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Commodities Market Module Work Book
NATIONAL STOCK EXCHANGE OF INDIA LIMITED
1 Introduction to derivatives............................................................................... 1.1 Derivatives defined.................................................................................... 1.2 Products, participants and functions.......................................................... 1.3 Derivatives markets...................................................................................
1.3.1 1.3.2 1.3.3
11 11 12 13
Spot versus forward transaction.................................................... 14 Exchange traded versus OTC derivatives...................................... 14 Some commonly used derivatives................................................. 16 19 19 19 21 22 22 24 24 24 24 25 27 31 31 32 32 32 32 33 33 34
Commodity derivatives.................................................................................... 2.1 Difference between commodity and financial derivatives......................... 2.1.1 Physical settlement........................................................................ 2.1.2 Warehousing................................................................................. 2.1.3 Quality of underlying assets.......................................................... 2.2 Global commodities derivatives exchanges............................................... 2.2.1 Africa............................................................................................. 2.2.2 Asia.............................................................................................. 2.2.3 Latin America................................................................................ 2.3 Evolution of the commodity market in India............................................. 2.3.1 The Kabra committee report......................................................... 2.3.2 Latest developments...................................................................... The NCDEX platform...................................................................................... 3.1 Structure of NCDEX.................................................................................. 3.1:1 Promoters...................................................................................... 3.1.2 Governance................................................................................... 3.2 Exchange membership............................................................................... 3.2.1 Trading cum clearing members (TCMs)....................................... 3.2.2 Professional clearing members (PCMs)........................................
Capital requirements.................................................................................. The NCDEX system..................................................................................
3.4.1 3.4.2 3.4.3
Trading......................................................................................... 34 Clearing........................................................................................ 35 Settlement...................................................................................... 35
CONTENTS 4 Commodities traded on the NCDEX platform.............................................. 4.1 Agricultural commodities.......................................................................... 4.1.1 Cotton............................................................................................ 4.1.2 Crude palm oil............................................................................... 4.1.3 RBD Palmolein............................................................................. 4.1.4 Soy oil........................................................................................... 4.1.5 Rapeseedoil................................................................................... 4.1.6 Soybean......................................................................................... 4.1.7 Rapeseed....................................................................................... 4.2 Precious metals.......................................................................................... 4.2.1 Gold.............................................................................................. 4.2.2 Silver............................................................................................ Instruments available for trading................................................................... 5.1 Forward contracts...................................................................................... 5.1.1 Limitations of forward markets..................................................... 5.2 Introduction to futures............................................................................... 5.2.1 Distinction between future and forwards contracts....................... 5.2.2 Futures terminology...................................................................... 5.3 Introduction to options............................................................................... 5.3.1 Option terminology...................................................................... 5.4 Basic payoffs............................................................................................. 5.4.1 Payoff for buyer of asset: Long asset............................................ 5.4.2 Payoff for seller of asset: Short asset............................................ 5.5 Payoff for futures....................................................................................... 5.5.1 Payoff for buyer of futures: Long futures..................................... 5.5.2 Payoff for seller of futures: Short futures..................................... 5.6 Payoff for options...................................................................................... 5.6.1 Payoff for buyer of call options: Long call................................... 5.6.2 Payoff for writer of call options: Shortcall................................... 5.6.3 Payoff for buyer of put options: Longput..................................... 5.6.4 Payoff for writer of put options: Shortput..................................... 5.7 Using futures versus us mg options........................................................... Pricing commodity futures............................................................................... 6.1 Investment assets versus consumption assets............................................ 6.2 The cost of carry model............................................................................. 6.2.1 Pricing futures contracts on investment commodities................... 6.2.2 Pricing .futures contracts on consumption commodities............... 6.3 The futures basis........................................................................................
4 37 37 38 40 42 43 45 46 47 49 50 54 59 59 60 60 61 62 62 63 64 65 65 65 65 67 68 68 69 69 70 71 77 77 78 80 82 83
.......3 Arbitrage.................................1 Permitted lot size....1... sell futures.......................................................1 Guidelines for allotment of client code..................................1 Clearing...................................................5..................5.............. 8...........3 Quantity freeze........4 Margining at NCDEX............................ 9......5................1..5.... 8................................................3 Contract specifications for commodity futures..... 8....................................................5 Order types and trading parameters................................ 9.......... 9......CONTENTS 7 Using commodity futures................2................................................................... 9............................................... 8......................................................................................... 7..................................... 8...........................................................7 Charges..........................................................2 Speculation.........................................1 Hedging...............................................1................ 8................. 8................................................... 8........... 7........5 Price ranges of contracts...............3 Depository participants........................3...5....... 8............. 5 87 87 87 88 89 91 92 93 94 94 95 95 96 97 101 101 101 102 103 103 104 108 108 109 109 109 110 112 113 117 117 118 118 119 119 119 122 124 125 126 126 8 9 ................................................1 Basic principles of hedging......................... 7.................................................. 8..... 9...............................3.................3 Long hedge...................................................... 9..................................................2.......... 7..............................................................................2 Underpriced commodity futures: buy futures..........1 Speculation: Bullish commodity.... 7.................. 7....................1....................................................................................... Clearing and settlement.....3 Risk management.................................. 7..1 Overpriced commodity futures: buy spot..............................2 Tick size for contracts........................................1...............................................................4 Base price....2..............................................................................................................1..................................2................1 Futures trading system........... 9.............. 8......1...............................................6 Margins for trading in futures....2 Settlement.............. 9........................2 Short hedge....................2 Entities in the trading system....1.... 8..6 Order entry on the trading system........................................................... 7..................................................2..5 Advantages of hedging....................2 Settlement methods.. Clearing mechanism............................................................................................... 9........................................ 8..................2 Clearing banks...................................................... 9.6 Limitation of hedging: basis Risk................. Trading.........................................4 Hedge ratio....................4...... sell spot.................................1........................ 7......................2................. sell futures.......1 SPAN.................1 Settlement mechanism..........3 Entities involved in physical settlement........... 7..5.... 7........... 9.......................... 8........................................... 7................................................................................. 7........................ buy futures.....................1...........................2 Speculation: Bearish commodity...............4 Commodity futures trading cycle...........................................................
...................1 Rules governing commodity derivatives exchanges....................................3 Rules governing investor grievances................2 Hearings and arbitral award..........3............ 10..................6 9.... 11 Implications of sales tax.................2 Clearing..................4 9............................................................... 10....................................................4...2.......2 Rules governing intermediaries.................................................. 10.............................................3.....................................................................................................5 CONTENTS Initial margin.................. 149 .........................4................3 9......................... arbitration......... 10........... 10..................................4........... Effect of violation......2.................. Computation of initial margin........ Implementation aspects of margining and risk management..1 Trading.................................... 126 126 128 130 135 135 136 136 140 144 145 146 10 Regulatory framework............................................... 10......4..2 9............................................. 10............................................1 Procedure for arbitration..........
............ 33 4...........1 Fee / deposit structure and networth requirement: TCM..................................2 Fee / deposit structure and networth requirement: PCM............................................. 89 7...................2 Distinction between futures and options..................................................................................... 51 5......................................................... 33 3................................3 Registered commodity exchanges in India.. 61 5.................................................................. 1968 and 1999.. 90 .1 Country-wise share in gold production..List of Tables 2...1 Refined soy oil futures contract specification...............indicative ware house charges....1 Distinction between futures and forwards...................1 The global derivatives industry.............. 23 2..... 28 3................................... 27 2............................................................................2 Silver futures contract specification.......................... 72 6....2 Volume on existing exchanges......................... 82 7............................1 NCDEX ........
.......................................... 131 .................1 Commodity futures contract and their symbols.......... 104 8.........................................................................3 Gold futures contract specification.................................................5 Commodity futures: Lot size another parameters.. 105 8...... 93 8....................5 Exposure limit as a multiple of liquid net worth...............................................................4 Minimum margin percentage on commodity futures contracts.................................................................. 121 9.8 List of Tables 7..............................1 MTM on along position in cotton futures........................ 120 9..2 Gold futures contract specification........4 Commodity futures: Quantity freeze unit....6 Number of days for physical settlement on various commodities...........................3 Calculating outstanding position at TCM level........2 MTM on a short position in cotton futures. 130 9........................ 111 9.................. 103 8......3 Long staple cotton futures contract specification. 127 9...................................... 127 9........................................................................... 109 8......
..... Payoff for writer of call option on gold.......... Payoff for a seller of cotton futures........................3 5.........4 5....List of Figures 5................ Payoff for a seller of gold..............................1 7........................................... 106 .............................................................................................. Payoff for buyer of call option on gold......... 88 Payoff for buyer of a long hedge............................................2 Payoff for buyer of a short hedge......................................................................2 5............. Payoff for buyer of put option on long staple cotton............ 84 7.................1 Contract cycle................................................................. Payoff for a buyer of gold futures...........1 5...........5 5.............................................. 90 8......... 66 66 67 68 69 70 71 Payoff for writer of put option on long staple cotton..............................................6 5......................................................................... 72 6...............................................................1 Variation of basis overtime...................................................................................................................8 Payoff for a buyer of gold.......7 5.........
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he would have to dispose off his harvest at a very low price. Today.that of having to pay exorbitant prices during dearth. Through the use of simple derivative products. These were eventually standardised. From the the time it was sown to the time it was ready for harvest. pepper. What they would then negotiate happened to be a futures-type contract. In years of scarcity.1 Derivatives defined A derivative is a product whose value is derived from the value of one or more underlying variables or assets in a contractual manner. wheat. derivatives contracts also exist on a lot of financial underlyings like stocks. forex. The underlying asset can be equity. Clearly this meant that the farmer and his family were exposed to a high risk of price uncertainty. silver. 1. These were simple contracts developed to meet the needs of farmers and were basically a means of reducing risk. 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. 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. derivative contracts exist on a variety of commodities such as corn. However. or CBOT. In 1848. although favourable prices could be obtained during periods of oversupply. Under such circumstances. and in 1925 the first futures clearing house came into existence. a merchant with an ongoing requirement of grains too would face a price risk . which would enable both parties to eliminate the price risk. interest rate. farmers would face price uncertainty. Besides commodities. it was possible for the farmer to partially or fully transfer price risks by locking-in asset prices.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. during times of oversupply. These to-arrive contracts proved useful as a device for hedging and speculation on price changes. exchange rate. On the other hand. etc. cotton. etc. was established to bring farmers and merchants together. A farmer who sowed his crop in June faced uncertainty over the price he would receive for his harvest in September. the Chicago Board of Trade. commodity . he would probably obtain attractive prices.
options and swaps. 3. 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. Consequently. If. Such a transaction is an example of a derivative. speculators. A security derived from a debt instrument. Speculators: Speculators are participants who wish to bet on future movements in the price of an asset. that is. 1952. 1956 (SC(R)A) defines "derivative" to include 1. Futures and options contracts can give them leverage. The most common ones are forwards. 1. Participants who trade in the derivatives market can be classified under the following three broad categories . regulates the forward/ futures contracts in commodities all over India. loan whether secured or unsecured. 1. . they can take large positions on the market. They use the futures or options markets to reduce or eliminate this risk. Hedgers face risk associated with the price of an asset. by putting in small amounts of money upfront.hedgers. The price of this derivative is driven by the spot price of wheat which is the "underlying" in this case. We thus have separate regulatory authorities for securities and commodity derivative markets. 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.2 Products. 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. Arbitragers: Arbitragers work at making profits by taking advantage of discrepancy between prices of the same product across different markets. 2. Hedgers: The farmer's example that we discussed about was a case of hedging. or index of prices. the term "security" in the Securities Contracts (Regulation) Act. 2. However when derivatives trading in securities was introduced in 2001. The Forwards Contracts (Regulation) Act. Thus derivatives help in discovery of future as well as current prices. risk instrument or contract for differences or any other form of security. was amended to include derivative contracts in securities. and arbitragers. they increase the potential for large gains as well as large losses. for example. derivative markets performs a number of economic functions.12 Introduction to derivatives or any other asset. The Securities Contracts (Regulation) Act. In our earlier discussion. A contract which derives its value from the prices. futures. regulation of derivatives came under the perview of Securities Exchange Board of India (SEBI). Derivatives are securities under the SCRA and hence the trading of derivatives is governed by the regulatory framework under the SCRA. of underlying securities. Whether the underlying asset is a commodity or a financial asset. participants and functions Derivative contracts are of different types. As a result of this leveraged speculative position. The prices of derivatives converge with the prices of the underlying at the expiration of the derivative contract. share. As per this the Forward Markets Commission (FMC) continues to have jurisdiction over commodity forward/ futures contracts. 1956 (SCRA).
silver. However. Financial derivatives came into spotlight in the post-1970 period due to growing instability in the financial markets. their complexity and also turnover. They often energize others to create new businesses. futures and options on stock indices have gained more popularity than on individual stocks. the benefit of which are immense. they accounted for about two-thirds of total transactions in derivative products. • Speculative traders shift to a more controlled environment of the derivatives market. With the introduction of derivatives. soybeans. monitoring and surveillance of the activities of various participants become extremely difficult in these kind of mixed markets.1. and commodity-linked derivatives remained the sole form of such products for almost three hundred years. The more popular financial derivatives are those which have equity. since their emergence. these products have become very popular and by 1990s. Margining. 1. The transfer of risk enables market participants to expand their volume of activity. Derivatives have a history of attracting many bright. the market for financial derivatives has grown tremendously in terms of variety of instruments available. As the name suggest. commodity derivatives markets trade contracts for which the underlying asset is a commodity. It can be an agricultural commodity like wheat. In recent years. well-educated people with an entrepreneurial attitude. cotton. Box 1.3 Derivatives markets Derivative markets can broadly be classified as commodity derivative market and financial derivatives markets. especially among institutional investors.1: Emergence of financial derivative products • The derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for them. • Derivatives markets help increase savings and investment in the long run. 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. In the class of equity derivatives the world over. Even small investors find these useful due to high correlation of the popular indexes with various portfolios and ease of use. • Derivatives. • An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. etc or precious metals like gold. Financial derivatives markets trade contracts that have a financial asset or variable as the underlying. interest rates and exchange rates as .3 Derivatives markets 13 Derivative products initially emerged as hedging devices against fluctuations in commodity prices. new products and new employment opportunities. are linked to the underlying cash markets. creative. etc. due to their inherent nature. In the absence of an organised derivatives market. The lower costs associated with index derivatives vis-a-vis derivative products based on individual securities is another reason for their growing use. who are major users of index-linked derivatives. speculators trade in the underlying cash markets. rapeseed.
futures and options which we shall discuss in detail later. If on the 1st of February. in this case gold. but wants to buy it a month later. clearing and settlement happens instantaneously. let us try to understand the difference between a spot and derivatives contract. but the clearing and settlement happens at the end of the specified period. This is trading. They agree upon the "forward" price for 20 grams of gold that Aditya wants to buy and Aditya leaves.3.6. In a forward contract the process of trading. clearing and settlement does not happen instantaneously. Every transaction has three components . Note that the value of the forward contract to the goldsmith varies exactly in an opposite manner to its value for Aditya. the trading.6. A primary motivation for prearranging a buyer or seller for a stock of commodities in early forward contracts was to lessen the possibility that large swings would inhibit marketing the commodity after a harvest. he is worse off because as per the terms of the contract.3. 12. These contracts were typically OTC kind of contracts.050 in the spot market.6.6.015 for the same gold. On 1st January 2004. "on the spot".990. takes the gold and leaves. A buyer and seller come together. he is bound to pay Rs. A month later. Settlement is the actual process of exchanging money and goods.2 Exchange traded versus OTC derivatives Derivatives have probably been around for as long as people have been trading with one another. Now suppose Aditya does not want to buy the gold on the 1st January. A forward is the most basic derivative contract. This is a spot transaction. i. If however. Consider this example. Forward contracting dates back at least to the 12th century. he pays the goldsmith Rs. clearing and settlement. Aditya wants to buy some gold.015. The exchange of money and the underlying goods only happens at the future date as specified in the contract. Merchants entered into contracts with one another for future delivery of specified amount of commodities at specified price.030 and collects his gold. 1. Later . and may well have been around before then.50 to B.6. 1. This is a forward contract. No money changes hands when the contract is signed. gold trades for Rs. the price of gold drops down to Rs. They agree upon this price and Aditya buys 20 grams of gold.1 Spot versus forward transaction Using the example of a forward contract.14 Introduction to derivatives the underlying. for a stated price and quantity.5. The contract has now lost value from Aditya's point of view. He pays Rs.015 per 10 grams. In a spot transaction. The trading happens today. Clearing involves finding out the net outstanding. Over the counter(OTC) derivatives are privately negotiated contracts. The goldsmith quotes Rs.trading. The most commonly used derivatives contracts are forwards. 12. the contract becomes more valuable to Aditya because it now enables him to buy gold at Rs. a contract by which two parties irrevocably agree to settie a trade at a future date.000 per 10 grams. that is exactly how much of goods and money the two should exchange. negotiate and arrive at a price.000. For instance A buys goods worth Rs.100 from B and sells goods worth Rs. The goldsmith quotes Rs. We call it a derivative because it derives value from the price of the asset underlying the contract.e. On a net basis A has to pay Rs.50 to B.
