Chicago Mercantile Exchange
Minneapolis Grain Exchange
New York Cotton Exchange
New York Mercantile Exchange
Kansas Board of Trade
New York Board of Trade
Canada The Winnipeg Commodity Exchange
Brazil Brazilian Futures Exchange Commodities and Futures
Exchange
Australia Sydney Futures Exchange Ltd.
Peoples Republic Of China Beijing Commodity Exchange Shanghai

Metal Exchange
Hong Kong Hong Kong Futures Exchange
Japan Tokyo International Financial Futures Exchange
Kansai Agricultural Commodities Exchange
Tokyo Grain Exchange
Malaysia Kuala Lumpur commodity Exchange
New Zealand New Zealand Futures& Options Exchange Ltd.
Singapore Singapore Commodity Exchange Ltd.
France Italy Le Nouveau Marche MATIF
Netherlands Italian Derivatives Market
Russia Amsterdam Exchanges Option Traders The Russian Exchange
MICEX/ Relis Online St. Petersburg Futures Exchange
Spain The Spanish Options Exchange Citrus Fruit and Commodity
Futures Market of Valencia
United Kingdom The London International Financial Futures Options exchange
The London Metal Exchange
exchanges in the world. The CBOT was established in 1948 to bring farmers and merchants together.
Initially its main task was to standardise the quantities and qualities of the grains that were traded. Within a
few years the rst futurestype contract was developed. It was know as the toarrive contract. Speculators soon
became interested in the contract and found trading in the contract to be an attractive alternative to trading
the underlying grain itself. In 1919, another exchange, the CME was established. Now futures exchanges
exist all over the world. On these exchanges, a wide range of commodities and nancial assets form the
underlying assets in various contracts. The commodities include pork bellies, live cattle, sugar, wool, lumber,
copper, aluminium, gold and tin. We look at commodity exchanges in some developing countries.
2.2.1 Africa
Africas most active and important commodity exchange is the South African Futures Exchange (SAFEX). It
was informally launched in 1987. SAFEX only traded nancial futures and gold futures for a long time, but the
creation of the Agricultural Markets Division (as of 2002, the Agricultural Derivatives Division) led to the
introduction of a range of agricultural futures contracts for commodities, in which trade was liberalised,
namely, white and yellow maize, bread milling wheat and sun ower seeds.
2.2.2 Asia
Chinas rst commodity exchange was established in 1990 and at least forty had appeared by 1993. The main
commodities traded were agricultural staples such as wheat, corn and in particularly soybeans. In late 1994,
more than half of Chinas exchanges were closed down or reverted to being wholesale markets, while only
15 restructured exchanges received formal government approval. At the beginning of 1999, the China
Securities Regulatory Committee began a nationwide consolidation process which resulted in three
commodity exchanges emerging; the Dalian Commodity Exchange (DCE), the Zhengzhou Commodity
Exchange and the Shanghai futures Exchange, formed in 1999 after the merger of three exchanges: Shanghai
Metal, Commodity, Cereals & Oils Exchanges. The Taiwan Futures Exchange was launched in 1998. Malaysia
and Singapore have active commodity futures exchanges. Malaysia hosts one futures and options exchange.
Singapore is home to the Singapore Exchange (SGX), which was formed in 1999 by the merger of two
wellestablished exchanges, the Stock Exchange of Singapore (SES) and Singapore International Monetary
Exchange (SIMEX).
2.2.3 Latin America
Latin Americas largest commodity exchange is the Bolsa de Mercadorias & Futuros, (BM&F) in Brazil.
Although this exchange was only created in 1985, it was the 8th largest exchange by 2001, with 98 million
contracts traded. There are also many other commodity exchanges operating in Brazil, spread throughout
the country. Argentinas futures market Mercado a Termino de Buenos Aires, founded in 1909, ranks as the
worlds 51st largest exchange. Mexico has only recently introduced a futures exchange to its markets. The
Mercado Mexicano de Derivados (Mexder) was launched in 1998.
2.3 Evolution of the commodity market in India
Bombay Cotton Trade Association Ltd., set up in 1875, was the rst organised futures market.
Bombay Cotton Exchange Ltd. was established in 1893 following the widespread discontent amongst
leading cotton mill owners and merchants over functioning of Bombay Cotton Trade Association. The
Futures trading in oilseeds started in 1900 with the establishment of the Gujarati Vyapari Mandali, which
carried on futures trading in groundnut, castor seed and cotton. Futures trading in wheat was existent at
several places in Punjab and Uttar Pradesh. But the most notable futures exchange for wheat was chamber of
commerce at Hapur set up in 1913. Futures trading in bullion began in Mumbai in 1920. Calcutta Hessian
Exchange Ltd. was established in 1919 for futures trading in rawjute and jute goods. But organised futures
trading in raw jute began only in 1927 with the establishment of East Indian Jute Association Ltd. These two
associations amalgamated in 1945 to form the East India Jute & Hessian Ltd. to conduct organised trading in
both Raw Jute and Jute goods. Forward Contracts (Regulation) Act was enacted in 1952 and the Forwards
Markets Commission (FMC) was established in 1953 under the Ministry of Consumer Affairs and Public
Distribution. In due course, several other exchanges were created in the country to trade in diverse
commodities.
2.3.1 The Kabra committee report
After the introduction of economic reforms since June 1991 and the consequent gradual trade and industry
liberalisation in both the domestic and external sectors, the Government of India appointed in June 1993 a
committee on Forward Markets under chairmanship of Prof. K.N. Kabra. The committee was setup with the
following objectives:
1. To assess
(a) The working of the commodity exchanges and their trading practices in India and to make suitable
recommendations with a view to making them compatible with those of other countries.
(b) The role of the Forward Markets Commission and to make suitable recommendations with a view to
making it compatible with similar regulatory agencies in other countries so as to see how effectively
these agencies can cope up with the reality of the fast changing economic scenario.
2. To review the role that forward trading has played in the Indian commodity markets during the last 10
years.
3. To examine the extent to which forward trading has special role to play in promoting exports.
4. To suggest amendments to the Forward Contracts (Regulation) Act, in the light of the recommendations,
particularly with a view to effective enforcement of the Act to check illegal forward trading when such
trading is prohibited under the Act.
5. To suggest measures to ensure that forward trading in the commodities in which it is allowed to be
operative remains constructive and helps in maintaining prices within reasonable limits.
6. To assess the role that forward trading can play in marketing/ distribution system in the commodities in
which forward trading is possible, particularly in commodities in which resumption of forward trading is
generally demanded.
The committee submitted its report in September 1994. The recommendations of the committee were
as follows:
4 The Forward Markets Commission(FMC) and the Forward Contracts (Regulation) Act, 1952, would
need to be strengthened.
4 Due to the inadequate infrastructural facilities such as space and telecommunication facilities the
commodities exchanges were not able to function effectively. Enlisting more members, ensuring capital
adequacy norms and encouraging computerisation would enable these exchanges to place themselves
on a better footing.
4 In-built devices in commodity exchanges such as the vigilance committee and the panels of surveyors and
arbitrators be strengthened further.
4 The FMC which regulates forward/ futures trading in the country, should continue to act a watchdog and
continue to monitor the activities and operations of the commodity exchanges. Amendments to the
rules, regulations and bye-laws of the commodity exchanges should require the approval of the FMC
only.
4 In the context of globalisation, commodity markets in India could not function effectively in an isolated
manner. Therefore, some of the commodity exchanges, particularly the ones dealing in pepper and
castor seed, be upgraded to the level of international futures markets.
4 The majority of the committee recommended that futures trading be introduced in the following
commodities:
1. Basmati rice
2. Cotton and kapas
3. Raw jute and jute goods
4. Groundnut, rapeseed/mustard seed, cottonseed, sesame seed, suno wer seed, safower seed, copra and
soybean, and oils and oilcakes of all of them.
5. Rice bran oil

6. Castor oil and its oilcake
7. Linseed
8. Silver
9. Onions
The liberalised policy being followed by the government of India and the gradual withdrawal of the
procurement and distribution channel necessitated setting in place a market mechanism to perform the
economic functions of price discovery and risk management.
The national agriculture policy announced in July 2000 and the announcements in the budget speech for
20022003 were indicative of the governments resolve to put in place a mechanism of futures trade/market.
As a follow up, the government issued notications on 1.4.2003 permitting futures trading in the
commodities, with the issue of these notications futures trading is not prohibited in any commodity. Options
trading in commodity is, however presently prohibited.
2.3.2 Latest developments

Commodity markets have existed in India for a long time. Table 2.3 gives the list of registered commodities
exchanges in India. Table 2.2 gives the total annualised volumes on various exchanges. While the
implementation of the Kabra committee recommendations were rather slow, today, the commodity
derivative market in India seems poised for a transformation. National level commodity derivatives
exchanges seem to be the new phenomenon. The Forward Markets Commission accorded in principle
approval for the following national level multi commodity exchanges. The increasing volumes on these
exchanges suggest that commodity markets in India seem to be a promising game.
1. National Board of Trade
2. Multi Commodity Exchange of India
3. National Commodity & Derivatives Exchange of India Ltd
Table 2.3 Registered commodity exchanges in India

Exchange Product traded
Bhatinda Om & Oil Exchange Ltd. Gur Sunower oil, Cotton (Seed and oil)
The Bombay Commodity Exchange Ltd. Safower (Seed, oil and oil cake) Groundnut (Nut and
oil)
Castor oil, Castorseed Sesamum (Oil and oilcake)
Rice bran, rice bran oil and oilcake Crude palm oil
The Rajkot Seeds oil & Bullion Merchants
Groundnut oil, Castorseed
Association, Ltd.
Rapeseed/ Mustardseed oil and cake Gur
The Kanpur Commodity Exchange Ltd.
Turmeric, Cottonseed, Castorseed
The Meerut Agro Commodities Exchange Co. Ltd.
Gur Pepper, Gur, Rapeseed/ Mustardseed
The Spices and Oilseeds Exchange
Sugar Grade-M
Ltd.Sangli
Rapeseed/ Mustard seed/ Oil/ Cake Soybean/ Meal/
Ahmedabad Commodities Exchange Ltd.
Oil, Crude Palm Oil Gur, Rapeseed/ Mustardseed
Vijay Beopar Chamber Ltd., Muzaffarnagar
Cotton, Gur, Hessian, Sacking
India Pepper & Spice Trade Association,
Copra, Coconut oil & Copra cake Coffee
Kochi Rajdhani.
Gur, RBD Pamolien, Crude Palm Oil, Copra
Oils and Oilseeds Exchange Ltd., Delhi
Rapeseed/ Mustardseed, Soy bean Cotton (Seed, oil,
National Board of Trade, Indore oilcake)
The Chamber of Commerce, Hapur Safower (seed, oil, oilcake) Groundnut (seed, oil,
oilcake), Sugar, Sacking, gram
The East India Cotton Association, Mumbai
Coconut (oil and oilcake), Castor (oil and oilcake)
The Central India Commercial Exchange Ltd.,
Sesamum (Seed,oil and oilcake) Linseed (seed, oil
Gwaliar. and oilcake)
The East India Jute & Hessian Exchange Ltd., Kolkata. Rice Bran Oil, Pepper, Guarseed Aluminium ingots,
First Commodity Exchange of India Ltd., Nickel, tin Vanaspati, Rubber, Copper, Zinc, lead Soy
Bean, Rened Soy Oil, Mustard Seed
Kochi The Coffee Futures Exchange
Expeller Mustard Oil
India Ltd., Bangalore National Multi
RBD Palmolein Crude Palm Oil Medium Staple
Commodity Exchange of India Limited, Ahmedabad Cotton
Long Staple Cotton, Gold, Silver

National Commodity & Derivatives Exchange
Limited
30 Commodity derivatives
Q: On the NCDEX
1. The clearing house assigns delivery to the 3. The buyer chooses which delivery to take
buyer 4. The warehouse assigns the delivery to the buyer
2. The seller assigns delivery to the buyer
Q: The committee recommended that the Forward Markets Commission(FMC) and the Forward
Contracts (Regulation) Act, 1952, need to be strengthened.
1. L C Gupta Committee 3. Khusro Committee
2. Kabra Committee 4. J R Varma Committee A: The correct answer is number 2.
Chapter 3
The NCDEX platform
National Commodity and Derivatives Exchange Ltd (NCDEX) is a technology driven commodity exchange.
It is a public limited company registered under the Companies Act, 1956 with the Registrar of Companies,
Maharashtra in Mumbai on April 23,2003. It has an independent Board of Directors and professionals not
having any vested interest in commodity markets. It has been launched to provide a worldclass commodity
exchange platform for market participants to trade in a wide spectrum of commodity derivatives driven by
best global practices, professionalism and transparency.
NCDEX is regulated by Forward Markets Commission in respect of futures trading in commodities.

Besides, NCDEX is subjected to various laws of the land like the Companies Act, Stamp Act, Contracts Act,
Forward Commission (Regulation) Act and various other legislations, which impinge on its working. It is
located in Mumbai and offers facilities to its members in about 91 cities throughout India at the moment.
NCDEX currently facilitates trading of ten commodities - gold, silver, soy bean, rened soy bean oil,
rapeseed-mustard seed, expeller rapeseed-mustard seed oil, RBD palmolein, crude palm oil and cotton
medium and long staple varieties. At subsequent phases trading in more commodities would be facilitated.
3.1 Structure of NCDEX
NCDEX has been formed with the following objectives:

4 To create a world class commodity exchange platform for the market participants.
4 To bring professionalism and transparency into commodity trading.

4 To inculcate best international practices like demodularization, technology platforms, low cost
solutions and information dissemination without noise etc. into the trade.
4 To provide nation wide reach and consistent offering.
4 To bring together the entities that the market can trust.
3.1.1 Promoters
NCDEX is promoted by a consortium of institutions. These include the ICICI Bank Limited (ICICI Bank), Life
Insurance Corporation of India (LIC), National Bank for Agriculture and Rural Development (NABARD) and
National Stock Exchange of India Limited (NSE). NCDEX is the only commodity exchange in the country
promoted by national level institutions. This unique parentage enables it to offer a variety of benets which are
currently in short supply in the commodity markets. The four institutional promoters of NCDEX are
prominent players in their respective elds and bring with them institution building experience, trust,
nationwide reach, technology and risk management skills.
3.1.2 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.
3.2 Exchange membership
Membership of NCDEX is open to any person, association of persons, partnerships, cooperative societies,
companies etc. that fullls 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, Trading cum Clearing Members (TCM) and Professional Clearing Members
(PCM).
3.2.1 Trading cum clearing members (TCMs)
NCDEX invites applications for Trading cum Clearing Members (TCMs) from persons who fulll the specied
eligibility criteria for trading in commodities. The TCM membership entitles the members to trade and clear,
both for themselves and/ or on behalf of their clients. Applicants accepted for admission as TCM are required
to pay the required fees/ deposits and also maintain net worth as given in Table 3.1.
3.2.2 Professional clearing members (PCMs)
NCDEX also invites applications for Professional Clearing Membership (PCMs) from persons who fulll the
specied eligibility criteria for trading in commodities. The PCM membership entitles the members to clear
trades executed through Trading cum Clearing Members (TCMs), both for themselves and/ or on behalf of
their clients. Applicants accepted for admission as PCMs are required to pay the following fee/ deposits and
also maintain net worth as given in Table 3.2.
3.3 Capital requirements

NCDEX has specied capital requirements for its members. On approval as a member of NCDEX, the
member has to deposit Base Minimum Capital (BMC) with the exchange. Base Minimum Capital comprises
of the following:
1. Interest free cash security deposit
2. Collateral security deposit

All Members have to comply with the security deposit requirement before the activation of their trading
terminal. Members can opt to meet the security deposit requirement by way of the following:
Cash: This can be deposited by issuing a cheque/ demand draft payable at Mumbai in favour of National
Commodity & Derivatives Exchange Limited.
4Bank guarantee: Bank guarantee in favour of NCDEX as per the specied format from approved banks.
The minimum term of the bank guarantee should be 12 months.
4Fixed deposit receipt: Fixed deposit receipts (FDRs) issued by approved banks are accepted. The FDR
should be issued for a minimum period of 36 months from any of the approved banks.
4Government of India securities: National Securities Clearing Corporation Limited (NSCCL) is the
approved custodian for acceptance of Government of India securities. The securities are valued on a daily
basis and a haircut of 25% is levied.
Members are required to maintain minimum level of security deposit i.e. Rs. 15 Lack in case of TCM and
Rs. 25 Lack in case of PCM at any point of time. If the security deposit falls below the minimum required level,
NCDEX may initiate suitable action including withdrawal of trading facilities as given below:
4 If the security deposit shortage is equal to or greater than Rs. 5 Lack, the trading facility would be
withdrawn with immediate effect.
4 If the security deposit shortage is less than Rs.5 Lack the member would be given one calendar weeks
time to replenish the shortages and if the same is not done within the specied time the trading facility would
be withdrawn.
Members who wish to increase their limit can do so by bringing in additional capital in the form of cash, bank
guarantee, xed deposit receipts or Government of India securities.
3.4 The NCDEX system

As we saw in the rst chapter, every market transaction consists of three components trading, clearing and
settlement. This section provides a brief overview of how transactions happen on the NCDEXs market.
3.4.1 Trading
The trading system on the NCDEX, provides a fully automated screenbased 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. All quantity elds are in units and
price in rupees. The exchange species the unit of trading and the delivery unit for futures contracts on
various commodities. The exchange noties 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 nd a match on
the other side of the book. If it nds a match, a trade is generated. If it does not nd a match, the order becomes
passive and gets
queued in the respective outstanding order book in the system. Time stamping is done for each trade and
provides the possibility for a complete audit trail if required.
NCDEX trades commodity futures contracts having onemonth, twomonth and three month expiry
cycles. All contracts expire on the 20th of the expiry month. Thus a January expiration contract would expire
on the 20th of January and a February expiry contract would cease trading on the 20th of February. If the
20th of the expiry month is a trading holiday, the contracts shall expire on the previous trading day. New
contracts will be introduced on the trading day following the expiry of the near month contract.
3.4.2 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) only 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 rstly, 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 nal settlement price.
3.4.3 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 nal settlement which happens on the last trading day of the futures contract.
On the NCDEX, daily MTM settlement and nal MTM settlement in respect of admitted deals in futures
contracts are 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 nal settlement price at the close of trading hours on a
day.
On the date of expiry, the nal 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 clients trades.
A professional clearing member is responsible for settling all the participants trades which he has conrmed 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 specied assayer. The commodities have to meet the
contract specications with allowed variances. If the commodities meet the
specications, the warehouse accepts them. Warehouse then ensures that the receipts get updated in the
depository system giving a credit in the depositors electronic account. The seller then gives the invoice to his
clearing member, who would courier the same to the buyers clearing member. On an appointed date, the
buyer goes to the warehouse and takes physical possession of the commodities.
Solved Problems
Q: Which of the following futures do not trade on the NCDEX?
1. Cotton futures 3. Silver futures
2. Gold futures 4. Energy futures
Q: NCDEX is regulated by
1. The Forward Markets Commission 3. Reserve Bank of India
2. SEBI 4. Controller of Capital Issues
Q: The net worth requirement for a TCM is
1. Rs.5Lakh 3. Rs.500Lakh
2. Rs.50 Lakh 4. Rs.5000 Lakh
Chapter 4
Commodities traded on the NCDEX platform
In December 2003, the National Commodity and Derivatives Exchange Ltd (NCDEX) launched futures
trading in nine major commodities. To begin with contracts in gold, silver, cotton, soyabean, soya oil, rape/
mustard seed, rapeseed oil, crude palm oil and RBD palmolein are being offered.
We have a brief look at the various commodities that trade on the NCDEX and look at some commodity
specic issues. The commodity markets can be classied as markets trading the following types of
commodities.
1. Agricultural products
2. Precious metal
3. Other metals
4. Energy
Of these, the NCDEX has commenced trading in futures on agricultural products and precious metals. For
derivatives with a commodity as the underlying, the exchange must specify the exact nature of the
agreement between two parties who trade in the contract. In particular, it must specify the underlying asset,
the contract size stating exactly how much of the asset will be delivered under one contract,where and
when the delivery will be made. In this chapter we look at the various underlying assets for the futures
contracts traded on the NCDEX. Trading, clearing and settlement details will be discussed later.
4.1 Agricultural commodities
The NCDEX offers futures trading in the following agricultural commodities Rened soy oil, mustard seed,
expeller mustard oil, RBD palmolein, crude palm oil, medium staple cotton and long staple cotton. Of these
we study cotton in detail and have a quick look at the others.
4.1.1 Cotton
Cotton accounts for 75% of the bre consumption in spinning mills in India and 58% of the total bre
consumption of its textile industry (by volume). At the average price of Rs.45/ kg, over 17 million bales
(average annual consumption, 1 bale = 170 kg) of raw cotton trade in the country. The market size of raw
cotton in India is over Rs. 130 billion. The average monthly uctuation in prices of cotton traded across India
has been at around 4.5% during the last three years. The maximum uctuation has been as high as 11%.
Historically, cotton prices in India have been uctuating in the range of 3-6% on a monthly basis.
Cotton is among the most important nonfood crops. It occupies a signicant position, both from agricultural
and manufacturing sectorspoints of view. It is the major source of a basic human need clothing, apart from
other bre sources like jute, silk and synthetic. Today, cotton occupies a signicant position in the Indian
economy on all fronts as a commodity that forms a means of livelihood to over millions of cotton cultivating
farmers at the primary agricultural sector. It is also a source of direct employment to over 35 million people in
the secondary manufacturing textile industry that contributes to 14% of the countrys industrial production,
2730% of the countrys export earnings and 4% of its GDP.
Cropping and Growth pattern
MISSING MATTER
C. During the period of fruiting, warm days and cool nights, with large diurnal variations are conducive to
good boll and bre development. In the case of the rainfed cotton, which predominates and occupies nearly
75% of the area under this crop, a rainfall of 50 cm is the minimum requirement. More than the actual
rainfall, a favourable distribution is the deciding factor in obtaining good yields from the rainfed cotton.
Cotton is grown on a variety of soils. It requires a soil amenable to good drainage, as it does not tolerate
water logging. It is grown mainly as a dry crop in the black and medium black soils and as an irrigated crop in
the alluvial soils. The predominant types of soils on which the crop is grown are (1)Alluvial soils predominant
in the northern states of Punjab, Haryana, Rajasthan and Uttar Pradesh, (2)The black cotton soils, (3)The red
sandy loams to loams predominant in the states of Gujarat, Maharashtra, Madhya Pradesh, Andhra Pradesh,
Karnataka and Tamil Nadu, and (4)Lateritic soils found in parts of Tamil Nadu, Assam and Kerala.
Cotton is a 90120 day annual crop. In the main producing countries of USA, China, India and Pakistan, the
crop is sown during the JuneJuly period and harvested during September-October. Harvested Kappas
(cotton with seed) start arriving into the market (from the producing centres) from October-November
onwards. Kappas are bought by ginners, who separate the seeds from the lint (cotton bre), a process called
ginning (lint recovery from kappas is 30
3 1%). The loose cotton lint so obtained is pressed and sold to the spinning mills in the form of full pressed
bales (1 bale = 170 kg cotton lint in India; in USA, it is 480 pounds). Spinned cotton yarn is used by clothe
manufacturers/ textile industry.
Global and domestic demandsupply dynamics
China, USA, India and Pakistan top the list of cotton producing countries. Uzbekistan, Brazil, Turkey and
Australia are the other major producers. These eight countries produced over 80% of the worlds cotton
production during 200 102.
China, India, USA and Pakistan top the list of cotton consuming countries. These along with Turkey, Brazil,
Indonesia, Mexico, Russia, Thailand, Italy and Korea consume over 80% of the worlds annual cotton
consumption. Global production of cotton during the post 1990 (till date i.e. 200203 forecast) has been
uctuating in the narrow range of 16.52 1 million tons. Similarly, consumption has been in the range in the
1820.5 million tons. The global export and import trade of cotton during the post 1990 era has been in the
range of 5.5 to 6.5 million tons.
Production of cotton in India during the post 1990 period has been uctuating in the range of 1217 million
bales (i.e. between 2.22.8 million tons), constituting about 15% of the global cotton production. Currently,
the countrys cotton consumption stands at 17-19 million bales (2.72.9 million tons). Indias position on the
global trade front has witnessed a drastic change during the post 1995 period. The country has turned from
being net exporter to net importer. The countrys raw cotton exports, which stood at 1.21.6 million bales
during the pre1996 period have dipped to less than 100 thousand bales. Contrary to this, the imports have
sharply risen from 3000050000 bales during the pre1995 to little over 2.2 million bales during the last three
years. Among several other reasons, it is the lack of availability of desired quality cotton that has made many
Indian buyers (particularly the export oriented units) to opt for purchases of foreign cotton despite enough
domestic supply. Most importing mills in India are ready to pay 510% premium for foreign cotton due to its
higher quality (less trash, uniform lots, higher ginning outturn) and better credit terms (36 months vs. 1530
days for local). Mills using ELS (extra long staple) have been pleased with US Pima and its bre characteristics.
US has emerged as an important supplier in the last two seasons. Apart from US, India is also importing from
Egypt, West Africa, and the CIS countries and Australia on account of lower freight and shorter delivery
periods.
Price trends and factors that inuence prices
Cotton production and trade is inuenced by various factors. Production (acreage under the crop) of cotton
varies from year to year based on the climatic factors that are crucial for the productivity of crop. Cotton
trade is inuenced by the supplydemand scenario, production and prices of synthetic bre (polyester, viscose
and acrylic) and prices of cotton itself, etc.
The global supply and demand statistics released by the International Cotton Advisory Committee (ICAC)
and the United States Department of Agriculture (USDA) periodically are closely watched by the trading
community.
The central government establishes minimum support prices (MSP) for Kappas at the start of each marketing
season. The CCI is responsible for establishing the price support in all States. Typically, market prices remain
well above the MSP, and CCI operations are generally limited to commercial purchases and sales (except for
a few years like 200102 when the prices were abysmally low).
Futures prices of cotton at the New York Board of Trade (NYBOT) serve as the reference price for cotton
traded in the international market. World cotton prices fell sharply during most part of 2001, NyBOT
witnessing a sharp downfall in prices from 61.78 US Cents/ lb (as on Jan 2, 2001) to the low of 28.20 US
Cents/ lb (as on Oct 26, 2001), a sharp fall by 54.35%. Towards mid2002, prices recovered to 53 cents, and
toward end of 2003 were currently ruling at 58.85 cents.
Cotton prices in India are therefore inuenced by various demandsupply factors operating within the country,
international raw cotton prices, demand for nished readymade garments from abroad, prices of synthetic
bre, etc. Jute, silk, wool and khadi the other bre sources, are less likely to have any major impact on cotton
prices in India.
4.1.2 Crude palm oil

