Professional Documents
Culture Documents
1 Introduction to derivatives............................................................................... 11
1.1 Derivatives defined.................................................................................... 11
1.2 Products, participants and functions.......................................................... 12
1.3 Derivatives markets................................................................................... 13
1.3.1 Spot versus forward transaction.................................................... 14
1.3.2 Exchange traded versus OTC derivatives...................................... 14
1.3.3 Some commonly used derivatives................................................. 16
2 Commodity derivatives.................................................................................... 19
2.1 Difference between commodity and financial derivatives......................... 19
2.1.1 Physical settlement........................................................................ 19
2.1.2 Warehousing................................................................................. 21
2.1.3 Quality of underlying assets.......................................................... 22
2.2 Global commodities derivatives exchanges............................................... 22
2.2.1 Africa............................................................................................. 24
2.2.2 Asia.............................................................................................. 24
2.2.3 Latin America................................................................................ 24
2.3 Evolution of the commodity market in India............................................. 24
2.3.1 The Kabra committee report......................................................... 25
2.3.2 Latest developments...................................................................... 27
8 Trading............................................................................................................. 101
8.1 Futures trading system............................................................................... 101
8.2 Entities in the trading system.................................................................... 101
8.2.1 Guidelines for allotment of client code......................................... 102
8.3 Contract specifications for commodity futures......................................... 103
8.4 Commodity futures trading cycle.............................................................. 103
8.5 Order types and trading parameters........................................................... 104
8.5.1 Permitted lot size........................................................................... 108
8.5.2 Tick size for contracts................................................................... 108
8.5.3 Quantity freeze.............................................................................. 109
8.5.4 Base price...................................................................................... 109
8.5.5 Price ranges of contracts............................................................... 109
8.5.6 Order entry on the trading system................................................. 110
8.6 Margins for trading in futures.................................................................... 112
8.7 Charges..................................................................................................... 113
2 Commodity Derivatives 7
8 Trading 16
10 Regulatory framework 8
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Chapter 1
Introduction to derivatives
The origin of derivatives can be traced back to the need of farmers to protect themselves against
fluctuations 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 locking-in 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 futures-type 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 'to-arrive' contract 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 first 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 financial
underlyings like stocks, interest rate, exchange rate, etc.
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 "underlying" in 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 "security" in 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) defines "derivative" to 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.
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 profits 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
profit.
Whether the underlying asset is a commodity or a financial asset, derivative markets performs
a number of economic functions.
Prices in an organised derivatives market reflect 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.
1.3 Derivatives markets 13
• 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 difficult in these
kind of mixed markets.
• An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new
entrepreneurial activity. Derivatives have a history of attracting many bright, creative, well-educated
people with an entrepreneurial attitude. They often energize others to create new businesses, new
products and new employment opportunities, the benefit 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.
the underlying. The most commonly used derivatives contracts are forwards, futures and options
which we shall discuss in detail later.
Early forward contracts in the US addressed merchants' concerns about ensuring that there were
buyers and sellers for commodities. However "credit risk" remained 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 first "exchange traded" derivatives 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 "financial" exchanges of any kind in the world today.
The first stock index futures contract was traded at Kansas City Board of Trade. Currently the
most popular stock index futures contract in the world is based on S&P 500 index, traded on
Chicago Mercantile Exchange. During the mid eighties, financial futures became the most active
derivative instruments generating volumes many times more than the commodity futures. Index
futures, futures on T-bills and Euro-Dollar futures are the three most popular futures contracts
traded today. Other popular international exchanges that trade derivatives are LIFFE in England,
DTB in Germany, SGX in Singapore, TIFFE in Japan, MATIF in France, Eurex etc.
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.
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 exchange's 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
financial 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
benefits, 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 exchange-traded and not OTC in nature.
16 Introduction to derivatives
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 today's 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 today's 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. Longer-dated options are called warrants and are generally
traded over-the-counter.
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 flows 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 flows between the parties in
the same currency.
• Currency swaps: These entail swapping both principal and interest between the parties, with the
cashflows 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 first on
1. Speculative 3. Volatility
2. Hedging 4. Risky
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 first exchange traded financial derivative in India commenced with the trading of_
1. Option 3. Forward
2. Future 4. Swap
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.
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.
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.
Derivatives as a tool for managing risk first originated in the commodities markets. They were
then found useful as a hedging tool in financial markets as well. In India, trading in commodity
futures has been in existence from the nineteenth century with organised trading in cotton through
the establishment of Cotton Trade Association in 1875. Over a period of time, other commodities
were permitted to be traded in futures exchanges. Regulatory constraints in 1960s resulted in
virtual dismantling of the commodities future markets. It is only in the last decade that commodity
future exchanges have been actively encouraged. However, the markets have been thin with poor
liquidity and have not grown to any significant level. In this chapter we look at how commodity
derivatives differ from financial derivatives. We also have a brief look at the global commodity
markets and the commodity markets that exist in India.
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 financial assets. We take a general
overview at the process flow of physical settlement of commodities. Later on we will look into
details of how physical settlement happens on the NCDEX.
A declaration verifying that the asset is free of any and all charges, including fiscal debts related to
the stored goods.
A provisional delivery order of the good to BM&F (Brazil), issued by the warehouse.
A warehouse certificate showing that storage and regular insurance have been paid.
Assignment
Whenever delivery notices are given by the seller, the clearing house of the exchange identifies the
buyer to whom this notice may be assigned. Exchanges follow different practices for the assignment
process. One approach is to display the delivery notice and allow buyers wishing to take delivery to
bid for taking delivery. Among the international exchanges, BMF, CBOT and CME display delivery
notices. Alternatively, the clearing houses may assign deliveries to buyers on some basis. Exchanges
such as COMMEX and the Indian commodities exchanges have adopted this method.
2.1 Difference between commodity and financial derivatives 21
Any seller/ buyer who has given intention to deliver/ been assigned a delivery has an option to
square off positions till the market close of the day of delivery notice. After the close of trading,
exchanges assign the delivery intentions to open long positions. Assignment is done typically either
on random basis or first-in-first out basis. In some exchanges (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 seller's account.
In India if a seller does not give notice of delivery then at the expiry of the contract the positions
are cash settled by price difference exactly as in cash settled equity futures contracts.
2.1.2 Warehousing
One of the main differences between financial and commodity derivative is the need for
warehousing. In case of most exchange-traded financial derivatives, all the positions are cash settled.
Cash settlement involves paying up the difference in prices between the time the contract was
entered into and the time the contract was closed. 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 efficacy of the commodities settlements
depends on the warehousing system available. Most international commodity exchanges used
certified warehouses (CWH) for the purpose of handling physical settlements. Such CWH are
required to provide storage facilities for participants in the commodities markets
22 Commodity derivatives
The New York Cotton Exchange has specified 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 flavour 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 specified
that "Each delivery unit shall consist of nominal 'i y- is 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
fir, Englemann spruce, hem-fir, lodgepole pine, and/ or spruce pine fir".
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 efficient as it is in some
of the other developed markets. Central and state government controlled warehouses are the major
providers of agri-produce storage facilities. Apart from these, there are a few private warehousing
being maintained. However there is no clear regulatory oversight of warehousing services.
exchanges in the world. The CBOT was established in 1848 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 first futures-type contract was developed. It was know as the
to-arrive 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 financial assets form the underlying assets in
24 Commodity derivatives
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
Africa's most active and important commodity exchange is the South African Futures Exchange
(SAFEX). It was informally launched in 1987. SAFEX only traded financial futures and gold futures
for a long time, but the creation of the Agricultural Markets Division (as of 2002, the Agricultural
Derivatives Division) led to the introduction of a range of agricultural futures contracts for
commodities, in which trade was liberalised, namely, white and yellow maize, bread milling wheat
and sunflower seeds.
2.2.2 Asia
China's first commodity exchange was established in 1990 and at least forty had appeared by 1993.