Eurex etc. was reorganised to allow futures trading. 4.3 Derivatives markets 15 Early forward contracts in the US addressed merchants' concerns about ensuring that there were buyers and sellers for commodities. Chicago Butter and Egg Board. SGX in Singapore. To deal with this problem. The CBOT and the CME remain the two largest organised futures exchanges. although they are affected indirectly by national legal systems. Commodity derivatives the world over are typically exchange-traded and not OTC in nature. a spin-off of CBOT. and for safeguarding the collective interests of market participants. The recent developments in information technology have contributed to a great extent to these developments. There are no formal rules or mechanisms for ensuring market stability and integrity.1. Box 1. DTB in Germany. which has accompanied the modernisation of commercial and investment banking and globalisation of financial activities. banking supervision and market surveillance. futures on T-bills and Euro-Dollar futures are the three most popular futures contracts traded today. traded on Chicago Mercantile Exchange. Index futures. The OTC derivatives markets have witnessed rather sharp growth over the last few years. financial futures became the most active derivative instruments generating volumes many times more than the commodity futures. or margining. The first stock index futures contract was traded at Kansas City Board of Trade. 5. 2. 3. Its name was changed to Chicago Mercantile Exchange (CME). However "credit risk" remained a serious problem. In 1919. Other popular international exchanges that trade derivatives are LIFFE in England. The largest OTC derivative market is the interbank foreign exchange market. The OTC contracts are generally not regulated by a regulatory authority and the exchange's selfregulatory organisation. indeed the two largest "financial" exchanges of any kind in the world today. a group of Chicago businessmen formed the Chicago Board of Trade (CBOT) in 1848. the CBOT went one step further and listed the first "exchange traded" derivatives contract in the US. these contracts were called "futures contracts".2: History of commodity derivatives markets many of these contracts were standardised in terms of quantity and delivery dates and began to trade on an exchange. During the mid eighties. In 1865. MATIF in France. The primary intention of the CBOT was to provide a centralised location known in advance for buyers and sellers to negotiate forward contracts. While both exchange-traded and OTC derivative contracts offer many benefits. There are no formal centralised limits on individual positions. leverage. TIFFE in Japan. . There are no formal rules for risk and burden-sharing. The management of counter-party (credit) risk is decentralised and located within individual institutions. The OTC derivatives markets have the following features compared to exchange-traded derivatives: 1. the former have rigid structures compared to the latter. Currently the most popular stock index futures contract in the world is based on S&P 500 index.
Chicago Board Options Exchange 4. Puts give the buyer the right. The underlying asset is usually a weighted average of a basket of assets.3. They can be regarded as portfolios of forward contracts. Forwards: As we discussed. 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. Longer-dated options are called warrants and are generally traded over-the-counter. Thus a swaption is an option on a forward swap. Warrants: Options generally have lives of upto one year. namely futures and options will be discussed in more details at a later stage. Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula.3 Some commonly used derivatives Here we define some of the more popularly used derivative contracts. with the cashflows in one direction being in a different currency than those in the opposite direction. but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date. Options: There are two types of options . Baskets: Basket options are options on portfolios of underlying assets. a forward contract is an agreement between two entities to buy or sell the underlying asset at a future date. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset. at today's pre-agreed price.calls and puts. the majority of options traded on options exchanges having a maximum maturity of nine months. 3. at a given price on or before a given future date. Chicago Board of Trade 2. Futures contracts differ from forward contracts in the sense that they are standardised and exchange traded.16 Introduction to derivatives 1. 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. • Currency swaps: These entail swapping both principal and interest between the parties. Solved Problems Q: Futures trading commenced first on 1. Equity index options are a form of basket options. Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Some of these. Chicago Mercantile Exchange A: The correct answer is number 1. London International Financial Futures and Options Exchange •• .
The buyer and seller exchanging goods and money. 4. Volatility 4. Q: In a transaction. Q: Which of the following exchanges offer commodity derivatives trading 1. A: The correct answer is number 1. Interconnected Stock Exchange A: The correct answer is number 1. Q: The first exchange traded financial derivative in India commenced with the trading of_ 1. The buyer and seller agreeing upon a price. 3. Speculative 2. Swap •• 3. None of the above. Index futures 2. trading involves____ 1. National Commodity Derivatives Exchange 2. Future A: The correct answer is number 3. Stock options 4. Index options A: The correct answer is number 1.1. They do not follow any formal rules or mechanisms. 2. above A: The correct answer is number 4. They are not settled on a clearing house. •• 3. Q: A______is the simplest derivative contract 1. 4. Over The Counter Exchange of India 4. Forward 4. Interest rate futures •• . Q: OTC derivatives are considered risky because 1. ICICI Securities Limited 3. Option 2. There is no formal margining system. The buyer and seller calculating the net out-standing. 3. All of the •• 2.3 Derivatives markets Q: Derivatives first emerged as------products 1. Hedging A: The correct answer is number 2. Risky 17 •• •• 3.
The buyer and seller calculating the net outstanding. 2. The buyer and seller agreeing upon a price. Introduction to derivatives 3. •• .18 Q: In a transaction. The buyer and seller agreeing upon a price. None of the above. Q: In a transaction. 2. 4. 4. The buyer and seller exchanging goods and money. The buyer and seller exchanging goods and money. None of the above. •• 3. A: The correct answer is number 2. The buyer and seller calculating the net outstanding. A: The correct answer is number 3. settlement involves____ 1. clearing involves 1.
1. other commodities were permitted to be traded in futures exchanges. 2. It is only in the last decade that commodity future exchanges have been actively encouraged. but the physical . 2. Even in the case of physical settlement.1 Physical settlement Physical settlement involves the physical delivery of the underlying commodity. typically at an accredited warehouse.1 Difference between commodity and financial derivatives The basic concept of a derivative contract remains the same whether the underlying happens to be a commodity or a financial asset. most of these contracts are cash settled. Similarly. Over a period of time. 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. However. the concept of varying quality of asset does not really exist as far as financial underlyings are concerned. In the case of financial derivatives. They were then found useful as a hedging tool in financial markets as well. financial assets are not bulky and do not need special facility for storage. However in the case of commodities. In India. We have a brief look at these issues. physical settlement in commodity derivatives creates the need for warehousing. We also have a brief look at the global commodity markets and the commodity markets that exist in India. the markets have been thin with poor liquidity and have not grown to any significant level.Chapter 2 Commodity derivatives Derivatives as a tool for managing risk first originated in the commodities markets. The seller intending to make delivery would have to take the commodities to the designated warehouse and the buyer intending to take delivery would have to go to the designated warehouse and pick up the commodity. However there are some features which are very peculiar to commodity derivative markets. Regulatory constraints in 1960s resulted in virtual dismantling of the commodities future markets. the quality of the asset underlying a contract can vary largely. Due to the bulky nature of the underlying assets. This may sound simple. In this chapter we look at how commodity derivatives differ from financial derivatives. This becomes an important issue to be managed.
In the case of BMF-Brazil a seller typically has to submit the following documents: • • • A declaration verifying that the asset is free of any and all charges. There are restrictions on interstate movement of commodities. in all commodity exchanges. including fiscal debts related to the stored goods. Some exchanges like LIFFE. We take a general overview at the process flow of physical settlement of commodities. BMF. However what is interesting and different from a typical options exercise is that in the commodities market. Exchanges such as COMMEX and the Indian commodities exchanges have adopted this method. Assignment Whenever delivery notices are given by the seller. Such contracts are then assigned to a buyer. Typically. In these exchanges the seller has to produce a verification report from these laboratories along with delivery notice. Delivery notice period Unlike in the case of equity futures. Alternatively. accept warehouse receipts as quality verification documents while others like BMF-Brazil have independent grading and classification agency to verify the quality. . the clearing houses may assign deliveries to buyers on some basis. Among the international exchanges. CBOT and CME display delivery notices. the clearing house of the exchange identifies the buyer to whom this notice may be assigned. issued by the warehouse. Some exchanges have certified laboratories for verifying the quality of goods. A warehouse certificate showing that storage and regular insurance have been paid. There are limits on storage facilities in different states. Exchanges follow different practices for the assignment process. typically a seller of commodity futures has the option to give notice of delivery. The warehouse receipt is the proof for the quantity and quality of commodities being delivered. both positions can still be closed out before expiry of the contract. A provisional delivery order of the good to BM&F (Brazil). Besides state level octroi and duties have an impact on the cost of movement of goods across locations. delivery notice is required to be supported by a warehouse receipt. Later on we will look into details of how physical settlement happens on the NCDEX. The intention of this notice is to allow verification of delivery and to give adequate notice to the buyer of a possible requirement to take delivery. One approach is to display the delivery notice and allow buyers wishing to take delivery to bid for taking delivery. in a manner similar to the assignments to a seller in an options market. The process of taking physical delivery in commodities is quite different from the process of taking physical delivery in financial assets.20 Commodity derivatives settlement of commodities is a complex process. These are required by virtue of the fact that the actual physical settlement of commodities requires preparation from both delivering and receiving members. This option is given during a period identified as 'delivery notice period'. The issues faced in physical settlement are enormous.
Assignment is done typically either on random basis or first-in-first out basis.2.100 and on the day of expiration. Which means that if the seller chooses to hand over the commodity instead of the difference in cash. Cash settlement involves paying up the difference in prices between the time the contract was entered into and the time the contract was closed. Delivery rate depends on the spot rate of the underlying adjusted for discount/ premium for quality and freight costs. the futures on that stock close Rs. clearing house/ exchange issues a delivery order to 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. does not have to deliver the underlying stock. The clearing house decides on the daily delivery order rate at which delivery will be settled. 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. Such CWH are required to provide storage facilities for participants in the commodities markets . if a trader buys futures on a stock at Rs. Delivery After the assignment process. all the positions are cash settled.20 in cash.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. exchanges assign the delivery intentions to open long positions. In some exchanges (CME).100. The efficacy of the commodities settlements depends on the warehousing system available. 2. This requires the exchange to make an arrangement with warehouses to handle the settlements. The period available for the buyer to take physical delivery is stipulated by the exchange. In case of commodity derivatives however. Similarly the person who sold this futures contract at Rs. In case of most exchange-traded financial derivatives. For instance. the buyer has the option to give his preference for delivery location. Buyer or his authorised representative in the presence of seller or his representative takes the physical stocks against the delivery order. The most active spot market is normally taken as the benchmark for deciding spot prices. The discount/ premium for quality and freight costs are published by the clearing house before introduction of the contract.120. Most international commodity exchanges used certified warehouses (CWH) for the purpose of handling physical settlements. The exchange also informs the respective warehouse about the identity of the buyer. All he does is take the difference of Rs.20 in cash. the buyer must take physical delivery of the underlying asset.2 Warehousing One of the main differences between financial and commodity derivative is the need for warehousing. he does not really have to buy the underlying stock. All he has to do is pay up the loss of Rs. Alternatively.1. the delivery rate is determined based on the previous day closing rate for the contract or the closing rate for the day. 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. After the close of trading. there is a possibility of physical settlement.
the Bureau of Indian Standards (BIS) under Ministry of Consumer Affairs specifies standards for processed agricultural commodities whereas AGMARK under the department of rural development under Ministry of Agriculture is responsible for promulgating standards for basic agricultural commodities. Apart from these. There may be quite some variation in the quality of what is available in the marketplace. Central and state government controlled warehouses are the major providers of agri-produce storage facilities. Washington. which specify standards for export oriented commodities. Box 2.22 Commodity derivatives The New York Cotton Exchange has specified the asset in its orange juice futures contract as "U. The Chicago Mercantile Exchange in its random-length lumber futures contract has specified that "Each delivery unit shall consist of nominal 'i y. however. The CBOT and CME are two of the oldest derivatives . Commodity derivatives demand good standards and quality assurance/ certification procedures. and/ or spruce pine fir". Wyoming. in no case may the quantity of Standard grade or #2 exceed 50%.1. Table 2. the warehousing system is not as efficient as it is in some of the other developed markets. having a Brix value to acid ratio of not less than 13 to 1 nor more than 19 to 1.1 gives a list of commodities exchanges across the world. Englemann spruce. Montana. When the asset is specified.3: Specifications of some commodities underlying derivatives contracts and to certify the quantity and quality of the underlying commodity. 2. Idaho. and contain lumber produced from grade-stamped Alpine fir. the quality of the underlying asset is of prime importance. with factors of color and flavour each scoring 37 points or higher and 19 for defects. The advantage of this system is that a warehouse receipt becomes a good collateral. with a minimum score 94". there are other agencies like EIA. or #1 and #2.2 Global commodities derivatives exchanges Globally commodities derivatives exchanges have existed for a long time. grade-stamped Construction Standard. 2. Standard and Better. In India. For example. lodgepole pine. However there is no clear regulatory oversight of warehousing services.3 Quality of underlying assets A derivatives contract is written on a given underlying. with Brix value of not less than 57 degrees. Canada. Oregon. Variance in quality is not an issue in case of financial derivatives as the physical attribute is missing.S Grade A. Each deliver unit shall be manufactured in California. there are a few private warehousing being maintained. A good grading system allows commodities to be traded by specification. it is therefore important that the exchange stipulate the grade or grades of the commodity that are acceptable. or Alberta or British Columbia. Nevada. not just for settlement of exchange trades but also for other purposes too. Apart from these.is of random lengths from 8 feet to 20 feet. hem-fir. Currently there are various agencies that are responsible for specifying grades for commodities. When the underlying asset is a commodity.
It was know as the to-arrive contract. Initially its main task was to standardise the quantities and qualities of the grains that were traded. 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. On these exchanges. Singapore Singapore Commodity Exchange Ltd. The CBOT was established in 1848 to bring farmers and merchants together.Table 2. France Le Nouveau Marche MATIF Italy Italian Derivatives Market Netherlands Amsterdam Exchanges Option Traders The Russian Exchange Russia MICEX/ Relis Online St. Within a few years the first futures-type contract was developed.1 The global derivatives industry Country Exchange Chicago Board of Trade (CBOT) Chicago Mercantile Exchange Minneapolis Grain Exchange New York Cotton Exchange New York Mercantile Exchange Kansas Board of Trade New York Board of Trade Canada The Winnipeg Commodity Exchange Brazil Brazilian Futures Exchange Commodities and Futures Exchange Australia Sydney Futures Exchange Ltd.2 Global Commodities derivatives exchanges 23 exchanges in the world. another exchange. Petersburg Futures Exchange The Spanish Options Exchange Spain Citrus Fruit and Commodity Futures Market of Valencia The London International Financial Futures United Kingdom Options exchange The London Metal Exchange United States of America 2. People's Republic Of China Beijing Commodity Exchange Shanghai Metal Exchange Hong Kong Hong Kong Futures Exchange Japan Tokyo International Financial Futures Exchange Kansai Agricultural Commodities Exchange Tokyo Grain Exchange Malaysia Kuala Lumpur commodity Exchange New Zealand New Zealand Futures& Options Exchange Ltd. Now futures exchanges exist all over the world. the CME was established. a wide range of commodities and financial assets form the underlying assets in .