Annual edible oil trade in India is worth over Rs.440 billion, with the share of CPO being nearly 20% (Rs.80-
90 billion). The country is overdependent on CPO imports to the extent of over 50% of its annual vegetable
oil imports. There is a close inter linkage between the various vegetable oils produced, traded and consumed
across the world. The average monthly uctuation in prices of imported CPO traded at Kandla (one of the
major importing ports in Gujarat) has been at 9.7% during the past two and a half years, the maximum
monthly uctuation being as high as 25% during the period.
Palm oil is extracted from the mature fresh fruit bunches (FFBs) of oil palm plantations. One hectare of oil
palm yields approximately 20 FFBs, which when crushed yields 6 tons of oil (including the kernel oil, which is
used both for edible and industrial purposes). Crude palm oil (CPO), crude palmolein, RBD (rened,
bleached, deodorized) palm oil, RBD palmolein and crude palm kernel oil (CPKO) are the various forms of
palm oil traded in the market.
Cropping and growth patterns
Oil palm requires an average annual rainfall of 2000 mm or more distributed evenly throughout the year.
Rainfall less than 100 mm for a period of more than three months is not suitable for
oil palm cultivation. Oil palm thrives well at temperatures of ~ ~ ~ ~ C with at least 5 hours sunshine per
day throughout the year. Oil palm can be grown on a wide range of soil. In general, the soil should be deep,
well structured and well drained. However, in areas where rainfall is marginally suitable, the waterholding
capacity of the soil is of greatest importance. Flat or gentle undulating land is preferred. Oil palm is sensitive
to pH above 7.5 and stagnant water.
CPO is used for human consumption as well as for industrial purposes. The consumption of palm oil (both
food and industrial consumption put together) in the world is growing at the rate of 7.37% compounded
annually during the last 12 years period. While in the importing countries like China and European Union, the
consumption of palm oil is growing at the rate of 5.2% and 4.8% respectively, the consumption growth rate
for the worlds leading palm oil importer(in specic, and edible oils in general), India, stands at 25%. India,
China, Pakistan and the European Union are the major importers of palm oil. India is the largest importer of
CPO with a share of over 15% of the total quantity traded in the international market. The total imports of
India, China, Pakistan and European Union amount to approximately 56% of the total global exports of palm
oil annually.
Production of palm oil stands at 2425 million tons (over 22% of the global vegetable oil). Palm oil dominates
the global vegetable oil export trade. The two producing countries viz. Malaysia and Indonesia dominate the
global trade in CPO. Their share in the global exports of CPO is to the tune of 90%. The major trading
centres of CPO in the world are Malaysia and Indonesia in Asia and Rotterdam in Europe. The Kuala Lumpur
based Malaysia Derivatives Exchange Bhd. (MDEX) could be considered as the price maker of palm oil
traded world over. This exchange trades only CPO among several derivatives of palm. The domestic
production of palm oil forms almost a negligible part of the total edible oil consumption in the country.
Rising consumption of palm oil in India, which could be mainly attributed to its price competitiveness among
several of its competing oils is being met through increasing imports. Palm oil supports many other industries
in India like rening, vanaspati and other industrial sectors apart from human consumption as RBD palmolein.
The major importing and trading centres for palm in India are Chennai, Kakinada, Mumbai and Kandla. The
other centers like Mundra, Kolkata, Mangalore and Karwar also play important role, but next to the four
major trading centers. Palm oil trade in India is inuenced by the supplydemand scene in the domestic market
including the factors inuencing various oilseed production in the country, prices of various domestically
produced and imported oils, production and trade policies of the Government, mainly the exportimport
policy, overall health of the economy that has a bearing on the purchasing power of ultimate consumers, etc.
The entire industry of CPO in India is dominated by importers, large reners, corporate involved in wholesale
and retail trade through valueaddition and retailregional level players along with a few national level players.
The industry is dominated by over 200 importing companies, who are mostly reners too. Domestic oilseed
and edible oil industry is organised in the form of oilseed crushers, processors, solvent extractors,
technologists, commodityspecic producers and traders.
There exists a clear trough and crest in the seasonality of CPO production, indicating a typical seasonality in
the production cycle. The production bottoms down in the months of February, March and April, while the it
is at its peak during the months of August, September and October. Palm oil trade is inuenced by various
production, market and policy related factors. Being a perennial plantation crop, acreage under palm
plantation does not vary from season to season. Production is almost evenly distributed throughout the year
between 0.81.1 million tons in a monthly. However, it exhibits seasonal highs and lows once in a year. Yield
levels of the plantations are inuenced by climatic conditions like rainfall, temperature, etc. Factors that
inuence price are market related factors viz. supplydemand scenario of palm and its competing soy oil in the
global market apart from other vegetable oil sources viz. canola/ rapeseed, coconut oil, sunower, groundnut,
etc.; supplydemand status of various consuming/ importing countries;
overall status of the edible oil industry during the immediate past; current and a shortterm forecast of the
future status of the industry in various producing and consuming countries. Production and trade related
policies of various exporting and importing nations of palm oil at the international scene have a major bearing
on the prices of palm oil.
Trade policies in India
Since oilseed is one among the major crops cultivated by millions of farmers spread across the country, and is
the major source of cooking oil to over one billion consuming populace of the country, like any other welfare
state, Government of India (GoI) adopts a protection policy with regard to production and trade in vegetable
oils, so as to protect the interests of both the producers and consumers. While the strategy of farm subsidies
and minimum support price (MSP) are on the production side, the duty structure on various forms of palm oil
is the major traderelated protectionist measure.
4.1.3 RBD Palmolein
The RBD (rened, bleached and deodorized) palmolein is the derivative of crude palm oil (CPO), which is
obtained from the crushing of freshfruit-bunches (FFBs) harvested from oil palm plantations. When CPO is
subjected to renement, RBD palm oil and fatty acids are obtained. Fractionation of RBD palm oil yields RBD
palmolein along with stearin, which is a white solid at room temperature. While Oil is a stable derivative
saturated fat, solid at room temperature), Olein is relatively unstable (unsaturated fat, liquid at room
temperature, but low cholesterol).
The whole quantity of CPO that is produced and used for human consumption is in the form of RBD
palmolein. Cropping of growth patterns of CPO has been already covered.

The European Union, Pakistan and MiddleEast countries are the major importers of RBD palmolein.
Malaysia and Indonesia, which supply palm oil to the world to the extent of over 85% of the annual global
trade in palm oil, export largely as CPO as is demanded by the importing nations who rene domestically and
consume. RBD palmolein exports from Malaysia have increased from 3.2 million tons in 1998 to 4.5 million
tons in 2002.
India, which is one of the largest importer and consumer of edible oils in the world, imports nearly 3 million
tons of palm oil annually (mainly from Malaysia, followed by Indonesia). This implies that the country is
dependent on palm oil imports for over 25% of its annual edible oil consumption. There has been a sharp rise
in the imports of palm oil into the country during the post 1998 period. At the same time, there has been a
drastic change in the composition of various forms of palm oil imported owing to the differential duty
structure adopted by Indian government for crude and rened palm oil imports. The import is mainly through
the ports of Kandla, Kakinada, Kolkata, Mangalore, Mundra, Mumbai and Chennai.
The domestic production of palm oil forms almost a negligible part of the total edible oil consumption in the
country. Its production grew from 5000 tons in 1991 to 35,000 tons in 2002,
while the consumption of palm in India grew from 0.254 million tons in 1990 to nearly 3 million tons during
200 102, growing at the rate of 25% compounded annually during the past decade. Rising consumption of
palm oil in India could be mainly attributed to the price sensitive nature of the Indian edible oil consumers.
Palm oil trade in India is inuenced by the supplydemand scene in the domestic market including the factors
inuencing various oilseed production in the country, prices of various domestically produced and imported
oils, production and trade policies of the Government mainly the exportimport policy, overall health of the
economy that has a bearing on the purchasing power of ultimate consumers, etc. Unlike the price of CPO
imported into the country, which is largely dependent on price of CPO traded at Malaysia and the importers
and stockiest/ traders demand in India, RBD palmolein prices are inuenced by CPO prices and the domestic
consumer demand for various edible oils at a given point of time.
4.1.4 Soyoil
Soy oil is among the major sources of edible oils in India. Of the annual edible oil trade worth over Rs.440
billion in the country, soy oils share is over 2021% at Rs.9092 billion in terms of value. Being an agricultural
commodity, which is often subjected to various production and marketrelated uncertainties, soy oil prices
traded across the world are highly volatile in nature. The average uctuation in spot prices of rened soy oil
traded at Mumbai has been at 6.6% during the past two and a half years, the maximum monthly uctuation
being as high as 17% during the period. Historically, soy oil prices in the major spot markets across the
country have been uctuating in the range of 4.58.5%. This offers immense opportunity for the investors to
protably deploy their funds in this sector apart from those actually associated with the value chain of the
commodity, which could use soy oil futures contract as the most effective hedging tool to minimise price risk
in the market.
Soy oil is the derivative of soybean. On crushing mature beans, 18% oil and 7880% meal is obtained. While
the oil is mainly used for human consumption, meal serves as the main source of protein in animal feeds. Soy
oil is the leading vegetable oil traded in the international markets, next only to palm. Palm and soy oils
together constitute around 68% of global edible oil export trade volume, with soy oil constituting 22.85%. It
accounts for nearly 25% of the worlds total oils and fats production. Increasing price competitiveness, and
aggressive cultivation and promotion from the major producing nations have given way to widespread soy oil
growth both in terms of production as well as consumption.
In India, soybean is purely a Kharif crop, whose sowing begins by endJune with the arrival of southwest
monsoon. The crop, which is ready for harvest by the end of September, starts
entering the market from October beginning onwards. Crushing for oil and meal starts from October,
peaking during the subsequent twothree months.
Global consumption of soy oil during 200102 shot up to 29.38 million tons. It has been growing at the rate of
5.63%. Notable upward movement in consumption of soy oil is being seen in EU, Central Europe, Russia,
Egypt, Morocco, US, Mexico, Brazil, China and India. The consumption of soy oil in USA is to the extent of
90% of its production; growing at the rate of 2.95%, slightly higher than the growth rate of its production
(2.92%). The domestic consumption of soy oil in Brazil and Argentina are to an extent of 63% and 3% of
their respective domestic production of soy oil.
The current world production of soy oil stands at 2930 million tons. It has been growing at the rate of 5.8%
compounded annually during the last decade. The production growth rate has been the highest for Argentina
at 10.8%, while that of Brazil and USA has been at 5.6% and 2.9% respectively. United States is the major
producer of soy oil in the world. It accounts to approximately 29% of world soy oil production with an annual
production of 8.5 million tons. Brazil and Argentina with 5.1 and 4.1 million tons of production, contribute to
17% and 14% of world production. Of the total world exports, Argentina contributes to an extent of
40.4%, growing at the rate of 11.36% compounded annually during the past decade.
Production of soy oil in India has been uctuating in the range of 0.70.9 million tons during the last ve years,
growing at the rate of 5%. In addition to domestic production, around 1.51.8 million tons of imports take the
countrys annual soy oil consumption to 2.22.7 million tons, with a market value of over Rs.90 billion. Imports
constitute to the extent of over 6568% of its annual soy oil requirement and 48% of its annual vegetable oil
imports. Imports have been growing at the rate of approximately 20% over the period of last ve years.
Madhya Pradesh is considered as the soybean bowl of India, contributing 80% of the countrys soybean
production, followed by Maharashtra and Rajasthan. Karnataka, Uttar Pradesh, Andhra Pradesh and Gujarat
also produce in small quantities. Indore, Ujjain, Dewas and Astha in Madhya Pradesh and Sangli in
Maharashtra are major trading centres of soybean, in and around which the crushing and solvent extraction
units are mostly located. The rening units are located at the importing ports of Mumbai and Gujarat.
Price trends and factors the inuence prices
In India, spot markets of Indore and Mumbai serve as the reference market for soy oil prices. While the
Indore price reects the domestically crushed soybean oil (rened and solvent extracted), Mumbai price
indicates the imported soy oil price. Indian edible oil market is highly price sensitive in nature. Hence, the
quantity of soy oil imports mainly depends on the price competitiveness of soy oil vis-a-vis its sole
competitor, palm oil apart from prices of domestically produced oils, production and trade policies of the
government mainly the exportimport policy, overall health of the economy that has a bearing on the
purchasing power of ultimate consumers, etc. Soy oil is among the most vibrant commodities in terms of
price volatility. Its
exposure in the international edible trade scene (910 million tons), concentration of production base in
limited countries as against its widespread consumption base, its close link with several of its substitutes and
its base raw material soybean in addition to its coderivative (soy meal), the nature of the existing supply and
value chain, etc. throw tremendous opportunity for trade in this commodity. The opportunity is further
enhanced by the expected rise in consumption base and the consequent expected rise in imports of
vegetable oils in the years to come. In addition is the stiffening competition among substitutable oils under
the WTO regime.
4.1.5 Rapeseed oil
Rapeseed (also called mustard or canola) oil is the third largest edible oil produced in the world, after soy and
palm oils. On crushing rapeseed, oil and meal are obtained. The average oil recovery from the seed is about
33%. The remaining is obtained as oil cake/ meal, which is rich in proteins and is used as an ingredient in
animal feed. Mustard oil, which is known for its pungency, is traditionally the most favoured oils in the major
production tracts world over.
Rapeseed is a 90110 day crop. In the countries of Canada, Australia and China, the rapeseed is sown during
the months of JuneJuly and harvested by AugustSeptember. Crushing for oil begins from October onwards.
In India, rapeseed is sown in the Rabi season (November December sowing). China also grows partly during
this season. Mustard/ Rapeseed is traditionally the most important oil for the northern, central and eastern
parts of the country. The pungency of the oil is considered as the major quality determining factor.
Therefore, traditional millers producing unrened oil are more favoured by the consumers. Rapeseed from
the producers moves into the hands of crushers via the regulated markets (mandies), gets crushed for oil and
cake in the ghanis or the expeller mills. It is largely consumed in the crude form in the local crushing regions.
The cake obtained from the seed crush contains some amount of oil, which is extracted by the solvent
extractors. The left over meal at the solvent extraction units forms a major portion of our oil meal basket,
part of which is consumed by the domestic animal feed industry, and the rest exported. Rening of rapeseed
oil was almost absent in the country till the end of the last century. As a result, the sector was more
unorganised when compared to the other edible oil sectors in the country. This resulted in rampant
adulteration of the oil. However, with the occurrence of dropsy in the country, Government of India issued
the edible oil packaging order in 1998, which made rening and packing of all oils sold in the retail sector
mandatory. Now, rening is present in rapeseed oil too.
Consumption of rapeseed oil in the world has increased from 11 million tons in 1997 to 14 million tons in
2001, growing at a rate of 4.68% compounded annually during the period. USA has been the fastest growing
market for rapeseed oil, growing at the rate of 10.3%, followed by China and European Union at 8% each.
Consumption in India and Canada has posted a negative growth
rate of 6% and 1.6% respectively. USA imports 50% of rapeseed oil traded at the international market.
Hong Kong and Russia are the major importers, whose share has been declining over the years.
At an annual production level of 1314 million tons, rapeseed oil accounts for about 12% of the total worlds
edible oil production. Globally, rapeseed oil production has witnessed a moderate compounded annual
growth rate (over the last decade) of 4.65%. While the production growth rates in major producing
countries viz. Canada and India have posted negative values of 1.2% and 7.8% respectively during the past
decade, China, France and Germanys rapeseed oil production during the period has been growing at 10%,
6.8% and 4.7% respectively. China contributes more than one thirds of world rapeseed oil production while
that of India has gone down from 18.2% in 1997 to 11.3% in 2001.
Domestic rapeseed/ mustard is one of the major sources of edible oil and meal to India. It forms over
onethird of the countrys annual edible oil production, which is substantial. The imports of mustard oil have
drastically come down in the country from around 172000 tons in 199899 to a mere 10000 tons (of crude
rapeseed oil) in 200 102, owing to stiff price competition from palm and soy oils. There have been no imports
of rened rapeseed oil for the last few years due to the differential duty structure. Unlike other oils,
consumption of rapeseed oil is concentrated in northern, northeastern and western part of the country.
Rapeseed oil has several industrial applications too viz. as lubricant, its erucic acid derivatives are used in
plastic industry, and it could also be transformed into a liquid biofuel. Rajasthan and Uttar Pradesh are the
major rapeseed producing states in the country. Together, they produce about 50% of the produce. The
production from Rajasthan is highly monsoon dependent. The other signicant producers are Madhya
Pradesh, Haryana, Gujarat, West Bengal, Assam, Bihar, Punjab and Jammu and Kashmir. Since the oil is known
and consumed preferably for its unique pungency, it is mostly crushed in the local kacchi and pakki ghanis (oil
mills) spread across the producing and trading centres.
Various production and trade related factors inuence rapeseed oil trade. Prices are largely dependent on the
domestic production of rapeseed during the year, availability of others edible oils, and general sentiments in
the overall edible oil industry within and outside the country. Being an important source of edible oil, it is
undoubtedly the focus of Indian edible oil industry. The seasonal nature of the production of rapeseed and its
vulnerability to natural fallacies, wide consumption spread all through the year, the nature of the existing
supply and value chain, susceptibility to the sentiments in the overall edible oil and meal industry in India and
abroad, inuences the prices of the oil, subjecting it to frequent uctuations.
4.1.6 Soybean
The market size of the popularly known miracle bean in India is over Rs.5000 crore. With an annual
production of 5.05.4 million tons, soybean constitutes nearly 25% of the countrys total oilseed production.
The average monthly uctuation in prices of soybean traded at one of the
active soybean spot market at Indore (Madhya Pradesh) has been at 10.07% during the past two years, the
maximum monthly uctuation being as high as 2430% during the period. Historically, soybean prices in the
major spot markets across the country have been uctuating in the range of 59%. Soybean is the single largest
oilseed produced in the world. The commodity has been commercially exploited for its utility as edible oil
and animal feed. On crushing mature beans, around 18% oil could be obtained; the rest being the oil cake/
meal, which forms the prime source of protein in animal feeds.
Soybean could be grown under rain fed conditions, provided a good amount of soil moisture is ensured at the
germination, vegetative growth and pod setting stages. The planting date of vegetable soybean is dependent
upon temperature and day length. The optimum temperature range of soybean cultivation is ~ ~ ~ ~ C
with short day length (14 hours or less). However,
planting should be avoided at cooler temperatures during winter. Loamy soil with pH of 6.06.5 is suitable for
its cultivation, but the eld should be well drained.
About 8285% of the global soybean production is crushed for oil and meal, while the rest is consumed either
in the form of bean itself or for valueadded soybean snack foods. USA, Brazil, Argentina, China and European
Union countries constitute for the bulk of worlds annual soybean consumption. Mexico, Japan, India and
Taiwan are among the other major consumers. During the past ve years period, global consumption of
soybean has grown at the rate of 5.25%, higher than the production growth rate of 5.19%.
Of the total 3 10320 million tons of oilseeds produced annually, soybean production alone stands at 170190
million tons, contributing to over 55% of the global oilseeds production. During the last decade, the
production of the commodity grew at the rate of 5.35% at the global level. USA, followed by Brazil and
Argentina are the major producing countries; India and China are among the other producers.
The market size of the popularly known miracle bean in India is over Rs.5000 crore. With an annual
production of 5.05.4 million tons, soybean constitutes nearly 25% of the countrys total oilseed production.
Of the total bean produced, 67 lakh tons goes for direct consumption in the form of bean itself (sowing,
human consumption as bean itself), leaving the rest of the quantity for crushing for meal and oil. While the
country imports soy oil, it is a leading exporter of meal in the Asian region. Madhya Pradesh is the soybean
bowl of India, contributing 6570% of the countrys soybean production, followed by Maharashtra and
Rajasthan. Karnataka, Uttar Pradesh, Andhra Pradesh and Gujarat also produce in small quantities.
4.1.7 Rapeseed
Rapeseed/ Mustard is one of the major sources of oil and meal to India. It supplies over 1.5 million tons of oil
(1518% of Indias annual edible oil requirement) and 33.2 million tons of
oil meal, the major protein source in animal feeds. The average monthly uctuation in prices of rapeseed
traded at one of the active rapeseed spot market at Jaipur (Rajasthan) has been at 9.8% during the past two
years (July 2001 to July 2003), the maximum monthly uctuation being as high as 23.4% during the period.
Rapeseed/ Mustard/ Canola is a traditionally important oilseed. China, Canada and India are the major
producers of this commodity. The other major producers are Germany, France, Australia, Pakistan and
Poland. The commodity has been commercially exploited in the form of seeds, oil (seed to oil recovery is
3940%) and meal. The hybrid form of rapeseed, known as canola, is more popular internationally.
Under the names rapeseed and mustard, several oilseeds belonging to the cuciferae are grown in India. They
are generally divided into three groups:
Brown mustard, commonly called rai (raya or laha)
Sarson: (i) Yellow sarson (ii) Brown sarson
Toria (Lahi or Maghi Labi)
Rapeseed and mustard crops are of the tropical as well as of the temperate zones and require relatively cool
temperatures for satisfactory growth. In India, they are grown during the Rabi season from
SeptemberOctober to FebruaryMarch. Rapeseed and mustard crops grow well in areas having 25 to 40 cm
of rainfall. Sarson is preferred in lowrainfall areas, whereas Rai and Toria are grown in medium and high
rainfall areas respectively. Rapeseed and mustard thrive best in light to heavy loams. Rai may be grown on all
types of soils, but Toria does best in loam to heavy loams. Sarson is suited to lightloam soils and Taramira is
mostly grown on very light soils.
Consumption of rapeseed oil in the world has increased from 11 million tons in 1997 to 14 million tons in
2001, growing at a rate of 4.68% compounded annually during the period. USA has been the fastest growing
market for rapeseed oil, growing at the rate of 10.3%, followed by China and European Union at 8% each.
Consumption in India and Canada has posted a negative growth rate of 6% and 1.6% respectively. USA
imports 50% of rapeseed oil traded at the international market. Hong Kong and Russia are the major
importers, whose share has been declining over the years.
Global production of rapeseed increased from 25 million tons in 1990 to 42.4 million tons in 1999, and
declined from there on to the current (2002) level of 32.5 million tons. It has been growing at the rate of
2.2% during the last 12 years period. The major contributors to global rapeseed production are China, India,
Germany, France, Canada and Australia with a share of 32%, 12.6%, 12.1%, 10%, 9.8% and 3%
respectively. Among the major contributors to world production, Australian rapeseed production grew at
the fastest rate of 21%. While China, France and Germany are growing at a moderate rate of 24%, India and
Canada have shown a decline
in the production. The global trade of rapeseed oil has come down from 1.9 million tons in 1997 to 1.2 million
tons in 2001. 68% of the global rapeseed oil export trade is dominated by Canada. Germany follows Canada
in the export of domestically produced rapeseed oil. Its exports too have fallen by 30% from 0.3 million tons
in 1997 to 0.07 million tons in 2001. India and China consume most of the rapeseed oil that is produced
domestically.
Rapeseed/ mustard is one of the major sources of edible oil and meal to India. Around 4.5 4.8 million tons of
rapeseed available for produced annually in the country supplies over 1.5 million tons of oil and 33.2 million
tons of meal on crushing. It is the largest produced edible oil in India (groundnut oil production also stands on
par with it during good years). It forms over onethird of the countrys annual edible oil production, which is
substantial. The imports of mustard oil have drastically come down in the country from around 172000 tons
in 199899 to a mere 10000 tons (of crude rapeseed oil) in 200102, owing to stiff price competition from palm
and soy oils. There have been no imports of rened rapeseed oil for the last few years due to the differential
duty structure. Rajasthan and Uttar Pradesh are the major rapeseed producing States in the country.
Together, they produce about 50% of the produce. The production from Rajasthan is highly monsoon
dependent. The other signicant producers are Madhya Pradesh, Haryana, Gujarat, West Bengal, Assam,
Bihar, Punjab and Jammu and Kashmir. Since the oil is known and consumed preferably for its unique
pungency, it is mostly crushed in the local kacchi and pakki ghanis (oil mills) spread across the producing and
trading centres.
Jaipur, Delhi, Hapur, Kolkata and Mumbai markets serve as the reference markets for rapeseed/ mustard oil
traded across the country. Various production and trade related factors inuence rapeseed oil trade. Prices
are largely dependent on the domestic production of rapeseed during the year, availability of others edible
oils, and general sentiments in the overall edible oil industry within and outside the country. Being an
important source of edible oil, it is undoubtedly the focus of Indian edible oil industry. The seasonal nature of
the production of rapeseed and its vulnerability to natural fallacies, wide consumption spread all through the
year, the nature of the existing supply and value chain, susceptibility to the sentiments in the overall edible oil
and meal industry in India and abroad, inuences the prices of the oil, subjecting it to frequent uctuations.
Futures trading would also provide a right tool for hedging the market-related risk for everyone in the value
chain of the commodity- the producing farmers, processors, brokers, speculators, mustard oil and traders of
other oils.
Import of both rened and crude rapeseed oil is permitted into the country. The import duty on crude oil is
75%, while that on rened oil is 82%. There have been no imports of rened oil for the last few years due to the
differential duty structure.
4.2 Precious metals
The NCDEX offers futures trading in following precious metals gold and silver. We will look briey at both.
Gold futures trading debuted at the Winnipeg Commodity Exchange (Comex) in Canada in November
1972. Delivery was also available in gold certicates issued by Bank of Nova Scotia and the Canadian Imperial
Bank of Commerce. The gold contracts became so popular that by 1974 there was as many as 10,00,000
contracts oating in the market. The futures trading in gold started in other countries too. This included the
following:
4The London gold futures exchange started operations in the early 1980s.
4The Sydney futures exchange in Australia began functioning with a contract in 1978. This exchange had a
relationship with the Comex where participants could take open positions in one exchange and liquidate
them in the other.
4The Singapore International Monetary Exchange (Simex) was set up in 1983 by way of an alliance between
the Gold Exchange of Singapore and the International Monetary Market (IMM) of Chicago.
4The Tokyo Commodity Exchange (Tocom), which launched a contract in 1982, was one of the few
commodity exchanges to successfully launch gold futures. Trading volume on the Tocom peaked with
seven million contracts.
4On December 31, 1974, the Commodity Exchange, the Chicago Board of Trade, the Chicago Mercantile
Exchange and the Mid-America Commodity Exchange introduced gold futures contracts.
4The Chinese exchange, Shanghai Gold Exchange was ofIcially opened on 30 October 2002.
4Mumbais rst multi commodity exchange, the National Commodities and Derivatives Exchange, NCDEX
launched in 2003 by a consortium of ICICI Bank Limited, Life Insurance Corporation, National Bank for
Agriculture and Rural Development and National Stock Exchange of India Limited, introduces gold futures
contracts.
Gold has a very active derivative market compared with other commodities. Gold accounts for 45 per cent
of the worlds commercial banks commodity derivatives portfolio.
Box 4.4: History of derivatives markets in gold
4.2.1 Gold
For centuries, gold has meant wealth, prestige, and power, and its rarity and natural beauty have made it
precious to men and women alike. Owning gold has long been a safeguard against disaster. Many times when
paper money has failed, men have turned to gold as the one true source of monetary wealth. Today is no
different. While there have been uctuations in every market and decided downturns in some, the
expectation is that gold will hold its own. There is a limited amount of gold in the world, so investing in gold is
still a good way to plan for the future. Gold is homogeneous, indestructible and fungible. These attributes set
gold apart from other commodities and nancial assets and tend to make its returns insensitive to business
cycle
uctuations. Gold is still bought (and sold) by different people for a wide variety of reasons as a use injewellery,
for industrial applications, as an investment and so on.
Production
Traditionally South Africa has been the largest producers of gold in the world accounting for almost 80% of all
noncommunist output in 1970. Although it retained its position as the single largest gold producing country,
its share had fallen to around 17% by 1999 because of high costs of mining and reduced resources. Table 4.1
gives the countrywise share in gold production. In contrast other countries like US, Australia, Canada and
China have increased their output exponentially with output from developing countries like Peru and other
Latin American countries also increasing impressively.
Mining and production of gold in India is negligible, now placed around 2 tonnes (mainly from the Kolar gold
mines in Karnataka) as against a total world production of about 2,272 tonnes in 1995.
Melting & rening assaying facility in India
At present, gold is mainly rened in Bombay where a few reneries like the India Government Mint and
National renery are active. Some private reneries are also operating elsewhere with limited capacity. As
none of the reneries is LBMA recognised, there is a need to upgrade and also increase the rening capacity.
The demand for gold may be categorised under two heads consumption demand and investment demand.
Consumption of gold differs according to type, namely industrial applications and jewellery. The special
feature of gold used in industrial and dental applications is that some of it cannot be salvaged and thus is truly
consumed. This is unlike consumption in the form of jewellery, which remains as stock and can reappear at
future time in market in another form. Consumer demand accounts for almost 90% of total gold demand
and the demand for jewelry forms 89% of consumer demand.O
In markets with poorly developed nancial systems, inaccessible or insecure banks, or where trust in the
government is low, gold is attractive as a store of value. If gold is held primarily as an investment asset, it does
not need to be held in physical form. The investor could hold goldlinked paper assets or could lend out the
physical gold on the market attaining a higher return in addition to savings on the storage costs. Japan has the
highest investment demand for gold followed closely by India. These two countries together account for
over 50% of total world demand of gold for retail investment. Investment demand can be split broadly into
two, private and public sector holdings.
There are several ways in which investors can invest in gold either directly or through a variety of investment
products, each of which lends it to specic investor preferences:
4Coins and small bars
4Gold accounts: allocated and unallocated
4Gold certicates and pool accounts
4Gold Accumulation Plan
4Gold backed bonds and structured notes
4Gold futures and options
4Gold oriented funds
Demand
The Consumer demand for gold is more than 3400 tonnes per year making it whopping $40 billion worth.
More than 80% of the gold consumed is in the form ofjewellery, which is generally predominated by women.
The Indian demand to the tune of 800 tonnes per year is making it the largest market for gold followed by
USA, Middle East and China. About 80% of the Physical gold is consumed in the form of jewellery while bars
and coins occupy not higher than 10% of the gold consumed. If we include jewellery ownership, then India is
the largest repository of gold in terms of total gold within the national boundaries.
Regarding pattern of demand, there are no authentic estimates, the available evidence shows that about
80% is for jewellery fabrication for domestic demand, and 15% is for investordemand (which is relatively
elastic to gold-prices, real estate prices, nancial markets, taxpolicies, etc.). Barely 5% is for industrial uses.
The demand for gold jewellery is rooted in societal preference for a variety of reasons religious, ritualistic, a
preferred form of wealth for women, and as a hedge against ination. It will be difcult to prioritise them but it
may be reasonable to conclude that it is a combined effect, and to treat any major part as exclusively a store
of value or hedging instrument would be unrealistic. It would not be realistic to assume that it is only the
afuent that creates demand for gold. There is reason to believe that a part of investment demand for gold
assets is out of black money.
Rural India continues to absorb more than 70% of the gold consumed in India and it has its own role to fuel
the barter economy of the agriculture community. The yellow metal used to
play an important role in marriage and religious festivals in India. In the Hindu, Jain and Sikh community,
where women did not inherit landed property whereas gold and silver jewellery was, and still is, a major
component of the gifts given to a woman at the time of marriage. The changeover hands of gold at the time of
marriage are from few grams to kgs. The gold also occupies a signicant position in the temple system where
gold is used to prepare idol and devotees offer gold in the temple. These temples are run in trust and gold
with the trust rarely comes into re-circulation. The existing social and cultural system continues to cause net
gold buyer market and the government policies have to take note of the root cause of gold demand, which
lies in the social and cultural system of India. The annual consumption of gold, which was estimated at 65
tonnes in 1982, has increased to more than 700 tonnes in late 90s. Although it is likely that, with prosperity
and enlightenment, there may be deceleration in demand, particularly in urban areas, it would be made good
by growing demand on account of prosperity in rural areas. In the near future, therefore, the annual demand
will continue to be over 600 tonnes per year.
Supply
Indian gold holding, which are predominantly private, is estimated to be in the range of 10000-13000 tonnes.
One fourth of world gold production is consumed in India and more than 60% of Indian consumption is met
through imports. The domestic production of the gold is very limited which is around 9 tonnes in 2002
resulting more dependence on imported gold. The availability of recycled gold is price sensitive and as such
the dominance of the gold supply through import is in existence. The fabricated old gold scraps is price elastic
and was estimated to be near 450 tonnes in 2002. It rose almost more than 40% compared to the previous
year because of rise in gold price by more than 15%.
The demandsupply for gold in India can be summed up thus:
4Demand for gold has an autonomous character. Supply follows demand.
4Demand exhibits income elasticity, particularly in the rural and semi-urban areas.
4Price differential creates import demand, particularly illegal import prior to the commencement of
liberalisation in 1990.
Indian gold prices follow more or less the international price trends. However, the strong domestic demand
for gold and the restrictive policy stance are reected in the higher price of gold in the domestic market
compared to that in the international market at the available exchange rate.
Since the demand for gold is closely tied to the production of jewelry, gold prices tend to increase during the
time of year when demand for jewellery is greatest. Christmas, Mothers Day and Valentine Day are all major
shopping seasons and hence the demand for metals tends to be strong a few months ahead of these holidays.
Also, the summer wedding season sees a large increase in the demand for metals, so price strength in March
and April is not uncommon. On the
other hand in November, December, January and February prices tend to decline and jewellers tend to have
holiday inventory to unwind.
4.2.2 Silver
The dictionary describes it as a white metallic element, sonorous, ductile, very malleable and capable of high
degree of polish. It also has the highest thermal and electrical conductivity of any substance. Silver is
somewhat harder than gold and is second only to gold in malleability and ductility. Silver remains one of the
most prominent candidates in the metals complex as far as futurestrading is concerned. Thanks to its unique
volatility, silver has remained a hot favourite speculative vehicle for the small time traders. Though futures
trading was banned in India since late sixties, parallel futures markets are still very active in Delhi and Indore.
Speculative interest in the white metal is so intense that it is believed that combined volume of Indian punters
represent almost 40 percent of volume traded at New York Commodity Exchange. Delhi, Rajasthan, MP and
UP are the active pockets for the silver futures. Until recently, Rajkot and Mathura were conducting futures
but now players have diverted toward comex trade.
Most of the worlds silver is mined in the US, Australia, Mexico, Peru, and Canada. Cash markets remain
highly unorganised in the silver and impurity and excessive speculation remain key issue for the trade. Taking
cue from gold, government of India is planning to introduce hallmarking in silver which is likely to address
quality and credibility of Indian silverware and jeweller industry. The unique properties of silver restrict its
substitution in most applications.
Production
Silver ore is most often found in combination with other elements, and silver has been mined and treasured
longer than any of the other precious metals. Mexico is the worlds leading producer of silver, followed by
Peru, Canada, the United States, and Australia. The main consumer countries for silver are the United States,
which is the worlds largest consumer of silver, followed by Canada, Mexico, the United Kingdom, France,
Germany, Italy, Japan and India. The main factors affecting these countries demand for silver are macro
economic factors such as GDP growth, industrial production, income levels, and a whole host of other
nancial macro economic indicators.
Demand
Demand for silver is built on three main pillars; industrial and decorative uses, photography and jewelry &
silverware. Together, these three categories represent more than 95 percent of annual silver consumption.
In recent years, the main world demand for silver is no longer monetary, but industrial. With the growing use
of silver in photography and electronics, industrial demand for silver accounts for roughly 85% of the total
demand for silver. Jewelry and silverware is the second largest component, with more demand from the
atware industry than from the jewelry industry in recent years. India, the largest consumer of silver, is gearing
up to start hallmarking of the white precious metal by April. India annually consumes around 4,000 tonnes of
silver,
Major markets like the London market (London Bullion Market Association), which started trading in the
17th century provide a vehicle for trade in silver on a spot basis, or on a forward basis. The London market
has ax which offers the chance to buy or sell silver at a single price. The x begins at 12:15 p.m. and is a
balancing exercise; the price is xed at the point at which all the members of the xing can balance their own,
plus clients, buying and selling orders.
Trading in silver futures resumed at the Comex in New York in 1963, after a gap of 30 years. The London
Metal Exchange and the Chicago Board of Trade introduced futures trading in silver in 1968 and 1969,
respectively. In the United States, the silver futures market functions under the surveillance of an ofcial body,
the Commodity Futures Trading Commission (CFTC). Although London remains the true center of the
physical silver trade for most of the world, the most signicant paper contracts trading market for silver in the
United States is the COMEX division of the New York Mercantile Exchange. Spot prices for silver are
determined by levels prevailing at the COMEX. Although there is no American equivalent to the London x,
Handy & Harman, a precious metals company, publishes a price for 99.9% pure silver at noon each working
day.
Box 4.5: Historical background of silver markets
Major markets like the London market (London Bullion Market Association), which started trading in the
17th century provide a vehicle for trade in silver on a spot basis, or on a forward basis. The London market
has ax which offers the chance to buy or sell silver at a single price. The x begins at 12:15 p.m. and is a
balancing exercise; the price is xed at the point at which all the members of the xing can balance their own,
plus clients, buying and selling orders.
Trading in silver futures resumed at the Comex in New York in 1963, after a gap of 30 years. The London
Metal Exchange and the Chicago Board of Trade introduced futures trading in silver in 1968 and 1969,
respectively. In the United States, the silver futures market functions under the surveillance of an ofcial body,
the Commodity Futures Trading Commission (CFTC). Although London remains the true center of the
physical silver trade for most of the world, the most signicant paper contracts trading market for silver in the
United States is the COMEX division of the New York Mercantile Exchange. Spot prices for silver are
determined by levels prevailing at the COMEX. Although there is no American equivalent to the London x,
Handy & Harman, a precious metals company, publishes a price for 99.9% pure silver at noon each working
day.
Box 4.5: Historical background of silver markets
with the rural areas accounting for the bulk of the sales. Indias demand for silver increased by 177 per cent
over the past 10 years as compared to 517 tonnes in 1991. According to GFMS, India has emerged as the
third largest industrial user of silver in the world after the US and Japan.
Supply
The supply of silver is based on two facts, mine production and recycled silver scraps. Mine production is
surprisingly the largest component of silver supply. It normally accounts for a little less than 2/3 rd of the total
(last year was slightly higher at 68%). Fifteen countries produce roughly 94 percent of the worlds silver from
mines. The most notable producers are Mexico, Peru, the United States, Canada and Australia. Mexico, the
largest producer of silver from mines. Peru is the worlds second largest producer of silver. Silver is often
mined as a byproduct of other base metal operations, which accounts for roughly four-fths of the mined
silver supply produced annually. Known reserves, or actual mine capacity, is evenly split along the lines of
production. The mine production is not the sole source others being scrap, disinvestments, government
sales and producers hedging. Scrap is the silver that returns to the market when recovered from existing
manufactured goods or waste. Old scrap normally makes up around a
fth of supply. Scrap supply increased marginally last year up by 1.2%. The other major source of silver is from
rening, or scrap recycling. Because silver is used in the photography industry, as well as by the chemical
industry, the silver used in solvents and the like can be removed from the waste and recycled. The United
States recycles the most silver in the world, accounting for roughly 43.6 million ounces. Japan is the second
largest producer of silver from scrap and recycling, accounting for roughly 27.8 million troy ounces in 1997.
In the United States and Japan, threequarters of all the recycled silver comes from the photographic scrap,
mainly in the form of spent xer solutions and old X-ray lms.Factors inuencing prices of the silver
The prices of silver, like that of other commodities, are dictated by forces of demand and supply and
consumption. Besides, a host of social, economic and political factors have powerful bearing on silver prices.
As in the case of gold prices, political tensions, the threat affects the price of silver too. When trading and
movement of silver is restricted, within or outside national boundaries, prices move in accordance with
demand and supply conditions prevalent in that environment Price of silver is also inuenced by changes in
factors such as ination (real or perceived), changing values of paper currencies, and uctuations in decits and
interest rates, etc. Although prices and incomes are important factors, they are also inuenced by factors such
as tastes, technological change and market liberalisation.
Approximately 70 percent of the silver mined in the western hemisphere is mined as a by product of other
metal products, such as gold, copper, nickel, lead, and zinc. As such, the price of these metals greatly affects
the supply of silver mined in any year. As the price of the other metal products increases, the increased prot
margin to mine operations stimulates greater production of the other metals, and as a result, the production
of silver increases in tandem. Because silver is a precious metal, its price is determined by the supply and
demand ratio at any given moment. As is the case with other precious metals, there is a limited amount of
silver in the world. It is not a product that can be manufactured en masse, and, therefore, is subject to issues
such as weather and politics that may affect silver mining operations.
Solved Problems
Q: Which of the following commodities do not trade on the NCDEX?
1. Gold 3. Silver
2. Rapeseed 4. Energy
Q: Which of the following agricultural commodities do not trade on the NCDEX at the moment?
1. Wheat 3. Soybean
2. Rapeseed 4. Soy oil
Q: In India ,is the most important non food crop.
1. Jute 3. Silk
2. Cotton 4. None of the above.
Q: Which of the following factors do not inuence the price of cotton?