The main commodities traded were agricultural staples such as wheat, corn and in particularly
soybeans. In late 1994, more than half of China's exchanges were closed down or reverted to being
wholesale markets, while only 15 restructured exchanges received formal government approval. At
the beginning of 1999, the China Securities Regulatory Committee began a nationwide consolidation
process which resulted in three commodity exchanges emerging; the Dalian Commodity Exchange
(DCE), the Zhengzhou Commodity Exchange and the Shanghai futures Exchange, formed in 1999
after the merger of three exchanges: Shanghai Metal, Commodity, Cereals & Oils Exchanges. The
Taiwan Futures Exchange was launched in 1998. Malaysia and Singapore have active commodity
futures exchanges. Malaysia hosts one futures and options exchange. Singapore is home to the
Singapore Exchange (SGX), which was formed in 1999 by the merger of two well-established
exchanges, the Stock Exchange of Singapore (SES) and Singapore International Monetary Exchange
(SIMEX).
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.
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.
26 Commodity derivatives
The committee submitted its report in September 1994. The recommendations of the
committee were as follows:
• The Forward Markets Commission(FMC) and the Forward Contracts (Regulation) Act, 1952, would
need to be strengthened.
• 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.
• In-built devices in commodity exchanges such as the vigilance committee and the panels of surveyors
and arbitrators be strengthened further.
• The FMC which regulates forward/ futures trading in the country, should continue to act a watch-dog
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.
• 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.
• The majority of me committee recommended that futures trading be introduced in the following
commodities:
1. Basmatirice
2. Cotton and kapas
3. Raw jute and jute goods
1. Groundnut, rapeseed/mustard seed, cottonseed, sesame seed, sunflower seed, safflower seed,
copra and soybean, and oils and oilcakes of all of them.
4. Rice bran oil
5. Castor oil and its oilcake
6. Linseed
7. Silver
8. 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 2002-2003 were indicative of the governments resolve to put in place a mechanism of
futures trade/market. As a follow up, the government issued notifications on 1.4.2003 permitting
futures trading in the commodities, with the issue of these notifications futures trading is not
prohibited in any commodity. Options trading in commodity is, however presently prohibited.
Table 2.2 Volume on existing exchanges
Commodity exchange Products Approx. annual vol
(Rs.Crore)
National board of trade, Indore Soya, mustard 80000
National multicommodity exchange, Ahmedabad Multiple 40000
Ahmedabad commodity exchange Castor, cotton 3500
Rajdhani Oil & oilseeds Mustard 3500
Vijai Beopar Chamber Ltd. Muzzaffarnagar Gur 2500
Rajkot seeds, oil & bullion exchange Castor, groundnut 2500
IPSTA, Cochin Pepper 2500
Chamber of commerce, Hapur Gur, mustard 2500
Bhatinda Om and oil exchange Gur 1500
Other (mostly inactive) 1500
Total 140000
Solved Problems
Q: Which of the following feature differentiates a commodity futures contract from a financial
futures contract?
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
2. The seller assigns delivery to the buyer buyer
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 world-class 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, refined 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.
• To create a world class commodity exchange platform for the market participants.
• To inculcate best international practices like de-modularization, technology platforms, low cost
solutions and information dissemination without noise etc. into the trade.
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 benefits which are currently in short supply
in the commodity markets. The four institutional promoters of NCDEX are prominent players
in their respective fields 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.
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.
34 The NCDEX platform
• Bank guarantee: Bank guarantee in favour of NCDEX as per the specified format from approved
banks. The minimum term of the bank guarantee should be 12 months.
• Fixed 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.
• Government 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 Lakh in case of
TCM and Rs. 25 Lakh 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:
• If the security deposit shortage is equal to or greater than Rs. 5 Lakh, the trading facility would be
withdrawn with immediate effect.
• If the security deposit shortage is less than Rs.5 Lakh the member would be given one calendar weeks'
time to replenish the shortages and if the same is not done within the specified 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, fixed deposit receipts or Government of India securities.
3.4.1 Trading
The trading system on the NCDEX, provides a fully automated screen-based trading for futures on
commodities on a nationwide basis as well as an online monitoring and surveillance mechanism.
It supports an order driven market and provides complete transparency of trading operations. The
trade timings of the NCDEX are 10.00 a.m. to 4.00 p.m. After hours trading has also been
proposed for implementation at a later stage.
The NCDEX system supports an order driven market, where orders match automatically.
Order matching is essentially on the basis of commodity, its price, time and quantity. All quantity
fields are in units and price in rupees. The exchange specifies the unit of trading and the delivery
unit for futures contracts on various commodities . The exchange notifies the regular lot size and
tick size for each of the contracts traded from time to time. When any order enters the trading
system, it is an active order. It tries to find a match on the other side of the book. If it finds a
match, a trade is generated. If it does not find a match, the order becomes passive and gets
3.4 The NCDEX system__________________________________________________35
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 one-month, two-month 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 firstly, on the basis of
locations and then randomly, keeping in view the factors such as available capacity of the vault/
warehouse, commodities already deposited and dematerialized and offered for delivery etc.
Matching done by this process is binding on the clearing members. After completion of the
matching process, clearing members are informed of the deliverable/ receivable positions and the
unmatched positions. Unmatched positions have to be settled in cash. The cash settlement is only
for the incremental gain/ loss as determined on the basis of final settlement price.
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 final settlement which happens on the last trading
day of the futures contract. On the NCDEX, daily MTM settlement and final MTM settlement in
respect of admitted deals in futures contracts are cash settled by debiting/ crediting the clearing
accounts of CMs with the respective clearing bank. All positions of a CM, either brought forward,
created during the day or closed out during the day, are market to market at the daily settlement
price or the final settlement price at the close of trading hours on a day.
On the date of expiry, the final settlement price is the spot price on the expiry day. The
responsibility of settlement is on a trading cum clearing member for all trades done on his own
account and his client's trades. A professional clearing member is responsible for settling all the
participants trades which he has confirmed to the exchange. On the expiry date of a futures
contract, members submit delivery information through delivery request window on the trader
workstations provided by NCDEX for all open positions for a commodity for all constituents
individually. NCDEX on receipt of such information, matches the information and arrives at a
delivery position for a member for a commodity.
The seller intending to make delivery takes the commodities to the designated warehouse.
These commodities have to be assayed by the exchange specified assayer. The commodities have
to meet the contract specifications with allowed variances. If the commodities meet the
36__________________________________________________________The NCDEX platform
specifications, the warehouse accepts them. Warehouse then ensures that the receipts get updated
in the depository system giving a credit in the depositor's electronic account. The seller then gives
the invoice to his clearing member, who would courier the same to the buyer's clearing member.
On an appointed date, the buyer goes to the warehouse and takes physical possession of the
commodities.
Solved Problems
Q: Which of the following futures do not trade on the NCDEX?
Q: NCDEX is regulated by
1. Rs.5Lakh 3. Rs.500Lakh
2. Rs.50Lakh 4. Rs.5000Lakh
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 specific issues. The commodity markets can be classified 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.
4.1.1 Cotton
Cotton accounts for 75% of the fibre consumption in spinning mills in India and 58% of the total fibre
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 fluctuation in prices of cotton traded
across India has been at around 4.5% during the last three years. The maximum fluctuation has been as
high as 11%. Historically, cotton prices in India have been fluctuating in the range of 3-6% on a
monthly basis.
Cotton is among the most important non-food crops. It occupies a significant position, both from
agricultural and manufacturing sectors' points of view. It is the major source of a basic human need -
clothing, apart from other fibre sources like jute, silk and synthetic. Today, cotton occupies a significant
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 country's industrial production, 27-30% of the country's export earnings and 4% of its
GDP.
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 mid-2002, prices
recovered to 53 cents, and toward end of 2003 were currently ruling at 58.85 cents.
Cotton prices in India are therefore influenced by various demand-supply factors operating within
the country, international raw cotton prices, demand for finished readymade garments from abroad,
prices of synthetic fibre, etc. Jute, silk, wool and khadi - the other fibre sources, are less likely to have
any major impact on cotton prices in India.
(in specific, 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 24-25 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 refining, 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 influenced by the supply-demand scene in the domestic market including the
factors influencing various oilseed production in the country, prices of various domestically
produced and imported oils, production and trade policies of the Government, mainly the export-
import 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 refiners,
corporate involved in wholesale and retail trade through value-addition and retail-regional level
players along with a few national level players. The industry is dominated by over 200 importing
companies, who are mostly refiners too. Domestic oilseed and edible oil industry is organised in the
form of oilseed crushers, processors, solvent extractors, technologists, commodity-specific
producers and traders.
over-all status of the edible oil industry during the immediate past; current and a short-term 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.
while the consumption of palm in India grew from 0.254 million tons in 1990 to nearly 3 million
tons during 2001-02, 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.
entering the market from October beginning onwards. Crushing for oil and meal starts from
October, peaking during the subsequent two-three months.
exposure in the international edible trade scene (9-10 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 co-derivative (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.