2. 2. was the first organised futures market.2. wool. Bombay Cotton Exchange Ltd. 2. the China Securities Regulatory Committee began a nationwide consolidation process which resulted in three commodity exchanges emerging. which was formed in 1999 by the merger of two well-established exchanges.1 Africa Africa's most active and important commodity exchange is the South African Futures Exchange (SAFEX). gold and tin. it was the 8th largest exchange by 2001. Singapore is home to the Singapore Exchange (SGX). while only 15 restructured exchanges received formal government approval. in which trade was liberalised. There are also many other commodity exchanges operating in Brazil. but the creation of the Agricultural Markets Division (as of 2002. The Taiwan Futures Exchange was launched in 1998. The commodities include pork bellies.3 Latin America Latin America's largest commodity exchange is the Bolsa de Mercadorias & Futures. Mexico has only recently introduced a futures exchange to its markets. bread milling wheat and sunflower seeds. SAFEX only traded financial futures and gold futures for a long time. Malaysia and Singapore have active commodity futures exchanges. Argentina's futures market Mercado a Termino de Buenos Aires. We look at commodity exchanges in some developing countries. It was informally launched in 1987. copper. the Dalian Commodity Exchange (DCE). Commodity.2. white and yellow maize. aluminium. Although this exchange was only created in 1985. (BM&F) in Brazil. spread throughout the country. more than half of China's exchanges were closed down or reverted to being wholesale markets. was established in 1893 following the widespread discontent .2. with 98 million contracts traded. lumber. namely. Cereals & Oils Exchanges. formed in 1999 after the merger of three exchanges: Shanghai Metal. corn and in particularly soybeans. the Zhengzhou Commodity Exchange and the Shanghai futures Exchange. The main commodities traded were agricultural staples such as wheat.24 Commodity derivatives various contracts.. founded in 1909. In late 1994. set up in 1875. live cattle. sugar. Malaysia hosts one futures and options exchange. the Agricultural Derivatives Division) led to the introduction of a range of agricultural futures contracts for commodities. 2. The Mercado Mexicano de Derivados (Mexder) was launched in 1998. At the beginning of 1999. ranks as the world's 51st largest exchange.3 Evolution of the commodity market in India Bombay Cotton Trade Association Ltd. the Stock Exchange of Singapore (SES) and Singapore International Monetary Exchange (SIMEX).2 Asia China's first commodity exchange was established in 1990 and at least forty had appeared by 1993.
To examine the extent to which forward trading has special role to play in promoting exports. 2. the Government of India appointed in June 1993 a committee on Forward Markets under chairmanship of Prof. The Futures trading in oilseeds started in 1900 with the establishment of the Gujarati Vyapari Mandali.3 Evolution of the commodity market in India 25 amongst leading cotton mill owners and merchants over functioning of Bombay Cotton Trade Association. 2. These two associations amalgamated in 1945 to form the East India Jute & Hessian Ltd. 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.3. But the most notable futures exchange for wheat was chamber of commerce at Hapur set up in 1913. Kabra. To review the role that forward trading has played in the Indian commodity markets during the last 10 years. particularly in commodities in which resumption of forward trading is generally demanded.N. 5. castor seed and cotton. 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. 6. was established in 1919 for futures trading in rawjute and jute goods. to conduct organised trading in both Raw Jute and Jute goods. 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.2. in the light of the recommendations.1 The Kabra committee report After the introduction of economic reforms since June 1991 and the consequent gradual trade and industry liberalisation in both the domestic and external sectors. The committee was setup with the following objectives: 1. But organised futures trading in raw jute began only in 1927 with the establishment of East Indian Jute Association Ltd. particularly with a view to effective enforcement of the Act to check illegal forward trading when such trading is prohibited under the Act. In due course. 3. . To suggest amendments to the Forward Contracts (Regulation) Act. K. 4. Futures trading in wheat was existent at several places in Punjab and Uttar Pradesh. several other exchanges were created in the country to trade in diverse commodities. To assess the role that forward trading can play in marketing/ distribution system in the commodities in which forward trading is possible. Calcutta Hessian Exchange Ltd. which carried on futures trading in groundnut. Futures trading in bullion began in Mumbai in 1920.
Cotton and kapas 3. ensuring capital adequacy norms and encouraging computerisation would enable these exchanges to place themselves on a better footing. 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. sunflower seed. • Due to the inadequate infrastructural facilities such as space and telecommunication facilities the commodities exchanges were not able to function effectively. 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. rapeseed/mustard seed.4. and oils and oilcakes of all of them. . Amendments to the rules. with the issue of these notifications futures trading is not prohibited in any commodity. Silver 9. As a follow up. Options trading in commodity is. Groundnut. however presently prohibited. • The majority of me committee recommended that futures trading be introduced in the following commodities: 1. the government issued notifications on 1. The recommendations of the committee were as follows: • The Forward Markets Commission(FMC) and the Forward Contracts (Regulation) Act. • In-built devices in commodity exchanges such as the vigilance committee and the panels of surveyors and arbitrators be strengthened further. 1952. Rice bran oil 6. safflower seed.26 Commodity derivatives The committee submitted its report in September 1994. regulations and bye-laws of the commodity exchanges should require the approval of the FMC only. particularly the ones dealing in pepper and castor seed.2003 permitting futures trading in the commodities. Castor oil and its oilcake 7. • In the context of globalisation. Raw jute and jute goods 4. copra and soybean. • The FMC which regulates forward/ futures trading in the country. Enlisting more members. be upgraded to the level of international futures markets. commodity markets in India could not function effectively in an isolated manner. sesame seed. would need to be strengthened. should continue to act a watch-dog and continue to monitor the activities and operations of the commodity exchanges. cottonseed. 5. Basmatirice 2. Therefore. some of the commodity exchanges. Linseed 8.
Table 2. groundnut Pepper Gur. National level commodity derivatives exchanges seem to be the new phenomenon. annual vol (Rs.2 Volume on existing exchanges Commodity exchange National board of trade.2 Latest developments Commodity markets have existed in India for a long time. today. mustard Gur Approx. Indore National multicommodity exchange. mustard Multiple Castor.3 Evolution of the commodity market in India Products Soya.3. Table 2. Cochin Chamber of commerce. • National Board of Trade • Multi Commodity Exchange of India • National Commodity & Derivatives Exchange of India Ltd . the commodity derivative market in India seems poised for a transformation. The increasing volumes on these exchanges suggest that commodity markets in India seem to be a promising game. While the implementation of the Kabra committee recommendations were rather slow. Ahmedabad Ahmedabad commodity exchange Rajdhani Oil & oilseeds Vijai Beopar Chamber Ltd. oil & bullion exchange IPSTA.Crore) 80000 40000 3500 3500 2500 2500 2500 2500 1500 1500 140000 27 2.2 gives the total annualised volumes on various exchanges. The Forward Markets Commission accorded in principle approval for the following national level multi commodity exchanges.Table 2.3 gives the list of registered commodities exchanges in India. Hapur Bhatinda Om and oil exchange Other (mostly inactive) Total 2. Muzzaffarnagar Rajkot seeds. cotton Mustard Gur Castor.
oil. Rubber. Kochi Pepper Rajdhani Oils and Oilseeds Exchange Ltd. Castorseed Vijay Beopar Chamber Ltd.3 Registered commodity exchanges in India Exchange Bhatinda Om & Oil Exchange Ltd. Rapeseed/ Mustardseed Sugar Grade-M National Board of Trade. Ltd. rice bran oil and oilcake Crude palm oil The Rajkot Seeds oil & Bullion Merchants Groundnut oil Association. tin Vanaspati. Bangalore Coffee National Multi Commodity Exchange of India Gur. Gur The Spices and Oilseeds Exchange Ltd. lead National Commodity & Derivatives Exchange Soy Bean.. Commodity derivatives Product traded Gur Sunflower oil Cotton (Seed and oil) Safflower (Seed.. Ltd. oil and oil cake) Groundnut (Nut and oil) Castor oil. Soy bean Cotton (Seed. Muzaffarnagar Gur India Pepper & Spice Trade Association.oil and oilcake) Linseed (seed. oil. Hessian. Gur The East India Jute & Hessian Exchange Ltd.. oil..Sangli Turmeric Ahmedabad Commodities Exchange Ltd. Copra Rapeseed/ Mustardseed. Mumbai Cotton The Central India Commercial Exchange Ltd. Pepper. Coconut oil & Copra cake The Coffee Futures Exchange India Ltd. Castorseed The Kanpur Commodity Exchange Ltd. Hapur Gur. oil and oilcake) Rice Bran Oil. Castorseed Sesamum (Oil and oilcake) Rice bran. oilcake) Sugar. Guarseed Aluminium ingots. Sacking. Delhi Gur.28 Table 2. oilcake) Groundnut (seed. Zinc. Crude Palm Oil The Chamber of Commerce. Nickel. Indore Rapeseed/ Mustard seed/ Oil/ Cake Soybean/ Meal/ Oil. oilcake) Safflower (seed. Sacking Kolkata First Commodity Exchange of India Ltd. RBD Pamohen Limited. The Bombay Commodity Exchange Ltd. Rapeseed/ Mustardseed oil and cake The Meerut Agro Commodities Exchange Co. Refined Soy Oil Limited Mustard Seed Expeller Mustard Oil RBD Palmolein Crude Palm Oil Medium Staple Cotton Long Staple Cotton Gold. Silver . Copper. Ahmedabad Crude Palm Oil... gram Coconut (oil and oilcake) Castor (oil and oilcake) Sesamum (Seed. Kochi Copra. Cottonseed. Rapeseed/ Mustardseed The East India Cotton Association.
2.3 Evolution of the commodity market in India 29 Solved Problems Q: Which of the following feature differentiates a commodity futures contract from a financial futures contract? 1. The clearing corporation A: The correct answer is number 2. None of the above • Q: Typically. Letter of credit 2. 3. The seller • . • 3. The warehouse 4. the exchange A: The correct answer is number 1 • 3. delivery notice is required to be supported by a 1. National Commodity Derivative Exchange 2. MTM settlement 4. Multi Commodity Exchange of India A: The correct answer is number 4. Exchange traded product 2. • 3. Advance payment • Q: Who identifies the buyer to whom the delivery notice is assigned? 1. Undertaking 4. National Stock Exchange •• 3. • Q: Which of the following exchanges do not offer commodity derivatives trading? 1. an accredited warehouse 2. National Board of Trade 4. Warehouse receipt A: The correct answer is number 2. The exchange 2. Standardised contract size A: The correct answer is number 4. in all commodity exchanges. the buyers requested destination 4. Varying quality of underlying asset • Q: Physical settlement involves the physical delivery of the underlying commodity at 1.
1952. Commodity derivatives 3. The clearing house assigns delivery to the buyer 2. 3. The warehouse assigns the delivery to the buyer •• Q: The_____committee recommended that the Forward Markets Commission(FMC) and the Forward Contracts (Regulation) Act. 1. need to be strengthened. Khusro Committee 4. The buyer chooses which delivery to take 4. L C Gupta Committee 2. J R Varma Committee •• .30 Q: On the NCDEX_____ 1. The seller assigns delivery to the buyer A: The correct answer is number 1. Kabra Committee A: The correct answer is number 2.
gold. • To provide nation wide reach and consistent offering. NCDEX is regulated by Forward Markets Commission in respect of futures trading in commodities. 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.medium and long staple varieties. low cost solutions and information dissemination without noise etc. At subsequent phases trading in more commodities would be facilitated. soy bean. Forward Commission (Regulation) Act and various other legislations. Maharashtra in Mumbai on April 23. It is a public limited company registered under the Companies Act. Contracts Act. Stamp Act. rapeseed-mustard seed. professionalism and transparency. 3.1 Structure of NCDEX NCDEX has been formed with the following objectives: • To create a world class commodity exchange platform for the market participants. silver. refined soy bean oil. . • To inculcate best international practices like de-modularization. It is located in Mumbai and offers facilities to its members in about 91 cities throughout India at the moment. technology platforms. • To bring professionalism and transparency into commodity trading. Besides. expeller rapeseed-mustard seed oil. into the trade.Chapter 3 The NCDEX platform National Commodity and Derivatives Exchange Ltd (NCDEX) is a technology driven commodity exchange. which impinge on its working. It has an independent Board of Directors and professionals not having any vested interest in commodity markets. crude palm oil and cotton . NCDEX currently facilitates trading of ten commodities . RBD palmolein. • To bring together the entities that the market can trust. 1956 with the Registrar of Companies.2003. NCDEX is subjected to various laws of the land like the Companies Act.
Applicants accepted for admission as TCM are required to pay the required fees/ deposits and also maintain net worth as given in Table 3. . which.2 Governance NCDEX is run by an independent Board of Directors.1 Promoters NCDEX is promoted by a consortium of institutions. association of persons. co-operative societies. The board is responsible for managing and regulating all the operations of the exchange and commodities transactions. help the Board in policy formulation. Audit Committee.32_____________________________________________________The NCDEX platform 3. This unique parentage enables it to offer a variety of benefits which are currently in short supply in the commodity markets. Apart from the executive committee the board has constitute committee like Membership committee. partnerships. NCDEX is the only commodity exchange in the country promoted by national level institutions. All the members of the exchange have to register themselves with the competent authority before commencing their operations.1. Life Insurance Corporation of India (LIC). The executive committee consists of Managing Director of the exchange who would be acting as the Chief Executive of the exchange. The TCM membership entitles the members to trade and clear. 3. trust. National Bank for Agriculture and Rural Development (NABARD) and National Stock Exchange of India Limited (NSE).1 Trading cum clearing members (TCMs) NCDEX invites applications for Trading cum Clearing Members (TCMs) from persons who fulfill the specified eligibility criteria for trading in commodities. Promoters do not participate in the day to day activities of the exchange.2. 3. Trading cum Clearing Members (TCM) and Professional Clearing Members (PCM). The members of NCDEX fall into two categories.1. Risk Committee. and also other members appointed by the board.2 Exchange membership Membership of NCDEX is open to any person. 3. The directors are appointed in accordance with the provisions of the Articles of Association of the company. Compensation Committee and Business Strategy Committee.1. technology and risk management skills. nationwide reach. The four institutional promoters of NCDEX are prominent players in their respective fields and bring with them institution building experience. These include the ICICI Bank Limited (ICICI Bank). Board appoints an executive committee and other committees for the purpose of managing activities of the exchange. that fulfills the eligibility criteria set by the exchange. both for themselves and/ or on behalf of their clients. Nomination Committee. companies etc. It formulates the rules and regulations related to the operations of the exchange.
00 3.2 Professional clearing members (PCMs) NCDEX also invites applications for Professional Clearing Membership (PCMs) from persons who fulfill the specified eligibility criteria for trading in commodities.00 1.00 33 Table 3.2. The PCM membership entitles the members to clear trades executed through Trading cum Clearing Members (TCMs). . Collateral security deposit All Members have to comply with the security deposit requirement before the activation of their trading terminal.50 0.1 Fee/ deposit structure and networth requirement: TCM Particulars (Rupees in Lakh) Interest free cash security deposit Collateral security deposit Annual subscription charges Advance minimum transaction charges Net worth requirement 15. both for themselves and/ or on behalf of their clients. 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. Interest free cash security deposit 2.3 Capital requirements Table 3.00 5000. the member has to deposit Base Minimum Capital (BMC) with the exchange.00 1.3 Capital requirements NCDEX has specified capital requirements for its members.00 25. Base Minimum Capital comprises of the following: 1.2 Fee/ deposit structure and networth requirement: PCM Particulars (Rupees in Lakh) Interest free cash security deposit Collateral security deposit Annual subscription charges Advance minimum transaction charges Net worth requirement 25. On approval as a member of NCDEX.2. Applicants accepted for admission as PCMs are required to pay the following fee/ deposits and also maintain net worth as given in Table 3. 3.00 15.3.50 50.00 0.