1. Demand supply scenario 3. Previous prices of cotton
2. Production and prices of synthetic bre 4. Prices of cotton products.
Q: Futures prices of cotton at the serve as the reference price for cotton traded in the international market.
1. CME 3. NYBOT
2. CBOT 4. SGX
Q: Palm oil is extracted from the of oil palm plantations.
1. Mature fresh fruit bunches 3. Stem
2. Dry fruit bunches 4. Leaves

Q: RBD Palmolein is the derivative of
1. Soy 3. CPO
2. Rapeseed 4. Coconut kernel
Q: Which of the following factor directly inuences the price of RBD palmolein?
1. Prices of Rapeseed oil 3. Prices of CPO
2. Prices of coconut oil 4. Prices sunower oil
Q: Soy oil is the derivative of
1. Soy 3. CPO
2. Soybean 4. Sunower seeds
Q: The market reects the price of domestically crushed soybean

1. Mumbai 3. Indore
2. Ahmedabad 4. Delhi
Q: The market reects the price of imported soybean
1. Mumbai 3. Indore
2. Ahmedabad 4. Delhi
Chapter 5
Instruments available for trading
In recent years, derivatives have become increasingly popular due to their applications for hedging,
speculation and arbitrage. Before we study about the applications of commodity derivatives, we will have a
look at some basic derivative products. While futures and options are now actively traded on many
exchanges, forward contracts are popular on the OTC market. In this chapter we shall study in detail these
three derivative contracts. While at the moment only commodity futures trade on the NCDEX, eventually,
as the market grows, we also have commodity options being traded.
5.1 Forward contracts

A forward contract is an agreement to buy or sell an asset on a specied date for a specied price. One of the
parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specied
future date for a certain specied price. The other party assumes a short position and agrees to sell the asset
on the same date for the same price. Other contract details like delivery date, price and quantity are
negotiated bilaterally by the parties to the contract. The forward contracts are normally traded outside the
exchanges.
The salient features of forward contracts are:
4They are bilateral contracts and hence exposed to counterparty risk.
4Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the
asset type and quality.
4The contract price is generally not available in public domain.
4On the expiration date, the contract has to be settled by delivery of the asset.
4If the party wishes to reverse the contract, it has to compulsorily go to the same counterparty, which often
results in high prices being charged.
However forward contracts in certain markets have become very standardised, as in the case of foreign
exchange, thereby reducing transaction costs and increasing transactions volume. This process of
standardisation reaches its limit in the organised futures market.
Forward contracts are very useful in hedging and speculation. The classic hedging application would be that
of an exporter who expects to receive payment in dollars three months later. He is exposed to the risk of
exchange rate uctuations. By using the currency forward market to sell dollars forward, he can lock on to a
rate today and reduce his uncertainty. Similarly an importer who is required to make a payment in dollars
two months hence can reduce his exposure to exchange rate uctuations by buying dollars forward.
If a speculator has information or analysis, which forecasts an upturn in a price, then he can go long on the
forward market instead of the cash market. The speculator would go long on the forward, wait for the price
to rise, and then take a reversing transaction to book prots. Speculators may well be required to deposit a
margin upfront. However, this is generally a relatively small proportion of the value of the assets underlying
the forward contract. The use of forward markets here supplies leverage to the speculator.
5.1.1 Limitations of forward markets
Forward markets world-wide are aficted by several problems:
4Lack of centralisation of trading,
4Illiquidity, and
4Counterparty risk
In the rst two of these, the basic problem is that of too much exibility and generality. The forward market is
like a real estate market in that any two consenting adults can form contracts against each other. This often
makes them design terms of the deal which are very convenient in that specic situation, but makes the
contracts non-tradeable.
Counterparty risk arises from the possibility of default by any one party to the transaction. When one of the
two sides to the transaction declares bankruptcy, the other suffers. Even when forward markets trade
standardized contracts, and hence avoid the problem of illiquidity, still the counterparty risk remains a very
serious issue.
5.2 Introduction to futures
Futures markets were designed to solve the problems that exist in forward markets. A futures contract is an
agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. But
unlike forward contracts, the futures contracts are standardized and exchange traded. To facilitate liquidity
in the futures contracts, the exchange species certain standard features of the contract. It is a standardized
contract with standard underlying instrument, a standard quantity and quality of the underlying instrument
that can be delivered, (or which can be used for reference purposes in settlement) and a standard timing of
such settlement. A futures contract may be offset prior to maturity by entering into an equal and opposite
transaction. More than 99% of futures transactions are offset this way.
The standardized items in a futures contract are:
5.2 Introduction to futures 61
Merton Miller, the 1990 Nobel laureate had said that nancial futures represent the most signicant nancial
innovation of the last twenty years. The rst exchange that traded nancial derivatives was launched in Chicago
in the year 1972. A division of the Chicago Mercantile Exchange, it was called the International Monetary
Market (IMM) and traded currency futures. The brain behind this was a man called Leo Melamed,
acknowledged as the father of nancial futures who was then the Chairman of the Chicago Mercantile
Exchange. Before IMM opened in 1972, the Chicago Mercantile Exchange sold contracts whose value was
counted in millions. By 1990, the underlying value of all contracts traded at the Chicago Mercantile Exchange
totalled 50 trillion dollars.
These currency futures paved the way for the successful marketing of a dizzying array of similar products at
the Chicago Mercantile Exchange, the Chicago Board of Trade, and the Chicago Board Options Exchange.
By the 1990s, these exchanges were trading futures and options on everything from Asian and American
stock indexes to interestrate swaps, and their success transformed Chicago almost overnight into the risk
transfer capital of the world.
Box 5.6: The rst nancial futures market
Table 5.1 Distinction between futures and forwards
Futures Forwards
Trade on an organised exchange OTC in nature
Standardized contract terms Customised contract terms
hence more liquid hence less liquid
Requires margin payments No margin payment
Follows daily settlement Settlement happens at end of period
4Quantity of the underlying

4Quality of the underlying
4The date and the month of delivery
4The units of price quotation and minimum price change
4Location of settlement
5.2.1 Distinction between futures and forwards contracts
Forward contracts are often confused with futures contracts. The confusion is primarily because both serve
essentially the same economic functions of allocating risk in the presence of future price uncertainty.
However futures are a signicant improvement over the forward contracts as they eliminate counterparty
risk and offer more liquidity. Table 5.1 lists the distinction between the two.
5.2.2 Futures terminology

4Spot price: The price at which an asset trades in the spot market.
4Futures price: The price at which the futures contract trades in the futures market.
4Contract cycle: The period over which a contract trades. The commodity futures contracts on the
NCDEX have one-month, two-months and three-months expiry cycles which expire on the 20th day of
the delivery month. Thus a January expiration contract expires on the 20th of January and a February
expiration contract ceases trading on the 20th of February. On the next trading day following the 20th, a
new contract having a three-month expiry is introduced for trading.
4Expiry date: It is the date specied in the futures contract. This is the last day on which the contract will be
traded, at the end of which it will cease to exist.
4Delivery unit: The amount of asset that has to be delivered under one contract. For instance, the delivery
unit for futures on Long Staple Cotton on the NCDEX is 55 bales. The delivery unit for the Gold futures
contract is 1 kg.
4Basis: Basis can be dened as the futures price minus the spot price. There will be a different basis for each
delivery month for each contract. In a normal market, basis will be positive. This reects that futures prices
normally exceed spot prices.
4Cost of carry: The relationship between futures prices and spot prices can be summarised in terms of
what is known as the cost of carry. This measures the storage cost plus the interest that is paid to nance the
asset less the income earned on the asset.
4Initial margin: The amount that must be deposited in the margin account at the time a futures contract is
rst entered into is known as initial margin.
4Marking-to-market(MTM): In the futures market, at the end of each trading day, the margin account is
adjusted to reect the investors gain or loss depending upon the futures closing price. This is called
markingtomark et.
4Maintenance margin: This is somewhat lower than the initial margin. This is set to ensure that the balance
in the margin account never becomes negative. If the balance in the margin account falls below the
maintenance margin, the investor receives a margin call and is expected to top up the margin account to
the initial margin level before trading commences on the next day.
5.3 Introduction to options
In this section, we look at another interesting derivative contract, namely options. Options are
fundamentally different from forward and futures contracts. An option gives the holder of the option the
right to do something. The holder does not have to exercise this right. In contrast, in a forward or futures
contract, the two parties have committed themselves to doing something. Whereas it costs nothing (except
margin requirements) to enter into a futures contract, the purchase of an option requires an upfront
payment.
5.3 Introduction to options 63
Although options have existed for a long time, they were traded OTC, without much knowledge of
valuation. The rst trading in options began in Europe and the US as early as the seventeenth century. It was
only in the early 1900s that a group of rms set up what was known as the put and call Brokers and Dealers
Association with the aim of providing a mechanism for bringing buyers and sellers together. If someone
wanted to buy an option, he or she would contact one of the member rms. The rm would then attempt to nd
a seller or writer of the option either from its own clients or those of other member
rms. If no seller could be found, the rm would undertake to write the option itself in return for a price.
This market however suffered from two deciencies. First, there was no secondary market and second, there
was no mechanism to guarantee that the writer of the option would honour the contract.
In 1973, Black, Merton and Scholes invented the famed Black-Scholes formula. In April 1973, CBOE was set
up specically for the purpose of trading options. The market for options developed so rapidly that by
early80s, the number of shares underlying the option contract sold each day exceeded the daily volume of
shares traded on the NYSE. Since then, there has been no looking back.
Box 5.7: History of options
5.3.1 Option terminology
4Commodity options: Commodity options are options with a commodity as the underlying. For instance a
gold options contract would give the holder the right to buy or sell a specied quantity of gold at the price
specied in the contract.
4Stock options: Stock options are options on individual stocks. Options currently trade on over 500 stocks
in the United States. A contract gives the holder the right to buy or sell shares at the specied price.
4Buyer of an option: The buyer of an option is the one who by paying the option premium buys the right but
not the obligation to exercise his option on the seller/ writer.
4Writer of an option: The writer of a call/ put option is the one who receives the option premium and is
thereby obliged to sell/ buy the asset if the buyer exercises on him.
There are two basic types of options, call options and put options.
4Call option: A call option gives the holder the right but not the obligation to buy an asset by a certain date
for a certain price.
4Put option: A put option gives the holder the right but not the obligation to sell an asset by a certain date for
a certain price.
4Option price: Option price is the price which the option buyer pays to the option seller. It is also referred
to as the option premium.
4Expiration date: The date specied in the options contract is known as the expiration date, the exercise
date, the strike date or the maturity.
4Strike price: The price specied in the options contract is known as the strike price or the exercise price.
4Option price: Option price is the price which the option buyer pays to the option seller. It is also referred
to as the option premium.
4Expiration date: The date specied in the options contract is known as the expiration date, the exercise
date, the strike date or the maturity.
4Strike price: The price specied in the options contract is known as the strike price or the exercise price.
4American options: American options are options that can be exercised at any time upto the expiration
date. Most exchange-traded options are American.
4European options: European options are options that can be exercised only on the expiration date itself.
European options are easier to analyse than American options, and properties of an American option are
frequently deduced from those of its European counterpart.
4In-the-money option: An in-the-money (ITM) option is an option that would lead to a positive cashow to
the holder if it were exercised immediately. A call option on the index is said to be in-the-money when the
current index stands at a level higher than the strike price (i.e. spot price~ strike price). If the index is
much higher than the strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the
index is below the strike price.
4At-the-money option: An at-the-money (ATM) option is an option that would lead to zero casho w if it
were exercised immediately. An option on the index is at-the-money when the current index equals the
strike price (i.e. spot price = strike price).
4Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to a negative
cashow it it were exercised immediately. A call option on the index is out-of-the-money when the current
index stands at a level which is less than the strike price (i.e. spot price ~ strike price). If the index is much
lower than the strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the index
is above the strike price.
4Intrinsic value of an option: The option premium can be broken down into two components - intrinsic
value and time value. The intrinsic value of a call is the amount the option is ITM, if it is ITM. If the call is
OTM, its intrinsic value is zero. Putting it another way, the intrinsic value of a call is
4Time value of an option: The time value of an option is the difference between its premium and its intrinsic
value. Both calls and puts have time value. An option that is OTM or ATM has only time value. Usually, the
maximum time value exists when the option is ATM. The longer the time to expiration, the greater is an
options time value, all else equal. At expiration, an option should have no time value.
5.4 Basic payoffs
A payoff is the likely prot/ loss that would accrue to a market participant with change in the price of the
underlying asset. This is generally depicted in the form of payoff diagrams which show the price of the
underlying asset on the Xaxis and the prots/ losses on the Yaxis. In this section we shall take a look at the
payoffs for buyers and sellers of futures and options. But rst we look at the basic payoff for the buyer or seller
of an asset. The asset could be a commodity like gold or cotton, or it could be a nancial asset like like a stock
or an index.
Options made their rst major mark in nancial history during the tulip-bulb mania in seventeenth-century
Holland. It was one of the most spectacular get rich quick binges in history. The rst tulip was brought into
Holland by a botany professor from Vienna. Over a decade, the tulip became the most popular and
expensive item in Dutch gardens. The more popular they became, the more Tulip bulb prices began rising.
That was when options came into the picture. They were initially used for hedging. By purchasing a call
option on tulip bulbs, a dealer who was committed to a sales contract could be assured of obtaining a xed
number of bulbs for a set price. Similarly, tulip-bulb growers could assure themselves of selling their bulbs at a
set price by purchasing put options. Later, however, options were increasingly used by speculators who
found that call options were an effective vehicle for obtaining maximum possible gains on investment. As long
as tulip prices continued to skyrocket, a call buyer would realize returns far in excess of those that could be
obtained by purchasing tulip bulbs themselves. The writers of the put options also prospered as bulb prices
spiralled since writers were able to keep the premiums and the options were never exercised. The tulip-bulb
market collapsed in 1636 and a lot of speculators lost huge sums of money. Hardest hit were put writers who
were unable to meet their commitments to purchase Tulip bulbs.
Box 5.8: Use of options in the seventeenth-century
5.4.1 Payoff for buyer of asset: Long asset
In this basic position, an investor buys the underlying asset, gold for instance, for Rs.6000 per 10 gms, and
sells it at a future date at an unknown price, @ + . Once it is purchased, the investor is said to be longthe
asset. Figure 5.1 shows the payoff for a long position on gold.
5.4.2 Payoff for seller of asset: Short asset