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 13-14 million tons, rapeseed oil accounts for about 12% of
the total world's 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 Germany's 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 one-third of the country's annual edible oil production, which is substantial. The
imports of mustard oil have drastically come down in the country from around 172000 tons in
1998-99 to a mere 10000 tons (of crude rapeseed oil) in 2001-02, owing to stiff price competition
from palm and soy oils. There have been no imports of refined rapeseed oil for the last few years
due to the differential duty structure. Unlike other oils, consumption of rapeseed oil is
concentrated in northern, north-eastern 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 significant 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.
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 5.0-5.4 million tons, soybean constitutes nearly 25% of the country's total
oilseed production. The average monthly fluctuation in prices of soybean traded at one of the
4.1 Agricultural commodities 47
active soybean spot market at Indore (Madhya Pradesh) has been at 10.07% during the past two
years, the maximum monthly fluctuation being as high as 24-30% during the period. Historically,
soybean prices in the major spot markets across the country have been fluctuating in the range of
5-9%. 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.
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 (15-18% of India's annual edible oil requirement) and 3-3.2 million tons of
48 Commodities traded on the NCDEX platform
oil meal, the major protein source in animal feeds. The average monthly fluctuation 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 fluctuation 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 39-40%) and meal. The hybrid form of
rapeseed, known as canola, is more popular internationally.
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 September-October to February-March. Rapeseed and mustard crops grow well in
areas having 25 to 40 cm of rainfall. Sarson is preferred in low-rainfall 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 light-loam soils and Taramira is mostly grown on very light soils.
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 3-3.2 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 one-third of
the country's annual edible oil production, which is substantial. The imports of mustard oil have
drastically come down in the country from around 172000 tons in 1998-99 to a mere 10000 tons
(of crude rapeseed oil) in 2001-02, owing to stiff price competition from palm and soy oils. There
have been no imports of refined 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 significant 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.
Gold futures trading debuted at the Winnipeg Commodity Exchange (Comex) in Canada in November
1972. Delivery was also available in gold certificates 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 floating in the market. The futures trading in gold started in other countries too. This
included the following:
• The London gold futures exchange started operations in the early 1980s.
• The 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.
• The 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 (TMM) of
Chicago.
• The 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.
• On 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.
• The Chinese exchange, Shanghai Gold Exchange was officially opened on 30 October 2002.
• Mumbai's first 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.
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 fluctuations 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 financial assets and tend to make its returns insensitive to business cycle fluctuations. Gold is
still bought (and sold) by different people for a wide variety of reasons - as a use in jewellery, for
industrial applications, as an investment and so on.
4.2 Precious metals 51
Production
Traditionally South Africa has been the largest producers of gold in the world accounting for
almost 80% of all non-communist 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 country-wise 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.
In markets with poorly developed financial 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 gold-linked
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 specific investor preferences:
• Coins and small bars
• Gold-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 of jewellery, 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 investor-demand
(which is relatively elastic to gold-prices, real estate prices, financial markets, tax-policies, 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 inflation. It will be difficult 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 affluent 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
4.2 Precious metals 53
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 significant 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 demand-supply for gold in India can be summed up thus:
• Demand for gold has an autonomous character. Supply follows demand.
• Demand exhibits income elasticity, particularly in the rural and semi-urban areas.
• Price differential creates import demand, particularly illegal import prior to the commencement of
liberalisation in 1990.
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
futures' trading 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 world's 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 financial 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 flatware 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,
4.2 Precious metals 55
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 a fix which offers the chance to buy or sell silver at a single
price. The fix begins at 12:15 p.m. and is a balancing exercise; the price is fixed at the point at
which all the members of the fixing 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 official 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 significant 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
fix, Handy & Harman, a precious metals company, publishes a price for 99.9% pure silver at
noon each working day.
with the rural areas accounting for the bulk of the sales. India's 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-fifths 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 fifth of supply. Scrap supply
increased marginally last year up by 1.2%. The other major source of silver is from refining, 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, three-quarters of all the recycled
silver comes from the photographic scrap, mainly in the form of spent fixer solutions and old
X-ray films.
56 Commodities traded on the NCDEX platform
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
1. Jute 3. Silk
2. Cotton 4. None of the above.
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
1. Soy 3. CPO
Q: Which of the following factor directly influences the price of RBD palmolein?
1. Soy 3. CPO
2. Soybean 4. Sunflower seeds
1. Mumbai 3. Indore
2. Ahmedabad 4. Delhi
1. Mumbai 3. Indore
2. Ahmedabad 4. Delhi
A: The correct answer is number 1. ••
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.
• Each contract is custom designed, and hence is unique in terms of contract size, expiration date and
the asset type and quality.
• On the expiration date, the contract has to be settled by delivery of the asset.
• If the party wishes to reverse the contract, it has to compulsorily go to the same 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.
60 Instruments available for trading
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 fluctuations. 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 fluctuations 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 profits.
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.
• Illiquidity, and
• Counterparty risk
In the first two of these, the basic problem is that of too much flexibility and generality. The
forward market is like a real estate market in that any two consenting adults can form contracts
against each other. This often makes them design terms of the deal which are very convenient in
that specific situation, but makes the contracts non-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.
Merton Miller, the 1990 Nobel laureate had said that "financial futures represent the most significant
financial innovation of the last twenty years." The first exchange that traded financial derivatives was
launched in Chicago in the year 1972. A division of the Chicago Mercantile Exchange, it was called the
International Monetary Market (EMM) and traded currency futures. The brain behind this was a man
called Leo Melamed, acknowledged as the "father of financial 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 interest-rate swaps, and their success transformed Chicago
almost overnight into the risk-transfer capital of the world.
Box 5.6: The first financial futures market
• Location of settlement
• Futures price: The price at which the futures contract trades in the futures market.
• Contract 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.
• Expiry date: It is the date specified 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.
• Delivery 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.
• Basis: Basis can be defined 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 reflects that
futures prices normally exceed spot prices.
• Cost 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
finance the asset less the income earned on the asset.
■ Initial margin: The amount that must be deposited in the margin account at the time a futures contract
is first entered into is known as initial margin.
• Marking-to-market(MTM): In the futures market, at the end of each trading day, the margin account is
adjusted to reflect the investor's gain or loss depending upon the futures closing price. This is called
marking-to-market.
• Maintenance 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.
Although options have existed for a long time, they were traded OTC, without much
knowledge of valuation. The first 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 firms 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 firms. The firm would then attempt to find a seller or writer of the
option either from its own clients or those of other member firms. If no seller could be found,
the firm would undertake to write the option itself in return for a price.
This market however suffered from two deficiencies. 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 specifically for the purpose of trading options. The market for
options developed so rapidly that by early '80s, 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.
■ Stock 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 specified
price.
• Buyer 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.
• Writer 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.
• Call 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.
• Put 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.
• Option price: Option price is the price which the option buyer pays to the option seller. It is also
referred to as the option premium.
■ Expiration date: The date specified in the options contract is known as the expiration date, the
exercise date, the strike date or the maturity.
• Strike price: The price specified in the options contract is known as the strike price or the exercise
price.
64 Instruments available for trading
• American options: American options are options that can be exercised at any time upto the expiration
date. Most exchange-traded options are American.
• European options: European options are options that can be exercised only on the expiration date
itself. European options are easier to analyse than American options, and properties of an American
option are frequently deduced from those of its European counterpart.
• In-the-money option: An in-the-money (ITM) option is an option that would lead to a positive
cashflow to the holder if it were exercised immediately. A call option on the index is said to be in-the-
money when the current index stands at a level higher than the strike price (i.e. spot price > strike
price). If the index is much higher than the strike price, the call is said to be deep ITM. In the case of a
put, the put is ITM if the index is below the strike price.
• At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cashflow if
it were exercised immediately. An option on the index is at-the-money when the current index equals
the strike price (i.e. spot price = strike price).