34 The NCDEX platform • Bank guarantee: Bank guarantee in favour of NCDEX as per the specified format from approved banks. the trading facility would be withdrawn with immediate effect. 5 Lakh. to 4. clearing and settlement. its price. It supports an order driven market and provides complete transparency of trading operations. Rs. bank guarantee.trading. • If the security deposit shortage is less than Rs. After hours trading has also been proposed for implementation at a later stage. The FDR should be issued for a minimum period of 36 months from any of the approved banks. every market transaction consists of three components .e. If it finds a match.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.m. Members who wish to increase their limit can do so by bringing in additional capital in the form of cash. 3. The NCDEX system supports an order driven market. • Fixed deposit receipt: Fixed deposit receipts (FDRs) issued by approved banks are accepted. If it does not find a match. 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. All quantity fields are in units and price in rupees. a trade is generated. The exchange specifies the unit of trading and the delivery unit for futures contracts on various commodities . The trade timings of the NCDEX are 10.4. provides a fully automated screen-based trading for futures on commodities on a nationwide basis as well as an online monitoring and surveillance mechanism. Order matching is essentially on the basis of commodity. time and quantity. When any order enters the trading system. • Government of India securities: National Securities Clearing Corporation Limited (NSCCL) is the approved custodian for acceptance of Government of India securities. It tries to find a match on the other side of the book. The exchange notifies the regular lot size and tick size for each of the contracts traded from time to time. This section provides a brief overview of how transactions happen on the NCDEX's market. where orders match automatically. Members are required to maintain minimum level of security deposit i. it is an active order.00 p. 25 Lakh in case of PCM at any point of time. 3. If the security deposit falls below the minimum required level.1 Trading The trading system on the NCDEX.00 a.4 The NCDEX system As we saw in the first chapter. fixed deposit receipts or Government of India securities. The minimum term of the bank guarantee should be 12 months. the order becomes passive and gets .m.15 Lakh in case of TCM and Rs. The securities are valued on a daily basis and a haircut of 25% is levied.
the final settlement price is the spot price on the expiry day. on the basis of locations and then randomly. The cash settlement is only for the incremental gain/ loss as determined on the basis of final settlement price. 3.2 Clearing National Securities Clearing Corporation Limited (NSCCL) undertakes clearing of trades executed on the NCDEX. Matching done by this process is binding on the clearing members. NCDEX on receipt of such information. clearing members are informed of the deliverable/ receivable positions and the unmatched positions. two-month and three-month expiry cycles. 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. the matching for deliveries takes place firstly. either brought forward. On the date of expiry. based on the available information. On the NCDEX. The seller intending to make delivery takes the commodities to the designated warehouse. Unmatched positions have to be settled in cash. A professional clearing member is responsible for settling all the participants trades which he has confirmed to the exchange. 3. These commodities have to be assayed by the exchange specified assayer. Only clearing members including professional clearing members (PCMs) only are entitled to clear and settle contracts through the clearing house. Time stamping is done for each trade and provides the possibility for a complete audit trail if required.4. All positions of a CM.3. the MTM settlement which happens on a continuous basis at the end of each day. After completion of the matching process. The commodities have to meet the contract specifications with allowed variances. The responsibility of settlement is on a trading cum clearing member for all trades done on his own account and his client's trades. If the 20th of the expiry month is a trading holiday. New contracts will be introduced on the trading day following the expiry of the near month contract.4. 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. NCDEX trades commodity futures contracts having one-month. and the final settlement which happens on the last trading day of the futures contract. If the commodities meet the . after the trading hours on the expiry date. All contracts expire on the 20th of the expiry month. created during the day or closed out during the day. commodities already deposited and dematerialized and offered for delivery etc. the contracts shall expire on the previous trading day.3 Settlement Futures contracts have two types of settlements. The settlement guarantee fund is maintained and managed by NCDEX. On the expiry date of a futures contract. At NCDEX.4 The NCDEX system__________________________________________________35 queued in the respective outstanding order book in the system. keeping in view the factors such as available capacity of the vault/ warehouse. matches the information and arrives at a delivery position for a member for a commodity. 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. are market to market at the daily settlement price or the final settlement price at the close of trading hours on a day.
Gold futures A: The correct answer is number 4. Cotton futures 2. who would courier the same to the buyer's clearing member. Energy futures •• . Warehouse then ensures that the receipts get updated in the depository system giving a credit in the depositor's electronic account.50Lakh A: The correct answer is number 2. Rs. Q: NCDEX is regulated by 1. the buyer goes to the warehouse and takes physical possession of the commodities. 3. Rs. the warehouse accepts them.5Lakh 2. The seller then gives the invoice to his clearing member. SEBI A: The correct answer is number 1. Q: The net worth requirement for a TCM is 1. Reserve Bank of India 4. Rs.5000Lakh •• 3. Silver futures 4. On an appointed date. The Forward Markets Commission 2. Solved Problems Q: Which of the following futures do not trade on the NCDEX? 1.500Lakh 4. Controller of Capital Issues •• 3. Rs.36__________________________________________________________The NCDEX platform specifications.
For derivatives with a commodity as the underlying. Precious metal 3. Of these we study cotton in detail and have a quick look at the others. Agricultural products 2. rape/ mustard seed. To begin with contracts in gold. silver. 1. the exchange must specify the exact nature of the agreement between two parties who trade in the contract. expeller mustard oil. the NCDEX has commenced trading in futures on agricultural products and precious metals. crude palm oil. where and when the delivery will be made. the contract size stating exactly how much of the asset will be delivered under one contract. cotton. soya oil. it must specify the underlying asset. Energy Of these. RBD palmolein. In particular. 4.1 Agricultural commodities The NCDEX offers futures trading in the following agricultural commodities . crude palm oil and RBD palmolein are being offered. clearing and settlement details will be discussed later.Refined soy oil. soyabean. In this chapter we look at the various underlying assets for the futures contracts traded on the NCDEX. The commodity markets can be classified as markets trading the following types of commodities. medium staple cotton and long staple cotton.Chapter 4 Commodities traded on the NCDEX platform In December 2003. the National Commodity and Derivatives Exchange Ltd (NCDEX) launched futures trading in nine major commodities. We have a brief look at the various commodities that trade on the NCDEX and look at some commodity specific issues. mustard seed. . rapeseed oil. Other metals 4. Trading.
27-30% of the country's export earnings and 4% of its GDP. the crop is sown during the June-July period and harvested during September-October. The maximum fluctuation has been as high as 11%. During the period of fruiting. Cotton is among the most important non-food crops. China. which predominates and occupies nearly 75% of the area under this crop. It is the major source of a basic human need clothing. a minimum temperature of 150°C is required. The average monthly fluctuation in prices of cotton traded across India has been at around 4. Madhya Pradesh. Maharashtra. Cotton is a 90-120 day annual crop.130 billion.270°CIt can tolerate temperatures as high as 430°C . More than the actual rainfall. a process called ginning (lint recovery from kappas is 30-31%). silk and synthetic. Haryana. Cotton is grown on a variety of soils. a rainfall of 50 cm is the minimum requirement. In the case of the rain-fed cotton. Kappas are bought by ginners. 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. a favourable distribution is the deciding factor in obtaining good yields from the rainfed cotton. 1 bale = 170 kg) of raw cotton trade in the country. (3)The red sandy loams to loams . In the main producing countries of USA.45/ kg. but does not do well if the temperature falls bellow 210°C. Today. apart from other fibre sources like jute. The optimum temperature range for vegetative growth is 21. India and Pakistan. and (4)Lateritic soils .1. The market size of raw cotton in India is over Rs. in USA. both from agricultural and manufacturing sectors' points of view. . 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. Harvested Kappas (cotton with seed) start arriving into the market (from the producing centres) from October-November onwards. who separate the seeds from the lint (cotton fibre). The predominant types of soils on which the crop is grown are (l)Alluvial soils predominant in the northern states of Punjab. Karnataka and Tamil Nadu. Rajasthan and Uttar Pradesh. Cropping and Growth pattern Cotton is a tropical and sub-tropical crop. cotton prices in India have been fluctuating in the range of 3-6% on a monthly basis. Historically. as it does not tolerate water logging. The loose cotton lint so obtained is pressed and sold to the spinning mills in the form of full pressed bales (1 bale = 170 kg cotton lint in India. It is grown mainly as a dry crop in the black and medium black soils and as an irrigated crop in the alluvial soils. over 17 million bales (average annual consumption. For the successful germination of its seeds. It requires a soil amenable to good drainage.38 Commodities traded on the NCDEX platform 4. It occupies a significant position.5% during the last three years. warm days and cool nights.predominant in the states of Gujarat.found in parts of Tamil Nadu.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). (2)The black cotton soils. with large diurnal variations are conducive to good boll and fibre development. Andhra Pradesh. it is 480 pounds). Spinned cotton yarn is used by clothe manufacturers/ textile industry. At the average price of Rs. Assam and Kerala.
9 million tons). . The global supply and demand statistics released by the International Cotton Advisory Committee (ICAC) and the United States Department of Agriculture (USDA) periodically are closely watched by the trading community. Mills using ELS (extra long staple) have been pleased with US Pima and its fibre characteristics. etc. Cotton trade is influenced by the supply-demand scenario. Global production of cotton during the post 1990 (till date i.2-2. consumption has been in the range in the 18-20. Among several other reasons. The CCI is responsible for establishing the price support in all States.5 million tons. which stood at 1. Indonesia. Most importing mills in India are ready to pay 5-10% premium for foreign cotton due to its higher quality (less trash. and CCI operations are generally limited to commercial purchases and sales (except for a few years like 2001-02 when the prices were abysmally low). The global export and import trade of cotton during the post 1990 era has been in the range of 5.8 million tons). The central government establishes minimum support prices (MSP) for Kappas at the start of each marketing season.6 million bales during the pre-1996 period have dipped to less than 100 thousand bales. USA and Pakistan top the list of cotton consuming countries. market prices remain well above the MSP. Production (acreage under the crop) of cotton varies from year to year based on the climatic factors that are crucial for the productivity of crop. Production of cotton in India during the post 1990 period has been fluctuating in the range of 1217 million bales (i.4. constituting about 15% of the global cotton production. Thailand. India is also importing from Egypt. and the CIS countries and Australia on account of lower freight and shorter delivery periods. Apart from US. the country's cotton consumption stands at 17-19 million bales (2. US has emerged as an important supplier in the last two seasons. Currently. Mexico.e. India's position on the global trade front has witnessed a drastic change during the post 1995 period. Brazil.1 Agricultural commodities Global and domestic demand-supply dynamics 39 China. Typically. Price trends and factors that influence prices Cotton production and trade is influenced by various factors. These eight countries produced over 80% of the world's cotton production during 2001-02. West Africa. Italy and Korea consume over 80% of the world's annual cotton consumption.e. These along with Turkey.2-1.2 million bales during the last three years.5-21 million tons. Contrary to this.5 to 6. Turkey and Australia are the other major producers.5 million tons. USA. higher ginning out-turn) and better credit terms (36 months vs. China. uniform lots. 15-30 days for local). Brazil. production and prices of synthetic fibre (polyester. India. the imports have sharply risen from 30000-50000 bales during the pre-1995 to little over 2. between 2. it is the lack of availability of desired quality cotton that has made many Indian buyers (particularly the export oriented units) to opt for purchases of foreign cotton despite enough domestic supply. Uzbekistan. Similarly. Russia. viscose and acrylic) and prices of cotton itself. 2002-03 forecast) has been fluctuating in the narrow range of 16. The country has turned from being net exporter to net importer. The country's raw cotton exports. India and Pakistan top the list of cotton producing countries.7-2.
2 Crude palm oil Annual edible oil trade in India is worth over Rs.78 US Cents/ lb (as on Jan 2.80-90 billion). Oil palm is sensitive to pH above 7.the other fibre sources.440 billion. silk. Oil palm thrives well at temperatures of 22 . While in the importing countries like China and European Union. the water-holding capacity of the soil is of greatest importance.33°C with at least 5 hours sunshine per day throughout the year. etc.5 and stagnant water. Global and domestic demand-supply dynamics CPO is used for human consumption as well as for industrial purposes. wool and khadi . the consumption of palm oil is growing at the rate of 5. deodorized) palm oil. One hectare of oil palm yields approximately 20 FFBs. a sharp fall by 54. the consumption growth rate for the worlds leading palm oil importer . international raw cotton prices. in areas where rainfall is marginally suitable. 4. Towards mid-2002. NyBOT witnessing a sharp downfall in prices from 61.40 Commodities traded on the NCDEX platform Futures prices of cotton at the New York Board of Trade (NYBOT) serve as the reference price for cotton traded in the international market. with the share of CPO being nearly 20% (Rs.20 US Cents/ lb (as on Oct 26. Crude palm oil (CPO). 2001). RBD (refined. There is a close inter linkage between the various vegetable oils produced. bleached. which is used both for edible and industrial purposes). The country is over-dependent on CPO imports to the extent of over 50% of its annual vegetable oil imports. the soil should be deep.7% during the past two and a half years.37% compounded annually during the last 12 years period. RBD palmolein and crude palm kernel oil (CPKO) are the various forms of palm oil traded in the market. 2001) to the low of 28. the maximum monthly fluctuation being as high as 25% during the period. Jute. The consumption of palm oil (both food and industrial consumption put together) in the world is growing at the rate of 7.85 cents. The average monthly fluctuation in prices of imported CPO traded at Kandla (one of the major importing ports in Gujarat) has been at 9. prices recovered to 53 cents. Flat or gentle undulating land is preferred. and toward end of 2003 were currently ruling at 58. Oil palm can be grown on a wide range of soil. which when crushed yields 6 tons of oil (including the kernel oil. prices of synthetic fibre. crude palmolein. demand for finished readymade garments from abroad. traded and consumed across the world. well structured and well drained. World cotton prices fell sharply during most part of 2001.1. Cropping and growth patterns Oil palm requires an average annual rainfall of 2000 mm or more distributed evenly throughout the year. In general. Cotton prices in India are therefore influenced by various demand-supply factors operating within the country. Palm oil is extracted from the mature fresh fruit bunches (FFBs) of oil palm plantations.2% and 4.35%.8% respectively. Rainfall less than 100 mm for a period of more than three months is not suitable for oil palm cultivation. However. are less likely to have any major impact on cotton prices in India.
India. acreage under palm plantation does not vary from season to season. Price trends and factors that influence prices There exists a clear trough and crest in the seasonality of CPO production. Rising consumption of palm oil in India. mainly the exportimport policy. China. (MDEX) could be considered as the price maker of palm oil traded world over. The major importing and trading centres for palm in India are Chennai. canola/ rapeseed. prices of various domestically produced and imported oils. Being a perennial plantation crop. it exhibits seasonal highs and lows once in a year. The entire industry of CPO in India is dominated by importers. sunflower. while the it is at its peak during the months of August. overall health of the economy that has a bearing on the purchasing power of ultimate consumers. large refiners. Production of palm oil stands at 24-25 million tons (over 22% of the global vegetable oil). etc. production and trade policies of the Government. groundnut. which could be mainly attributed to its price competitiveness among several of its competing oils is being met through increasing imports.8-1. Palm oil trade is influenced by various production.. etc. temperature. Domestic oilseed and edible oil industry is organised in the form of oilseed crushers. corporate involved in wholesale and retail trade through value-addition and retail-regional level players along with a few national level players. Mangalore and Karwar also play important role. Kakinada. . solvent extractors. India.1 Agricultural commodities 41 (in specific. Factors that influence price are market related factors viz.4. Pakistan and European Union amount to approximately 56% of the total global exports of palm oil annually. The industry is dominated by over 200 importing companies. supply-demand status of various consuming/importing countries. Mumbai and Kandla. The other centers like Mundra. This exchange trades only CPO among several derivatives of palm. Palm oil dominates the global vegetable oil export trade. but next to the four major trading centers. The Kuala Lumpur based Malaysia Derivatives Exchange Bhd. and edible oils in general). supply-demand scenario of palm and its competing soy oil in the global market apart from other vegetable oil sources viz. etc. Malaysia and Indonesia dominate the global trade in CPO. The major trading centres of CPO in the world are Malaysia and Indonesia in Asia and Rotterdam in Europe. vanaspati and other industrial sectors apart from human consumption as RBD palmolein. indicating a typical seasonality in the production cycle. coconut oil. Production is almost evenly distributed throughout the year between 0. Yield levels of the plantations are influenced by climatic conditions like rainfall. 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. processors. who are mostly refiners too. Their share in the global exports of CPO is to the tune of 90%.1 million tons in a monthly. The domestic production of palm oil forms almost a negligible part of the total edible oil consumption in the country. Palm oil supports many other industries in India like refining. market and policy related factors. technologists. September and October. Kolkata. Pakistan and the European Union are the major importers of palm oil. commodity-specific producers and traders. China. stands at 25%. The two producing countries viz. March and April. India is the largest importer of CPO with a share of over 15% of the total quantity traded in the international market. The production bottoms down in the months of February. However. The total imports of India.