In this basic position, an investor shorts the underlying asset, cotton for instance, for Rs.6500 per Quintal,
and buys it back at a future date at an unknown price, @ + . Once it is sold, the investor is said to be
shortthe asset. Figure 5.2 shows the payoff for a short position on cotton.
5.5 Payoff for futures
Futures contracts have linear payoff, just like the payoff of the underlying asset that we looked at earlier. If the
price of the underlying rises, the buyer makes prots. If the price of the underlying falls, the buyer makes
losses. The magnitude of prots or losses for a given upward or downward movement is the same. The prots
as well as losses for the buyer and the seller of a futures contract are unlimited. These linear payoffs are
fascinating as they can be combined with options and the underlying to generate various complex payoffs.
5.5.1 Payoff for buyer of futures: Long futures
The payoff for a person who buys a futures contract is similar to the payoff for a person who holds an asset.
He has a potentially unlimited upside as well as a potentially unlimited downside.
Figure 5.3 Payoff for a buyer of gold futures

The gure shows the prots/ losses for a long futures position.The investor bought futures when gold futures
were trading at Rs.6000 per 10 gms. If the price of the underlying gold goes up, the gold futures price too
would go up and his futures position starts making prot. If the price of gold falls, the futures price falls too and
his futures position starts showing losses.
Take the case of a speculator who buys a twomonth gold futures contract on the NCDEX when it sells for
Rs.6000 per 10 gms. The underlying asset in this case is gold. When the prices of gold in the spot market goes
up, the futures price too moves up and the long futures position starts making prots. Similarly when the
prices of gold in the spot market goes down, the futures prices too move down and the long futures position
starts making losses. Figure 5.3 shows the payoff diagram for the buyer of a gold futures contract.
5.5.2 Payoff for seller of futures: Short futures
The payoff for a person who sells a futures contract is similar to the payoff for a person who shorts an asset.
He has a potentially unlimited upside as well as a potentially unlimited downside. Take the case of a
speculator who sells a twomonth cotton futures contract when the contract sells Rs.6500 per Quintal. The
underlying asset in this case is long staple cotton. When the prices of long staple cotton move down, the
cotton futures prices also move down and the short futures position starts making prots. When the prices of
long staple cotton move up, the cotton futures price also moves up and the short futures position starts
making losses. Figure 5.4 shows the payoff diagram for the seller of a futures contract.
\
Figure 5.4 Payoff for a seller of cotton futures
The gure shows the prots/ losses for a short futures position. The investor sold cotton futures at Rs.6500 per
Quintal. If the price of the underlying long staple cotton goes down, the futures price also falls, and the short
futures position starts making prot. If the price of the underlying long staple cotton rises, the futures too rise,
and the short futures position starts showing losses.
5.6 Payoff for options

The optionality characteristic of options results in a nonlinear payoff for options. In simple words, it means
that the losses for the buyer of an option are limited, however the prots are potentially unlimited. The writer
of an option gets paid the premium. The payoff from the option written is exactly the opposite to that of the
option buyer. His prots are limited to the option premium, however his losses are potentially unlimited.
These nonlinear payoffs are fascinating as they lend themselves to be used for generating various complex
payoffs using combinations of options and the underlying asset. We look here at the four basic payoffs.
5.6.1 Payoff for buyer of call options: Long call

A call option gives the buyer the right to buy the underlying asset at the strike price specied in the option. The
prot/ loss that the buyer makes on the option depends on the spot price of the underlying. If upon expiration,
the spot price exceeds the strike price, he makes a prot. Higher the spot price, more is the prot he makes. If
the spot price of the underlying is less than the strike price, he lets his option expire unexercised. His loss in
this case is the premium he paid for buying the option. Figure 5.5 gives the payoff for the buyer of a three
month call option on gold (often referred to as long call) with a strike of Rs.7000 per 10 gms, bought at a
premium of Rs.500.
Figure 5.5 Payoff for buyer of call option on gold

The gure shows the prots/ losses for the buyer of a threemonth call option on gold at a strike of Rs.7000 per
10 gms. As can be seen, as the prices of gold rise in the spot market, the call option becomes inthemoney. If
upon expiration, gold trades above the strike of Rs.7000, the buyer would exercise his option and prot to the
extent of the difference between the spot goldclose and the strike price. The prots possible on this option
are potentially unlimited. However if the price of gold falls below the strike of Rs.7000, he lets the option
expire. His losses are limited to the extent of the premium he paid for buying the option.
5.6.2 Payoff for writer of call options: Short call

A call option gives the buyer the right to buy the underlying asset at the strike price specied in the option. For
selling the option, the writer of the option charges a premium. The prot/ loss that the buyer makes on the
option depends on the spot price of the underlying. Whatever is the buyers prot is the sellers loss. If upon
expiration, the spot price exceeds the strike price, the buyer will exercise the option on the writer. Hence as
the spot price increases the writer of the option starts making losses. Higher the spot price, more is the loss
he makes. If upon expiration the spot price of the underlying is less than the strike price, the buyer lets his
option expire un
exercised and the writer gets to keep the premium. Figure 5.6 gives the payoff for the writer of a three
month call option on gold (often referred to as short call) with a strike of Rs.7000 per 10 gms, sold at a
premium of Rs.500.
5.6.3 Payoff for buyer of put options: Long put
A put option gives the buyer the right to sell the underlying asset at the strike price specied in the option. The
prot/ loss that the buyer makes on the option depends on the spot price of the
Figure 5.6 Payoff for writer of call option on gold
The gure shows the prots/ losses for the seller of a threemonth call option on gold with a strike price of
Rs.7000 per 10 gms. As the price of gold in the spot market rises, the call option becomes inthemoney and
the writer starts making losses. If upon expiration, gold price is above the strike of Rs.7000, the buyer would
exercise his option on the writer who would suffer a loss to the extent of the difference between the spot
goldclose and the strike price. The loss that can be incurred by the writer of the option is potentially
unlimited, whereas the maximum prot is limited to the extent of the upfront option premium of Rs.500
charged by him.
underlying. If upon expiration, the spot price is below the strike price, he makes a prot. Lower the spot price,
more is the prot he makes. If the spot price of the underlying is higher than the strike price, he lets his option
expire unexercised. His loss in this case is the premium he paid for buying the option. Figure 5.7 gives the
payoff for the buyer of a three month put option on cotton (often referred to as long put) with a strike of
Rs.6000 per Quintal, bought at a premium of Rs.400.
5.6.4 Payoff for writer of put options: Short put
A put option gives the buyer the right to sell the underlying asset at the strike price specied in the option. For
selling the option, the writer of the option charges a premium. The prot/ loss that the buyer makes on the
option depends on the spot price of the underlying. Whatever is the buyers prot is the sellers loss. If upon
expiration, the spot price happens to be below the strike price, the buyer will exercise the option on the
writer. If upon expiration the spot price of the underlying is more than the strike price, the buyer lets his
option expire unexercised and the writer gets to keep the premium. Figure 5.8 gives the payoff for the writer
of a three month put option on long staple cotton (often referred to as short put) with a strike of Rs.6000 per
Quintal,
Figure 5.7 Payoff for buyer of put option on long staple cotton
The gure shows the prots/ losses for the buyer of a threemonth put option on long staple cotton. As can be
seen, as the price of cotton in the spot market falls, the put option becomes inthemoney. If at expiration,
cotton prices fall below the strike of Rs.6000 per Quintal, the buyer would exercise his option and prot to the
extent of the difference between the strike price and spot cottonclose. The prots possible on this option can
be as high as the strike price. However if spot price of cotton on the day of expiration of the contract is above
the strike of Rs.6000, he lets the option expire. His losses are limited to the extent of the premium he paid for
buying the option, Rs.400 in this case.
Sold at a premium of Rs.400.

5.7 Using futures versus using options
An interesting question to ask at this stage is - when would one use options instead of futures? Options are
different from futures in several interesting senses. At a practical level, the option buyer faces an interesting
situation. He pays for the option in full at the time it is purchased. After this, he only has an upside. There is no
possibility of the options position generating any further losses to him (other than the funds already paid for
the option). This is different from futures, which is free to enter into, but can generate very large losses. This
characteristic makes options attractive to many occasional market participants, who cannot put in the time
to closely monitor their futures positions.
More generally, options offer nonlinearpayoffswhereas futures only have linearpayoffs. By combining futures
and options, a wide variety of innovative and useful payoff structures can
Figure 5.8 Payoff for writer of put option on long staple cotton
The gure shows the prots/ losses for the seller of a threemonth put option on long staple cotton. As the price
of cotton in the spot market falls, the put option becomes inthemoney and the writer starts making losses. If
upon expiration, cotton prices fall below the strike of Rs.6000 per Quintal, the buyer would exercise his
option on the writer who would suffer a loss to the extent of the difference between the strike price and spot
cottonclose. The prot that can be made by the writer of the option is limited to extent of the premium
received by him, i.e. Rs.400, whereas the losses are unlimited (actually they are limited to the strike price
since the worst that can happen is that the price of the underlying asset falls to zero.
Table 5.2 Distinction between futures and options

Futures Options
Exchange traded, with novation
Exchange denes the product Same as futures. Same as futures
Price is zero, strike price moves Strike price is xed, price moves.
Price is zero Linear payoff Price is always positive
Both long and short at risk Nonlinear payoff. Only short at risk.
Solved Problems
Q: Which of the following cannot be an underlying asset for a nancial derivative contract?
1. Equity index 3. Interest rate
2. Commodities 4. Foreign exchange
A: The correct answer is 2
Q: Which of the following cannot be an underlying asset for a commodity derivative contract?
1. Wheat 3. Cotton
2. Gold 4. Stocks
A: The correct answer is 4
Q: Which of the following exchanges was the rst to start trading commodity futures?
1. Chicago Board of Trade 3. Chicago Board Options Exchange
2. Chicago Mercantile Exchange 4. London International Financial Futures and Options Exchange
A: The correct answer is 3.
Q: In an options contract, the option lies with the
1. Buyer 3. Both
2. Seller 4. Exchange
A: The option to exercise lies with the buyer. The correct answer is number 1.
Q: The potential returns on a futures position are:
Limited 3. a function of the volatility of the index
Unlimited 4. None of the above
Q: Two persons agree to exchange 100 gms of gold three months later at Rs.400/ gm. This is an example of a
1. Futures contract 3. Spot contract
2. Forward contract 4. None of the above
Q: Typically option premium is
1. Less than the sum of intrinsic value and time value
2. Greater than the sum of intrinsic value and time value
3. Equal to the sum of intrinsic value and time value 4. Independent of intrinsic value and time value
Q: An asset currently sells at 120. The put option to sell the asset at Rs. 134 costs Rs. 18. The time value of the
option is
1. Rs. 18 3. Rs. 14
2. Rs. 4 4. Rs. 12 A: The correct answer is number 2.
Q: Two persons agree to exchange 100 gms of gold three months later at Rs.400/ gm. This is an example of a
1. OTC contract 3.pot contract
2. Exchange traded contract 4. None of the above A: The correct answer is number 1.
Q: Unit of trading for soy bean futures is 10 Quintals, and delivery unit is 100 Quintals. A trader buys futures
on 10 units of soy bean at Rs. 1500/Quintal. A week later soy bean futures trade at Rs. 1550/Quintal. How
much prot/loss has he made on his position?
1. (+) 5000 3. (+) 50,000

2. (-)5000 4. (-) 50,000
A: Each unit is for 10 Quintals. He buys 10 units which means a futures position 100 Quintals. He makes
A prot of Rs.50/Quintal. i.e. he makes a prot of Rs.5000. The correct answer is number 1.
Q: Unit of trading for soy bean futures is 10 Quintals, and delivery unit is 100 Quintals. A trader buys futures
1. (+) 5000 3. (+) 50,000
2. (-)5000 4. (-) 50,000
A: Each unit is for 10 Quintals. He buys 10 units which means a futures position in 100 Quintals. He
Makes a loss of Rs.50/Quintal. i.e. he makes a loss of Rs.5000. The correct answer is number 2.
Q: Unit of trading for soy bean futures is 10 Quintals, and delivery unit is 100 Quintals. A trader sells futures
1. (+) 5000 3. (+) 50,000
2. (-)5000 4. (-) 50,000
A: Each unit is for 10 Quintals. He buys 10 units which means a futures position in 100 Quintals. He
makes a loss of Rs.50/Quintal. i.e. he makes a loss of Rs.5000. The correct answer is number 2.
Q: Unit of trading for soy bean futures is 10 Quintals, and delivery unit is 100 Quintals. A trader sells futures
1. (+) 5000 3. (+) 50,000
2. (-)5000 4. (-) 50,000
A: Each unit is for 10 Quintals. He sells 10 units which means a futures position in 100 Quintals. He
makes a prot of Rs.50/Quintal. i.e. he makes a prot of Rs.5000. The correct answer is number 1.
Q: A trader buys threemonth call options on 10 units of gold with a strike of Rs.7000/10 gms at a premium of
Rs.70. Unit of trading is 100 gms. On the day of expiration, the spot price of gold is Rs.7080/10 gms. What is
his net payoff?
1. (+) 10,000 3. (-) 10,000
2. (+) 1,000 4. (-) 1,000
A: Per 10 gms he makes a net prot of Rs.10, i.e.[(7080 - 7000) - 70]. He has a long position in 1000
gms.So he makes a net profit of Rs. 1000 on his position (1000 / 10 x10). The correct answer is number 2.
Q: A trader buys threemonth call options on 10 units of gold with a strike of Rs.7000/10 gms at a premium of
Rs.70. Unit of trading is 100 gms. On the day of expiration, the spot price of gold is Rs.6080/10 gms. What is
his net payoff?
1. (-)7000 3. (-)700
2. (+)1,000 4. (-) 1,000
A: The option is OTM. Unit of trading is 100 gms and he has bought 10 units. So he has a position in 1000 gms
of gold. He pays an option premium of Rs.70 per 10 gms. He losses the premium amount of
Rs.7000 on his position. The correct answer is number 1.
Q: A trader sells threemonth call options on 10 units of gold with a strike of Rs.7000 per 10 gms at a premium
of Rs.70. Unit of trading is 100 gms. On the day of expiration, the spot price of gold is Rs.7080/10 gms. What
is his net payoff?
1. (+)10,000 3. (-)10,000
2. (+)1,000 4. (-)1,000
A: On the day of expiration, the option is ITM so the buyer exercises on him. The buyers prot is the sellers
loss. Per 10 gms he makes a net loss of Rs.10, i.e. [(7080 - 7000) - 70]. He has a short position in
Q: A trader sells threemonth call options on 10 units of gold with a strike of Rs.7000 per 10 gms at a premium
of Rs.70. Unit of trading is 100 gms. On the day of expiration, the spot price of gold is Rs.6080/10 gms. What
is his net payoff
1. (-)7000 3. (-)700
2. (+)1,000 4. (-) 1,000
A: The option is OTM. The buyer does not exercise so the seller gets to keep the premium. Unit of trading is
100 gms and he has sold 10 units. So he has a position in 1000 gms of gold. He recieves an option premium of
Rs.70 per 10 gms. He earns the premium amount of Rs.7000 on his position. The correctanswer is number 1.
Chapter 6
Pricing commodity futures
Commodity futures began trading on the NCDEX from the 14th December 2003. The market is still in its
nascent phase, however the volumes and open interest on the various contracts trading in this market have
been steadily growing.
The process of arriving at a gure at which a person buys and another sells a futures contract for a specic
expiration date is called price discovery. In an active futures market, the process of price discovery continues
from the markets opening until its close. The prices are freely and competitively derived. Future prices are
therefore considered to be superior to the administered prices or the prices that are determined privately.
Further, the low transaction costs and frequent trading encourages wide participation in futures markets
lessening the opportunity for control by a few buyers and sellers.
In an active futures markets the free ow of information is vital. Futures exchanges act as a focal point for the
collection and dissemination of statistics on supplies, transportation, storage, purchases, exports, imports,
currency values, interest rates and other pertinent information. Any signicant change in this data is
immediately reacted in the trading pits as traders digest the new information and adjust their bids and offers
accordingly. As a result of this free ow of information, the market determines the best estimate of today and
tomorrows prices and it is considered to be the accurate reaction of the supply and demand for the
underlying commodity. Price discovery facilitates this free ow of information, which is vital to the effective
functioning of futures market.
In this chapter we try to understand the pricing of commodity futures contracts and look at how the futures
price is related to the spot price of the underlying asset. We study the cost of carry model to understand the
dynamics of pricing that constitute the estimation of fair value of futures.
6.1 Investment assets versus consumption assets
When studying futures contracts, it is essential to distinguish between investment assets and consumption
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 alsoexamples of investment assets. Note
however that investment assets do not always have to be held exclusively for investment. As we saw earlier,
silver, for example, has a number of industrial uses. 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. 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.
As we will learn, we can use arbitrage arguments to determine the futures prices of an investment asset from
its spot price and other observable market variables. For pricing consumption assets, we need to review the
arbitrage arguments a little differently. To begin with, we look at the costofcarry model and try to understand
the pricing of futures contracts on investment assets.
6.2 The cost of carry model
We use arbitrage arguments to arrive at the fair value of futures. For pricing purposes, we treat the forward
and the futures market as one and the same. A futures contract is nothing but a forward contract that is
exchange traded and that is settled at the end of each day. The buyer who needs an asset in the future has the
choice between buying the underlying asset today in the spot market and holding it, or buying it in the
forward market. If he buys it in the spot market today, it involves opportunity costs. He incurs the cash outlay
for buying the asset and he also incurs costs for storing it. If instead he buys the asset in the forward market,
he does not incur an initial outlay. However the costs of holding the asset are now incurred by the seller of the
forward contract who charges the buyer a price that is higher than the price of the asset in the spot market.
This forms the basis for the cost of carry model where the price of the futures contract is dened as:
MATTER
Chapter 7
Using commodity futures
For a market to succeed, it must have all three kinds of participants hedgers, speculators and arbitragers. The
conuence of these participants ensures liquidity and efcient price discovery on the market. Commodity
markets give opportunity for all three kinds of participants. In this chapter we look at the use of commodity
derivatives for hedging, speculation and arbitrage.
7.1 Hedging
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 wheat or oil or any other commodity that
the person deals in. The classic hedging example is that of wheat farmer who wants to hedge the risk of
uctuations 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 nancial 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 nancial
institutions, trading companies and even other participants in the value chain, for instance farmers,
extractors, ginners, processors etc., who are inuenced by the commodity prices.
7.1.1 Basic principles of hedging
When an individual or a company decides to use the futures markets to hedge a risk, the objective is to take a
position that neutralises the risk as much as possible. Take the case of a company that knows that it will gain
Rs.1,00,000 for each 1 rupee increase in the price of a commodity over the next three months and will lose
Rs. 1,00,000 for each 1 rupee decrease in the price of a commodity over the same period. To hedge, the
company should take a short futures position that is designed to offset this risk. The futures position should
lead to a loss of Rs.1,00,000 for each 1 rupee increase in the price of the commodity over the next three
months and a gain of Rs. 1,00,000 for each 1 rupee decrease in the price during this period. If the price of the
commodity goes down, the gain on the futures position offsets the loss on the commodity. If
Figure 7.1 Payoff for buyer of a short hedge

The gure shows the payoff for a soy oil producer who takes a short hedge. Irrespective of what the spot price
of soy oil is three months later, by going in for a short hedge he locks on to a price of Rs.450 per MT.
the price of the commodity goes up, the loss on the futures position is offset by the gain on the commodity.
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. 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. We will study these two hedges in detail.
7.1.2 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. For example, a short hedge could be used by a cotton farmer who expects the
cotton crop to be ready for sale in the next two months. A short hedge can also be used when the asset is not
owned at the moment but is likely to be owned in the future. For example, an exporter who knows that he or
she will receive a dollar payment three months later. He makes a gain if the dollar increases in value relative to
the rupee and makes a loss if the dollar decreases in value relative to the rupee. A short futures position will
give him the hedge he desires.
Let a look at a more detailed example to illustrate a short hedge. We assume that today is the
Table 7.1 Rened soy oil futures contract specication
Trading system
Trading hours NCDEX trading system
Monday to Friday
Normal market hours 10:00 am to 4:00 pm
Closing session 4:15 pm to 4:30 pm 1000
Unit of trading Delivery Kgs (=1 MT)
unit Quotation/ base 10000 Kgs (=10 MT)
value Tick size Rs. per 10 Kg
5 paisas
15th of January and that a rened soy oil producer has just negotiated a contract to sell 10,000 Kgs of soy oil. It
has been agreed that the price that will apply in the contract is the market price on the 15th April. The oil
producer is therefore in a position where he will gain Rs.10000 for each 1 rupee increase in the price of oil
over the next three months and lose Rs.10000 for each one rupee decrease in the price of oil during this
period. Suppose the spot price for soy oil on January 15 is Rs.450 per 10 Kgs and the April soy oil futures price
on the NCDEX is Rs.465 per 10 Kgs. Table 7.1 gives the soy oil futures contract specication. The producer
can hedge his exposure by selling 10,000 Kgs worth of April futures contracts(10 units). If the oil producers
closes his position on April 15, the effect of the strategy would be to lock in a price close to Rs.465 per 10 Kgs.
Figure 7.1 gives the payoff for a short hedge. Let us look at how this works. On April 15, the spot price can
either be above Rs.465 or below Rs.465.
1.) Case 1: The spot price is Rs.455 per 10 Kgs. The company realises Rs.4,55,000 under its sales contract.
Because April is the delivery month for the futures contract, the futures price on April 15 should be very
close to the spot price of Rs.455 on that date. The company closes its short futures position at Rs.455, making
a gain of Rs.465 - Rs.455 = Rs.10 per 10 Kgs, or Rs.10,000 on its short futures position. The total amount
realised from both the futures position and the sales contract is therefore about Rs.465 per 10 Kgs,
Rs.4,65,000 in total.
2.) Case 2: The spot price is Rs.475 per 10 Kgs. The company realises Rs.4,75,000 under its sales contract.
Because April is the delivery month for the futures contract, the futures price on April 15 should be very
close to the spot price of Rs.475 on that date. The company closes its short futures position at Rs.475, making
a loss of Rs.475 - Rs.465 = Rs.10 per 10 Kgs, or Rs.10,000 on its short futures position. The total amount
realised from both the futures position and the sales contract is therefore about Rs.465 per 10 Kgs,
Rs.4,65,000 in total.
7.1.3 Long hedge
Hedges that involve taking a long position in a futures contract are known as long hedges. 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.
Suppose that it is now January 15. A rm involved in industrial fabrication knows that it will require 300 kgs of
silver on April 15 to meet a certain contract. The spot price of silver is Rs. 1680
Figure 7.2 Payoff for buyer of a long hedge
The gure shows the payoff for an industrial fabricator who takes a long hedge. Irrespective of what the spot
price of silver is three months later, by going in for a long hedge he locks on to a price of Rs.1730 per kg.
Table 7.2 Silver futures contract specication