• Intrinsic 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 Max [0, (St
- K)] which means the intrinsic value of a call is the greater of 0 or (St - K). Similarly, the intrinsic
value of a put is Max [0, (K - St )],i.e. the greater of 0 or (K - St). K is the strike price and St is the spot
price.
• Time 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 option's time value, all else equal. At expiration, an option should have no
time value.
Options made their first major mark in financial history during the tulip-bulb mania in
seventeenth-century Holland. It was one of the most spectacular get rich quick binges in
history. The first 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 fixed
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.
Take the case of a speculator who buys a two-month 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
profits. 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.
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 two-month 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 profits. 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.
68 Instruments available for trading
underlying. If upon expiration, the spot price is below the strike price, he makes a profit. Lower
the spot price, more is the profit he makes. If the spot price of the underlying is higher than the
strike price, he lets his option expire un-exercised. 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 ofRs.400.
Figure 5.7 Payoff for buyer of put option on long staple cotton
The figure shows the profits/ losses for the buyer of a three-month put option on long staple cotton. As can
be seen, as the price of cotton in the spot market falls, the put option becomes in-the-money. If at expiration,
cotton prices fall below the strike of Rs.6000 per Quintal, the buyer would exercise his option and profit to
the extent of the difference between the strike price and spot cotton-close. The profits 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.
Figure 5.8 Payoff for writer of put option on long staple cotton
The figure shows the profits/ losses for the seller of a three-month put option on long staple cotton. As the
price of cotton in the spot market falls, the put option becomes in-the-money 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 cotton-close. The profit 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.
be created.
5.7 Using futures versus using options 73
Solved Problems
Q: Which of the following cannot be an underlying asset for a financial derivative contract?
Q: Which of the following cannot be an underlying asset for a commodity derivative contract?
1. Wheat 3. Cotton
2. Gold 4. Stocks
Q: Which of the following exchanges was the first to start trading commodity futures?
1. Buyer 3. Both
2. Seller 4. Exchange
A: The option to exercise lies with the buyer. The correct answer is number 1. ••
Q: Two persons agree to exchange 100 gms of gold three months later at Rs.400/ gm. This is an
example of a
1. Less than the sum of intrinsic value and time 3. Equal to the sum of intrinsic value and
time value value
1. Greater than 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
Q: Two persons agree to exchange 100 gms of gold three months later at Rs.400/ gm. This is an
example of a
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 profit/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 profit of Rs.50/Quintal. i.e. he makes a profit of Rs.5000. The correct answer is number 1. • •
5.7 Using futures versus using options 75
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. 1450/Quintal. How much profit/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 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 on 10 units of soy bean at Rs. 1500/Quintal. A week later soy bean futures trade at
Rs. 1550/Quintal. How much profit/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 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 on 10 units of soy bean at Rs. 1500/Quintal. A week later soy bean futures trade at
Rs. 1450/Quintal. How much profit/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 sells 10 units which means a futures position in 100 Quintals.
He makes a profit of Rs.50/Quintal. i.e. he makes a profit of Rs.5000. The correct answer is
number 1. • •
Q: A trader buys three-month 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?
A: Per 10 gms he makes a net profit of Rs.10, i.e.[(7080 - 7000) - 70]. He has a long position in 1000 gms. So
100
he makes a net profit of Rs. 1000 on his position 10 The correct answer is number 2. • •
10
76 Instruments available for trading
Q: A trader buys three-month 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 three-month 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?
A: On the day of expiration, the option is ITM so the buyer exercises on him. The buyers profit is
the sellers loss. Per 10 gms he makes a net loss of Rs.10, i.e.[(7080 - 7000) - 70]. He has a short
100
position in 1000 gms. So he makes a net loss of Rs.1000 on his position 10 . The
10
correct answer is number 4.
Q: A trader sells three-month 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
receives an option premium of Rs.70 per 10 gms. He earns the premium amount of Rs.7000 on
his position. The correct answer is number 1. ••
Chapter 6
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 figure at which a person buys and another sells a futures contract
for a specific expiration date is called price discovery. In an active futures market, the process of
price discovery continues from the market's 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 flow 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
significant change in this data is immediately reflected in the trading pits as traders digest the new
information and adjust their bids and offers accordingly. As a result of this free flow of
information, the market determines the best estimate of today and tomorrow's prices and it is
considered to be the accurate reflection of the supply and demand for the underlying commodity.
Price discovery facilitates this free flow 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.
examples 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 cost-of-carry model and try to understand the pricing of futures contracts on
investment assets.
F = S-C (6.1)
where:
F Futures price
S Spot price
C Holding costs or carry costs
where:
Whenever the futures price moves away from the fair value, there would be opportunities for
arbitrage. If F < S(1 + r)T or F > S(1 + r)T, arbitrage would exist. We know what are the spot and
futures prices, but what are the components of holding costs? The components of holding cost
vary with contracts on different assets. At times the holding cost may even be negative. In the case
of commodity futures, the holding cost is the cost of financing plus cost of storage and insurance
purchased. In the case of equity futures, the holding cost is the cost of financing minus the
dividends returns.
Equation 6.2 uses the concept of discrete compounding, where interest rates are compounded
at discrete intervals, for example, annually or semiannually. Pricing of options and other complex
derivative securities requires the use of continuously compounded interest rates. Most books on
derivatives use continuous compounding for pricing futures too. When we use continuous com-
pounding, equation 6.2 is expressed as:
F - SerT (6.3)
where:
rate)
e 2.71828
So far we were talking about pricing futures in general. To understand the pricing of
commodity futures, let us start with the simplest derivative contract - a forward contract. We use
examples of forward contracts to explain pricing concepts because forward contracts are easier to
understand. However, the logic for pricing a futures contract is exactly the same as the logic for
pricing a forward contract. We begin with a forward contract on an asset that provides the holder
with no income and has no storage or other costs. Then we introduce real world factors as they
apply to investment commodities and later to consumption commodities.
Consider a three-month forward contract on a stock that does not pay dividend. Assume that
the price of the underlying stock is Rs.40 and the three-month interest rate is 5% per annum. We
consider the strategies open to an arbitrager in two extreme situations.
1. Suppose that the forward price is relatively high at Rs.43. An arbitrager can borrow Rs.40 from the
market at an interest rate of 5% per annum, buy one share in the spot market, and sell the stock in the
forward market at Rs.43. At the end of three months, the arbitrager delivers the share and receives
Rs.43. The sum of money required to pay off the loan is 40e 0.05 0.25 40.50. By
following this strategy, the arbitrager locks in a profit of Rs.43.00 - Rs.40.50 = Rs.2.50 at the end of the three
month period.
80 Pricing commodity futures
2. Suppose that the forward price is relatively low at Rs.39. An arbitrager can short one share for Rs.40,
invest the proceeds of the short sale at 5% per annum for three months, and take a long position in a
three-month forward contract. The proceeds of the short sale grow to 40e 0.05 0.25 40.50
in three months. At the end of the three months, the arbitrager pays Rs.39, takes delivery of the share
under the terms of the forward contract and uses it to close his short position, in the process making a
net gain of Rs. 1.50 at the end of three months.
We see that if the forward price is greater than Rs.40.50, there exists arbitrage. Under such a
situation, arbitragers will sell the asset in the forward market, eventually driving the forward price
down to Rs.40.50. Similarly if the forward price is less than Rs.40.50, there exists arbitrage.
Arbitragers will buy the asset in the forward market, eventually pushing the forward price up to
Rs.40.50. At a forward price of Rs.40.50 there will be no arbitrage. This is the fair value of the
forward contract. The same arguments hold good for a futures contract on an investment asset.
Now let us try to extend this logic to a futures contract on a commodity. Let us take the
example of a futures contract on a commodity and work out the price of the contract. The spot
price of gold is Rs.7000/ 10 gms. If the cost of financing is 15% annually, what should be the
futures price of 10 gms of gold one month down the line ? Let us assume that we're on 1st January
2004. How would we compute the price of a gold futures contract expiring on 30th January? From
the discussion above we know that the futures price is nothing but the spot price plus the cost-of-
carry. Let us first try to work out the components of the cost-of-carry model.