India. Kolkata. While Oil is a stable derivative saturated fat. This implies that the country is dependent on palm oil imports for over 25% of its annual edible oil consumption. At the same time. Kakinada. Mundra. While the strategy of farm subsidies and minimum support price (MSP) are on the production side. which is a white solid at room temperature. The import is mainly through the ports of Kandla. the duty structure on various forms of palm oil is the major trade-related protectionist measure. Mumbai and Chennai. imports nearly 3 million tons of palm oil annually (mainly from Malaysia. Government of India (Gol) adopts a protection policy with regard to production and trade in vegetable oils. Trade policies in India Since oilseed is one among the major crops cultivated by millions of farmers spread across the country. The whole quantity of CPO that is produced and used for human consumption is in the form of RBD palmolein. . bleached and deodorized) palmolein is the derivative of crude palm oil (CPO).1. RBD palmolein exports from Malaysia have increased from 3. which supply palm oil to the world to the extent of over 85% of the annual global trade in palm oil. so as to protect the interests of both the producers and consumers.5 million tons in 2002. The domestic production of palm oil forms almost a negligible part of the total edible oil consumption in the country. and is the major source of cooking oil to over one billion consuming populace of the country. There has been a sharp rise in the imports of palm oil into the country during the post 1998 period.2 million tons in 1998 to 4. Cropping of growth patterns of CPO has been already covered.3 RBD Palmolein The RBD (refined. Pakistan and Middle-East countries are the major importers of RBD palmolein.000 tons in 2002. Mangalore. Its production grew from 5000 tons in 1991 to 35. Olein is relatively unstable (unsaturated fat. export largely as CPO as is demanded by the importing nations who refine domestically and consume. RBD palm oil and fatty acids are obtained. Global and domestic demand-supply dynamics The European Union.42 Commodities traded on the NCDEX platform over-all status of the edible oil industry during the immediate past. which is obtained from the crushing of fresh-fruit-bunches (FFBs) harvested from oil palm plantations. but low cholesterol). solid at room temperature). which is one of the largest importer and consumer of edible oils in the world. 4. 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. followed by Indonesia). When CPO is subjected to refinement. liquid at room temperature. there has been a drastic change in the composition of various forms of palm oil imported owing to the differential duty structure adopted by Indian government for crude and refined palm oil imports. like any other welfare state. Malaysia and Indonesia. Fractionation of RBD palm oil yields RBD palmolein along with stearin. current and a short-term forecast of the future status of the industry in various producing and consuming countries.
254 million tons in 1990 to nearly 3 million tons during 2001-02.90-92 billion in terms of value. Unlike the price of CPO imported into the country. Soy oil is the leading vegetable oil traded in the international markets. soy oil prices traded across the world are highly volatile in nature. next only to palm. and aggressive cultivation and promotion from the major producing nations have given way to widespread soy oil growth both in terms of production as well as consumption. soybean is purely a Kharif crop. Of the annual edible oil trade worth over Rs. This offers immense opportunity for the investors to profitably deploy their funds in this sector apart from those actually associated with the value chain of the commodity. whose sowing begins by end-June with the arrival of southwest monsoon. RBD palmolein prices are influenced by CPO prices and the domestic consumer demand for various edible oils at a given point of time. On crushing mature beans. the maximum monthly fluctuation being as high as 17% during the period. 4. Palm and soy oils together constitute around 68% of global edible oil export trade volume. prices of various domestically produced and imported oils.440 billion in the country. which is largely dependent on price of CPO traded at Malaysia and the importers and stockiest/ traders demand in India. Increasing price competitiveness. which is often subjected to various production and marketrelated uncertainties. Cropping and growth patterns In India. Soy oil is the derivative of soybean.6% during the past two and a half years. 18% oil and 78-80% meal is obtained. growing at the rate of 25% compounded annually during the past decade. which could use soy oil futures contract as the most effective hedging tool to minimise price risk in the market. production and trade policies of the Government mainly the exportimport policy.1 Agricultural commodities 43 while the consumption of palm in India grew from 0.4. The crop.5%. While the oil is mainly used for human consumption.85%.1. Historically. starts . with soy oil constituting 22. which is ready for harvest by the end of September. overall health of the economy that has a bearing on the purchasing power of ultimate consumers. Being an agricultural commodity.4 Soy oil Soy oil is among the major sources of edible oils in India. It accounts for nearly 25% of the world's total oils and fats production. Price trends and factors that influence prices 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. soy oil prices in the major spot markets across the country have been fluctuating in the range of 4. etc. soy oils share is over 20-21% at Rs. Rising consumption of palm oil in India could be mainly attributed to the price sensitive nature of the Indian edible oil consumers. meal serves as the main source of protein in animal feeds. The average fluctuation in spot prices of refined soy oil traded at Mumbai has been at 6.5-8.
Russia.36% compounded annually during the past decade. followed by Maharashtra and Rajasthan. It has been growing at the rate of 5. spot markets of Indore and Mumbai serve as the reference market for soy oil prices.5-1.7 million tons. Brazil. Central Europe. Hence.7-0. Imports have been growing at the rate of approximately 20% over the period of last five years. Global and domestic demand-supply dynamics Global consumption of soy oil during 2001-02 shot up to 29. Of the total world exports. Morocco.9% respectively.5 million tons.9 million tons during the last five years.8% compounded annually during the last decade.8%.6% and 2. palm oil apart from prices of domestically produced oils. Argentina contributes to an extent of 40. contributing 80% of the country's soybean production. growing at the rate of 11. Imports constitute to the extent of over 65-68% of its annual soy oil requirement and 48% of its annual vegetable oil imports. Its . etc. Andhra Pradesh and Gujarat also produce in small quantities. Price trends and factors the influence prices In India. Indore. slightly higher than the growth rate of its production (2.92%). production and trade policies of the government . The current world production of soy oil stands at 29-30 million tons.8 million tons of imports take the country's annual soy oil consumption to 2.44 Commodities traded on the NCDEX platform entering the market from October beginning onwards. Mumbai price indicates the imported soy oil price. Brazil and Argentina with 5. The production growth rate has been the highest for Argentina at 10. Notable upward movement in consumption of soy oil is being seen in EU. contribute to 17% and 14% of world production. While the Indore price reflects the domestically crushed soybean oil (refined and solvent extracted). Uttar Pradesh.4%. in and around which the crushing and solvent extraction units are mostly located. over-all health of the economy that has a bearing on the purchasing power of ultimate consumers. It accounts to approximately 29% of world soy oil production with an annual production of 8. with a market value of over Rs. Karnataka. Production of soy oil in India has been fluctuating in the range of 0. Ujjain. Dewas and Astha in Madhya Pradesh and Sangli in Maharashtra are major trading centres of soybean. In addition to domestic production.38 million tons. Soy oil is among the most vibrant commodities in terms of price volatility. The refining units are located at the importing ports of Mumbai and Gujarat. Crushing for oil and meal starts from October. Indian edible oil market is highly price sensitive in nature.1 and 4. United States is the major producer of soy oil in the world. It has been growing at the rate of 5.90 billion.mainly me export-import policy. China and India. US.95%. peaking during the subsequent two-three months. Madhya Pradesh is considered as the soybean bowl of India. Mexico.1 million tons of production. growing at the rate of 5%. growing at the rate of 2.63%.2-2. around 1. the quantity of soy oil imports mainly depends on the price competitiveness of soy oil vis-a-vis its sole competitor. while that of Brazil and USA has been at 5. The domestic consumption of soy oil in Brazil and Argentina are to an extent of 63% and 3% of their respective domestic production of soy oil. The consumption of soy oil in USA is to the extent of 90% of its production. Egypt.
the rapeseed is sown during the months of June-July and harvested by August-September. Mustard oil. USA has been the fastest growing market for rapeseed oil. China also grows partly during this season. As a result.68% compounded annually during the period. etc. Crushing for oil begins from October onwards. part of which is consumed by the domestic animal feed industry. The remaining is obtained as oil cake/ meal. Mustard/ Rapeseed is traditionally the most important oil for the northern. On crushing rapeseed. after soy and palm oils. growing at a rate of 4. Consumption in India and Canada has posted a negative growth . which is known for its pungency. Therefore. which is extracted by the solvent extractors. The cake obtained from the seed crush contains some amount of oil. The pungency of the oil is considered as the major quality determining factor. This resulted in rampant adulteration of the oil. its close link with several of its substitutes and its base raw material soybean in addition to its co-derivative (soy meal). 4. traditional millers producing unrefined oil are more favoured by the consumers. and the rest exported. gets crushed for oil and cake in the ghanis or the expeller mills. followed by China and European Union at 8% each. The left over meal at the solvent extraction units forms a major portion of our oil meal basket. Australia and China. Government of India issued the edible oil packaging order in 1998. It is largely consumed in the crude form in the local crushing regions. refining is present in rapeseed oil too. In addition is the stiffening competition among substitutable oils under the WTO regime.1. the nature of the existing supply and value chain. In the countries of Canada. Rapeseed from the producers moves into the hands of crushers via the regulated markets (mandies). Global and domestic demand-supply dynamics Consumption of rapeseed oil in the world has increased from 11 million tons in 1997 to 14 million tons in 2001. rapeseed is sown in the Rabi season (November-December sowing). concentration of production base in limited countries as against its widespread consumption base. 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. oil and meal are obtained. In India. central and eastern parts of the country. throw tremendous opportunity for trade in this commodity. the sector was more unorganised when compared to the other edible oil sectors in the country. Refining of rapeseed oil was almost absent in the country till the end of the last century.5 Rapeseed oil Rapeseed (also called mustard or canola) oil is the third largest edible oil produced in the world. Cropping and growth patterns Rapeseed is a 90-110 day crop. The average oil recovery from the seed is about 33%.1 Agricultural commodities 45 exposure in the international edible trade scene (9-10 million tons). with the occurrence of dropsy in the country. which made refining and packing of all oils sold in the retail sector mandatory. which is rich in proteins and is used as an ingredient in animal feed. However. is traditionally the most favoured oils in the major production tracts world over. Now. growing at the rate of 10.3%.4.
Bihar. subjecting it to frequent fluctuations. 4. Unlike other oils. consumption of rapeseed oil is concentrated in northern. France and Germany's rapeseed oil production during the period has been growing at 10%. wide consumption spread all through the year. There have been no imports of refined rapeseed oil for the last few years due to the differential duty structure. The other significant producers are Madhya Pradesh. which is substantial. Rajasthan and Uttar Pradesh are the major rapeseed producing states in the country. as lubricant. At an annual production level of 13-14 million tons.65%. Price trends and factors the influence prices Various production and trade related factors influence rapeseed oil trade. Gujarat. influences the prices of the oil. Rapeseed oil has several industrial applications too viz. Canada and India have posted negative values of 1. it is undoubtedly the focus of Indian edible oil industry. Domestic rapeseed/ mustard is one of the major sources of edible oil and meal to India. rapeseed oil production has witnessed a moderate compounded annual growth rate (over the last decade) of 4. its erucic acid derivatives are used in plastic industry. China. and it could also be transformed into a liquid biofuel. China contributes more than one thirds of world rapeseed oil production while that of India has gone down from 18. Since the oil is known and consumed preferably for its unique pungency. Together.6% respectively. Prices are largely dependent on the domestic production of rapeseed during the year. soybean constitutes nearly 25% of the country's total oilseed production. Being an important source of edible oil.5000 crore.3% in 2001. 6. The average monthly fluctuation in prices of soybean traded at one of the .8% and 4. While the production growth rates in major producing countries viz. Hong Kong and Russia are the major importers.2% and 7. Punjab and Jammu and Kashmir. West Bengal. it is mostly crushed in the local kacchi and pakki ghanis (oil mills) spread across the producing and trading centres. 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. whose share has been declining over the years. Haryana. the nature of the existing supply and value chain. and general sentiments in the overall edible oil industry within and outside the country.7% respectively.4 million tons. It forms over one-third of the country's annual edible oil production.6 Soybean The market size of the popularly known miracle bean in India is over Rs. Assam. they produce about 50% of the produce.8% respectively during the past decade. With an annual production of 5. The production from Rajasthan is highly monsoon dependent. USA imports 50% of rapeseed oil traded at the international market. north-eastern and western part of the country. owing to stiff price competition from palm and soy oils. The seasonal nature of the production of rapeseed and its vulnerability to natural fallacies.1.46 Commodities traded on the NCDEX platform rate of 6% and 1. Globally. availability of others edible oils.2% in 1997 to 11. susceptibility to the sentiments in the overall edible oil and meal industry in India and abroad.0-5. rapeseed oil accounts for about 12% of the total world's edible oil production.
contributing to over 55% of the global oilseeds production.5 million tons of oil (15-18% of India's annual edible oil requirement) and 3-3.30°C with short day length (14 hours or less). Soybean is the single largest oilseed produced in the world.19%. contributing 65-70% of the country's soybean production. Uttar Pradesh. while the rest is consumed either in the form of bean itself or for value-added soybean snack foods. planting should be avoided at cooler temperatures during winter.35% at the global level.7 Rapeseed Rapeseed/ Mustard is one of the major sources of oil and meal to India. During the past five years period. global consumption of soybean has grown at the rate of 5. China and European Union countries constitute for the bulk of world's annual soybean consumption. the rest being the oil cake/ meal. The commodity has been commercially exploited for its utility as edible oil and animal feed. human consumption as bean itself). soybean constitutes nearly 25% of the country's total oilseed production. Argentina. On crushing mature beans. The planting date of vegetable soybean is dependent upon temperature and day length. 4. the production of the commodity grew at the rate of 5. The optimum temperature range of soybean cultivation is 20 . Historically. Global and domestic demand-supply dynamics About 82-85% of the global soybean production is crushed for oil and meal. Of the total 310-320 million tons of oilseeds produced annually.4. While the country imports soy oil. it is a leading exporter of meal in the Asian region. Of the total bean produced. Mexico.07% during the past two years. USA. Madhya Pradesh is the soybean bowl of India. followed by Maharashtra and Rajasthan. However.25%. The market size of the popularly known miracle bean in India is over Rs. soybean production alone stands at 170-190 million tons. Karnataka.2 million tons of .4 million tons. Loamy soil with pH of 6. 6-7 lakh tons goes for direct consumption in the form of bean itself (sowing. leaving the rest of the quantity for crushing for meal and oil. Andhra Pradesh and Gujarat also produce in small quantities. India and Taiwan are among the other major consumers. soybean prices in the major spot markets across the country have been fluctuating in the range of 5-9%. USA. During the last decade. vegetative growth and pod setting stages. provided a good amount of soil moisture is ensured at the germination. Brazil. It supplies over 1.0-6. which forms the prime source of protein in animal feeds. India and China are among the other producers. followed by Brazil and Argentina are the major producing countries. Japan. With an annual production of 5.1. the maximum monthly fluctuation being as high as 24-30% during the period.0-5.5 is suitable for its cultivation. but the field should be well drained.5000 crore.1 Agricultural commodities 47 active soybean spot market at Indore (Madhya Pradesh) has been at 10. higher than the production growth rate of 5. Cropping and growth patterns Soybean could be grown under rain fed conditions. around 18% oil could be obtained.