Trading system NCDEX trading system
Trading hours Monday to Friday
Normal market hours 10:00 am to 4:00 pm Closing session4:15 pm to 4:30
pm
Unit of trading 5 Kgs
Delivery unit 30 Kgs
Quotation/ base value Rs. per kg of Silver with peness
Tick size 5 paisa
per kg and the April silver futures price is Rs. 1730. Table 7.2 gives the contract specication for silver. A unit of
trading is 5 Kgs. The fabricator can hedge his position by taking a long position in sixty units of futures on the
NCDEX. If the fabricator closes his position on April 15, the effect of the strategy would be to lock in a price
close to Rs. 1730 per kg. Figure 7.2 gives the payoff for the buyer of a long hedge. Let us look at how this
works. On April 15, the spot price can either be above Rs.1730 or below Rs.1730.
1. Case 1: The spot price is Rs.1780 per kg. The fabricator pays Rs.5,34,000 to buy the silver from the spot
market. Because April is the delivery month for the futures contract, the futures price on April 15 should be
very close to the spot price of Rs. 1780 on that date. The company closes its longfutures position at Rs.1780,
making a gain of Rs.1780 - Rs.1730 = Rs.50 per kg, or Rs.15,000 on its long futures position. The effective
cost of silver purchased works out to be about Rs. 1730 per MT, or Rs.5,19,000 in total.
2. Case 2: The spot price is Rs. 1690 per MT. The fabricator pays Rs.5,07,000 to buy the silver from the spot
market. Because April is the delivery month for the futures contract, the futures price on April 15 should be
very close to the spot price of Rs.1690 on that date. The company closes its long futures position at Rs.1690,
making a loss of Rs.1730 - Rs.1690 = Rs.40 per kg, or Rs.12,000 on its long futures position. The effective
cost of silver purchased works out to be about Rs. 1730 per MT, or Rs.5,19,000 in total.
Note that the purpose of hedging is not to make prots, but to lock on to a price to be paid in the future
upfront. In the industrial fabricator example, since prices of silver rose in three months, on hind sight it would
seem that the company would have been better off buying the silver in January and holding it. But this would
involve incurring interest cost and warehousing costs. Besides, if the prices of silver fell in April, the company
would have not only incurred interest and storage costs, but would also have ended up buying silver at a
much higher price.
In the examples above we assume that the futures position is closed out in the delivery month. The hedge has
the same basic effect if delivery is allowed to happen. However, making or taking delivery can be a costly
process. In most cases, delivery is not made even when the hedger keeps the futures contract until the
delivery month. Hedgers with long positions usually avoid any possibility of having to take delivery by closing
out their positions before the delivery period.
7.1.4 Hedge ratio
Hedge ratio is the ratio of the size of position taken in the futures contracts to the size of the exposure in the
underlying asset. So far in the examples we used, we assumed that the hedger would take exactly the same
amount of exposure in the futures contract as in the underlying asset. For example, if the hedgers exposure
in the underlying was to the extent of 11 bales of cotton, the futures contracts entered into were exactly for
this amount of cotton. We were assuming here that the optimal hedge ratio is one. In situations where the
underlying asset in which the hedger has an exposure is exactly the same as the asset underlying the futures
contract he uses, and the spot and futures market are perfectly correlated, a hedge ratio of one could be
assumed. In all other cases, a hedge ratio of one may not be optimal. Equation 7.1 gives the optimal hedge
ratio, one that minimizes the variance of the hedgers position.
MATTER
1. Hedging stretches the marketing period. For example, a livestock feeder does not have to wait until his
cattle are ready to market before he can sell them. The futures market permits him to sell futures contracts
to establish the approximate sale price at any time between the time he buys his calves for feeding and the
time the fed cattle are ready to market, some four to six months later. He can take advantage of good prices
even though the cattle are not ready for market.
Hedging protects inventory values. For example, a merchandiser with a large, unsold inventory can sell
futures contracts that will protect the value of the inventory, even if the price of the commodity drops.
Hedging permits forward pricing of products. For example, a jewelry manufacturer can determine the cost
for gold, silver or platinum by buying a futures contract, translate that to a price for the nished products, and
make forward sales to stores at rm prices. Having made the forward sales, the manufacturer can use his
capital to acquire only as much gold, silver, or platinum as may be needed to make the products that will llits
orders.
7.1.6 Limitation of hedging: basis Risk
In the examples we used above, the hedges considered were perfect. The hedger was able to identify the
precise date in the future when an asset would be bought or sold. The hedger was then able to use the
futures contract to remove almost all the risk arising out of price of the asset on that date. In reality, hedging is
not quite this simple and straightforward. Hedging can only minimise the risk but cannot fully eliminate it.
The loss made during selling of an asset may not always be equal to the prots made by taking a short futures
position. This is because the value of the asset sold in the spot market and the value of the asset underlying
the future contract may not be the same. This is called the basis risk. In our examples, the hedger was able to
identify the precise date in the future when an asset would be bought or sold. The hedger was then able to
use the perfect futures contract to remove almost all the risk arising out of price of the asset on that date. In
reality, this may not always be possible for a various reasons.
4The asset whose price is to be hedged may not be exactly the same as the asset underlying the futures
contract. For example, in India we have a large number of varieties of cotton being cultivated. It is impractical
for an exchange to have futures contracts with all these varieties of cotton as an underlying. The NCDEX has
futures contracts on two varieties of cotton, long staple cotton and medium staple cotton. If a hedger has an
underlying asset that is exactly the same as the one that underlies the futures contract, he would get a better
hedge. But in many cases, farmers producing small staple cotton could use the futures contract on medium
staple cotton for hedging. While this would still provide the farmer with a hedge, since the price of the
farmers cotton and the price of the cotton underlying the futures contract do match perfectly, the hedge
would not be perfect.
4The hedger may be uncertain as to the exact date when the asset will be bought or sold. Often the hedge
may require the futures contract to be closed out well before its expiration date. This could result in an
imperfect hedge.
4The expiration date of the hedge may be later than the delivery date of the futures contract. When this
happens, the hedger would be required to close out the futures contracts entered into and take the same
position in futures contracts with a later delivery date. This is called a rollover. Hedges can be rolled forward
many times. However, multiple rollovers could lead to shortterm cash ow problems.
94 Using commodity futures

Table 7.3 Gold futures contract specication
Unit of trading Closing session 4:15 pm to 4:30 pm 100gm
Delivery unit 1kg
Quotation/ base value Rs.per 10 gms of gold with 999 neness
Tick size 5 paisa
7.2 Speculation
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 nancial 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 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).
We look here at how the commodity futures markets can be used for speculation.
7.2.1 Speculation: Bullish commodity, buy futures
Take the case of a speculator who has a view on the direction of the price movements of gold. Perhaps he
knows that towards the end of the year due to festivals and the upcoming wedding season, the prices of gold
are likely to rise. He would like to trade based on this view. Gold trades for Rs.6000 per 10 gms in the spot
market and he expects its price to go up in the next twothree months. How can he trade based on this belief?
In the absence of a deferral product, he would have to buy gold and hold on to it. Suppose he buys a 1 kg of
gold which costs him Rs.6,00,000. Suppose further that his hunch proves correct and three months later gold
trades at Rs.6400 per 10 grms. He makes a prot of Rs.40,000 on an investment of Rs.6,00,000 for a period of
three months. This works out to an annual return of about 26 percent.
Today a speculator can take exactly the same position on gold by using gold futures contracts. Let us see how
this works. Gold trades at Rs.6000 per 10 gms and threemonth gold futures trades at Rs.6150. Table 7.3 gives
the contract specications for gold futures. The unit of tradingis 100 gms and the delivery unit for the gold
futures contract on the NCDEX is 1 kg. He buys one kg of gold futures which have a value of Rs.6, 15,000.
Buying an asset in the futures market only require making margin payments. To take this position, he pays a
margin of Rs.1,20,000. Three months later gold trades at Rs.6400 per 10 gms. As we know, on the day of
expiration, the futures price converges to the spot price (else there would be a riskfree arbitrage
opportunity). He closes his long futures position at Rs.6400 in the process making a prot of Rs.25,000 on an
initial margin investment of Rs. 1,20,000. This works out to an annual return of 83 percent. Because of the
leverage they provide, commodity futures form an attractive tool for speculators.
7.2.2 Speculation: Bearish commodity, sell futures
Commodity futures can also be used by a speculator who believes that there is likely to be excess supply of a
particular commodity in the near future and hence the prices are likely to see a fall. How can he trade based
on this opinion? In the absence of a deferral product, there wasnt much he could do to prot from his opinion.
Today all he needs to do is sell commodity futures.
Let us understand how this works. Simple arbitrage ensures that the price of a futures contract on a
commodity moves correspondingly with the price of the underlying commodity. If the commodity price
rises, so will the futures price. If the commodity price falls, so will the futures price. Now take the case of the
trader who expects to see a fall in the price of cotton. He sells ten twomonth cotton futures contract which is
for delivery of 550 bales of cotton. The value of the contract is Rs.4,00,000. He pays a small margin on the
same. Three months later, if his hunch were correct the price of cotton falls. So does the price of cotton
futures. He close out his short futures position at Rs.3,50,000, making a prot of Rs.50,000.
7.3 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, involves the
simultaneous purchase and sale of the same or essentially similar security in two different markets for
advantageously different prices. The buying cheap and selling expensive continues till prices in the two
markets reach an equilibrium. Hence, arbitrage helps to equalise prices and restore market efciency.
F F (S+U)U V M (7.8)
where:
R Cost of nancing (annualised) T
Time till expiration
U Present value of all storage costs
In the chapter on pricing, we discussed that the costofcarry ensures that futures prices stay in tune with the
spot prices of the underlying assets. Equation 7.8 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 prot from the arbitrage.
7.3.1 Overpriced commodity futures: buy spot, sell futures

An arbitrager notices that gold futures seem overpriced. How can he cash in on this opportunity to earn
riskless prots? Say for instance, gold trades for Rs.600 per gram in the spot market. Three month gold futures
on the NCDEX trade at Rs.625 and seem overpriced. He could make riskless prot by entering into the
following set of transactions.
1.) On day one, borrow Rs.60,07,460 at 6% per annum to cover the cost of buying and holding gold. Buy 10
kgs of gold on the cash/ spot market at Rs.60,00,000. Pay (310 + 7150) as warehouse costs. (We assume that
xed charge is Rs.310 per deposit upto 500 kgs. and the variable storage costs are Rs.55 per kg per week for
13 weeks).
2.) Simultaneously, sell 10 gold futures contract at Rs.62,50,000.
3.) Take delivery of the gold purchased and hold it for three months.
4.) On the futures expiration date, the spot and the futures price converge. Now unwind the position.
5.) Say gold closes at Rs.615 in the spot market. Sell the gold for Rs.61,50,000.
6.) Futures position expires with prot of Rs. 1,00,000.
7.) From the Rs.62,50,000 held in hand, return the borrowed amount plus interest of Rs.60,98,25 1.
8.) The result is a riskless prot of Rs. 1,51,749.
When does it make sense to enter into this arbitrage? If the cost of borrowing funds to buy the commodity is
less than the arbitrage prot possible, it makes sense to arbitrage. This is termed as cashandcarry arbitrage.
Remember however, that exploiting an arbitrage opportunity involves trading on the spot and futures
market. In the real world, one has to build in the transactions costs into the arbitrage strategy.
7.3.2 Underpriced commodity futures: buy futures, sell spot
An arbitrager notices that gold futures seem underpriced. How can he cash in on this opportunity to earn
riskless prots? Say for instance, gold trades for Rs.600 per gram in the spot market. Three month gold futures
on the NCDEX trade at Rs.605 and seem underpriced. If he happens to hold gold, he could make riskless
prot by entering into the following set of transactions.
1.) On day one, sell 10 kgs of gold in the spot market at Rs.60,00,000.
2.) Invest the Rs.60,00,000 plus the Rs.7 150 saved by way of warehouse costs for three months 6%.
3.) Simultaneously, buy threemonth gold futures on NCDEX at Rs.60,50,000.
4.) Suppose the price of gold is Rs.6 15 per gram. On the futures expiration date, the spot and the futures
5.) price of gold converge. Now unwind the position.
6.) The gold sales proceeds grow to Rs.60,97,936.
7.) The futures position expires with a prot of Rs. 1,00,000.
8.) Buy back gold at Rs.61,50,000 on the spot market.
9.) The result is a riskless prot of Rs.47,936.
If the returns you get by investing in riskless instruments is more than the return from the arbitrage trades, it
makes sense for you to arbitrage. This is termed as reversecashandcarry arbitrage. It is this arbitrage activity
that ensures that the spot and futures prices stay in line with the costofcarry. As we can see, exploiting
arbitrage involves trading on the spot market. As more and more players in the market develop the
knowledge and skills to do cashandcarry and reverse cashandcarry, we will see increased volumes and lower
spreads in both the cash as well as the derivatives market.
Solved problems
Q: A speculator thinks that the price of mustard seed will rise. He should
1. buy mustard seed futures 3. sell mustard seed futures
2. sell mustard seed 4. sell index futures
Q: A speculator thinks that the price of silver will fall. He should
1. buy silver futures 3. sell silver futures
2. buy silver 4. sell index futures
Q: A long hedge should be taken by a person who
1. Wants to buy the underlying asset in the future. 3. Expects to own the underlying asset in the future
2. Sell the underlying asset in the future 4. None of the above
Q: A short hedge should be taken by a person who
1. Wants to buy the underlying asset in the future. 3. Wants to sell the underlying asset today
2. Wants to sell the underlying asset in the future. 4. None of the above
Q: A farmer who has just sown wheat can hedge his position by
1. buying wheat futures 3. buying index futures
2. selling wheat futures 4. selling the wheat
Q: On the 15th of January a rened soy oil producer has negotiated a contract to sell 10,000 Kgs of soy oil. It
has been agreed that the price that will apply in the contract is the market price on the 15th April. The spot
price for soy oil on January 15 is Rs.450 per 10 Kgs and the April soy oil futures price on the NCDEX is Rs.465
per 10 Kgs. Unit of trading in soy oil futures is 1000 Kgs (=1 MT) and the delivery unit is 10000 Kgs (=10
MT). The producer can hedge his exposure by
1. Selling 10 units of April futures. 3. Selling 100 units of April futures.

2. Buying 10 units of April futures. 4. Buying 100 units of April futures.
A: The producer needs to take a short hedge to the extent of 10,000 Kgs of soy oil. One trading unit is for
1000 Kgs of soy oil. He gets the hedge by selling 10 units of April futures. The correct answer is number 1.
Q: On the 15th of January a rm involved in industrial fabrication knows that it will require 300 kgs of silver on
April 15 to meet a certain contract. The spot price of silver is Rs. 1680 per kg and the April silver futures price
is Rs. 1730. A unit of trading is 5 Kgs and the delivery unit is 30 Kgs. The fabricator can hedge his position by
Selling 60 units of April silver futures. 3. Buying 30 units of April silver futures.
Buying 60 units of April silver futures. 4. Selling 30 units of April silver futures.
A: The fabricator needs to take a long hedge to the extent of 300 kgs of silver. One trading unit is for 5 Kgs of
silver. He gets the hedge by selling 60 units of April silver futures. The correct answer is number 2.
Q: A company knows that it will require 33,000 bales of cotton in three months. The hedge ratio works out
to be 0.85. The unit of trading is 11 bales and the delivery unit for cotton on the NCDEX is 55 bales. The
company can obtain a hedge by
1. Buying 2550 units of three month cotton futures.
2. Selling 2550 units of three month cotton futures.
3. Buying 2550 units of three month cotton fu-tures.
4. Selling 600 units of three month cotton fu-tures.
A: One trading unit is for 11 bales of cotton. The hedge ratio is 0.85. The company obtains a hedge by” B''
MATTER
Chapter 8
Trading
In this chapter we shall take a brief look at the trading system for futures on NCDEX. However, the best way
to get a feel of the trading system is to actually watch the screen and observe how it operates.
8.1 Futures trading system
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 on 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. All quantity elds are in units and price in
rupees. The exchange species the unit of trading and the delivery unit for futures contracts on various
commodities. The exchange noties 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 nd a match on the
other side of the book. If it nds a match, a trade is generated. If it does not nd a match, the order becomes
passive and gets queued in the respective outstanding order book in the system. Time stamping is done for
each trade and provides the possibility for a complete audit trail if required.
8.2 Entities in the trading system
There are two entities in the trading system of NCDEX trading cum clearing members and professional
clearing members.
1. Trading cum clearing members (TCMs): Trading cum clearing members are members of NCDEX. They
can trade and clear either on their own account or on behalf of their clients including participants. The
exchange assigns an ID to each TCM. Each TCM can have more than one user. The number of users allowed
for each trading member is notied by the exchange from time to time.
While most exchanges the world over are moving towards the electronic form of trading, some still follow
the open outcry method. Open outcry trading is a facetoface and highly activate form of trading used on the
oors of the exchanges. In open outcry system the futures contracts are traded in pits. A pit is a raised platform
in octagonal shape with descending steps on the inside that permit buyers and sellers to see each other.
Normally only one type of contract is traded in each pit like a Eurodollar pit, Live Cattle pit etc. Each side of
the octagon forms a pie slice in the pit. All the traders dealing with a certain delivery month trade in the same
slice. The brokers, who work for institutions or the general public stand on the edges of the pit so that they
can easily see other traders and have easy access to their runners who bring orders.
The trading process consists of an auction in which all bids and offers on each of the contracts are made
known to the public and everyone can see the markets best price. To place an order under this method, the
customer calls a broker, who time-stamps the order and prepares an ofce order ticket. The broker then
sends the order to a booth on the exchange oor called brokers oor booth. There, a oor order ticket is
prepared, and a clerk hand delivers the order to the oor trader for execution. In some cases, the oor clerk
may use hand signals to convey the order to oor traders. Large orders typically go directly from the customer
to the brokers oor booth. The oor trader, standing in a central location i.e. trading pit, negotiates a price by
shouting out the order to other oor traders, who bid on the order using hand signals. Once lled, the order is
recorded manually by both parties in the trade. At the end of each day, the clearing house settles trades by
ensuring that no discrepancy exists in the matchedtrade information.
Box 8.10: The open outcry system of trading
Each user of a TCM must be registered with the exchange and is assigned an unique user ID. The unique
TCM ID functions as a reference for all orders/ trades of different users. This ID is common for all users of a
particular TCM. It is the responsibility of the TCM to maintain adequate control over persons having access
to the rm s User IDs.
2. Professional clearing members: Professional clearing members are members of NSCCL. The PCM
membership entitles the members to clear trades executed through Trading cum Clearing Members
(TCMs), both for themselves and/ or on behalf of their clients. They carry out risk management activities and
conrmation/ inquiry of trades through the trading system.
8.2.1 Guidelines for allotment of client code
The trading members are recommended to follow guidelines outlined by the exchange for allotment and use
of client codes at the time of order entry on the futures trading system:
1.) All clients trading through a member are to be registered clients at the members back ofce.
2.) A unique client code is to be allotted for each client. The client code should be alphanumeric and no
special characters can be used.
3.) The same client should not be allotted multiple codes.
8.3 Contract specications for commodity futures 103

Table 8.1 Commodity futures contract and their symbols
1. Pure Gold Mumbai GLDPURMUM
2. Pure Silver New Delhi SLVPURDEL
3. Soybean Indore SYBEANIDR
4. Rened Soya Oil Indore SYOREFIDR
5. Rapeseed Mustard Seed Jaipur RMSEEDJPR
6. Expeller Rapeseed Mustard Oil Jaipur RMOEXPJPR
7. RBD Palm Olein Kakinada RBDPLNKAK
8. Crude Palm Oil Kandla CRDPOLKDL
9. J34 Medium Staple Cotton Bhatinda COTJ34BTD
10. S06 L S Cotton Ahmedabad COTS06ABD
8.3 Contract specications for commodity futures

NCDEX plans to trade in all the major commodities approved by FMC (Forwards Market Commission) but
in a phased manner. In the rst phase, under the category of bullion, it has already started trading in gold and
silver, and in agri commodities, trading has commenced in cotton (long and medium staple), soybean, soya
oil, rape/ mustardseed, rape/ mustard oil, crude palm oil and RBD palmolein.
In the second phase NCDEX plans to offer the following commodities for trading rice, wheat, coffee, tea.
edible oil products like groundnut, sunower, castor (seed, oil and cake), base metals (aluminium, copper, zinc
and nickel) and commodity indices like agri commodity index and metal commodity index.
Table 8.1 gives the list and symbols of underlying commodities on which futures contracts are available. Table
8.2 and Table 8.3 give the futures contract specications for gold and long staple cotton.
8.4 Commodity futures trading cycle
NCDEX trades commodity futures contracts having onemonth, twomonth and threemonth expiry cycles.
All contracts expire on the 20th of the expiry month. Thus a January expiration contract would expire on the
20th of January and a February expiry contract would cease trading on the 20th of February. If the 20th of the
expiry month is a trading holiday, the contracts shall expire on the previous trading day. New contracts will
be introduced on the trading day following the expiry of the near month contract. Figure 8.1 shows the
contract cycle for futures contracts on NCDEX.
Table 8.2 Gold futures contract specication
Closing session 4:15 pm to 4:30 pm 100 gms
Unit of trading Delivery 1 Kg
unit Quotation/ base value Rs. per 10 gms of Gold with 999.9
neness (called Pure Goldin trade circles) 5 paisa
Tick size Limit 10%. Limits will not apply if the limit is reached
Price band during nal 30 minutes of trading. Not less than 995
neness bearing a serial number
Quality specication and identifying stamp of a rener approved by NCDEX.
List of approved reners will be available with the
exchange and also on its web site:
www.ncdex.com
Quantity variation None
No. of active contracts At any date, 3 concurrent month contracts will be active.
There will be a total of twelve month contracts in a year.
Delivery center Opening date Mumbai Trading in any contract month will open on the 21st day of the
month, 3 months prior to the contract month i.e. January 2004
contract pens on 21st October 2003. 20th day of the delivery month, if 20th
happens to be a holiday then previous working day.
Due date Memberwise: Max (Rs.200 crore, 15% of open interest) Clientwise:
Max
Position limits (Rs. 100 crore, 10% of Open interest) The discount will be given for
the Premium/ Discount neness below 999.9. The settlement price for less than 999.9 neness
will be calculated as: (Actual neness/ 999.9) * Settlement price
8.5 Order types and trading parameters

An electronic trading system allows the trading members to enter orders with various conditions attached to
theas per their requirements. These conditions are broadly divided into the
8.5 Order types and trading parameters 107
Table 8.3 Long staple cotton futures contract specication
Closing session 4:15 pm to 4:30 pm 18.7
Unit of trading Quintal (= 11 bales)
Delivery unit 93.5 Quintals (=55 bales)
Quotation/ base value Rs. per Quintal
Tick size 5 paisa
Price band Limit 10%. Limits will not apply if the limit is
reached during nal 30 minutes of trading. Main/
Quality specication Base Variety: Shankar-6
Staple Length: 27-30 mm (Basis: 29 mm)
Micronaire: 3.4-4.5 (Basis: 3.7-4.2)
Strength, Min: 21 G/ Tex
Grade: Good to Fully Good, Fully Good, Fine,
Superne, Extra Superne, (Basis: Fine) Crop:
Current Year Crop in which the delivery date falls
(current year for Shankar-6 is dened as from 1st Nov
of one year to 31st Oct of the subsequent year),
Moisture, % Max: 8.5
No. of active contracts At any date, 3 concurrent month contracts will be active. There will be a total
of twelve month contracts in a year. Ahmedabad
Delivery center Trading in any contract month will open on

Opening date the 21st day of the month, 3 months prior to
the contract month i.e. January 2004
contract opens on 21st October 2003. 20th
day of the delivery month, if 20th happens to
be a holiday then previous working day.
Due Date Member wise: Max (Rs. 40 crore, 15% of open interest)
Position limits Client wise: Max (Rs. 20 crore, 10% of Open interest) Will
Premium/ Discount be given on the basis of Staple Length (at 0.5 mm
intervals) & grade combinations. The exchange will
communicate the premium/ discounts applicable before
the settlement date.
Figure 8.1 Contract cycle
The gure 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 three month contract starts trading from the following day,
once more making available three index futures contracts for trading.
Jan Feb Mar Apr