1. What is the spot price of gold? The spot price of gold, S= Rs.7000/ 10 gms.
30
2. What is the cost of financing for a month? 0.15
e 365
3. What are the holding costs? Let us assume that the storage cost = 0.
In this case the fair value of the futures, works out to be = Rs.7086.80
30
0.15
F Se rT 7000e 365 Rs. 7086.80
If the contract was for a three-month period i.e. expiring on 30th March, the cost of financing
would increase the futures price. Therefore, the futures price would be
90
0.15
F 7000e 365 Rs.7263.75
81
Under normal market conditions, F, the futures price is very close to S(X + r)T. However, on
October 19,1987, the US market saw a breakdown in this classic relationship between spot and
futures prices. It was the day the markets fell by over 20% and the volume of shares traded on
the New York Stock Exchange far exceeded all previous records. For most of the day, futures
traded at significant discount to the underlying index. This was largely because delays in
processing orders to sell equity made index arbitrage too risky. On the next day, October
20,1987, the New York Stock Exchange placed temporary restrictions on the way in which
program trading could be done. The result was that the breakdown of the traditional linkages
between stock indexes and stock futures continued. At one point, the futures price for the
December contract was 18% less than the S&P 500 index which was the underlying index for
these futures contracts! However, the highlight of the whole episode was the fact that inspite of
huge losses, there were no defaults by futures traders. It was the ultimate test of the efficiency
of the margining system in the futures market.
a fixed charge per deposit of commodity into the warehouse, and a per unit per week charge. The
per unit charges include storage costs and insurance charges.
We saw that in the absence of storage costs, the futures price of a commodity that is an
investment asset is given by F = SerT Storage costs add to the cost of carry. If U is the present
value of all the storage costs that will be incurred during the life of a futures contract, it follows
that the futures price will be equal to
F = (S + U)erT (6.4)
where:
r Cost of financing (annualised)
T Time till expiration
U Present value of all storage costs
For ease of understanding let us consider a one-year futures contract on gold. Suppose the
fixed charge is Rs.310 per deposit upto 500 kgs. and the variable storage costs are Rs.55 per week,
it costs Rs.3170 to store one kg of gold for a year(52 weeks). Assume that the payment is made at
the beginning of the year. Assume further that the spot gold price is Rs.6000 per 10 grams and the
risk-free rate is 7% per annum. What would the price of one year gold futures be if the delivery
unit is one kg?
F = (S+ U)erT
= (600000 + 310 + 2860)e0.07 x 1
= 646904.76
82 Pricing commodity futures
We see that the one-year futures price of a kg of gold would be Rs.6,46,904.76. The one-year
futures price for 10 grams of gold would be about Rs.6469.
Now let us consider a three-month futures contract on gold. We make the same assumptions -
the fixed charge is Rs.310 per deposit upto 500 kgs. and the variable storage costs are Rs.55 per
week. It costs Rs.1025 to store one kg of gold for three months(13 weeks). Assume that the
storage costs are paid at the time of deposit. Assume further that the spot gold price is Rs.6000 per
10 grams and the risk-free rate is 7% per annum. What would the price of three month gold
futures if the delivery unit is one kg?
F = (S + U)erT
= (600000 + 310 + 715)e0.07 x
0.25
= 611635.50
We see that the three-month futures price of a kg of gold would be Rs.6,11,635.50. The three-
month futures price for 10 grams of gold would be about Rs.6116.
1. Borrow an amount S+ U at the risk-free interest rate and use it to purchase one unit of the commodity
and pay storage costs.
If we regard the futures contract as a forward contract, this strategy leads to a profit of
F - (S + U) e rT at the expiration of the futures contract. As arbitragers exploit this opportunity, the
spot price will increase and the futures price will decrease until Equation 6.5 does not hold good.
Suppose next that
In case of investment assets such as gold and silver, many investors hold the commodity
purely for investment. When they observe the inequality in equation 6.6, they will find it
profitable to trade in the following manner:
1. Sell the commodity, save the storage costs, and invest the proceeds at the risk-free interest rate.
This would result in a profit at maturity of (S + U) erT - F relative to the position that the
investors would have been in had they held the underlying commodity. As arbitragers exploit this
opportunity, the spot price will decrease and the futures price will increase until equation 6.6 does
not hold good. This means that for investment assets, equation 6.4 holds good. However, for
commodities like cotton or wheat that are held for consumption purpose, this argument cannot be
used. Individuals and companies who keep such a commodity in inventory, do so, because of its
consumption value - not because of its value as an investment. They are reluctant to sell these
commodities and buy forward or futures contracts because these contracts cannot be consumed.
Therefore there is unlikely to be arbitrage when equation 6.6 holds good. In short, for a
consumption commodity therefore,
That is the futures price is less than or equal to the spot price plus the cost of carry.
opportunity for traders. In case of such arbitrage the trader can short his futures contract, buy the
asset from the spot market and make the delivery. This will lead to a profit equal to the difference
between the futures price and spot price. As traders start exploiting this arbitrage opportunity the
demand for the contract will increase and futures prices will fall leading to the convergence of the
future price with the spot price. If the futures price is below the spot price during the delivery
period all parties interested in buying the asset will take a long position. The trader would buy the
contract and sell the asset in the spot market making a profit equal to the difference between the
future price and the spot price. As more traders take a long position the demand for the particular
asset would increase and the futures price would rise nullifying the arbitrage opportunity.
Nuances
• As the date of expiration comes near, the basis reduces - there is a convergence of the futures price
towards the spot price(Figure 6.1). On the date of expiration, the basis is zero. If it is not, then there is
an arbitrage opportunity. Arbitrage opportunities can also arise when the basis (difference between
spot and futures price) or the spreads (difference between prices of two futures contracts) during the
life of a contract are incorrect. At a later stage we shall look at how these arbitrage opportunities can
be exploited.
• There is nothing but cost-of-carry related arbitrage that drives the behaviour of the futures price in the
case of investment assets. In the case of consumption assets, we need to factor in the benefit provided
by holding the physical commodity.
Note: The pricing models discussed in this chapter give an approximate idea about the true
future price. However the price observed in the market is the outcome of the price-discovery
mechanism (demand-supply principle) and may differ from the so-called true price.
Solved problems
Q: The________model is used for pricing futures contracts.
Q: What is the fair value of one month futures if the spot value of gold is Rs.6000 per 10 grams?
The money can be invested at 10% p.a. and warehousing cost are Rs.25
1. 6025.00 3. 6090.00
2. 6075.40 4. 6050.30
Q: When the futures price happens to be higher than the fair value of the futures contract,
arbitragers profit by
Q: When the futures price happens to be lower than the fair value of the futures contract,
arbitragers profit by
For a market to succeed, it must have all three kinds of participants - hedgers, speculators and
arbitragers. The confluence of these participants ensures liquidity and efficient 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 fluctuations in the price of wheat around the time that his crop is
ready for harvesting. By selling his crop forward, he obtains a hedge by locking in to a
predetermined price. Hedging does not necessarily improve the financial outcome; indeed, it could
make the outcome worse. What it does however is, that it makes the outcome more certain.
Hedgers could be government institutions, private corporations like financial institutions, trading
companies and even other participants in the value chain, for instance farmers, extractors, ginners,
processors etc., who are influenced by the commodity prices.
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.
15th of January and that a refined 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 specification. 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.
per kg and the April silver futures price is Rs.1730. Table 7.2 gives the contract specification 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 long
7.1 Hedging 91
futures 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,
orRs.5,19,000intotal.
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,
orRs.5,19,000intotal.
Note that the purpose of hedging is not to make profits, 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.
S
h
F
(7.1)
where:
• S: Change in spot price, S, during a period of time equal to the life of the hedge
• F: Change in futures price, F, during a period of time equal to the life of the hedge
• S : Standard deviation of S
92 Using commodity futures
• R : Standard deviation of F
• : Coefficient of correlation between S and F
• h : Hedge ratio
Let us consider an example. A company knows that it will require 11,000 bales of cotton in
three months. Suppose the standard deviation of the change in the price per Quintal of cotton over
a three-month period is calculated as 0.032. The company chooses to hedge by buying futures
contracts on cotton. The standard deviation of the change in the cotton futures price over a three-
month period is 0.040 and the coefficient of correlation between the change in price of cotton and
the change in the cotton futures price is 0.8. The unit of trading is 11 bales and the delivery unit
for cotton on the NCDEX is 55 bales. What is the optimal hedge ratio? How many cotton futures
contracts should it buy?