but Toria does best in loam to heavy loams.48 Commodities traded on the NCDEX platform oil meal. The major contributors to global rapeseed production are China. growing at the rate of 10. is more popular internationally. Canada and Australia with a share of 32%. 9. Global and domestic demand-supply dynamics Consumption of rapeseed oil in the world has increased from 11 million tons in 1997 to 14 million tons in 2001. they are grown during the Rabi season from September-October to February-March. The hybrid form of rapeseed.8% and 3% respectively.8% during the past two years (July 2001 to July 2003). Rapeseed/ Mustard/ Canola is a traditionally important oilseed. and declined from there on to the current (2002) level of 32.3%.5 million tons. commonly called rai (raya or laha) 2. Pakistan and Poland. USA has been the fastest growing market for rapeseed oil. USA imports 50% of rapeseed oil traded at the international market. France. Australia. 12. 10%. Australian rapeseed production grew at the fastest rate of 21%. Hong Kong and Russia are the major importers. Germany. Toria (Lahi or Maghi Labi) Rapeseed and mustard crops are of the tropical as well as of the temperate zones and require relatively cool temperatures for satisfactory growth. Rapeseed and mustard crops grow well in areas having 25 to 40 cm of rainfall. Sarson is suited to light-loam soils and Taramira is mostly grown on very light soils. The commodity has been commercially exploited in the form of seeds. France and Germany are growing at a moderate rate of 2-4%. 12.2% during the last 12 years period. India and Canada have shown a decline . Rapeseed and mustard thrive best in light to heavy loams.4 million tons in 1999. In India. Rai may be grown on all types of soils. Among the major contributors to world production. They are generally divided into three groups: 1. oil (seed to oil recovery is 39-40%) and meal. Global production of rapeseed increased from 25 million tons in 1990 to 42. While China.6% respectively. India. Sarson is preferred in low-rainfall areas. It has been growing at the rate of 2. Consumption in India and Canada has posted a negative growth rate of 6% and 1. France. whereas Rai and Toria are grown in medium and high rainfall areas respectively. Sarson: (i) Yellow sarson (ii) Brown sarson 3. Brown mustard. Cropping and growth patterns Under the names rapeseed and mustard. The average monthly fluctuation in prices of rapeseed traded at one of the active rapeseed spot market at Jaipur (Rajasthan) has been at 9. growing at a rate of 4. China.6%. the major protein source in animal feeds.68% compounded annually during the period. The other major producers are Germany. the maximum monthly fluctuation being as high as 23.1%. followed by China and European Union at 8% each. whose share has been declining over the years.4% during the period. known as canola. several oilseeds belonging to the cuciferae are grown in India. Canada and India are the major producers of this commodity.
wide consumption spread all through the year.2 million tons of meal on crushing. Around 4. Various production and trade related factors influence rapeseed oil trade.5-4. it is undoubtedly the focus of Indian edible oil industry. it is mostly crushed in the local kacchi and pakki ghanis (oil mills) spread across the producing and trading centres. the nature of the existing supply and value chain.the producing farmers.9 million tons in 1997 to 1. 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. availability of others edible oils. The import duty on crude oil is 75%. Rajasthan and Uttar Pradesh are the major rapeseed producing States in the country. while that on refined oil is 82%. 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. brokers. which is substantial. Its exports too have fallen by 30% from 0. Import of both refined and crude rapeseed oil is permitted into the country. speculators. influences the prices of the oil. Being an important source of edible oil. West Bengal. Germany follows Canada in the export of domestically produced rapeseed oil.gold and silver. Kolkata and Mumbai markets serve as the reference markets for rapeseed/ mustard oil traded across the country. Gujarat. It forms over one-third of the country's annual edible oil production. owing to stiff price competition from palm and soy oils.2 Precious metals 49 in the production. mustard oil and traders of other oils. There have been no imports of refined oil for the last few years due to the differential duty structure. The other significant producers are Madhya Pradesh. . subjecting it to frequent fluctuations. Assam. Prices are largely dependent on the domestic production of rapeseed during the year.3 million tons in 1997 to 0. Price trends and factors the influence prices Jaipur. There have been no imports of refined rapeseed oil for the last few years due to the differential duty structure. The global trade of rapeseed oil has come down from 1. and general sentiments in the overall edible oil industry within and outside the country. Delhi. Futures trading would also provide a right tool for hedging the market-related risk for everyone in the value chain of the commodity. Bihar. Since the oil is known and consumed preferably for its unique pungency.2 Precious metals The NCDEX offers futures trading in following precious metals . they produce about 50% of the produce. Together. Hapur. susceptibility to the sentiments in the overall edible oil and meal industry in India and abroad. It is the largest produced edible oil in India (groundnut oil production also stands on par with it during good years). 4. The seasonal nature of the production of rapeseed and its vulnerability to natural fallacies. We will look briefly at both. Haryana. processors.8 million tons of rapeseed available for produced annually in the country supplies over 1. 68% of the global rapeseed oil export trade is dominated by Canada.07 million tons in 2001. The production from Rajasthan is highly monsoon dependent.4. Punjab and Jammu and Kashmir.5 million tons of oil and 3-3.2 million tons in 2001.
000 contracts floating in the market. the Chicago Mercantile Exchange and the Mid-America Commodity Exchange introduced gold futures contracts. Gold is still bought (and sold) by different people for a wide variety of reasons . The gold contracts became so popular that by 1974 there was as many as 10. • The Chinese exchange. Many times when paper money has failed.2. the expectation is that gold will hold its own. the Chicago Board of Trade. Shanghai Gold Exchange was officially opened on 30 October 2002. so investing in gold is still a good way to plan for the future. the National Commodities and Derivatives Exchange. gold has meant wealth. prestige. • Mumbai's first multi-commodity exchange. Gold has a very active derivative market compared with other commodities. • On December 31. NCDEX launched in 2003 by a consortium of ICICI Bank Limited. introduces gold futures contracts. Gold accounts for 45 per cent of the worlds commercial banks commodity derivatives portfolio. While there have been fluctuations in every market and decided downturns in some. Owning gold has long been a safeguard against disaster. Delivery was also available in gold certificates issued by Bank of Nova Scotia and the Canadian Imperial Bank of Commerce. and its rarity and natural beauty have made it precious to men and women alike. Life Insurance Corporation. This exchange had a relationship with the Comex where participants could take open positions in one exchange and liquidate them in the other. Trading volume on the Tocom peaked with seven million contracts. • 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. indestructible and fungible. 1974. was one of the few commodity exchanges to successfully launch gold futures. for industrial applications. Gold is homogeneous. • The Sydney futures exchange in Australia began functioning with a contract in 1978. These attributes set gold apart from other commodities and financial assets and tend to make its returns insensitive to business cycle fluctuations. the Commodity Exchange. .as a use in jewellery. as an investment and so on. which launched a contract in 1982. There is a limited amount of gold in the world.1 Gold For centuries.00.50 Commodities traded on the NCDEX platform Gold futures trading debuted at the Winnipeg Commodity Exchange (Comex) in Canada in November 1972.4: History of derivatives markets in gold 4. • The Tokyo Commodity Exchange (Tocom). Today is no different. and power. The futures trading in gold started in other countries too. men have turned to gold as the one true source of monetary wealth. National Bank for Agriculture and Rural Development and National Stock Exchange of India Limited. This included the following: • The London gold futures exchange started operations in the early 1980s. Box 4.
4. gold is mainly refined in Bombay where a few refineries like the India Government Mint and National refinery are active. Melting & refining assaying facility in India At present. The special feature of gold used in industrial and dental applications is that some of it cannot be salvaged and thus is truly consumed. Some private refineries are also operating elsewhere with limited capacity. 1968 Share 1968 Tonnes. Consumer demand accounts for almost 90% of total gold demand and the demand for jewelry forms 89% of consumer demand. Table 4. 1999 South Africa Australia Canada USA China Indonesia India Rest of the world Total 972 87 44 67 6 3 437 309 154 334 154 154 51 463 2571 51 Share. Consumption of gold differs according to type. 1999 17 12 6 13 6 6 2 18 100 87 1450 6 100 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. Mining and production of gold in India is negligible.1 Country-wise share in gold production. In contrast other countries like US. namely industrial applications and jewellery. its share had fallen to around 17% by 1999 because of high costs of mining and reduced resources. Although it retained its position as the single largest gold producing country. Australia. which remains as stock and can reappear at future time in market in another form.2 Precious metals Table 4. now placed around 2 tonnes (mainly from the Kolar gold mines in Karnataka) as against a total world production of about 2. Canada and China have increased their output exponentially with output from developing countries like Peru and other Latin American countries also increasing impressively.1 gives the country-wise share in gold production. Global and domestic demand-supply dynamics The demand for gold may be categorised under two heads . This is unlike consumption in the form of jewellery. there is a need to upgrade and also increase the refining capacity. .272 tonnes in 1995.consumption demand and investment demand. As none of the refineries is LBMA recognised. 1968 and 1999 Country Tonnes.
There are several ways in which investors can invest in gold either directly or through a variety of investment products. 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. and to treat any major part as exclusively a store of value or hedging instrument would be unrealistic. It will be difficult to prioritise them but it may be reasonable to conclude that it is a combined effect. Regarding pattern of demand. real estate prices. Middle East and China. More than 80% of the gold consumed is in the form of jewellery. It would not be realistic to assume that it is only the affluent that creates demand for gold.52 Commodities traded on the NCDEX platform In markets with poorly developed financial systems. The yellow metal used to . These two countries together account for over 50% of total world demand of gold for retail investment. inaccessible or insecure banks. If gold is held primarily as an investment asset. The demand for gold jewellery is rooted in societal preference for a variety of reasons . ritualistic. and 15% is for investor-demand (which is relatively elastic to gold-prices. then India is the largest repository of gold in terms of total gold within the national boundaries. which is generally predominated by women. 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. or where trust in the government is low.). Japan has the highest investment demand for gold followed closely by India. there are no authentic estimates. Barely 5% is for industrial uses. financial markets. There is reason to believe that a part of investment demand for gold assets is out of black money. If we include jewellery ownership. each of which lends it to specific investor preferences: • Coins and small bars • Gold accounts: allocated and unallocated • Gold certificates and pool accounts • Gold Accumulation Plan • Gold backed bonds and structured notes • Gold futures and options • Gold-oriented funds Demand The Consumer demand for gold is more than 3400 tonnes per year making it whopping $40 billion worth. etc. Investment demand can be split broadly into two. it does not need to be held in physical form. The Indian demand to the tune of 800 tonnes per year is making it the largest market for gold followed by USA. 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. the available evidence shows that about 80% is for jewellery fabrication for domestic demand. and as a hedge against inflation.religious. gold is attractive as a store of value. tax-policies. private and public sector holdings. a preferred form of wealth for women.
Supply Indian gold holding. particularly in urban areas. a major component of the gifts given to a woman at the time of marriage. gold prices tend to increase during the time of year when demand for jewellery is greatest. However. Price trends and factors that influence prices Indian gold prices follow more or less the international price trends. where women did not inherit landed property whereas gold and silver jewellery was. which was estimated at 65 tonnes in 1982. Also. The fabricated old gold scraps is price elastic and was estimated to be near 450 tonnes in 2002. the strong domestic demand for gold and the restrictive policy stance are reflected in the higher price of gold in the domestic market compared to that in the international market at the available exchange rate. is estimated to be in the range of 1000013000 tonnes. In the near future. which are predominantly private. Since the demand for gold is closely tied to the production of jewelry. it would be made good by growing demand on account of prosperity in rural areas. The changeover hands of gold at the time of marriage are from few grams to kgs. 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. The domestic production of the gold is very limited which is around 9 tonnes in 2002 resulting more dependence on imported gold. there may be deceleration in demand. The demand-supply for gold in India can be summed up thus: • Demand for gold has an autonomous character. Jain and Sikh community. Although it is likely that. particularly illegal import prior to the commencement of liberalisation in 1990.2 Precious metals 53 play an important role in marriage and religious festivals in India. Supply follows demand. • Demand exhibits income elasticity. particularly in the rural and semi-urban areas. with prosperity and enlightenment. therefore. In the Hindu. These temples are run in trust and gold with the trust rarely comes into re-circulation. • Price differential creates import demand. so price strength in March and April is not uncommon. The availability of recycled gold is price sensitive and as such the dominance of the gold supply through import is in existence. which lies in the social and cultural system of India. The annual consumption of gold. the summer wedding season sees a large increase in the demand for metals. 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. Mothers Day and Valentine Day are all major shopping seasons and hence the demand for metals tends to be strong a few months ahead of these holidays. and still is. One fourth of world gold production is consumed in India and more than 60% of Indian consumption is met through imports. has increased to more than 700 tonnes in late 90s. It rose almost more than 40% compared to the previous year because of rise in gold price by more than 15%. Christmas. On the . the annual demand will continue to be over 600 tonnes per year.4.
industrial and decorative uses. and Canada. India. Germany. It also has the highest thermal and electrical conductivity of any substance. . and silver has been mined and treasured longer than any of the other precious metals. Australia. Cash markets remain highly unorganised in the silver and impurity and excessive speculation remain key issue for the trade. The main factors affecting these countries demand for silver are macro economic factors such as GDP growth. and a whole host of other financial macro economic indicators. industrial demand for silver accounts for roughly 85% of the total demand for silver. government of India is planning to introduce hallmarking in silver which is likely to address quality and credibility of Indian silverware and jeweller industry. Mexico. In recent years. the United States. The unique properties of silver restrict its substitution in most applications. France. parallel futures markets are still very active in Delhi and Indore. Until recently.2. followed by Canada. January and February prices tend to decline and jewellers tend to have holiday inventory to unwind. Rajkot and Mathura were conducting futures but now players have diverted toward comex trade. Though futures trading was banned in India since late sixties. Together. the main world demand for silver is no longer monetary. Most of the world's silver is mined in the US. Taking cue from gold. which is the worlds largest consumer of silver. Italy. Japan and India. followed by Peru. Rajasthan. silver has remained a hot favourite speculative vehicle for the small time traders. with more demand from the flatware industry than from the jewelry industry in recent years. Peru. photography and jewelry & silverware. income levels. and Australia. The main consumer countries for silver are the United States. 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. but industrial. sonorous. is gearing up to start hallmarking of the white precious metal by April. these three categories represent more than 95 percent of annual silver consumption. December. Thanks to its unique volatility. 4. Jewelry and silverware is the second largest component.000 tonnes of silver. Production Silver ore is most often found in combination with other elements. ductile. Mexico is the worlds leading producer of silver. Silver is somewhat harder than gold and is second only to gold in malleability and ductility. Delhi. India annually consumes around 4.2 Silver The dictionary describes it as a white metallic element. Demand Demand for silver is built on three main pillars. With the growing use of silver in photography and electronics. Canada. Mexico. industrial production. Silver remains one of the most prominent candidates in the metals complex as far as futures' trading is concerned. MP and UP are the active pockets for the silver futures. very malleable and capable of high degree of polish. the largest consumer of silver. the United Kingdom.54 Commodities traded on the NCDEX platform other hand in November.