Time
Jan 20 contract
Feb 20 contract
March 20 contract
April 20 contract
May 20 contract
Jun 20 contract
following categories:
4Time conditions
4Price conditions
4Other conditions
Several combinations of the above are possible thereby providing enormous exibility to users. The order
types and conditions are summarised below. Of these, the order types available on the NCDEX system are
regular lot order, stop loss order, immediate or cancel order, good till day order, good till cancelled order,
good till date order and spread order.
4Time 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. Example: A trader wants to go long on March 1, 2004 in rened palm oil on the commodity exchange.
A day order is placed at Rs.340/ 10 kg. If the market does not reach this price the order does not get lled even
if the market touches Rs.341 and closes. In other words day order is for a specic price and if the order does
not get lled that day, one has to place the order again the next 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 notied by the exchange from time to time after which the order is automatically
cancelled by the system. Each day counted is a calendar day inclusive of holidays. The days counted are
inclusive of the day on which the order is
placed and the order is cancelled from the system at the end of the day of the expiry period. Example: A
trader wants to go long on rened palm oil when the market touches Rs.400/ 10kg. Theoritically, the order
exists until it is lled up, even if it takes months for it to happen. 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. Each day/ date counted are inclusive of the day/
date on which the order is placed and the order is cancelled from the system at the end of the day/ date of the
expiry period.
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. Unlike a ll-or -kill order, an all-or-none order is not cancelled if it is not executed as soon as it is
represented in the exchange. An all-or-none order position can be closed out with another AON order.
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 lled immediately, it gets cancelled.
4Price condition
Limit order: An order to buy or sell a stated amount of a commodity at a specied price, or at a better price, if
obtainable at the time of execution. The disadvantage is that the order may not get lled at all if the price for
that day does not reach the specied price.
Stop loss: A stoploss 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 specied level. Futures traders often use stop orders in an
effort to limit the amount they might lose if the futures price moves against their position. Stop orders are not
executed until the price reaches the specied point. When the price reaches that point the stop order
becomes a market order. Most of the time, stop orders are used to exit a trade. But, stop orders can be
executed for buying/ selling positions too. 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. The order gets lled at the suggested stop
order price or at a better price. Example: A trader has purchased crude oil futures at Rs.750 per barrel. He
wishes to limit his loss to Rs.50 a barrel. A stop order would then be placed to sell an offsetting contract if the
price falls to Rs 700 per barrel. When the market touches this price, stop order gets executed and the trader
would exit the market. For the stoploss sell order, the trigger price has to be greater than the limit price.
4Other conditions
Market price: Market orders are orders for which no price is specied 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. When this kind of order is placed, it gets executed irrespective of the current market price of
that particular asset.
After hours electronic trading rst began in 1992 at CME (Chicago Mercantile Exchange). Called Globex, this
was introduced to meet the needs of an increasingly integrated global economy and to have an access to the
currency price protection around the clock. Typically electronic trading systems are used in the open outcry
exchanges after the day trading is over.
Box 8.11: After hours electronic trading system
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 ll 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 (calendar spread) 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 prot from a change in the difference between the two
futures prices. The trader is virtually unconcerned whether the entire price structure moves up or down,
just so long as the futures contract he bought goes up more (or down less) than the futures contract he sold.
One cancels the other order: It is called one cancels the other order (OCO). 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. Example: A trader has a
buy position at Rs. 14,000/ tonne on Soybean. He wishes to have both stop and limit orders in order to ll the
order in a particular price range. A stop order is placed at Rs. 14,100/ tonne and a limit order at Rs. 13,900/
tonne. If the market trades at Rs. 13,900/ tonne, the limit order gets lled and the stop order is immediately
gets cancelled. The trader exits the market at Rs. 13,900/ tonne.
8.5.1 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 in
Table 8.5
8.5.2 Tick size for contracts
The tick size is the smallest price change that can occur for the trades on the exchange. The tick size in
respect of all futures contracts admitted to dealings on the NCDEX is 5 paise.
Table 8.4 Comm dity futures: Quantity freeze unit
Instrument Asset Quantity
Type Asset Symbol Freeze Unit
FUTCOM GLDPURMUM 30,000 Grams (gm)
FUTCOM SLVPURDEL 1,500 kilograms (Kgs)
FUTCOM SYBEANIDR 300 Metric Tonnes (MT)
FUTCOM SYOREFIDR
FUTCOM RMSEEDJPR 300 Metric Tonnes (MT)
FUTCOM RMOEXPJPR 300 Metric Tonnes (MT)
FUTCOM RMOEXPJPR 300 Metric Tonnes (MT)
FUTCOM CRDPOLKDL 300 Metric Tonnes (MT)
FUTCOM COTJ34BTD 300 Metric Tonnes (MT)
FUTCOM COTS06ABD 3,300 Bales
3,300 Bales
8.5.3 Quantity freeze
All orders placed by members have to be within the quantity specied by the exchange in this regard. Any
order exceeding this specied quantity will not be executed but will lie pending with the exchange as a
quantity freeze. Table 8.4 gives the quantity freeze for each commodity contract. In respect of orders which
have come under quantity freeze, the member is required to conrm to the exchange that there is no
inadvertent error in the order entry and that the order is genuine. On such conrmation, 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 for any reason whatsoever including nonavailability of
exposure limits.
8.5.4 Base price
On introduction of new contracts, the base price is the previous day sclosing price of the underlying
commodity in the prevailing spot markets. These spot prices are polled across multiple centers and a single
spot price is determined by the bootstrapping method. The base price of the contracts on all subsequent
trading days is the daily settlement price of the futures contracts on the previous trading day.
8.5.5 Price ranges of contracts
In order to prevent erroneous order entry by trading members, operating price ranges on the NCDEX are
kept at +/- 10% from the base price. Orders exceeding the range specied are not executed and lie pending
with the exchange as a price freeze. In respect of orders which have come under price freeze, the members
are required to confirm to the exchange that there is no inadvertent error in the order entry and that the
order is genuine. The exchange can approve or disapprove such orders solely at its own discretion. Unless
specially noticed by the exchange, there will be no price ranges applicable in the last half hour of normal
market trading.
8.5.6 Order entry on the trading system
The NCDEX trading system has a set of function keys built into the trading frontend. These keys have been
provided to facilitate faster operation of the system and enable quicker trading on the system. The function
keys can be operated from the keyboard of the user. The set of function keys enable the following:
4Buy open
4Sell open
4Order cancellation
4Order modication
4Exercise/ Position liquidation
4Outstanding orders
4Quick order cancel
4Spread order entry
4Market watch setup
4Trade modify
4Trade cancel
4Client master maintenance
4Market by order
4Market by price
4Activity log
4Security list/ portfolio setup

4Portfolio ofine order entry
4Spread market by price
4Previous trades
4Contract description
4Alphabetical sorting of contracts
Table 8.5 Commodity futures: Lot size and other parameters
Instrument asset Market Quantity Price Delivery Delivery
Type Asset Symbol Lot Unit Unity Lot Unit
FUTCOM GLDPURMUM 100 GM Rs./ 10 GM 1KG
FUTCOM SLVPURDEL 5Kg Rs./Kg 30KG
FUTCOM SYBEANIDR 1MT Rs./ Quintal 10 MT
FUTCOM SYOREFIDR 1MT Rs./ 10 Kg 10 MT
FUTCOM RMSEEDJPR 1MT Rs./ 20 Kg 10 MT
FUTCOM RMOEXPJPR 1MT Rs./ 10 Kg 10 MT
FUTCOM RBDPLNKAK 1MT Rs./ 10 Kg 10 MT
FUTCOM CRDPOLKDL 1MT Rs./ 10 Kg 10 MT
FUTCOM COTJ34BTD 11 Bales Rs./ Quintal 55 Bales
FUTCOM COTS06ABD 11 Bales Rs./ Quintal 55 Bales
4Spread order status
4Spread activity log
4Snap quote
4Online ofine order entry
4Message log
4Market movement
4Full message display
4Market inquiry
4Spread outstanding orders
4Net position upload
4Order status
4Liquidity schedule
4Buy close
4Sell close
8.6 Margins for trading in futures

Margin is 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 performance bond or good faith money. The margin levels are set by
the exchanges based on volatility (market conditions) and can be changed at any time. The margin
requirements for most futures contracts range from 2% to 15% of the value of the contract.
In the futures market, there are different types of margins that a trader has to maintain. We will discuss them
in more details when we talk about risk management in the next chapter. At this stage we look at the types of
margins as they apply on most futures exchanges.
Initial margin: The amount that must be deposited by a customer at the time of entering into a contract is
called initial margin. This margin is meant to cover the largest potential loss in one day. The margin is a
mandatory requirement for parties who are entering into the contract.
Maintenance margin: A trader is entitled to withdraw any balance in the margin account in excess of the
initial margin. To ensure that the balance in the margin account never becomes negative, a maintenance
margin, which is somewhat lower than the initial margin, is set. If the balance in the margin account falls
below the maintenance margin, the trader receives a margin call and is requested to deposit extra funds to
bring it to the initial margin level within a very short period of time. The extra funds deposited are known as a
variation margin. If the trader does not provide the variation margin, the broker closes out the position by
offsetting the contract.
Additional margin: In case of sudden higher than expected volatility, the exchange calls for an additional
margin, which is a preemptive move to prevent breakdown. This is imposed when the exchange fears that
the markets have become too volatile and may result in some payments crisis, etc.
Mark-to-Market margin (MTM): At the end of each trading day, the margin account is adjusted to reect
the traders gain or loss. This is known as marking to market the account of each trader. All futures contracts
are settled daily reducing the credit exposure to one days movement. Based on the settlement price, the
value of all positions is markedtomark et each day after the ofcial close. i.e. the accounts are either debited or
credited based on how well the positions fared in that days trading session. If the account falls below the
maintenance margin level the trader needs to replenish the account by giving additional funds. On the other
hand, if the position generates a gain, the funds can be withdrawn (those funds above the required initial
margin) or can be used to fund additional trades.
Just as a trader is required to maintain a margin account with a broker, a clearing house member is required
to maintain a margin account with the clearing house. This is known as clearing margin. In the case of clearing
house member, there is only an original margin and no maintenance margin. Clearing house and clearing
house margins have been discussed further in detail under the chapter on clearing and settlement.
8.7 Charges
Members are liable to pay transaction charges for the trade done through the exchange during the previous
month. The important provisions are listed below: The billing for the all trades done during the previous
month will be raised in the succeeding month.
1.) Rate of charges: 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.
2.) Due date: 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.
3.) Collection process: NCDEX has engaged the services of Bill Junction Payments Limited (BJPL) to collect
the transaction charges through Electronic Clearing System.
4.) Registration with BJPL and their services: Members have to llup the mandate form and submit the same to
NCDEX. NCDEX then forwards the mandate form to BJPL. BJPL sends the login ID and password to the
mailing address as mentioned in the registration form. The members can then log on through the website of
BJPL and view the billing amount and the due date. Advance email intimation is also sent to the members.
Besides, the billing details can be viewed on the website upto a maximum period of 12 months.
5.) Adjustment against advances transaction charges: In terms of the regulations, members are required to
remit Rs.50,000 as advance transaction charges on registration. The transaction charges due rst will be
adjusted against the advance transaction charges already paid as advance and members need to pay
transaction charges only after exhausting the balance lying in advance transaction.
6.) Penalty for delayed payments: If the transaction charges are not paid on or before the due date, a penal
interest is levied as specied by the exchange.
Finally, the futures market is a zero sum game i.e. the total number of long in any contract always equals the
total number of short in any contract. The total number of outstanding contracts (long/ short) at any point in
time is called the Open interest. This Open interest gure is a good indicator of the liquidity in every contract.
Based on studies carried out in international exchanges, it is found that open interest is maximum in near
month expiry contracts.
Solved Problems
Q: The trading system on the NCDEX, does not provide
1.) A fully automated screen-based trading. 3. Online monitoring and surveillance mechanism.
2.) Trading on a nationwide basis. 4. Trading by openoutcry
Q: Order matching on the NCDEX happens on the basis of

1.) Commodity 3. Quantity
2.) Price and time 4. All of the above
A: Correct answer is number 4.
Q: COTS06ABD is the symbol for

1.) Medium staple cotton Bhatinda 3. Small staple cotton Aurangabad
2.) Long staple cotton Ahmedabad 4. None of the above
Q: Initial margin is meant to cover the largest potential loss over a

1.) One day horizon 3. One hour horizon
2.) One week horizon 4. One month horizon
Q: NCDEX does not trade commodity futures contracts having expiry cycles
1.) One month 3. Three month
2.) Two month 4. Six month
Q: Billing to members for the all trades done on the NCDEX will be raised
1.) At the end of each day. 3. At the end of each week.
2.) In the succeeding month. 4. Once every two weeks.
Q: A trader buys 10 units of gold futures at Rs.6,500 per 10 gms. What is the value of his open long position?
Unit of trading is 100 gms and delivery unit is one Kg
1.) Rs.6,50,000 3. Rs.6,500
2.) Rs.65,000 4. Rs.65,00,000
A: One trading unit is for 100 gms. He has bought 10 units. The value of his long gold futures position is
The correct answer is number 1.
matter missing
Q: A trader requires to take a long gold futures position worth Rs.7,00,000 as part of his hedging strategy.
Two month futures trade at Rs.7,000 per 10 gms. Unit of trading is 100 gms and delivery unit is one Kg. How
many units must he purchase to give him the hedge?
1.) 10 units 3. 1,000 units
2.) 100 units 4. 10,000 units
A: Futures price of 10 gms of gold is Rs.7,000. This means gold futures cost Rs.700 per gram. To take a
position in 1000 gms of gold he has to buy 10 units of gold futures contracts. The correct answer is number 1.
Q: A trader requires to take a short gold futures position worth Rs.7,00,000 as part of his hedging strategy.
Two month futures trade at Rs.7,000 per 10 gms. Unit of trading is 100 gms and delivery unit is one Kg. How
many units must he sell to give him the hedge?
1.) 10 units 3. 1,000 units
2.( 100 units 4. 10,000 units
A: Futures price of 10 gms of gold is Rs.7,000. This means gold futures cost Rs.700 per gram. To take a
position in 1000 gms of gold he has to sell 10 units of gold futures contracts. The correct answer is number 1.
Chapter 9
Clearing and settlement
Most futures contracts do not lead to the actual physical delivery of the underlying asset. The settlement is
done by closing out open positions, physical delivery or cash settlement. All these settlement functions are
taken care of by an entity called clearing house or clearing corporation. National Securities Clearing
Corporation Limited (NSCCL) undertakes clearing of trades executed on the NCDEX. The settlement
guarantee fund is maintained and managed by NCDEX.
9.1 Clearing
Clearing of trades that take place on an exchange happens through the exchange clearing house. A clearing
house is a system by which exchanges guarantee the faithful compliance of all trade commitments
undertaken on the trading oor or electronically over the electronic trading systems. The main task of the
clearing house is to keep track of all the transactions that take place during a day so that the net position of
each of its members can be calculated. It guarantees the performance of the parties to each transaction.
Typically it is responsible for the following:
1. Effecting timely settlement.
2. Trade registration and follow up.
3. Control of the evolution of open interest.
4. Financial clearing of the payment ow.
5. Physical settlement (by delivery) or nancial settlement (by price difference) of contracts.
6. Administration of nancial guarantees demanded by the participants.
The clearing house has a number of members, who are mostly nancial institutions responsible for the
clearing and settlement of commodities traded on the exchange. The margin accounts for the clearing house
members are adjusted for gains and losses at the end of each day (in the same way as the individual traders
keep margin accounts with the broker). On the NCDEX, in the case of clearing house members only the
original margin is required (and
not maintenance margin). Everyday the account balance for each contract must be maintained at an amount
equal to the original margin times the number of contracts outstanding. Thus depending on a days
transactions and price movement, the members either need to add funds or can withdraw funds from their
margin accounts at the end of the day. The brokers who are not the clearing members need to maintain a
margin account with the clearing house member through whom they trade in the clearing house
9.1.1 Clearing mechanism
Only clearing members including professional clearing members (PCMs) are entitled to clear and settle
contracts through the clearing house.
The clearing mechanism essentially involves working out open positions and obligations of clearing
members. This position is considered for exposure and daily margin purposes. The open positions of PCMs
are arrived at by aggregating the open positions of all the TCMs clearing through him, in contracts in which
they have traded. A TCMs open position is arrived at by the summation of his clientsopen positions, in the
contracts in which they have traded. Client positions are netted at the level of individual client and grossed
across all clients, at the member level without any setoffs between clients. Proprietary positions are netted at
member level without any setoffs between client and proprietary positions.
At NCDEX, after the trading hours on the expiry date, based on the available information, the matching for
deliveries takes place rstly, 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 nal settlement price.
9.1.2 Clearing banks
NCDEX has designated clearing banks through whom funds to be paid and/ or to be received must be
settled. Every clearing member is required to maintain and operate a clearing account with any one of the
designated clearing bank branches. The clearing account is to be used exclusively for clearing operations i.e.,
for settling funds and other obligations to NCDEX including payments of margins and penal charges. A
clearing member can deposit funds into this account, but can withdraw funds from this account only in his
selfname. A clearing member having funds obligation to pay is required to have clear balance in his clearing
account on or before the stipulated payin day and the stipulated time. Clearing members must authorise
their clearing bank to access their clearing account for debiting and crediting their accounts as per the
instructions of NCDEX, reporting of balances and other operations as may be required by NCDEX from
time to time. The clearing bank will debit/ credit the clearing account of clearing members as per instructions
received from NCDEX. The following banks have been designatedas clearing banks ICICI Bank Limited,
Canara Bank, UTI Bank Limited and HDFC Bank Limited.
9.1.3 Depository participants

Every clearing member is required to maintain and operate a CM pool account with any one of the
empanelled depository participants. The CM pool account is to be used exclusively for clearing operations
i.e., for effecting and receiving deliveries from NCDEX.
9.2 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 nal settlement which happens on the last trading day of the futures contract.
On the NCDEX, daily MTM settlement and nal MTM settlement in respect of admitted deals in futures
contracts are 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
marked to market at the daily settlement price or the nal settlement price at the close of trading hours on a
day.
Daily settlement price: Daily settlement price is the consensus closing price as arrived after closing session
of the relevant futures contract for the trading day. However, in the absence of trading for a contract during
closing session, daily settlement price is computed as per the methods prescribed by the exchange from time
to time.
Final settlement price: Final settlement price is the closing price of the underlying commodity on the last
trading day of the futures contract. All open positions in a futures contract cease to exist after its expiration
day.
9.2.1 Settlement mechanism
Settlement of commodity futures contracts is a little different from settlement of nancial futures which are
mostly cash settled. The possibility of physical settlement makes the process a little more complicated.
Daily mark to market settlement
Daily mark to market settlement is done till the date of the contract expiry. This is done to take care of daily
price actuations for all trades. All the open positions of the members are marked to market at the end of the
day and the prot/ loss is determined as below:
On the day of entering into the contract, it is the difference between the entry value and daily settlement
price for that day.
On any intervening days, when the member holds an open position, it is the difference between the daily
settlement price for that day and the previous days settlement price.
Table 9.1 MTM on a long position in cotton futures
A clearing member buys one December expiration long staple cotton futures contract at Rs.6435 per
Quintal on December 15. The unit of trading is 11 bales and each contract is for delivery of 55 bales of cotton.
The member closes the position on December 19. The MTM prots/ losses get added/ deducted from his
initial margin on a daily basis.
Date Settlement price MTM
Dec 15,2003 6320 -115
Dec 16,2003 6250 -70
Dec 17,2003 6312 +62
Dec 18,2003 6310 -2
Dec 19,2003 6315 +5
On the expiry date if the member has an open position, it is the difference between the nal settlement price
and the previous days settlement price.
Table 9.1 explains the MTM margins to be paid by a member who buys one unit of December expiration long
staple cotton contract at Rs.6435 per Quintal (18.7 Quintals = 11 bales) on December 15. The unit of
trading is 11 bales and each contract is for delivery of 55 bales of cotton. The member closes the position on
December 19. The MTM prot/ loss per unit of trading shows at he makes a total loss of Rs. 120 per Quintal of
trading. So upon closing his
position, he makes a total loss of Rs.2244, i.e.H u
Missing letter
~ v ~ ~ L on the long position taken by him.
The prot/ loss made by him however gets added/ deducted from his initial margin on a daily basis.
Table 9.2 explains the MTM margins to be paid by a member who sells December expiration long staple
cotton futures contract at Rs.6435 per Quintal on December 15. The unit of trading is 11 bales(18.7
Quintals) and each contract is for delivery of 55 bales of cotton. The member closes the position on
December 19. The MTM prot/ loss shows that he makes a total prot of Rs. 120 per Quintal. So upon closing
his position, he makes a total prot of Rs.2244 on the short position taken by him. The prot/ loss made by him
however gets added/ deducted from his initial margin on a daily basis.
Final settlement
On the date of expiry, the nal settlement price is the spot price on the expiry day. The spot prices are
collected from members across the country through polling. The polled bid/ ask prices are bootstrapped and
the mid of the two bootstrapped prices is taken as the nal settlement price. The responsibility of settlement
is on a trading cum clearing member for all trades done on his own account and his clients trades. A
professional clearing member is responsible for settling all the participants trades which he has conrmed to
the exchange.
On the expiry date of a futures contract, members are required to submit delivery information
Date Settlement price MTM

Dec 15,2003 6320 +115
Dec 16,2003 6250 +70
Dec 17,2003 6312 -62
Dec 18,2003 6310 +2
Dec 19,2003 6315 -5
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. A detailed report containing all
matched and unmatched requests is provided to members through the extranet.
Pursuant to regulations relating to submission of delivery information, failure to submit delivery information
for open positions attracts penal charges as stipulated by NCDEX from time to time. NCDEX also adds all
such open positions for a member, for which no delivery information is submitted with nal settlement
obligations of the member concerned and settled in cash.
Nonfullment of either the whole or part of the settlement obligations is treated as a violation of the rules,
byelaws and regulations of NCDEX and attracts penal charges as stipulated by NCDEX from time to time. In
addition NCDEX can withdraw any or all of the membership rights of clearing member including the
withdrawal of trading facilities of all trading members clearing through such clearing members, without any
notice. Further, the outstanding positions of such clearing member and/ or trading members and/ or
constituents, clearing and settling through such clearing member, may be closed out forthwith or any time
thereafter by the exchange to the extent possible, by placing at the exchange, counter orders in respect of
the outstanding position of clearing member without any notice to the clearing member and/ or trading
member and/ or constituent. NCDEX can also initiate such other risk containment measures as it deems
appropriate with respect to the open positions of the clearing members. It can also take additional measures
like, imposing penalties, collecting appropriate deposits, invoking bank guarantees or xed deposit receipts,
realizing money by disposing off the securities and exercising such other risk containment measures as it
deems t or take further disciplinary action.
9.2.2 Settlement methods

Settlement of futures contracts on the NCDEX can be done in three ways by physical delivery of the
underlying asset, by closing out open positions and by cash settlement. We shall look at each of these in some
detail. On the NCDEX all contracts settling in cash are settled on the following day after the contract expiry
date. All contracts materialising into deliveries are settled in a period 27 days after expiry. The exact
settlement day for each commodity is specied by the exchange.
Physical delivery of the underlying asset
For open positions on the expiry day of the contract, the buyer and the seller can announce intentions for
delivery. Deliveries take place in the electronic form. All other positions are settled in cash.
When a contract comes to settlement, the exchange provides alternatives like delivery place, month and
quality specications. Trading period, delivery date etc. are all dened as per the settlement calendar. A
member is bound to provide delivery information. If he fails to give information, it is closed out with penalty
as decided by the exchange. A member can choose an alternative mode of settlement by providing counter
party clearing member and constituent. The exchange is however not responsible for, nor guarantees
settlement of such deals. The settlement price is calculated and notied by the exchange. The delivery place is
very important for commodities with signicant transportation costs. The exchange also species the precise
period (date and time) during which the delivery can be made. For many commodities, the delivery period
may be an entire month. The party in the short position (seller) gets the opportunity to make choices from
these alternatives. The exchange collects delivery information. The price paid is normally the most recent
settlement price (with a possible adjustment for the quality of the asset and the delivery location). Then the
exchange selects a party with an outstanding long position to accept delivery.
As mentioned above, after the trading hours on the expiry date, based on the available information, the
matching for deliveries is done, rstly, on the basis of locations and then randomly keeping in view factors such
as available capacity of the vault/ warehouse, commodities already deposited and dematerialized and offered
for delivery and any other factor as may be specied by the exchange from time to time. 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 done only for
the incremental gain/ loss as determined on the basis of the nal settlement price.
Any buyer intending to take physicals has to put a request to his depository participant. The DP uploads such
requests to the specied depository who in turn forwards the same to the registrar and transfer agent (R&T
agent) concerned. After due verication of the authenticity, the R&T agent forwards delivery details to the
warehouse which in turn arranges to release the commodities after due verication of the identity of
recipient. On a specied day, the buyer would go to the warehouse and pick up the physicals.
The seller intending to make delivery has to take the commodities to the designated
warehouse. These commodities have to be assayed by the exchange specied assayer. The commodities have
to meet the contract specications with allowed variances. If the commodities meet the specications, the
warehouse accepts them. Warehouses then ensure that the receipts get updated in the depository system
giving a credit in the depositors electronic account. The seller then gives the invoice to his clearing member,
who would courier the same to the buyers clearing member.
NCDEX contracts provide a standardized description for each commodity. The description is provided in
terms of quality parameters specic to the commodities. At the same time, it is realized that with
commodities, there could be some amount of variances in quality/ weight etc., due to natural causes, which
are beyond the control of any person. Hence, NCDEX contracts also provide tolerance limits for variances.
A delivery is treated as good delivery and accepted if the delivery lies within the tolerance limits. However, to
allow for the difference, the concept of premium and discount has been introduced. Goods that come to the
authorised warehouse for delivery are tested and graded as per the prescribed parameters. The premium
and discount rates apply depending on the level of variation. The price payable by the party taking delivery is
then adjusted as per the premium/ discount rates xed by the exchange. This ensures that some amount of
leeway is provided for delivery, but at the same time, the buyer taking delivery does not face windfall loss/
gain due to the quantity/ quality variation at the time of taking delivery. This, to some extent, mitigates the
difculty in delivering and receiving exact quality/ quantity of commodity
Closing out by offsetting positions
Most of the contracts are settled by closing out open positions. In closing out, the opposite transaction is
effected to close out the original futures position. A buy contract is closed out by a sale and a sale contract is
closed out by a buy. For example, an investor who took a long position in two gold futures contracts on the
January 30, 2004 at 6090, can close his position by selling two gold futures contracts on February 27, 2004 at
Rs.5928. In this case, over the period of holding the position, he has suffered a loss of Rs.162 per unit. This
loss would have been debited from his margin account over the holding period by way of MTM at the end of
each day, and nally at the price that he closes his position, that is Rs.5928 in this case.
Cash settlement
Contracts held till the last day of trading can be cash settled. When a contract is settled in cash, it is marked to
the market at the end of the last trading day and all positions are declared closed. The settlement price on the
last trading day is set equal to the closing spot price of the underlying asset ensuring the convergence of
future prices and the spot prices. For example an investor took a short position in ve long staple cotton
futures contracts on December 15 at Rs.6950. On 20th February, the last trading day of the contract, the
spot price of long staple cotton is Rs.6725. This is the settlement price for his contract. As a holder of a short
position on cotton, he does not have to actually deliver the underlying cotton, but simply takes away the prot
of Rs.225 per trading unit of cotton in the form of cash.9.2.3 Entities involved in physical settlement
Physical settlement of commodities involves the following three entities an accredited warehouse, registrar
& transfer agent and an assayer. We will briey look at the functions of each.
Accredited warehouse
NCDEX species accredited warehouses through which delivery of a specic commodity can be effected and
which will facilitate for storage of commodities. For the services provided by them, warehouses charge a fee
that constitutes storage and other charges such as insurance, assaying and handling charges or any other
incidental charges. Following are the functions of an accredited warehouse:
1. Earmark separate storage area as specied by the exchange for the purpose of storing commodities to be
delivered against deals made on the exchange. The warehouses are required to meet the specications
prescribed by the exchange for storage of commodities.
2. Ensure and coordinate the grading of the commodities received at the warehouse before they are stored.
3. Store commodities in line with their grade specifications and validity period and facilitate maintenance of
identity. On expiry of such validity period of the grade for such commodities, the warehouse has to
segregate such commodities and store them in a separate area so that the same are not mixed with
commodities which are within the validity period as per the grade certificate issued by the approved
assayers.
Approved registrar and transfer agents (R&T agents)
The exchange species approved R&T agents through whom commodities can be dematerialized and who
facilitate for demeterialization / remeterialization of commodities in the manner prescribed by the exchange
from time to time. The R&T agent performs the following functions:
1. Establishes connectivity with approved warehouses and supports them with physical infrastructure.
2. Verias the information regarding the commodities accepted by the accredited warehouse and assigns the
identification number (ISIN) allotted by the depository in line with the grade/ validity period.
3. Further processes the information, and ensures the credit of commodity holding to the demat account of
the constituent.
5. Ensures that the credit of commodities goes only to the demat account of the constituents held with the
exchange empanelled DPs.
6. On receiving a request for rematerialization (physical delivery) through the depository, arranges for
issuance of authorisation to the relevant warehouse for the delivery of commodities.
R&T agents also maintain proper records of beneciary position of constituents holding dematerialized
commodities in warehouses and in the depository for a period and also as on a particular date. They are
required to furnish the same to the exchange as and when demanded by the exchange. R&T agents also do
the job of coordinating with DPs and warehouses for billing of charges for services rendered on periodic
intervals. They also reconcile dematerialized commodities in the depository and physical commodities at the
warehouses on periodic basis and coordinate with all parties concerned for the same.
Approved assayer
The exchange species approved assayers through whom grading of commodities (received at approved
warehouses for delivery against deals made on the exchange) can be availed by the constituents of clearing
members. Assayers perform the following functions:
1. Inspect the warehouses identied by the exchange on periodic basis to verify the compliance of technical/
safety parameters detailed in the warehousing accreditation norms of the exchange. The compliance
certicate so given by the assayer forms the basis of warehouse accreditation by the exchange.
2. Make available grading facilities to the constituents in respect of the specic commodities traded on the
exchange at specied warehouse. The assayer ensures that the grading to be done (in a certicate format
prescribed by the exchange) in respect of specic commodity is as per the norms specied by the exchange
in the respective contract specications.
3. Grading certicate so issued by the assayer species the grade as well as the validity period up to which the
commodities would retain the original grade, and the time up to which the commodities are t for trading
subject to environment changes at the warehouses.
9.3 Risk management
NCDEX has developed a comprehensive risk containment mechanism for the its commodity futures
market. The salient features of risk containment mechanism are:
The nancial 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.
NCDEX charges an upfront initial margin for all the open positions of a member. It species 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.
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.
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.
The most critical component of risk containment mechanism for futures market on the NCDEX is the
margining system and online position monitoring. The actual position monitoring and margining is carried
out online through the SPAN (Standard Portfolio Analysis of Risk) system.
Table 9.4 Minimum margin percentage on commodity futures contracts