If the hedge ratio were one, that is if the cotton spot and futures were perfectly correlated, as
shown in Equation 7.3, the hedger would have to buy 1000 units (one unit of trading =11 bales of
cotton) to obtain a hedge for the 11,000 bales of cotton it requires in three months.
11,000
Number of contracts (7.2)
11
N p 1 1000 (7.3)
However, in this case as shown in Equation 7.5, the hedge ratio works out to be 0.64. The
company will hence require to take a long position in 140 units of cotton futures to get an
effective hedge (Equation 7.7).
0.032
Optimal hedge ratio 0.8 (7.4)
0.040
h = 640 (7.5)
11,000
Number of contracts 0.64 (7.6)
11
N p 0.64 640 (7.7)
2. 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.
3. 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 finished
products, and make forward sales to stores at firm 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 fill its orders.
• The 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.
• The 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.
• The 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 short-term cash flow problems.
94 Using commodity futures
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 financial market. For a speculator
who thinks the shares of a given company will rise, it is easy to buy the shares and hold them for
whatever duration he wants to. However, commodities are bulky products and come with all the
costs and procedures of handling these products. The commodities futures markets provide
speculators with an easy mechanism to speculate on the price of underlying commodities.
To trade commodity futures on the NCDEX, a customer must open a futures trading account
with a commodity derivatives broker. Buying futures simply involves putting in the margin
money. This enables futures traders to take a position in the underlying commodity without having
to 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.
is 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 risk-free arbitrage opportunity). He closes
his long futures position at Rs.6400 in the process making a profit 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.
7.3 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 efficiency.
F = (S+U)erT (7.8)
where:
r Cost of financing (annualised)
In the chapter on pricing, we discussed that the cost-of-carry 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 profit from the arbitrage.
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 fixed charge is Rs.310 per deposit upto 500 kgs. and the variable storage costs are Rs.55
per kg per week for 13 weeks).
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.
7. From the Rs.62,50,000 held in hand, return the borrowed amount plus interest of Rs.60,98,251.
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 profit possible, it makes sense to arbitrage. This is termed as
cash-and-carry 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 Arbitrage 97
2. Invest the Rs.60,00,000 plus the Rs.7150 saved by way of warehouse costs for three months 6%.
1. Suppose the price of gold is Rs.615 per gram. On the futures expiration date, the spot and the futures
price of gold converge. Now unwind the position.
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 reverse-cash-and-carry
arbitrage. It is this arbitrage activity that ensures that the spot and futures prices stay in line with
the cost-of-carry. 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 cash-and-carry and
reverse cash-and-carry, 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. Wants to buy the underlying asset in the fu- 3. Expects to own the underlying asset in the
future. ture
1. Sell the underlying asset in the future 4. None of the above
1. Wants to buy the underlying asset in the fu- 3. Wants to sell the underlying asset
today. ture.
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__
Q: On the 15th of January a refined 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
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.
7.3 Arbitrage 99
Q: On the 15th of January a firm 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
1. Selling 60 units of April silver futures. 3. Buying 30 units of April silver futures.
2. 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 fu- 3. Buying 2550 units of three-month cotton
futures. tures.
2. Selling 2550 units of three-month cotton fu- 4. Selling 600 units of three-month cotton
futures. tures.
A: One trading unit is for 11 bales of cotton. The hedge ratio is 0.85. The company obtains a
hedge by
33,000
Buying 0.85 units of futures. The correct answer is number 3. ••
11
Q: Gold trades at Rs.6000 per 10 gms in the spot market. Three-month gold futures trade at
Rs.6150. One unit of trading is 100 gms and the delivery unit for the gold futures contract on the
NCDEX is 1 kg. A speculator who expects gold prices to rise in the near future buys 10 units of
gold futures. Two months later gold futures trade at Rs.6400 per 10 gms. He makes a profit/loss
of
1. (+)2,500 3. (+)25,000
2. (-)2,500 4. (-)25,000
A: One unit of trading is 100 gms. He is long 10 units of futures, or 1000 grms of gold. He makes
250
a profit of Rs.250 per 10 gms. His total profit from the position 1000. The correct answer
10
is number 3. • •
100 Using commodity futures
Q: Gold trades at Rs.6000 per 10 gms in the spot market. Three-month gold futures trade at
Rs.6150. One unit of trading is 100 gms and the delivery unit for the gold futures contract on the
NCDEX is 1 kg. A speculator who expects gold prices to fall in the near future sells 10 units of
gold futures. Two months later gold futures trade at Rs.6000 per 10 gms. He makes a profit/loss
of
1. (+)1,500 3. (-)15,000
2. (-)1,500 4. (+)15,000
A: One unit of trading is 100 gms. He is short 10 units of futures, or 1000 grms of gold. He makes
a profit
150
of Rs.150 per 10 gms. His total profit from the position is 1000. The correct answer
10
is number 4.
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.
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 notified by the exchange from time to time.
102 Trading
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 face—to-face and highly activate
form of trading used on the floors 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 market's best price. To place an order
under this method, the customer calls a broker, who time-stamps the order and prepares an
office order ticket. The broker then sends the order to a booth on the exchange floor called
broker's floor booth. There, a floor order ticket is prepared, and a clerk hand delivers the order
to the floor trader for execution. In some cases, the floor clerk may use hand signals to convey
the order to floor traders. Large orders typically go directly from the customer to the broker's
floor booth. The floor trader, standing in a central location i.e. trading pit, negotiates a price by
shouting out the order to other floor traders, who bid on the order using hand signals. Once
filled, 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 matched-trade
information.
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 firm'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 confirmation/ inquiry of trades through the trading system.
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.
NCDEX plans to trade in all the major commodities approved by FMC (Forwards Market
Commission) but in a phased manner. In the first 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, sunflower, 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 specifications for gold and long staple
cotton.
NCDEX trades commodity futures contracts having one-month, two-month 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. Figure 8.1 shows the contract cycle for futures contracts on
NCDEX.
104 Trading
following categories:
• Time conditions
• Price conditions
• Other conditions
Several combinations of the above are possible thereby providing enormous flexibility 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.
• Time conditions
- Good till day order: A day order, as the name suggests is an order which is valid for the day on
which it is entered. If the order is not executed during the day, the system cancels the order
automatically at the end of the day. Example: A trader wants to go long on March 1, 2004 in
refined 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 filled even if the market touches Rs.341
and closes. In other words day order is for a specific price and if the order does not get filled
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 notified 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
8.5 Order types and trading parameters 107
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 refined palm oil when the market touches Rs.400/ 10kg.
Theoritically, the order exists until it is filled 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 fill-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 filled immediately, it gets cancelled.
• Price condition
- Limit order: An order to buy or sell a stated amount of a commodity at a specified price, or at a
better price, if obtainable at the time of execution. The disadvantage is that the order may not get
filled at all if the price for that day does not reach the specified price.
- Stop-loss: A stop-loss order is an order, placed with the broker, to buy or sell a particular futures
contract at the market price if and when the price reaches a specified level. 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 specified 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 filled 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 stop-loss sell order, the trigger price has to be greater
than the limit price.
• Other conditions
- Market price: Market orders are orders for which no price is specified at the time the order is
entered (i.e. price is market price). For such orders, the system determines the price. Only the
position to be taken long/ short is stated. When this kind of order is placed, it gets executed
irrespective of the current market price of that particular asset.
108 Trading
After-hours electronic trading first 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.
- Market on open: The order will be executed on the market open within the opening range. This
trade is used to enter a new trade, or exit an open trade.
- Market on close: The order will be executed on the market close. The fill price will be within
the closing range, which may, in some markets, be substantially different from the setdement
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 profit
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 fill 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 filled and the stop order is
immediately gets cancelled. The trader exits the market at Rs.13,900/ tonne.
disapprove such orders solely at its own discretion. Unless specifically notified by the exchange,
there will be no price ranges applicable in the last half hour of normal market trading.