It normally accounts for a little less than 2/3 rd of the total (last year was slightly higher at 68%). accounting for roughly 43. the price is fixed at the point at which all the members of the fixing can balance their own. which accounts for roughly four-fifths of the mined silver supply produced annually. Handy & Harman. Scrap is the silver that returns to the market when recovered from existing manufactured goods or waste. Spot prices for silver are determined by levels prevailing at the COMEX. Peru is the worlds second largest producer of silver.2%.6 million ounces. the largest producer of silver from mines. plus clients. accounting for roughly 27. India has emerged as the third largest industrial user of silver in the world after the US and Japan. India's demand for silver increased by 177 per cent over the past 10 years as compared to 517 tonnes in 1991. In the United States and Japan. mine production and recycled silver scraps.m. the silver futures market functions under the surveillance of an official body. government sales and producers hedging.others being scrap. Mine production is surprisingly the largest component of silver supply. Peru. publishes a price for 99. which started trading in the 17th century provide a vehicle for trade in silver on a spot basis. Old scrap normally makes up around a fifth of supply. Mexico. Silver is often mined as a byproduct of other base metal operations. Although London remains the true center of the physical silver trade for most of the world. a precious metals company.8 million troy ounces in 1997. The London market has a fix which offers the chance to buy or sell silver at a single price.4. Trading in silver futures resumed at the Comex in New York in 1963. Box 4.9% pure silver at noon each working day. buying and selling orders. mainly in the form of spent fixer solutions and old X-ray films. disinvestments. Although there is no American equivalent to the London fix. In the United States. The other major source of silver is from refining. Canada and Australia. Japan is the second largest producer of silver from scrap and recycling. or actual mine capacity. is evenly split along the lines of production. The London Metal Exchange and the Chicago Board of Trade introduced futures trading in silver in 1968 and 1969. the silver used in solvents and the like can be removed from the waste and recycled. or scrap recycling. According to GFMS. after a gap of 30 years.5: Historical background of silver markets with the rural areas accounting for the bulk of the sales. or on a forward basis. respectively. The mine production is not the sole source . the most significant paper contracts trading market for silver in the United States is the COMEX division of the New York Mercantile Exchange. The fix begins at 12:15 p. . Supply The supply of silver is based on two facts. The most notable producers are Mexico. and is a balancing exercise. The United States recycles the most silver in the world. the United States. the Commodity Futures Trading Commission (CFTC). Known reserves. as well as by the chemical industry. Because silver is used in the photography industry.2 Precious metals 55 Major markets like the London market (London Bullion Market Association). Fifteen countries produce roughly 94 percent of the worlds silver from mines. Scrap supply increased marginally last year up by 1. three-quarters of all the recycled silver comes from the photographic scrap.
economic and political factors have powerful bearing on silver prices. the threat affects the price of silver too. such as gold. its price is determined by die supply and demand ratio at any given moment. Although prices and incomes are important factors. •• 3. As is the case with other precious metals. Solved Problems Q: Which of the following commodities do not trade on the NCDEX? 1. Besides. None of the above. within or outside national boundaries. Soy oil •• . Because silver is a precious metal. Soybean 4. Silk 4. Q: In India. and as a result. It is not a product mat can be manufactured en masse. Energy •• Q: Which of the following agricultural commodities do not trade on the NCDEX at the moment? 1. etc. the price of these metals greatly affects the supply of silver mined in any year._____is the most important non-food crop. Jute 2. die increased profit margin to mine operations stimulates greater production of die omer metals. technological change and market liberalisation. Wheat 2. die production of silver increases in tandem. and. Cotton A: The correct answer is number 2. Rapeseed A: The correct answer is number 1. they are also influenced by factors such as tastes. Rapeseed A: The correct answer is number 4. 3. like that of other commodities. merefore. When trading and movement of silver is restricted. a host of social. are dictated by forces of demand and supply and consumption. 1. Silver 4. As die price of die omer metal products increases. and fluctuations in deficits and interest rates. lead. changing values of paper currencies. Approximately 70 percent of the silver mined in the western hemisphere is mined as a byproduct of other metal products. copper. 3. nickel. As in the case of gold prices. and zinc. Gold 2.56 Commodities traded on the NCDEX platform Factors influencing prices of the silver The prices of silver. is subject to issues such as weamer and politics mat may affect silver mining operations. there is a limited amount of silver in the world. prices move in accordance with demand and supply conditions prevalent in mat environment Price of silver is also influenced by changes in factors such as inflation (real or perceived). political tensions. As such.
4.2 Precious metals Q: Which of the following factors do not influence the price of cotton? 1. Demand-supply scenario 2. Production and prices of synthetic fibre A: The correct answer is number 4. Q: Futures prices of cotton at the____serve as the reference price for cotton traded in the international market. 1. CME 2. CBOT A: The correct answer is number 3. Q: Palm oil is extracted from the___of oil palm plantations. 1. Mature fresh fruit bunches 2. Dry fruit bunches A: The correct answer is number 1. Q: RBD Palmolein is the derivative of 1. Soy 2. Rapeseed A: The correct answer is number 3. Q: Which of the following factor directly influences the price of RBD palmolein? 1. Prices of Rapeseed oil 2. Prices of coconut oil A: The correct answer is number 3. Q: Soy oil is the derivative of 1. Soy 2. Soybean A: The correct answer is number 2. 3. CPO 4. Sunflower seeds 3. Prices of CPO 4. Prices sunflower oil 3. CPO 4. Coconut kernel 3. Stem 4. Leaves 3. NYBOT 4. SGX 3. Previous prices of cotton 4. Prices of cotton products.
Commodities traded on the NCDEX platform
Q: The______market reflects the price of domestically crushed soybean 1. Mumbai 2. Ahmedabad A: The correct answer is number 3. Q: The______market reflects the price of imported soybean 1. Mumbai 2. Ahmedabad 3. Indore 4. Delhi 3. Indore 4. Delhi ••
A: The correct answer is number 1.
The forward contracts are normally traded outside the exchanges.1 Forward contracts A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. as the market grows. we will have a look at some basic derivative products. Before we study about the applications of commodity derivatives. eventually. In this chapter we shall study in detail these three derivative contracts. the contract has to be settled by delivery of the asset. This process of standardisation reaches its limit in the organised futures market. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. derivatives have become increasingly popular due to their applications for hedging. .Chapter 5 Instruments available for trading In recent years. • If the party wishes to reverse the contract. • The contract price is generally not available in public domain. • On the expiration date. thereby reducing transaction costs and increasing transactions volume. forward contracts are popular on the OTC market. However forward contracts in certain markets have become very standardised. The other party assumes a short position and agrees to sell the asset on the same date for the same price. speculation and arbitrage. which often results in high prices being charged. • Each contract is custom designed. price and quantity are negotiated bilaterally by the parties to the contract. The salient features of forward contracts are: • They are bilateral contracts and hence exposed to counter-party risk. While at the moment only commodity futures trade on the NCDEX. 5. we also have commodity options being traded. Other contract details like delivery date. it has to compulsorily go to the same counterparty. as in the case of foreign exchange. and hence is unique in terms of contract size. expiration date and the asset type and quality. While futures and options are now actively traded on many exchanges.
To facilitate liquidity in the futures contracts. 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. The standardized items in a futures contract are: . A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Even when forward markets trade standardized contracts.60 Instruments available for trading Forward contracts are very useful in hedging and speculation. still the counterparty risk remains a very serious issue. this is generally a relatively small proportion of the value of the assets underlying the forward contract. More than 99% of futures transactions are offset this way. which forecasts an upturn in a price.1 Limitations of forward markets Forward markets world-wide are afflicted by several problems: • Lack of centralisation of trading. and • Counterparty risk In the first two of these. 5. Speculators may well be required to deposit a margin upfront. The forward market is like a real estate market in that any two consenting adults can form contracts against each other. The classic hedging application would be that of an exporter who expects to receive payment in dollars three months later. the basic problem is that of too much flexibility and generality. (or which can be used for reference purposes in settlement) and a standard timing of such settlement. He is exposed to the risk of exchange rate fluctuations. the futures contracts are standardized and exchange traded. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction.2 Introduction to futures Futures markets were designed to solve the problems that exist in forward markets. • Illiquidity. a standard quantity and quality of the underlying instrument that can be delivered. wait for the price to rise. By using the currency forward market to sell dollars forward. the other suffers. the exchange specifies certain standard features of the contract. Counterparty risk arises from the possibility of default by any one party to the transaction. he can lock on to a rate today and reduce his uncertainty. However. When one of the two sides to the transaction declares bankruptcy.1. If a speculator has information or analysis. then he can go long on the forward market instead of the cash market. It is a standardized contract with standard underlying instrument. 5. The speculator would go long on the forward. This often makes them design terms of the deal which are very convenient in that specific situation. The use of forward markets here supplies leverage to the speculator. and then take a reversing transaction to book profits. but makes the contracts non-tradeable. and hence avoid the problem of illiquidity. But unlike forward contracts.
Before IMM opened in 1972. Box 5. . the Chicago Mercantile Exchange sold contracts whose value was counted in millions. These currency futures paved the way for the successful marketing of a dizzying array of similar products at the Chicago Mercantile Exchange. acknowledged as the "father of financial futures" who was then the Chairman of the Chicago Mercantile Exchange.2 Introduction to futures 61 Merton Miller. A division of the Chicago Mercantile Exchange. However futures are a significant improvement over the forward contracts as they eliminate counterparty risk and offer more liquidity." The first exchange that traded financial derivatives was launched in Chicago in the year 1972. By the 1990s. The confusion is primarily because both serve essentially the same economic functions of allocating risk in the presence of future price uncertainty. Table 5. and their success transformed Chicago almost overnight into the risk-transfer capital of the world. By 1990.1 Distinction between futures and forwards contracts Forward contracts are often confused with futures contracts. and the Chicago Board Options Exchange.1 Distinction between futures and forwards Futures Trade on an organised exchange Standardized contract terms hence more liquid Requires margin payments Follows daily settlement Forwards OTC in nature Customised contract terms hence less liquid No margin payment Settlement happens at end of period • Quantity of the underlying • Quality of the underlying • The date and the month of delivery • The units of price quotation and minimum price change • Location of settlement 5. the Chicago Board of Trade.2. the underlying value of all contracts traded at the Chicago Mercantile Exchange totalled 50 trillion dollars. these exchanges were trading futures and options on everything from Asian and American stock indexes to interest-rate swaps. the 1990 Nobel laureate had said that "financial futures represent the most significant financial innovation of the last twenty years.5.6: The first financial futures market Table 5.1 lists the distinction between the two. The brain behind this was a man called Leo Melamed. it was called the International Monetary Market (EMM) and traded currency futures.
the margin account is adjusted to reflect the investor's gain or loss depending upon the futures closing price. There will be a different basis for each delivery month for each contract. a new contract having a three-month expiry is introduced for trading. • Maintenance margin: This is somewhat lower than the initial margin. The holder does not have to exercise this right. This is called marking-to-market. An option gives the holder of the option the right to do something. in a forward or futures contract. The commodity futures contracts on the NCDEX have one-month. On the next trading day following the 20th. The delivery unit for the Gold futures contract is 1 kg.62 Instruments available for trading 5. namely options. two-months and three-months expiry cycles which expire on the 20th day of the delivery month. 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. the purchase of an option requires an up-front payment. In contrast. at the end of which it will cease to exist. • Contract cycle: The period over which a contract trades.2 Futures terminology • Spot price: The price at which an asset trades in the spot market. • 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. the delivery unit for futures on Long Staple Cotton on the NCDEX is 55 bales.3 Introduction to options In this section. • Futures price: The price at which the futures contract trades in the futures market. If the balance in the margin account falls below the maintenance margin. • Basis: Basis can be defined as the futures price minus the spot price. basis will be positive. ■ 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. This is set to ensure that the balance in the margin account never becomes negative. • Expiry date: It is the date specified in the futures contract. This is the last day on which the contract will be traded. In a normal market. at the end of each trading day. This measures the storage cost plus the interest that is paid to finance the asset less the income earned on the asset. Whereas it costs nothing (except margin requirements) to enter into a futures contract. . For instance. This reflects that futures prices normally exceed spot prices. the two parties have committed themselves to doing something. we look at another interesting derivative contract. 5. • Delivery unit: The amount of asset that has to be delivered under one contract. Options are fundamentally different from forward and futures contracts. Thus a January expiration contract expires on the 20th of January and a February expiration contract ceases trading on the 20th of February.2.
call options and put options.5. 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. • Option price: Option price is the price which the option buyer pays to the option seller. If no seller could be found. In April 1973. there was no mechanism to guarantee that the writer of the option would honour the contract. If someone wanted to buy an option. The market for options developed so rapidly that by early '80s.3. Since then. Merton and Scholes invented the famed Black-Scholes formula. there has been no looking back. the exercise date. • Strike price: The price specified in the options contract is known as the strike price or the exercise price. ■ Expiration date: The date specified in the options contract is known as the expiration date. the number of shares underlying the option contract sold each day exceeded the daily volume of shares traded on the NYSE. there was no secondary market and second. . For instance a gold options contract would give the holder the right to buy or sell a specified quantity of gold at the price specified in the contract. The first trading in options began in Europe and the US as early as the seventeenth century. CBOE was set up specifically for the purpose of trading options. the firm would undertake to write the option itself in return for a price. Options currently trade on over 500 stocks in the United States. It is also referred to as the option premium. 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. A contract gives the holder the right to buy or sell shares at the specified price. First. • 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.3 Introduction to options 63 Although options have existed for a long time. • 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. ■ Stock options: Stock options are options on individual stocks.7: History of options 5.1 Option terminology ■ Commodity options: Commodity options are options with a commodity as the underlying. the strike date or the maturity. In 1973. without much knowledge of valuation. • 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. This market however suffered from two deficiencies. they were traded OTC. he or she would contact one of the member firms. Box 5. There are two basic types of options. • 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. Black.
In the case of a put. European options are easier to analyse than American options. If the index is much lower than the strike price.4 Basic payoffs A payoff is the likely profit/ loss that would accrue to a market participant with change in the price of the underlying asset. Most exchange-traded options are American.intrinsic value and time value. Putting it another way. (St . The asset could be a commodity like gold or cotton. A call option on the index is out-of-the-money when the current index stands at a level which is less than the strike price (i. In this section we shall take a look at the payoffs for buyers and sellers of futures and options. the call is said to be deep OTM. • 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. the maximum time value exists when the option is ATM. A call option on the index is said to be in-themoney when the current index stands at a level higher than the strike price (i.St).e. • Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to a negative cashflow it it were exercised immediately.e. if it is ITM. • Time value of an option: The time value of an option is the difference between its premium and its intrinsic value. spot price < strike price). the greater of 0 or (K . the put is OTM if the index is above the strike price. the greater is an option's time value. An option on the index is at-the-money when the current index equals the strike price (i. an option should have no time value. .64 Instruments available for trading • American options: American options are options that can be exercised at any time upto the expiration date. its intrinsic value is zero. This is generally depicted in the form of payoff diagrams which show the price of the underlying asset on the X-axis and the profits/ losses on the Y-axis. the put is ITM if the index is below the strike price. If the call is OTM. An option that is OTM or ATM has only time value. The intrinsic value of a call is the amount the option is ITM.K). or it could be a financial asset like like a stock or an index. the intrinsic value of a call is Max [0. Similarly. But first we look at the basic payoff for the buyer or seller of an asset. • At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cashflow if it were exercised immediately. (K .St )].i. In the case of a put. If the index is much higher than the strike price. At expiration. and properties of an American option are frequently deduced from those of its European counterpart.e. Usually. spot price = strike price). The longer the time to expiration.e. K is the strike price and St is the spot price. • European options: European options are options that can be exercised only on the expiration date itself. Both calls and puts have time value. the intrinsic value of a put is Max [0. spot price > strike price). the call is said to be deep ITM.K)] which means the intrinsic value of a call is the greater of 0 or (St . all else equal. • Intrinsic value of an option: The option premium can be broken down into two components . 5.
5.6500 per Quintal. 5. 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 first tulip was brought into Holland by a botany professor from Vienna.1 Payoff for buyer of asset: Long asset In this basic position. an investor buys the underlying asset. The tulip-bulb market collapsed in 1636 and a lot of speculators lost huge sums of money. Figure 5. Hardest hit were put writers who were unable to meet their commitments to purchase Tulip bulbs. He has a potentially unlimited upside as well as a potentially unlimited downside. If the price of the underlying falls. These linear payoffs are fascinating as they can be combined with options and the underlying to generate various complex payoffs. the buyer makes profits. If the price of the underlying rises. however.4. It was one of the most spectacular get rich quick binges in history. St.5 Payoff for futures Futures contracts have linear payoff. for Rs. By purchasing a call option on tulip bulbs. The more popular they became.5.1 Payoff for buyer of futures: Long futures The payoff for a person who buys a futures contract is similar to the payoff for a person who holds an asset. the investor is said to be "long" the asset. Once it is sold. the tulip became the most popular and expensive item in Dutch gardens. Once it is purchased.8: Use of options in the seventeenth-century 5. 5. gold for instance. Similarly. St. As long as tulip prices continued to skyrocket. just like the payoff of the underlying asset that we looked at earlier. They were initially used for hedging. the buyer makes losses. an investor shorts the underlying asset. Box 5. options were increasingly used by speculators who found that call options were an effective vehicle for obtaining maximum possible gains on investment. tulip-bulb growers could assure themselves of selling their bulbs at a set price by purchasing put options. cotton for instance. 5. for Rs. and buys it back at a future date at an unknown price. Later.4. a call buyer would realize returns far in excess of those that could be obtained by purchasing tulip bulbs themselves. and sells it at a future date at an unknown price.2 shows the payoff for a short position on cotton. a dealer who was committed to a sales contract could be assured of obtaining a fixed number of bulbs for a set price. Over a decade. the investor is said to be "short" the asset. Figure 5. The magnitude of profits or losses for a given upward or downward movement is the same.6000 per 10 gms. the more Tulip bulb prices began rising. The profits as well as losses for the buyer and the seller of a futures contract are unlimited.1 shows the payoff for a long position on gold.2 Payoff for seller of asset: Short asset In this basic position.5 Payoff for futures 65 Options made their first major mark in financial history during the tulip-bulb mania in seventeenth-century Holland. That was when options came into the picture.