Commodity Minimum margin percentage
Pure gold Mumbai 4
Pure silver New Delhi 4
J34 medium staple cotton Bhatinda 3
S06 L S cotton Ahmedabad 3
Soybean Indore 4
Rened soya oil Indore 4
Rapeseed mustard seed Jaipur 4
Expeller rapeseed mustard oil Jaipur 4
Crude palm oil Kandla 4
RBD palm olein Kakinada 4
Consider the case of a trading member who has proprietary and clientlevel positions in a April 2004 gold
futures contract. On his proprietary account, he bought 3000 trading units and sold 1000 trading units within
the day. On account of client A, he bought 2000 trading units at the beginning of the day and sold 1500 units
an hour later. And on account of client B, he sold 1000 trading units. Table 9.3 gives the total outstanding
position for which the TCM would be margined.
For the purpose of SPAN margin, various parameters as given below will be specied from time to time:
1. Price scan range: Price scan range will be four standard deviations (4 sigma) as calculated for VaR purpose
for the prices of futures contracts. The minimum margin percentages for various commodities are given
in Table 9.4. These may change from time to time as specied by the exchange.
2. Volatility scan range: Volatility scan range will be taken at 2% or such other percentage as may be specied
by the exchange from time to time.
3. Calendar spread charge: Calendar spread is dened as the purchase of one delivery month of a given futures
contract and simultaneous sale of another delivery month of the same commodity on the sameexchange.
Margins are charged on all open calendar spread positions at 2% on the higher value of the near month or
the far month position, or at such rate as may be specied by the exchange from time to time. The near
month position is the buy/ sell position on the calendarspread position that expires rst. The far month
position is the buy/ sell position on the calendarspread position that expires next. A calendar spread
position is treated as nonspread (naked) positions in the far month contract, 3 trading days prior to
expiration of the near month contract. However, calendar spread
missing
position is reduced gradually at the rate of letter % per day for three days or at such rate as may be
prescribed by the exchange from time to time. The reduction of the spread position starts ve days before the
date of expiry of the near month contract.
more than half of Chinas exchanges were closed down or reverted to being wholesale markets, while only
15 restructured exchanges received formal government approval. At the beginning of 1999, the China
Securities Regulatory Committee began a nationwide consolidation process which resulted in three
commodity exchanges emerging; the Dalian Commodity Exchange (DCE), the Zhengzhou Commodity
Exchange and the Shanghai futures Exchange, formed in 1999 after the merger of three exchanges: Shanghai
Metal, Commodity, Cereals & Oils Exchanges. The Taiwan Futures Exchange was launched in 1998. Malaysia
and Singapore have active commodity futures exchanges. Malaysia hosts one futures and options exchange.
Singapore is home to the Singapore Exchange (SGX), which was formed in 1999 by the merger of two
wellestablished exchanges, the Stock Exchange of Singapore (SES) and Singapore International Monetary
Exchange (SIMEX).
2.2.3 Latin America
Latin Americas largest commodity exchange is the Bolsa de Mercadorias & Futuros, (BM&F) in Brazil.
Although this exchange was only created in 1985, it was the 8th largest exchange by 2001, with 98 million
contracts traded. There are also many other commodity exchanges operating in Brazil, spread throughout
the country. Argentinas futures market Mercado a Termino de Buenos Aires, founded in 1909, ranks as the
worlds 51st largest exchange. Mexico has only recently introduced a futures exchange to its markets. The
Mercado Mexicano de Derivados (Mexder) was launched in 1998.
2.3 Evolution of the commodity market in India
Bombay Cotton Trade Association Ltd., set up in 1875, was the rst organised futures market.
Bombay Cotton Exchange Ltd. was established in 1893 following the widespread discontent amongst
leading cotton mill owners and merchants over functioning of Bombay Cotton Trade Association. The
Futures trading in oilseeds started in 1900 with the establishment of the Gujarati Vyapari Mandali, which
carried on futures trading in groundnut, castor seed and cotton. Futures trading in wheat was existent at
several places in Punjab and Uttar Pradesh. But the most notable futures exchange for wheat was chamber of
commerce at Hapur set up in 1913. Futures trading in bullion began in Mumbai in 1920. Calcutta Hessian
Exchange Ltd. was established in 1919 for futures trading in rawjute and jute goods. But organised futures
trading in raw jute began only in 1927 with the establishment of East Indian Jute Association Ltd. These two
associations amalgamated in 1945 to form the East India Jute & Hessian Ltd. to conduct organised trading in
both Raw Jute and Jute goods. Forward Contracts (Regulation) Act was enacted in 1952 and the Forwards
Markets Commission (FMC) was established in 1953 under the Ministry of Consumer Affairs and Public
Distribution. In due course, several other exchanges were created in the country to trade in diverse
commodities.
2.3.1 The Kabra committee report
After the introduction of economic reforms since June 1991 and the consequent gradual trade and industry
liberalisation in both the domestic and external sectors, the Government of India appointed in June 1993 a
committee on Forward Markets under chairmanship of Prof. K.N. Kabra. The committee was setup with the
following objectives:
1. To assess
(a) The working of the commodity exchanges and their trading practices in India and to make suitable
recommendations with a view to making them compatible with those of other countries.
9.4.4 Implementation aspects of margining and risk management
We look here at some implementation aspects of the margining and risk management system for trading on
NCDEX.
1. Mode of payment of initial margin: Margins can be paid by the members in cash, or in collateral security
deposits in the form of bank guarantees, xed deposits receipts and approved Government of India
securities.
9.4.4 Implementation aspects of margining and risk management

We look here at some implementation aspects of the margining and risk management system for trading on
NCDEX.
1. Mode of payment of initial margin: Margins can be paid by the members in cash, or in collateral security
deposits in the form of bank guarantees, xed deposits receipts and approved Government of India
securities.
2. Payment of initial margin: The initial margin is payable upfront by members.
3. Effect offailure to pay initial margins: Nonfullment of either the whole or part of the initial margin
obligations is treated as a violation of the rules, byelaws and regulations of the exchange and attracts penal
charges as stipulated by NCDEX from time to time. In addition, the exchange can withdraw any or all of
the membership rights of a member including the withdrawal of trading facilities of the members clearing
through such clearing members, without any notice. The outstanding positions of such members and/ or
constituents clearing and settling through such members, can be closed out forthwith or any time
thereafter at the discretion of the Exchange, to the extent possible, by placing counter orders in respect
of the outstanding position of members. Such action is nal and binding on the members and/ or
constituents.
The exchange can also initiate such other risk containment measures as it deems t with respect to the open
positions of the members and/ or constituents. The exchange can take additional measures like imposing
penalties, collecting appropriate deposits, invoking bank guarantees/xed deposit receipts, realizing money
by disposing off the securities and exercising such other risk containment measures as it deems t.
4. Exposure limits: This is dened as the maximum open positions that a member can take across all contracts
and is linked to the liquid net worth of the member available with the exchange. The member is not
allowed to trade once the exposure limits have been exceeded on the exchange. The trader workstation
of the member is disabled and trading permitted only on enhancement of exposure limits by deposit of
additional capital.
(a) Liquid networth: Liquid networth is computed as effective deposits less initial margin payable at any point
in time. The liquid networth maintained by the members at any point in time cannot be less than Rs.25 lakh
(referred to as minimum liquid net worth) or such other amount, as may be specied by the exchange from
time to time.
b.) Effective deposits: This includes all deposits made by the members in the form of cash or cash equivalents
form the effective deposits. For the purpose of computing effective deposits, cash equivalents mean bank
guarantees, xed deposit receipts and Government of Indian securities.
c.) Method of computation of exposure limits: Exposure limits is specied as a multiple of the liquid net
worth. i.e. a member can have an exposure limit of ! times his liquid net worth. The multiple is as specied in
Table 9.5 or as may be prescribed by the exchange from time.
d.) Exposure limits for calendar spread positions: In case of calendar spread positions in futures, contracts
are treated as open position of one third of the value of the far month futures contract. However the spread
positions is treated as a naked position in far month contract three trading days prior to expiry of the near
month contract.
5. Imposition of additional margins and close out of open positions: As a risk containment measure, the
exchange may require the members to make payment of additional margins as may be decided from time
to time. This is in addition to the initial margin, which are or may have been imposed. The exchange may
also require the members to reduce/ close out open positions to such levels and for such contracts as may
be decided by it from time to time.
6. Failure to pay additional margins: Nonfullment of either the whole or part of the additional margin
obligations is treated as a violation of the rules, bye-Laws and regulations of the exchange and attracts
penal charges as stipulated by NCDEX. The exchange may withdraw any or all of the membership rights
of the members including the withdrawal of trading facilities of trading members clearing through such
members, without any notice.
In addition, the outstanding positions of such members and/ or constituents, clearing and settling through
such members, can be closed out forthwith or any time thereafter, at the discretion of the exchange, to the
extent possible, by placing counter orders in respect of their outstanding positions.
7. Return of excess deposit: Members can request the exchange to release excess deposits held by it or by a
specied agent on behalf of the exchange. Such requests may be considered by the exchange subject to the
byelaws, rules and regulations.
8. Initial margin deposit or additional deposit or additional base capital: Members who wish to make a
margin deposit (additional base capital) with the exchange and/ or wish to retain deposits and/ or such
amounts which are receivable by them from the exchange, at any point of time, over and above their
deposit requirement towards initial margin and/ or other obligations, must inform the exchange as per
the procedure.
9. Position limits: Position wise limits are the maximum open positions that a member or his constituents can
have in any commodity at any point of time. This is calculated as the higher of a specied percentage of the
total open interest in the commodity or a specied value. Open interest is the total number of open
positions in that futures contract multiplied by its last available traded price or closing price, as the case
may be.
10. Intraday price limit: The maximum price movement during a day can be +/- 10% of the previous days
settlement price prescribed for each commodity. If the price hits the intra day price limit (at upper side or
lower side), there will be a cooling period of 15 minutes. During the cooling period, trading in that
particular contract will be suspended and normal trading will resume after the cooling period. The base
price when trading resumes after cooling period will be the last traded price before the commencement
of cooling period. There would be no cooling period if the price hits the intra day limit during the last 30
minutes of trading.
Table 9.5 Exposure limit as a multiple of liquid net worth

Commodity Multiple
Pure gold Mumbai 25
Soybean Indore 25
a.) Daily settlement price: The daily prot/ losses of the members are settled using the daily settlement price.
The daily settlement price notied by the exchange is binding on all members and their constituents.
b). Mark to market settlement: All the open positions of the members are marked to market at the end of
the day and the prot/ loss determined as below: (a) On the day of entering into the contract, it is the
difference between the entry value and daily settlement price for that day. (b) On any intervening days, when
the member holds an open position, it is the difference between the daily settlement value for that day and
the previous days settlement price. (c) On the expiry date if the member has an open position, it is the
difference between the nal settlement price and the previous days settlement price.
11. In traday margin call: The exchange at its discretion can make intra day margin calls as risk containment
measure if, in its opinion, the market price changes sufciently . For example, it can make an intraday margin
call if the intra day price limit has been reached, or any other situation has arisen, which in the opinion of the
exchange could result in an enhanced risk. The exchange at its discretion may make selective margin calls, for
example, only for those members whose variation losses or initial margin decits exceed a threshold value
prescribed by the exchange.
12. Delivery margin: In case of positions materialising into physical delivery, delivery margins are calculated
as ¶ days VaR margins plus additional margins. ¶ days refer to the number of days for completing the physical
delivery settlement. The number of days are commodity specic, as described hereunder or as may be
prescribed by the exchange from time to time. There is a mark up on the VaR based delivery margin to cover
for default. Table 9.6 gives the number of days for physical settlement on various commodities.
9.4.5 Effect of violation
Whenever any of the margin or position limits are violated by members, the exchange can withdraw any or
all of the membership rights of members including the withdrawal of trading
Table 9.6 Number of days for physical settlement on various commodities

Commodity Number of days for physical settlement
Pure gold Mumbai 2
Soybean Indore 7
facilities of all members and/ or clearing facility of custodial participants clearing through such trading cum
members, without any notice. In addition, the outstanding positions of such member and/ or constituents
clearing and settling through such member, can be closed out at any time at the discretion of the exchange.
This can be done without any notice to the member and/ or constituent. The exchange can initiate further
risk containment measures with respect to the open positions of the member and/ or constituent. These
could include imposing penalties, collecting appropriate deposits, invoking bank guarantees/xed deposit
receipts, realizing money by disposing off the securities, and exercising such other risk containment
measures it considers necessary.
Solved Problems
Q: The settlement of futures contracts cannot be done by
1. Closing out open positions. 3. Cash settlement.
2. Physical delivery. 4. Carrying forward the position.
Q: undertakes clearing and settlement of all trades executed on the NCDEX
1. NSE 3. NSDL
2. NSCCL 4. NCDEX
Q: The settlement guarantee fund for trades done on the NCDEX is maintained and managed by
1. NSE 3. NSDL
2. NSCCL 4. NCDEX
Q: The clearing house of an exchange is responsible for