• Sell open
• Order cancellation
• Order modification
• Outstanding orders
• Trade modify
• Trade cancel
• Market by order
• Market by price
• Activity log
• Previous trades
• Contract description
• Snap quote
• Message log
• Market movement
• Market inquiry
• Order status
• Liquidity schedule
• Buy close
• Sell close
112 Trading
• 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
reflect the trader's 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 day's movement. Based on the
settlement price, the value of all positions is marked-to-market each day after the official close. i.e. the
accounts are either debited or credited based on how well the positions fared in that day's 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 113
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 fill up the mandate form and submit
the same to NCDEX. NCDEX then forwards the mandate form to BJPL. BJPL sends the log-in 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 first
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 specified 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 figure 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. Commodity 3. Quantity
2. Price and time 4. All of the above
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
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
5,500
position is 100 10 . The correct aanswer is number 1.
10
Q: A trader sells 20 units of gold futures at Rs.7,100 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.1,42,000 3. Rs.1,420
A: One trading unit is for 100 gms. He has bought 20 units. The value of his long gold futures position is
7,100
100 20 . The correct answer is number 4.
10
Q: A trader requires to take a long gold futures position worth Rs. 10,00,000 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.
Roughly how many units must he purchase to give him the hedge?
1. 10 units 3. 14 units
2. 20 units 4. 28 units
A: Futures price of 10 gms of gold is Rs.7,000. This means gold futures cost Rs.700 per gram. He has
10,00,000
to take a position , i.e. in 1428.57 gms of gold gms. He has to buy 14 units of gold futures
700
contracts. The correct answer is number 3. ••
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?
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. ••
116____________________________________________________________________Trading
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?
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 floor or electronically over the electronic trading systems.
The main task of the clearing house is to keep track of all the transactions that take place during a
day so that the net position of each of its members can be calculated. It guarantees the
performance of the parties to each transaction. Typically it is responsible for the following:
1. Effecting timely settlement.
5. Physical settlement (by delivery) or financial settlement (by price difference) of contracts.
The clearing house has a number of members, who are mostly financial 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
118 Clearing and settlement
not maintenance margin). Everyday the account balance for each contract must be maintained at
an amount equal to the original margin times the number of contracts outstanding. Thus depending
on a day's transactions and price movement, the members either need to add funds or can
withdraw funds from their margin accounts at the end of the day. The brokers who are not the
clearing members need to maintain a margin account with the clearing house member through
whom they trade in the clearing house
as clearing banks - ICICI Bank Limited, Canara Bank, UTI Bank Limited and HDFC Bank
Limited.
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 final settlement which happens on the last trading
day of the futures contract. On the NCDEX, daily MTM settlement and final MTM settlement in
respect of admitted deals in futures contracts are 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 final 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.
• 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 day's settlement price.
120 Clearing and settlement
• On the expiry date if the member has an open position, it is the difference between the final
settlement price and the previous day's 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 profit/ 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. (18.7 x 120) on the long position taken by him. The profit/ 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 profit/ loss shows that he makes a total profit of Rs.120
per Quintal. So upon closing his position, he makes a total profit of Rs.2244 on the short position
taken by him. The profit/ loss made by him however gets added/ deducted from his initial margin
on a daily basis.
Final settlement
On the date of expiry, the final 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 final settlement price. The
responsibility of settlement is on a trading cum clearing member for all trades done on his own
account and his client's trades. A professional clearing member is responsible for settling all the
participants trades which he has confirmed to the exchange.
On the expiry date of a futures contract, members are required to submit delivery information
9.2 Settlement 121
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.
Non-fulfilment of either the whole or part of the settlement obligations is treated as a violation
of the rules, bye-laws 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
fixed deposit receipts, realizing money by disposing off the securities and exercising such other
risk containment measures as it deems fit or take further disciplinary action.
122 Clearing and settlement
warehouse. These commodities have to be assayed by the exchange specified assayer. The
commodities have to meet the contract specifications with allowed variances. If the commodities
meet the specifications, the warehouse accepts them. Warehouses then ensure that the receipts get
updated in the depository system giving a credit in the depositor's electronic account. The seller
then gives the invoice to his clearing member, who would courier the same to the buyer's clearing
member.
NCDEX contracts provide a standardized description for each commodity. The description is
provided in terms of quality parameters specific to the commodities. At the same time, it is
realized that with commodities, there could be some amount of variances in quality/ weight etc.,
due to natural causes, which are beyond the control of any person. Hence, NCDEX contracts also
provide tolerance limits for variances. A delivery 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 fixed 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 difficulty in delivering and receiving exact quality/ quantity of
commodity
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 five 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 profit of Rs.225 per trading
unit of cotton in the form of cash.
124 Clearing and settlement
Accredited warehouse
NCDEX specifies accredited warehouses through which delivery of a specific 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 specified 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
specifications prescribed by the exchange for storage of commodities.
2. Ensure and co-ordinate 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.
1. Establishes connectivity with approved warehouses and supports them with physical infrastructure.
2. Verifies 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.
4. Ensures that the credit of commodities goes only to the demat account of the constituents held with the
exchange empanelled DPs.
5. On receiving a request for re-materialization (physical delivery) through the depository, arranges for
issuance of authorisation to the relevant warehouse for the delivery of commodities.
9.3 Risk management 125
R&T agents also maintain proper records of beneficiary 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 co-ordinating 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
co-ordinate with all parties concerned for the same.
Approved assayer
The exchange specifies 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 identified 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 certificate 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 specific commodities traded on
the exchange at specified warehouse. The assayer ensures that the grading to be done (in a certificate
format prescribed by the exchange) in respect of specific commodity is as per the norms specified by
the exchange in the respective contract specifications.
3. Grading certificate so issued by the assayer specifies the grade as well as the validity period up to
which the commodities would retain the original grade, and the time up to which the commodities are
fit for trading subject to environment changes at the warehouses.
2. NCDEX charges an upfront initial margin for all the open positions of a member. It specifies the
initial margin requirements for each futures contract on a daily basis. It also follows value-at-risk
(VaR) based margining through SPAN. The PCMs and TCMs in turn collect the initial margin from
the TCMs and their clients respectively.
3. The open positions of the members are marked to market based on contract settlement price for each
contract. The difference is settled in cash on a T+l basis.
4. A member is alerted of his position to enable him to adjust his exposure or bring in additional capital.
Position violations result in withdrawal of trading facility for all TCMs of a PCM in case of a violation
by the PCM.
126 Clearing and settlement
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 on-line position monitoring. The actual position monitoring
and margining is carried out on-line through the SPAN (Standard Portfolio Analysis of Risk)
system.
9.4.1 SPAN
SPAN is a registered trademark of the Chicago Mercantile Exchange, used by NCDEX under
license obtained from CME. The objective of SPAN is to identify overall risk in a portfolio of all
futures contracts for each member. Its over-riding objective is to determine the largest loss that a
portfolio might reasonably be expected to suffer from one day to the next day based on 99% VaR
methodology.
1. For client positions: These are netted at the level of individual client and grossed across all clients, at
the member level without any set-offs between clients.
2. For proprietary positions: These are netted at member level without any set-offs between client and
proprietary positions.
9.4 Margining at NCDEX 127
Consider the case of a trading member who has proprietary and client-level 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 specified 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 specified by the exchange.
2. Volatility scan range: Volatility scan range will be taken at 2% or such other percentage as may be
specified by the exchange from time to time.
3. Calendar spread charge: Calendar spread is defined 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 same
128 Clearing and settlement
exchange. 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 specified by the exchange from time to time. The near month
position is the buy/ sell position on the calendar-spread position that expires first. The far month position is the
buy/ sell position on the calendar-spread position that expires next. A calendar spread position is treated as non-
spread (naked) positions in the far month contract, 3 trading days prior to expiration of the near month contract.
However, calendar spread position is reduced gradually at the rate of 33^% 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 five days before
the date of expiry of the near month contract.
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, fixed deposits receipts and approved Government of
India securities.
3. Effect of failure to pay initial margins: Non-fulfilment of either the whole or part of the initial 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 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 final and binding on
the members and/ or constituents.
The exchange can also initiate such other risk containment measures as it deems fit 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/ fixed deposit receipts,
realizing money by disposing off the securities and exercising such other risk containment measures
as it deems fit.