1. Effecting timely settlement. 3. NSDL
2. Control of the evolution of open interest. 4. NCDEX
Q: The clearing house of an exchange is responsible for
1. Effecting timely settlement. 3. Financial clearing of the payment ow.
2. Control of the evolution of open interest. 4. All of the above.
Q: On expiry of a commodity futures contract, the settlement price is the
1. Spot price of the underlying asset 3. Spot price plus cost-of-carry
2. Futures close price 4. None of the above.
Q: The clearing house of an exchange is not responsible for
1. Effecting timely settlement. 3. Control of the evolution of open interest.
2. Ensuring that the buyer and seller get the best price.4. Financial clearing of the payment ow.
Q: The exposure limit for each member is linked to the of the member available with the exchange.
1. Liquid net worth. 3. Bank guarantees.
2. Security deposits. 4. Base capital.
Q: A cotton trader bought ten one month, long staple cotton futures contracts at Rs. 6020 per Quintal at the
beginning of the day. The unit of trading is 11 bales and each contract is for delivery of 55 bales. The
settlement price at the end of the day was Rs. 6050 per Quintal. The traders MTM account will show
1. A prot of Rs.5610 3. A prot of Rs.1500
2. A loss of Rs.5610 4. A loss of Rs.1500
A: He makes a prot of Rs.30 per Quintal on his futures position. One futures contract consists is for 18.7
Quintals. He has bought ten futures contract. So he makes a prot of 30 * 18.7 * 10 = Rs. 5610. The correct
answer is number 1.
Q: A gold merchant bought two units of onemonth gold futures contracts at Rs.6000 per 10 gms at the
beginning of the day. The unit of trading is 100 gms and each contract is for delivery of one kg of gold. The
settlement price at the end of the day was Rs.6025 per 10 gms. The traders MTM account will show
1. A prot of Rs.500 3. A prot of Rs.5000
2. A loss of Rs.500 4. A loss of Rs.5000
A: Each unit of trading is 100 gms. He has bought two units. This means he has a long position in 200 gms of
gold. He makes a prot of Rs.25 per 10 gms on his futures position. So he makes a prot of
Rs.500, i.e. \% = Rs.500. The correct answer is number 1.
Q: A trading member took proprietary positions in a March 2004 cotton futures contract. He bought 3000
trading units at Rs.6000 per Quintal and sold 2400 at Rs.6015 per Quintal. What is the outstanding position
on which he would be margined?
1. Long 3000 units 3. Long 5400 units
2. Short 2400 units 4. Long 600 units
A: After netting, the trading member has a long open position in 600 trading units. The correct answer is
number 4.
Q: A trading member has proprietary and client positions in a March cotton futures contract. On his
proprietary account, he bought 3000 trading units at Rs.6000 per Quintal and sold 2400 at Rs.6015 per
Quintal. On account of client A, he bought 2000 trading units at Rs.6012 per Quintal, and on account of client
B, he sold 1000 trading units at Rs.5990 per Quintal. What is the outstanding position on which he would be
margined?
A: After netting, the trading member has a proprietary open position in 600 trading units. He would be
margined on a net basis at the proprietary level and on a gross basis across clients, i.e. (600 + 2000 +
1000). The correct answer is number 3.
Q: A trading member has proprietary and client positions in a April 2004 gold futures contract. On his
proprietary account, he bought 3000 trading units at Rs.6000 per 10 gms. On account of client A, he bought
2000 trading units at Rs.6012 per 10 gms and sold 1500 units at Rs.6020 per 10 gms, and on account of client
B, he sold 1000 trading units at Rs.5990 per 10 gms. What is the outstanding position on which he would be
margined?
A: He would be margined on a net basis at the proprietary level and at the individual client level and on a gross
basis across clients. i.e. (3000 + (2000 - 1500) + 1000). The correct answer is number 2.
Chapter 10
Regulatory framework
At present, there are three tiers of regulations of forward/futures trading system in India, namely,
government of India, Forward Markets Commission(FMC) and commodity exchanges. The need for
regulation arises on account of the fact that the benets of futures markets accrue in competitive conditions.
Proper regulation is needed to create competitive conditions. In the absence of regulation, unscrupulous
participants could use these leveraged contracts for manipulating prices. This could have undesirable
inuence on the spot prices, thereby affecting interests of society at large.. Regulation is also needed to ensure
that the market has appropriate risk management system. In the absence of such a system, a major default
could create a chain reaction. The resultant nancial crisis in a futures market could create systematic risk.
Regulation is also needed to ensure fairness and transparency in trading, clearing, settlement and
management of the exchange so as to protect and promote the interest of various stakeholders, particularly
nonmember users of the market.
10.1 Rules governing commodity derivatives exchanges
The trading of commodity derivatives on the NCDEX is regulated by Forward Markets Commission(FMC).
Under the Forward Contracts (Regulation) Act, 1952, forward trading in commodities notied under section
15 of the Act can be conducted only on the exchanges, which are granted recognition by the central
government (Department of Consumer Affairs, Ministry of Consumer Affairs, Food and Public Distribution).
All the exchanges, which deal with forward contracts, are required to obtain certicate of registration from
the FMC. Besides, they are subjected to various laws of the land like the Companies Act, Stamp Act,
Contracts Act, Forward Commission (Regulation) Act and various other legislations, which impinge on their
working.
Forward Markets Commission provides regulatory oversight in order to ensure nancial integrity (i.e. to
prevent systematic risk of default by one major operator or group of operators), market integrity (i.e. to
ensure that futures prices are truly aligned with the prospective demand and supply conditions) and to
protect and promote interest of customers/ nonmembers. It prescribes the following regulatory measures:
1. Limit on net open position as on the close of the trading hours. Some times limit is also imposed on
intraday net open position. The limit is imposed operatorwise, and in some cases, also member wise.
2. Circuitlters or limit on price uctuations to allow cooling of market in the event of abrupt upswing or
downswing in prices.
3. 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. By making further purchases/sales relatively costly,
the price rise or fall is sobered down. This measure is imposed only on the request of the exchange.
4. Circuit breakers or minimum/maximum prices: These are prescribed to prevent futures prices from
falling below as rising above not warranted by prospective supply and demand factors. This measure is also
imposed on the request of the exchanges.
5. Skipping trading in certain derivatives of the contract, closing the market for a specied period and even
closing out the contract: These extreme measures are taken only in emergency situations.
Besides these regulatory measures, the F.C(R) Act provides that a clients position cannot be appropriated by
the member of the exchange, except when a written consent is taken within three days time. The FMC is
persuading increasing number of exchanges to switch over to electronic trading, clearing and settlement,
which is more customerfriendly. The FMC has also prescribed simultaneous reporting system for the
exchanges following open outcry system. These steps facilitate audit trail and make it difcult for the members
to indulge in malpractices like trading ahead of clients, etc. The FMC has also mandated all the exchanges
following open outcry system to display at a prominent place in exchange premises, the name, address,
telephone number of the ofcer of the commission who can be contacted for any grievance. The website of
the commission also has a provision for the customers to make complaint and send comments and
suggestions to the FMC. Ofcers of the FMC have been instructed to meet the members and clients on a
random basis, whenever they visit exchanges, to ascertain the situation on the ground, instead of merely
attending meetings of the board of directors and holding discussions with the ofcebearers.
10.2 Rules governing intermediaries
In addition to the provisions of the Forward Contracts (Regulation) Act 1952 and rules framed thereunder,
exchanges are governed by its own rules and bye laws(approved by the FMC). In this section we have brief
look at the important regulations that govern NCDEX. For the sake of convenience, these have been divided
into two main divisions pertaining to trading and clearing. The detailed bye laws, rules and regulations are
available on the NCDEX home page.
10.2.1 Trading
The NCDEX provides an automated trading facility in all the commodities admitted for dealings on the spot
market and derivative market. Trading on the exchange is allowed only through
approved workstation(s) located at locations for the ofce(s) of a trading member as approved by the
exchange. If LAN or any other way to other workstations at any place connects an approved workstation of a
trading Member it shall require an approval of the exchange.
Each trading member is required to have a unique identication number which is provided by the exchange
and which will be used to log on (sign on) to the trading system. A trading member has a nonexclusive
permission to use the trading system as provided by the exchange in the ordinary course of business as
trading member. He does not have any title rights or interest whatsoever with respect to trading system, its
facilities, software and the information provided by the trading system.
For the purpose of accessing the trading system, the member will install and use equipment and software as
specied by the exchange at his own cost. The exchange has the right to inspect equipment and software used
for the purposes of accessing the trading system at any time. The cost of the equipment and software
supplied by the exchange, installation and maintenance of the equipment is borne by the trading member.
Trading members and users
Trading members are entitled to appoint, (subject to such terms and conditions, as may be specied by the
relevant authority) from time to time -
4Authorised persons
4Approved users
Trading members have to pass a certication program, which has been prescribed by the exchange. In case of
trading members, other than individuals or sole proprietorships, such certication program has to be passed
by at least one of their directors/ employees/ partners/ members of governing body.
Each trading member is permitted to appoint a certain number of approved users as notied from time to
time by the exchange.
The appointment of approved users is subject to the terms and conditions prescribed by the exchange. Each
approved user is given a unique identification number through which he will have access to the trading
system. An approved user can access the trading system through a password and can change the password
from time to time.
The trading member or its approved users are required to maintain complete secrecy of its password. Any
trade or transaction done by use of password of any approved user of the trading member, will be binding on
such trading member. Approved user shall be required to change his password at the end of the password
expiry period.
Trading days
The exchange operates on all days except Saturday and Sunday and on holidays that it declares from time to
time. Other than the regular trading hours, trading members are provided a facility to place orders offline i.e.
outside trading hours. These are stored by the system but get traded only once the market opens for trading
on the following working day.
The types of order books, trade books, price limits, matching rules and other parameters pertaining to each
or all of these sessions is specied by the exchange to the members via its circulars or notices issued from time
to time. Members can place orders on the trading system during these sessions, within the regulations
prescribed by the exchange as per these bye laws, rules and regulations, from time to time.
Trading hours and trading cycle
The exchange announces the normal trading hours/ open period in advance from time to time. In case
necessary, the exchange can extend or reduce the trading hours by notifying the members. Trading cycle for
each commodity/ derivative contract has a standard period, during which it will be available for trading.
Contract expiration
Derivatives contracts expire on a predetermined date and time up to which the contract is available for
trading. This is notied by the exchange in advance. The contract expiration period will not exceed twelve
months or as the exchange may specify from time to time.
Trading parameters
The exchange from time to time species various trading parameters relating to the trading system. Every
trading member is required to specify the buy or sell orders as either an open order or a close order for
derivatives contracts. The exchange also prescribes different order books that shall be maintained on the
trading system and also species various conditions on the order that will make it eligible to place it in those
books.
The exchange species the minimum disclosed quantity for orders that will be allowed for each commodity/
derivatives contract. It also prescribes the number of days after which Good Till Cancelled orders will be
cancelled by the system. It species parameters like lot size in which orders can be placed, price steps in which
orders shall be entered on the trading system, position limits in respect of each commodity etc.
Failure of trading member terminal
In the event of failure of trading members workstation and/ or the loss of access to the trading system, the
exchange can at its discretion undertake to carry out on behalf of the trading member the necessary
functions which the trading member is eligible for. Only requests made in writing in a clear and precise
manner by the trading member would be considered. The trading member is accountable for the functions
executed by the exchange on its behalf and has to indemnity the exchange against any losses or costs
incurred by the exchange. Trade operations
Trading members have to ensure that appropriate conrmed order instructions are obtained from the
constituents before placement of an order on the system. They have to keep relevant records or documents
concerning the order and trading system order number and copies of the order conrmation slip/ modication
slip must be made available to the constituents.
The trading member has to disclose to the exchange at the time of order entry whether the order is on his
own account or on behalf of constituents and also specify orders for buy or sell as open or close orders.
Trading members are solely responsible for the accuracy of details of orders entered into the trading system
including orders entered on behalf of their constituents.
Trades generated on the system are irrevocable and locked in. The exchange species from time to time the
market types and the manner if any, in which trade cancellation can be effected. Where a trade cancellation is
permitted and trading member wishes to cancel a trade, it can be done only with the approval of the
exchange.
Margin requirements
Subject to the provisions as contained in the exchange bye laws and such other regulations as may be in force,
every clearing member, in respect of the trades in which he is party to, has to deposit a margin with exchange
authorities.
The exchange prescribes from time to time the commodities/ derivative contracts, the settlement periods
and trade types for which margin would be attracted. The exchange levies initial margin on derivatives
contracts using the concept of Value at Risk (VaR) or any other concept as the exchange may decide from
time to time. The margin is charged so as to cover one day loss that can be encountered on the position on
99% of the days. Additional margins may be levied for deliverable positions, on the basis of VaR from the
expiry of the contract till the actual settlement date plus a markup for default.
The margin has to be deposited with the exchange within the time notied by the exchange. The exchange
also prescribes categories of securities that would be eligible for a margin deposit, as well as the method of
valuation and amount of securities that would be required to be deposited against the margin amount.
The procedure for refund/ adjustment of margins is also specied by the exchange from time to time. The
exchange can impose upon any particular trading member or category of trading member any special or
other margin requirement. On failure to deposit margin/s as required under this clause, the
exchange/clearing house can withdraw the trading facility of the trading member. After the pay-out, the
clearing house releases all margins.
Unfair trading practices
No trading member should buy, sell, deal in derivatives contracts in a fraudulent manner, or indulge in any
unfair trade practices including market manipulation. This includes the following:
~ Effect, take part either directly or indirectly in transactions, which are likely to have effect of articially ,
raising or depressing the prices of spot/ derivatives contracts.
4Indulge in any act, which is calculated to create a false or misleading appearance of trading, resulting in
reaction of prices, which are not genuine.
4Buy, sell commodities/ contracts on his own behalf or on behalf of a person associated with him pending
the execution of the order of his constituent or of his company or director for the same contract.
4Delay the transfer of commodities in the name of the transferee.
4Indulge in falsication of his books, accounts and records for the purpose of market manipulation.
4When acting as an agent, execute a transaction with a constituent at a price other than the price at which it
was executed on the exchange.
4Either take opposite position to an order of a constituent or execute opposite orders which he is holding in
respect of two constituents except in the manner laid down by the exchange.
10.2.2 Clearing
As mentioned earlier, National Securities Clearing Corporation Limited (NSCCL) undertakes clearing of
trades executed on the NCDEX. All deals executed on the Exchange are cleared and settled by the trading
members on the settlement date by the trading members themselves as clearing members or through other
professional clearing members in accordance with these regulations, bye laws and rules of the exchange.
Last day of trading
Last trading day for a derivative contract in any commodity is the date as specied in the respective
commodity contract. If the last trading day as specied in the respective commodity contract is a holiday, the
last trading day is taken to be the previous working day of exchange.
On the expiry date of contracts, the trading members/ clearing members have to give delivery information as
prescribed by the exchange from time to time. If a trading member/ clearing member fails to submit such
information during the trading hours on the expiry date for the contract, the deals have to be settled as per
the settlement calendar applicable for such deals, in cash together with penalty as stipulated by the exchange.
Delivery
Delivery can be done either through the clearing house or outside the clearing house. On the expiry date,
during the trading hours, the exchange provides a window on the trading system to submit delivery
information for all open positions.
After the trading hours on the expiry date, based on the available information, the matching for deliveries
takes place rstly, on the basis of locations and then randomly keeping in view the factors such as available
capacity of the vault/ warehouse, commodities already deposited and dematerialized and offered for
delivery and any other factor as may be specied by the exchange from time to time. Matching done 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 the nal settlement
price. All matched and unmatched positions are settled in accordance with the applicable settlement
calendar.
The exchange may allow an alternate mode of settlement between the constituents directly provided that
both the constituents through their respective clearing members notify the exchange before the closing of
trading hours on the expiry date. They have to mention their preferred identied counterparty and the
deliverable quantity, along with other details required by the exchange. The exchange however, is not be
responsible or liable for such settlements or any consequence of such alternate mode of settlements. If the
information provided by the buyer/ seller clearing members fails to match, then the open position would be
settled in cash together with penalty as may be stipulated by the exchange.
The clearing members are allowed to deliver their obligations before the pay in date as per applicable
settlement calendar, whereby the clearing house can reduce the margin requirement to that extent.
The exchange species the parameters and methodology for premium/ discount, as the case may be, from
time to time for the quality/ quantity differential, sales tax, taxes, government levies/ fees if any. Pay in/ Pay
out for such additional obligations is settled on the supplemental settlement date as specied in the settlement
calendar.
Procedure for payment of sales tax/VAT
The exchange prescribes procedure for payment of sales tax/VAT or any other state/local/central tax/fee
applicable to the deals culminating into sale with physical delivery of commodities.
All members have to ensure that their respective constituents, who intend to take or give delivery of
commodity, are registered with sales tax authorities of all such states in which the exchange has a delivery
center for a particular commodity in which constituent has or is expected to have open positions. Members
have to maintain records/details of sales tax registration of each of such constituent and furnish the same to
the exchange as and when required.
The seller is responsible for payment of sales tax/VAT, however the seller is entitled to recover from the
buyer, the sales tax and other taxes levied under the local state sales tax law to the extent permitted by law. In
no event is the exchange/ clearing house liable for payment of sales tax/ VAT or any other local tax, fees, levies
etc.
Penalties for defaults
In the event of a default by the seller or the buyer in delivery of commodities or payment of the price, the
exchange closes out the derivatives contracts and imposes penalties on the defaulting buyer or seller, as the
case may be. It can also use the margins deposited by such clearing member to recover the loss. The
settlement for the defaults in delivery is to be done in cash within the period as prescribed by the exchange at
the highest price from the last trading date till the nal settlement date with a mark up thereon as may be
decided from time to time.
Process of dematerialization
Dematerialization refers to issue of an electronic credit, instead of a vault/ warehouse receipt, to the
depositor against the deposit of commodity. Any person (a constituent) seeking to dematerialize a
commodity has to open an account with an approved depository participant (DP). The exchange provides
the list of approved DPs from time to time.
In case of commodities (other than precious metals) the constituent delivers the commodity to the exchange
approved warehouses. The commodity brought by the constituent is checked for the quality by the
exchange approved assayers before the deposit of the same is accepted by the warehouse. If the quality of
the commodity is as per the norms denied and notied by the exchange from time to time, the warehouse
accepts the commodity and sends conrmation in the requisite format to the R & T agent who upon
verication, conrms the deposit of such commodity to the depository for giving credit to the demat account of
the said constituent.
In case of precious metals, the commodity must be accompanied with the assayerscerticate. The vault
accepts the precious metal, after verifying the contents of assayers certicate with the precious metal being
deposited. On acceptance, the vault issues an acknowledgement to the constituent and sends conrmation in
the requisite format to the R & T agent who upon verication, conrms the deposit of such precious metal to
the depository for giving credit to the demat account of the said constituent.
Validity date
In case of commodities having validity date assigned to it by the approved assayer, the delivery of the
commodity upon expiry of validity date is not considered as a good delivery. The clearing member has to
ensure that his concerned constituent removes the commodities on or before the expiry of validity date for
such commodities.
For the depository, commodities, which have reached the trading validity date, are moved out of the
electronic deliverable quantity. Such commodities are suspended from delivery. The constituent has to
rematerialize such quantity and remove the same from the warehouse. Failure to remove deliveries after the
validity date from warehouse is levied with penalty as specied by the relevant authority from time to time.
Process of rematerialisation
Rematerialization refers to issue of physical delivery against the credit in the demat account of the
constituent. The constituent seeking to rematerialize his commodity holding has to make a request to his DP
in the prescribed format and the DP then routes his request through the depository system to the R & T
agent issues the authorisation addressed to the vault/ warehouse to release physical delivery to the
constituent. The vault/warehouse on receipt of such authorisation releases the commodity to the
constituent or constituents authorised person upon verifying the identity.Delivery through the depository
clearing system
Delivery in respect of all deals for the clearing in commodities happens through the depository clearing
system. The delivery through the depository clearing system into the account of the buyer with the
depository participant is deemed to be delivery, notwithstanding that the commodities are located in the
warehouse along with the commodities of other constituents.
Payment through the clearing bank
Payment in respect of all deals for the clearing has to be made through the clearing bank(s); Provided
however that the deals of sales and purchase executed between different constituents of the same clearing
member in the same settlement, shall be offset by process of netting to arrive at net obligations.
Clearing and settlement process
The relevant authority from time to time xes the various clearing days, the payin and pay out days and the
scheduled time to be observed in connection with the clearing and settlement operations of deals in
commodities/ futures contracts.
1. Settlement obligations statements for TCMs: The exchange generates and provides to each trading
clearing member, settlement obligations statements showing the quantities of the different kinds of
commodities for which delivery/ deliveries is/ are to be given and/ or taken and the funds payable or
receivable by him in his capacity as clearing member and by professional clearing member for deals made by
him for which the clearing Member has conrmed acceptance to settle. The obligations statement is deemed
to be conrmed by the trading member for which deliveries are to be given and/ or taken and funds to be
debited and/ or credited to his account as specied in the obligations statements and deemed instructions to
the clearing banks/ institutions for the same.
2. Settlement obligations statements for PCMs: The exchange/ clearing house generates and provides to
each professional clearing member, settlement obligations statements showing the quantities of the different
kinds of commodities for which delivery/ deliveries is/ are to be given and/ or taken and the funds payable or
receivable by him. The settlement obligation statement is deemed to have been conrmed by the said clearing
member in respect of every and all obligations enlisted therein.
Delivery of commodities
Based on the settlement obligations statements, the exchange generates delivery statement and receipt
statement for each clearing member. The delivery and receipt statement contains details of commodities to
be delivered to and received from other clearing members, the details of the corresponding buying/ selling
constituent and such other details. The delivery and receipt statements are deemed to be conrmed by
respective member to deliver and receive on account of his constituent, commodities as specied in the
delivery and receipt statements.
On respective payin day, clearing members effect depository delivery in the depository clearing system as
per delivery statement in respect of depository deals. Delivery has to be made in terms of the delivery units
notied by the exchange.
Commodities, which are to be received by a clearing member, are delivered to him in the depository clearing
system in respect of depository deals on the respective payout day as per instructions of the exchange/
clearing house.
Delivery units
The exchange species from time to time the delivery units for all commodities admitted to dealings on the
exchange. Electronic delivery is available for trading before expiry of the validity date. The exchange also
species from time to time the variations permissible in delivery units as per those stated in contract
specications.
Depository clearing system
The exchange species depository(ies) through which depository delivery can be effected and which shall act
as agents for settlement of depository deals, for the collection of margins by way of securities for all deals
entered into through the exchange, for any other commodities movement and transfer in a depository(ies)
between clearing members and the exchange and between clearing member to clearing member as may be
directed by the relevant authority from time to time.
Every clearing member must have a clearing account with any of the Depository Participants of specied
depositories. Clearing Members operate the clearing account only for the purpose of settlement of
depository deals entered through the exchange, for the collection of margins by way of commodities for
deals entered into through the exchange. The clearing member cannot operate the clearing account for any
other purpose.
Clearing members are required to authorise the specied depositories and depository participants with
whom they have a clearing account to access their clearing account for debiting and crediting their accounts
as per instructions received from the exchange and to report balances and other credit information to the
exchange.
10.3 Rules governing investor grievances, arbitration
In matters where the exchange is a party to the dispute, the civil courts at Mumbai have exclusive jurisdiction
and in all other matters, proper courts within the area covered under the respective regional arbitration
center have jurisdiction in respect of the arbitration proceedings falling/ conducted in that regional
arbitration center.
For the purpose of clarity, we dene the following:
4Arbitrator means a sole arbitrator or a panel of arbitrators.
4Applicant means the person who makes the application for initiating arbitral proceedings.
4Respondent means the person against whom the applicant lodges an arbitration application, whether or
not there is a claim against such person.
If the value of claim, difference or dispute is more than Rs.25 Lakh on the date of application, then such claim,
difference or dispute are to be referred to a panel of three arbitrators. If the value of the claim, difference or
dispute is up to Rs.25 Lakh, then they are to be referred to a sole arbitrator. Where any claim, difference or
dispute arises between agent of the member and client of the agent of the member, in such claim, difference
or dispute, the member, to whom such agent of the member is afliated, is impeded as a party. In case the
warehouse refuses or fails to communicate to the constituent the transfer of commodities, the date of
dispute is deemed to have arisen on
The date of receipt of communication of warehouse refusing to transfer the commodities in favoure of the
constituent.
The date of expiry of 5 days from the date of lodgment of dematerialized request by the constituent for
transfer with the seller, whichever is later.
10.3.1 Procedure for arbitration
The applicant has to submit to the exchange application for arbitration in the specied form (Form No. I/IA)
along with the following enclosures:
The statement of case (containing all the relevant facts about the dispute and relief sought).
The statement of accounts.
Copies of member constituent agreement.
Copies of the relevant contract notes, invoice and delivery challan.
The Applicant has to also submit to the exchange the following along with the arbitration form:
A cheque/ pay order/ demand draft for the deposit payable at the seat of arbitration in favour of National
Commodity & Derivatives Exchange Limited.
Form No. II/IIA containing list of names of the persons eligible to act as arbitrators.
If any deciency/ defect in the application is found, the exchange calls upon the applicant to rectify the
deciency/ defect and the applicant must rectify the deciency/ defect within 15 days of receipt of intimation
from the exchange. If the applicant fails to rectify the deciency/ defect within the prescribed period, the
exchange returns the decient/ defective application to the applicant. However, the applicant has the right to
le a revised application, which will be considered as a fresh application for all purposes and dealt with
accordingly.
Upon receipt of Form No.I/IA, the exchange forwards a copy of the statement of case and related
documents to the respondent. The respondent then has to submit Form II/IIA to the exchange within 7 days
from the date of receipt. If the respondent fails to submit Form II/IIA within the time period prescribed by the
exchange, then the arbitrator is appointed in the manner as specied in the regulation. The respondent(s)
should within 15 days from the date of receiptof Form No. I/IA from the exchange, submit to the exchange in
Form No. III/IIIA three copies in case of sole arbitrator and ve copies in case of panel of arbitrators along with
the following enclosures:
4The statement of reply (containing all available defences to the claim)
4The statement of accounts
4Copies of the member constituent agreement.
4Copies of the relevant contract notes, invoice and delivery challan
4Statement of the setof f or counter claim along with statements of accounts and copies of relevant contract
notes and bills
The respondent has to also submit to the exchange a cheque/ pay order/ demand draft for the deposit
payable at the seat of arbitration in favour of National Commodity & Derivatives Exchange Limited along
with Form No.III/IIIA If the respondent fails to submit Form III/IIIA within the prescribed time, then the
arbitrator can proceed with the arbitral proceedings and make the award exparte. Upon receiving Form No.
III/IIIA from the respondent the exchange forwards one copy to the applicant. The applicant should within
ten days from the date of receipt of copy of Form III/IIIA, submit to the exchange, a reply to any counterclaim,
if any, which may have been raised by the respondent in its reply to the applicant. The exchange then
forwards the reply to the respondent. The time period to le any pleading referred to herein can be extended
for such further periods as may be decided by the relevant authority in consultation with the arbitrator
depending on the circumstances of the matter.
10.3.2 Hearings and arbitral award
No hearing is required to be given to the parties to the dispute if the value of the claim difference or dispute is
Rs.25,000 or less. In such a case the arbitrator proceeds to decide the matter on the basis of documents
submitted by both the parties provided. However the arbitrator for reasons to be recorded in writing may
hear both the parties to the dispute.
If the value of claim, difference or dispute is more than Rs.25,000, the arbitrator offers to hear the parties to
the dispute unless both parties waive their right for such hearing in writing.
The exchange in consultation with the arbitrator determines the date, the time and place of the rst hearing.
Notice for the rst hearing is given at least ten days in advance, unless the parties, by their mutual consent,
waive the notice. The arbitrator determines the date, the time and place of subsequent hearings of which the
exchange gives a notice to the parties concerned.
If after the appointment of an arbitrator, the parties settle the dispute, then the arbitrator records the
settlement in the form of an arbitral award on agreed terms. All fees and charges relating to the appointment
of the arbitrator and conduct of arbitration proceedings are to borne by the parties to the reference equally
or in such proportions as may be decided by the arbitrator. The costs, if any, are awarded to either of the
party in addition to the fees and charges, as decided by the arbitrator.
Solved Problems
Q: Which of the following is not involved in regulating forward/futures trading system in India?
1. Government of India 3. Commodity exchanges
2. Forward Markets Commission(FMC) 4. Commodity board of trading
Q: All the exchanges, which deal with forward contracts, are required to obtain certicate of registration from
the
1. Government of India 3. Commodity exchanges
2. Forward Markets Commission(FMC) 4. Commodity board of trading
Q: To ensure nancial integrity and market integrity, the FMC prescribes certain regulatory measures. Which
of the following is not a measure prescribed?
1. Limit on net open positions. 3. Special margin deposits.
2. Circuitlters or limit on price uctuations. 4. Price determination
Q: Every trading member is required to specify the buy or sell orders as either an open order or a close order
for derivatives contracts.
1. Open order or close order 3. take order or give order
2. call order or put order 4. bid order or ask order
Q: In matters where the NCDEX is a party to the dispute, the civil courts at have exclusive jurisdiction.
1. Delhi 3. Ahmedabad
2. Mumbai 4. Calcutta
Q: No hearing is required to be given to the parties to the dispute if the value of the claim difference or
dispute is Rs.25,000 or less.
1. Rs.25,000 3. Rs.1,00,000
2. Rs.50,000 4. Rs.10,000
Q: In the case of an arbitration, the exchange in consultation with the determines the date, the time and
place of the rst hearing.
1. Respondent 3. Arbitrator
2. Applicant 4. Warehouse
Chapter 11
Implications of sales tax
The physical settlement in the case of commodities futures contracts involves issues concerned with sales
tax. The fact that delivery could happen across various states, and these states have different sales tax rules,
makes the issue a little complicated. In the case of settlements culminating into delivery, sales tax at the rates
applicable in the state where the delivery center is located will be payable. In many states, the sales tax laws,
also provide for levy of additional tax, turnover tax, resale tax, etc. which may or may not be recoverable
from the buyer depending on the provisions of the local state sales tax law.
The NCDEX has examined the implications of trading on NCDEX system under the relevant state sales tax
laws and has also sought opinion from independent tax advisors on the matter. The present understanding of
the implications are given below for reference.
4Futures contracts are in the nature of agreement to buy or sell at a future date and hence are not liable for
payment of sales tax.
4If the futures contract is closed out and settled between the constituents prior to the settlement date
without actually buying or selling the commodities, there is no liability for payment of sales tax.
4When the futures contract fructies into a sale and culminates into delivery, there would be liability for
payment of sales tax. This liability will arise in the state in which the warehouse (into which the goods are
lodged by the constituent) is situated when the commodities are delivered to the buyer.
It is the responsibility of the selling constituent to comply with the relevant local state sales tax laws and other
local enactments. The selling constituent will be responsible for the following:
1. Obtaining registration under the relevant state sales tax laws, ling of returns, payment of taxes and due
compliance of laws.
2. Payment of entry tax, octroi, etc., when the commodities are brought into the designated local area for
lodging the same with the warehouse.
3. Complying with any check post regulations prescribed under the local sales tax, entry tax or other
municipal laws and ensuring that the prescribed documents accompany the goods.
4. Liability for central sales tax if the commodities are moved from outside the state pursuant to a
transaction of sale.
5. The selling constituent may move the commodities into the warehouse well in advance and ensure
compliance of provisions of law.
6. Furnishing of duly completed sales invoices, declaration forms and certificates prescribed under the local
sales tax, entry tax or other municipal laws to enable the buyer to avail of exemption or deduction as
provided in the relevant laws.
It is the responsibility of the buying constituent to comply with the applicable local state sales tax laws and
other local enactments. The buying constituent will be responsible for the following:
1. Obtaining registration under the relevant state sales tax laws based on the purchase of commodities, ling
of returns, payment of taxes and due compliance of laws.
2. Furnishing of duly completed declaration forms and certificates prescribed under the local sales tax, entry
tax or other municipal laws to enable the seller to avail of exemption or deduction as provided in the relevant
laws.
Solved Problems
Q: When the futures contract fructies into a sale and culminates into delivery, the payment of sales tax is to be
done in the state in which the is situated.
1. Clearing corporation 3. Buyer
2. Warehouse 4. Seller
Q: It is the responsibility of the to comply with the relevant local state sales tax laws and other local
enactments.
1. Warehouse 3. Seller
2. Buyer 4. Buyer and seller
Q: The issue of paying sales tax arises only when the futures contracts fructies into a sale and culminates into
of the underlying.
1. Payment 3. Delivery
2. Sale 4. Exchange
Sources/references/suggested readings
The readings suggested here are supplementary in nature and would prove to be helpful for those interested
in learning more about derivatives.
4Derivatives FAQ by Ajay Shah and Susan Thomas
4Escape to the futures by Leo Melamed
4Futures and options by Hans R.Stoll and Robert E. Whaley.
4Futures and options in risk management by Terry J. Watsham.
4Options, futures and other derivatives by John Hull.
4Futures, options and swaps by Robert W. Kolb.
4Introduction to futures and options markets by John Kolb
4Options and nancial future: Valuation and uses by David A. Dubofsky.
4Rubinstein on derivatives by Mark Rubinstein.
4Derivative markets in India 2003 edited by Susan Thomas.
4http://www.ncdex. com
4http://fmc.gov.in
Index
arbitragers, 10 in-the-money, 61
assignment, 18 index, 61 intrinsic
value, 62 out-of-
basis, 60 money, 61
baskets, 14 premium, 61
cost of carry, 60 cost-of- put, 61
carry, 76 stock, 61 time
value, 62
delivery, 19 writer, 61
derivatives
exchange traded, order
13 OTC, 13 day, 104 GTC,
forwards, 57 105 GTD, 105
futures, 14 IOC, 105
commodity, 77 stoploss, 105
hedge price
long, 87 short, 86 limit, 106
hedgers, 10 trigger, 106
long settlement
call, 66 put, 68 physical, 17
margin short
initial, 60 call, 67
maintenance, 60 put, 69
MTM, 60 speculators, 10
option spot price, 60
american, 61 at swaps, 14
the-money, 61 currency, 14
buyer, 61 interest rate, 14
call, 61 swaptions, 14
european, 61 transaction
forward, 12
spot, 12
Warrants,14

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Study Material for Commodities

3 The NCDEX platform ..........................................................................................................29

4 Commodities traded on the NCDEX platform...........................................................35

4.2 Precious metals ...............................................................................................................47

5 Instruments available for trading .............................................................57

6 Pricing commodity futures ..................................................................................75

7.2 Speculation ......................................................................................................................92

9 Clearing and settlement....................................................................................................115

9.4.2 Initial margin .................................................................................................................124

10 Regulatory framework ....................................................................................................133

10.2.1 Trading ............................................................................................................134

1.1 Derivatives denied

1.2 Products, participants and functions

3. Arbitragers: Arbitragers work at making prots by taking advantage of discrepancy between

Whether the underlying asset is a commodity or a nancial asset, derivative markets

Derivative products initially emerged as hedging devices against uctuations in commodity

Box 1.1: Emergence of nancial derivative products

1.3 Derivatives markets

1.3.1 Spot versus forward transaction

1.3.2 Exchange traded versus OTC derivatives

Box 1.2: History of commodity derivatives markets

1. The management of counter-party (credit) risk is decentralised and located within

2. There are no formal centralised limits on individual positions, leverage, or margining.

3. There are no formal rules for risk and burden sharing.

1.3.3 Some commonly used derivatives

Forwards: As we discussed, a forward contract is an agreement between two entities to buy

Q: Futures trading commenced rst on

1. Chicago Board of Trade 2. Chicago Mercantile Exchange

3. Chicago Board Options Exchange

4. London International Financial Futures and Options Exchange

Q: Derivatives rst emerged as products

A: The correct answer is number 2.

Q: Which of the following exchanges offer commodity derivatives trading

2. Interconnected Stock Exchange 4. ICICI Securities Limited

A: The correct answer is number 1.

Q: OTC derivatives are considered risky because

A: The correct answer is number 4.

1. Index futures 2. Index options

A: The correct answer is number 3.

Q: In a transaction, trading involves

1. The buyer and seller agreeing upon a price.

4. None of the above.

Q: In a transaction, clearing involves

A: The correct answer is number 3.

Q: In a transaction, settlement involves

A: The correct answer is number 2.

2.1 Difference between commodity and nancial derivatives

Delivery notice period

Typically, in all commodity exchanges, delivery notice is required to be supported by a warehouse

In case of commodity derivatives however, there is a possibility of physical settlement. Which

2.2 Global commodities derivatives exchanges 23

Table 2.1 The global derivatives industry

Peoples Republic Of China Beijing Commodity Exchange Shanghai

5. Rice bran oil

2.3.2 Latest developments

Table 2.3 Registered commodity exchanges in India

Long Staple Cotton, Gold, Silver

1. L C Gupta Committee 3. Khusro Committee

2. Kabra Committee 4. J R Varma Committee A: The correct answer is number 2.

The NCDEX platform

NCDEX is regulated by Forward Markets Commission in respect of futures trading in commodities.

3.1 Structure of NCDEX