4. Exposure limits: This is defined 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 specified by the exchange from time to time.
9.4 Margining at NCDEX 129
(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, fixed deposit receipts and Government of Indian securities.
(c) Method of computation of exposure limits: Exposure limits is specified as a multiple of the
liquid net worth, i.e. a member can have an exposure limit of x times his liquid net worth. The
multiple is as specified 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: Non-fulfilment 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 specified agent on behalf of the exchange. Such requests may be considered by the exchange subject
to the bye-laws, 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 specified
percentage of the total open interest in the commodity or a specified 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. Intra-day price limit: The maximum price movement during a day can be +/- 10% of the previous
day's 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.
130 Clearing and settlement
(a) Daily settlement price: The daily profit/ losses of the members are settled using the daily
settlement price. The daily settlement price notified 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 profit/ 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 day's settlement price, (c) On the expiry
date if the member has an open position, it is the difference between the final settlement price
and the previous day's settlement price.
11. Intra-day 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 sufficiently. For example, it can make
an intra-day 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 deficits exceed a threshold value prescribed by the exchange.
12. Delivery margin: In case of positions materialising into physical delivery, delivery margins are
calculated as i\ days VaR margins plus additional margins. N days refer to the number of days for
completing the physical delivery settlement. The number of days are commodity specific, 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.
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/ fixed 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. 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 exposure limit for each member is linked to the………of the member available with the
exchange.
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
trader's MTM account will show
A: He makes a profit 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 profit of 30 * 18.7 * 10 =
Rs.5610. The
correct answer is number 1. •
•
Q: A gold merchant bought two units of one-month 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 trader's MTM
account will show
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 profit of Rs.25 per 10 gms on his futures position. So he makes a profit
of
20
Rs.500, i.e 200 = Rs.500. The correct answer is number 1. ••
10
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?
A: After netting, the trading member has a long open position in 600 trading units. The correct
answer is number 4. ••
134 Clearing and settlement
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 benefits 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 influence 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 financial 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 non-
member users of the market.
1. Limit on net open position as on the close of the trading hours. Some times limit is also imposed on
intra-day net open position. The limit is imposed operator-wise, and in some cases, also memberwise.
2. Circuit-filters or limit on price fluctuations 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 specified 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 client's 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 customer-friendly. The FMC has also prescribed
simultaneous reporting system for the exchanges following open out-cry system. These steps
facilitate audit trail and make it difficult 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
officer 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. Officers 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 office-bearers.
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
10.2 Rules governing intermediaries 137
approved workstation(s) located at locations for the offlce(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 identification 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 non-exclusive 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 specified 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 have to pass a certification program, which has been prescribed by the
exchange. In case of trading members, other than individuals or sole proprietorships, such
certification 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 notified
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 off-line 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.
138 Regulatory framework
The types of order books, trade books, price limits, matching rules and other parameters
pertaining to each or all of these sessions is specified 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.
Contract expiration
Derivatives contracts expire on a pre-determined date and time up to which the contract is
available for trading. This is notified 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 specifies 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 specifies various conditions on the order that
will make it eligible to place it in those books.
The exchange specifies 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 specifies 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.
Trade operations
Trading members have to ensure tiiat appropriate confirmed 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
confirmation slip/ modification 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 specifies 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 mark-up for default.
The margin has to be deposited with the exchange within the time notified 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 specified 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.
• Effect, take part either directly or indirectly in transactions, which are likely to have effect of
artificially, raising or depressing the prices of spot/ derivatives contracts.
140 Regulatory framework
• Indulge in any act, which is calculated to create a false or misleading appearance of trading, resulting
in reflection of prices, which are not genuine.
• Buy, 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.
• Indulge in falsification of his books, accounts and records for the purpose of market manipulation.
• When 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.
• Either 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.
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 - firstly, on the basis of locations and then randomly keeping in view the
factors such as available capacity of the vault/ warehouse, commodities already deposited and
dematerialized and offered for delivery and any other factor as may be specified by the exchange
from time to time. Matching done is binding on the clearing members. After completion of the
10.2 Rules governing intermediaries 141
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
final 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
identified counter-party 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 specifies 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 specified in the settlement calendar.
Process of dematerialization
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 specified by the
relevant authority from time to time.
Process of rematerialisation
Re-materialization 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 constituent's authorised person upon verifying the
identity.
10.2 Rules governing intermediaries 143
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 confirmed acceptance to settle. The obligations
statement is deemed to be confirmed 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 specified 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
confirmed 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 confirmed by respective member to deliver and receive on account of
his constituent, commodities as specified in the delivery and receipt statements.
On respective pay-in 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 notified by the exchange.
144 Regulatory framework
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 pay-out day as per
instructions of the exchange/ clearing house.
Delivery units
The exchange specifies 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 specifies from time to time the variations permissible in delivery units as
per those stated in contract specifications.
• Applicant means the person who makes the application for initiating arbitral proceedings.
• Respondent means the person against whom the applicant lodges an arbitration application, whether or
not there is a claim against such person.
10.3 Rules governing investor grievances, arbitration 145
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 affiliated, 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
1. The date of receipt of communication of warehouse refusing to transfer the commodities in favour of
the constituent.
2. 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.
The Applicant has to also submit to the exchange the following along with the arbitration
form:
1. A cheque/ pay order/ demand draft for the deposit payable at the seat of arbitration in favour of
National Commodity & Derivatives Exchange Limited.
2. Form No. II/IIA containing list of names of the persons eligible to act as arbitrators.
If any deficiency/ defect in the application is found, the exchange calls upon the applicant to
rectify the deficiency/ defect and the applicant must rectify the deficiency/ defect within 15 days
of receipt of intimation from the exchange. If the applicant fails to rectify the deficiency/ defect
within the prescribed period, the exchange returns the deficient/ defective application to the
applicant. However, the applicant has the right to file 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 H/HA to the
exchange within 7 days from the date of receipt. If the respondent fails to submit Form n/HA
within the time period prescribed by the exchange, then the arbitrator is appointed in the manner
as specified in the regulation. The respondent(s) should within 15 days from the date of receipt
146 Regulatory framework
of Form No. I/IA from the exchange, submit to the exchange in Form No. IH/IIIA three copies in
case of sole arbitrator and five copies in case of panel of arbitrators along with the following
enclosures:
• Statement of the set-off 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.ni/IIIA If the respondent fails to submit Form III/niA
within the prescribed time, then the arbitrator can proceed with the arbitral proceedings and make
the award ex-parte. Upon receiving Form No. UMIIA 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/TIIA, 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 file 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.
Solved Problems
Q: Which of the following is not involved in regulating forward/futures trading system in India?
Q: All the exchanges, which deal with forward contracts, are required to obtain certificate of
registration from the
Q: To ensure financial integrity and market integrity, the FMC prescribes certain regulatory
measures. Which of the following is not a measure prescribed?
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.
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.
Q: In the case of an arbitration, the exchange in consultation with the__determines the date, the
time
and place of the first hearing.
1. Respondent 3. Arbitrator
2. Applicant 4. Warehouse
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.
• Futures 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.
• If 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.
• When the futures contract fructifies 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, filing 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.
150 Implications of sales tax
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, filing 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 fructifies into a sale and culminates into delivery, the payment of
sales tax
is to be done in the state in which the___is situated.
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 fructifies 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.
arbitragers, 10 in-the-money, 61
assignment, 18 index, 61
intrinsic value, 62
basis, 60 out-of-money, 61
baskets, 14 premium, 61
cost of carry, 60 put, 61
cost-of-carry, 76 stock, 61
time value, 62
delivery, 19 writer, 61
derivatives order
exchange traded, 13 day, 104
OTC, 13 GTC, 105
GTD, 105
forwards, 57 IOC, 105
futures, 14 stop-loss, 105
commodity, 77
price
hedge limit, 106
long, 87 trigger, 106
short, 86
hedgers, 10 settlement
physical, 17
long short
call, 66 call, 67
put, 68 put, 69
speculators, 10
margin spot price, 60
initial, 60 swaps, 14
maintenance, 60 currency, 14
MTM, 60 interest rate, 14
option swaptions, 14
american, 61 transaction
at-the-money, 61 forward, 12
buyer, 61 spot, 12
call, 61
european, 61 warrants, 14