The investor sold long staple cotton at Rs. he looses. he profits. If the price of gold rises.1 Payoff for a buyer of gold Instruments available for trading The figure shows the profits/losses from a long position on gold. The investor brought gold at Rs. If the price of cotton rises. Figure 5. . 65000 per Quintal.2 Payoff for a seller of gold The figure shows the profits/losses from a short position on cotton.66. If the price of cotton falls. If price of gold falls he looses. Figure 5. he profits. 6000 per 10 gms.
If the price of the underlying gold goes up.3 shows the payoff diagram for the buyer of a gold futures contract.6000 per 10 gms. Figure 5. the futures prices too move down and the long futures position starts making losses.6500 per Quintal. the gold futures price too would go up and his futures position starts making profit. the futures price falls too and his futures position starts showing losses.5. 5. The underlying asset in this case is gold. Take the case of a speculator who sells a two-month cotton futures contract when the contract sells Rs. When the prices of long staple cotton move down.3 Payoff for a buyer of gold futures 67 The figure shows the profits/ losses for a long futures position. He has a potentially unlimited upside as well as a potentially unlimited downside. the cotton futures prices also move down and the short futures position starts making profits.5. Similarly when the prices of gold in the spot market goes down. If the price of gold falls. Take the case of a speculator who buys a two-month gold futures contract on the NCDEX when it sells for Rs. When the prices of gold in the spot market goes up.2 Payoff for seller of futures: Short futures The payoff for a person who sells a futures contract is similar to the payoff for a person who shorts an asset. .The investor bought futures when gold futures were trading at Rs. the cotton futures price also moves up and the short futures position starts making losses. The underlying asset in this case is long staple cotton. the futures price too moves up and the long futures position starts making profits.4 shows the payoff diagram for the seller of a futures contract. Figure 5.6000 per 10 gms. When the prices of long staple cotton move up.5 Payoff for futures Figure 5.
In simple words. it means that the losses for the buyer of an option are limited. His profits are limited to the option premium. If the price of the underlying long staple cotton rises. 5. 5. more is the profit he makes. however his losses are potentially unlimited. and the short futures position starts showing losses. His loss in this case is the premium he paid for buying the option. If upon expiration.6500 per Quintal. These non-linear payoffs are fascinating as they lend themselves to be used for generating various complex payoffs using combinations of options and the underlying asset. Higher the spot price. If the price of the underlying long staple cotton goes down. he makes a profit. bought at a premium of Rs. If the spot price of the underlying is less than the strike price.5 gives the payoff for the buyer of a three month call option on gold (often referred to as long call) with a strike of Rs. however the profits are potentially unlimited. the spot price exceeds the strike price. The writer of an option gets paid the premium.1 Payoff for buyer of call options: Long call A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option.68 Figure 5. The payoff from the option written is exactly the opposite to that of the option buyer.4 Payoff for a seller of cotton futures Instruments available for trading The figure shows the profits/ losses for a short futures position.500.6. the futures too rise. We look here at the four basic payoffs. . and the short futures position starts making profit. he lets his option expire un-exercised. The profit/ loss that the buyer makes on the option depends on the spot price of the underlying. Figure 5.6 Payoff for options The optionality characteristic of options results in a non-linear payoff for options.7000 per 10 gms. The investor sold cotton futures at Rs. the futures price also falls.
the buyer would exercise his option and profit to the extent of the difference between the spot gold-close and the strike price.7000. as the prices of gold rise in the spot market. the buyer will exercise the option on the writer. His losses are limited to the extent of the premium he paid for buying the option. However if the price of gold falls below the strike of Rs. he lets the option expire. the spot price exceeds the strike price. sold at a premium of Rs.7000 per 10 gms. If upon expiration.2 Payoff for writer of call options: Short call A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option. For selling the option.500. the writer of the option charges a premium. Whatever is the buyer's profit is the seller's loss. Higher the spot price.6 gives the payoff for the writer of a three month call option on gold (often referred to as short call) with a strike of Rs. The profit/ loss that the buyer makes on the option depends on the spot price of the underlying. The profits possible on this option are potentially unlimited.5 Payoff for buyer of call option on gold 69 The figure shows the profits/ losses for the buyer of a three-month call option on gold at a strike of Rs.7000 per 10 gms. If upon expiration the spot price of the underlying is less than the strike price.6.3 Payoff for buyer of put options: Long put A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. more is the loss he makes. the call option becomes in-themoney.6. 5. the buyer lets his option expire un-exercised and the writer gets to keep the premium. Figure 5.7000. As can be seen.5. gold trades above the strike of Rs. Hence as the spot price increases the writer of the option starts making losses.6 Payoff for options Figure 5. 5. The profit/ loss that the buyer makes on the option depends on the spot price of the . If upon expiration.
the buyer lets his option expire un-exercised and the writer gets to keep the premium.8 gives the payoff for the writer of a three month put option on long staple cotton (often referred to as short put) with a strike of Rs. Whatever is the buyer's profit is the seller's loss. he lets his option expire un-exercised. If upon expiration. As the price of gold in the spot market rises. the spot price happens to be below the strike price. the writer of the option charges a premium. His loss in this case is the premium he paid for buying the option. the call option becomes in-the-money and the writer starts making losses.6000 per Quintal. Lower the spot price. more is the profit he makes. The loss that can be incurred by the writer of the option is potentially unlimited. the buyer will exercise the option on the writer. the buyer would exercise his option on the writer who would suffer a loss to the extent of the difference between the spot gold-close and the strike price.6. whereas the maximum profit is limited to the extent of the up-front option premium of Rs. For selling the option. 5.6 Payoff for writer of call option on gold Instruments available for trading The figure shows the profits/ losses for the seller of a three-month call option on gold with a strike price of Rs. Figure 5. Figure 5.500 charged by him. If the spot price of the underlying is higher than the strike price. gold price is above the strike of Rs. underlying.6000 per Quintal. . he makes a profit. If upon expiration. The profit/ loss that the buyer makes on the option depends on the spot price of the underlying.400. the spot price is below the strike price. bought at a premium ofRs.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. If upon expiration the spot price of the underlying is more than the strike price.7000 per 10 gms.7000. If upon expiration.4 Payoff for writer of put options: Short put A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option.70 Figure 5.
This is different from futures. At a practical level. More generally. the put option becomes in-the-money. who cannot put in the time to closely monitor their futures positions.6000 per Quintal. Rs. After this. which is free to enter into. If at expiration.6000. the option buyer faces an interesting situation. He pays for the option in full at the time it is purchased. but can generate very large losses. As can be seen. options offer "nonlinear payoffs" whereas futures only have "linear payoffs". sold at a premium of Rs.400.when would one use options instead of futures? Options are different from futures in several interesting senses. 5. a wide variety of innovative and useful payoff structures can . However if spot price of cotton on the day of expiration of the contract is above the strike of Rs.7 Using futures versus using options An interesting question to ask at this stage is .7 Payoff for buyer of put option on long staple cotton 71 The figure shows the profits/ losses for the buyer of a three-month put option on long staple cotton. cotton prices fall below the strike of Rs. The profits possible on this option can be as high as the strike price. as the price of cotton in the spot market falls.400 in this case. This characteristic makes options attractive to many occasional market participants. the buyer would exercise his option and profit to the extent of the difference between the strike price and spot cotton-close. There is no possibility of the options position generating any further losses to him (other than the funds already paid for the option).5.7 Using futures versus using options Figure 5. he lets the option expire. he only has an upside. By combining futures and options. His losses are limited to the extent of the premium he paid for buying the option.
400. Price is always positive. Nonlinear payoff. Rs.e. the put option becomes in-the-money and the writer starts making losses. Same as futures. be created. Only short at risk. If upon expiration. 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. Strike price is fixed. strike price moves Price is zero Linear payoff Both long and short at risk Same as futures. As the price of cotton in the spot market falls. . The profit that can be made by the writer of the option is limited to extent of the premium received by him.2 Distinction between futures and options Futures Options Exchange traded.72 Instruments available for trading 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.6000 per Quintal. with novation Exchange defines the product Price is zero. 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. cotton prices fall below the strike of Rs. price moves. Table 5. i.
5.7 Using futures versus using options
Q: Which of the following cannot be an underlying asset for a financial derivative contract? 1. Equity index 2. Commodities A: The correct answer is 2 3. Interest rate 4. Foreign exchange ••
Q: Which of the following cannot be an underlying asset for a commodity derivative contract? 1. Wheat 2. Gold A: The correct answer is 4 3. Cotton 4. Stocks ••
Q: Which of the following exchanges was the first to start trading commodity futures? 1. Chicago Board of Trade 2. Chicago Mercantile Exchange A: The correct answer is 3. 3. Chicago Board Options Exchange 4. London International Financial Futures and Options Exchange ••
Q: In an options contract, the option lies with the 1. Buyer 2. Seller 3. Both 4. Exchange ••
A: The option to exercise lies with the buyer. The correct answer is number 1.
Q: The potential returns on a futures position are: 1. Limited 2. Unlimited 3. a function of the volatility of the index 4. None of the above
A: The correct answer is number 2.
Instruments available for trading
Q: Two persons agree to exchange 100 gms of gold three months later at Rs.400/ gm. This is an example of a 1. Futures contract 2. Forward contract A: The correct answer is number 2. Q: Typically option premium is 1. Less than the sum of intrinsic value and time time value 2. Greater than the sum of intrinsic value and time value value A: The correct answer is number 3. 3. Equal to the sum of intrinsic value and value 4. Independent of intrinsic value and time •• 3. Spot contract 4. None of the above ••
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 2. Rs.4 A: The correct answer is number 2. 3. Rs.14 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 1. OTC contract 2. Exchange traded contract A: The correct answer is number 1. 3. Spot contract 4. None of the above ••
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 2. (-)5000 3. (+)50,000 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. • •
000 A: Each unit is for 10 Quintals.50/Quintal. How much profit/loss has he made on his position? 1. and delivery unit is 100 Quintals. (-)5000 3. What is his net payoff? 1. A week later soy bean futures trade at Rs. • • Q: A trader buys three-month call options on 10 units of gold with a strike of Rs. i. (+)50.5. How much profit/loss has he made on his position? 1. On the day of expiration. 1450/Quintal. So he makes a net profit of Rs. i. (-)50. (+) 1. (+)5000 2. A week later soy bean futures trade at Rs. The correct answer is number 2. 1500/Quintal. (-)5000 3. (+)5000 2. (+)5000 2.50/Quintal.000 4.e. 1450/Quintal.000 A: Each unit is for 10 Quintals.000 4. he makes a loss of Rs. 1550/Quintal. (+) 10.[(7080 .000 A: Each unit is for 10 Quintals. He has a long position in 1000 gms. (+)50.5000. A trader sells futures on 10 units of soy bean at Rs. • • Q: Unit of trading for soy bean futures is 10 Quintals. 1000 on his position 100 × 10 The correct answer is number 2.e. He makes a loss of Rs. he makes a loss of Rs. He buys 10 units which means a futures position in 100 Quintals.5000. A week later soy bean futures trade at Rs. the spot price of gold is Rs. and delivery unit is 100 Quintals. Unit of trading is 100 gms.7 Using futures versus using options 75 Q: Unit of trading for soy bean futures is 10 Quintals.000 A: Per 10 gms he makes a net profit of Rs. i. He buys 10 units which means a futures position in 100 Quintals.5000.70].7000/10 gms at a premium of Rs. (-)50. The correct answer is number 1.000 2.e. He makes a loss of Rs. He makes a profit of Rs. and delivery unit is 100 Quintals. (-) 10. (+)50.000 4.7000) .50/Quintal. The correct answer is number 2. How much profit/loss has he made on his position? 1. A trader buys futures on 10 units of soy bean at Rs. • • Q: Unit of trading for soy bean futures is 10 Quintals. 1500/Quintal. he makes a profit of Rs. (-) 1. He sells 10 units which means a futures position in 100 Quintals. i.10. A trader sells futures on 10 units of soy bean at Rs.e. (-)50. 1500/Quintal.000 3.70.7080/10 gms.000 4. • • 10 . (-)5000 3.
(+) 10. i. (+) 1. On the day of expiration. The correct answer is number 1.1000 on his position correct answer is number 4.000 A: The option is OTM.000 100 × 10 .[(7080 . (-) 1.70 per 10 gms.7000) . Unit of trading is 100 gms and he has bought 10 units. On the day of expiration. He receives an option premium of Rs. So he has a position in 1000 gms of gold. the spot price of gold is Rs. On the day of expiration. The 10 A: The option is OTM.7080/10 gms. the spot price of gold is Rs.70. He losses the premium amount of Rs. What is his net payoff? 1. Per 10 gms he makes a net loss of Rs. (-)7000 2. (-) 1. He has a short position in 1000 gms. So he has a position in 1000 gms of gold.10.000 3. What is his net payoff? 1. (-)7000 2. Unit of trading is 100 gms and he has sold 10 units. the spot price of gold is Rs. So he makes a net loss of Rs. Unit of trading is 100 gms. (-) 1. The correct answer is number 1.7000/10 gms at a premium of Rs.000 3. The buyer does not exercise so the seller gets to keep the premium. (-)700 4.70. the option is ITM so the buyer exercises on him.000 2.7000 per 10 gms at a premium of Rs. He pays an option premium of Rs. What is his net payoff? 1. He earns the premium amount of Rs.70. The buyers profit is the sellers loss.6080/10 gms.76 Instruments available for trading Q: A trader buys three-month call options on 10 units of gold with a strike of Rs. Unit of trading is 100 gms.70]. (-)700 4.70 per 10 gms. (-) 10.000 4.7000 on his position. •• Q: A trader sells three-month call options on 10 units of gold with a strike of Rs. (+) 1.7000 on his position.7000 per 10 gms at a premium of Rs. •• .e.000 3. Unit of trading is 100 gms.000 A: On the day of expiration. Q: A trader sells three-month call options on 10 units of gold with a strike of Rs. (+) 1.6080/10 gms.
Price discovery facilitates 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. the process of price discovery continues from the market's opening until its close. An investment asset is an asset that is held for investment purposes by most investors. 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. Further. Gold and silver are also . We study the cost-of-carry model to understand the dynamics of pricing that constitute the estimation of fair value of futures. storage. which is vital to the effective functioning of futures market.1 Investment assets versus consumption assets When studying futures contracts. In an active futures market. however the volumes and open interest on the various contracts trading in this market have been steadily growing. 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. 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. purchases. The prices are freely and competitively derived. exports. it is essential to distinguish between investment assets and consumption assets. Stocks and bonds are examples of investment assets. 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. transportation. Future prices are therefore considered to be superior to the administered prices or the prices that are determined privately.Chapter 6 Pricing commodity futures Commodity futures began trading on the NCDEX from the 14th December 2003. The market is still in its nascent phase. imports. As a result of this free flow of information. currency values. 6. Futures exchanges act as a focal point for the collection and dissemination of statistics on supplies. interest rates and other pertinent information.
he does not incur an initial outlay. to classify as investment assets. A consumption asset is an asset that is held primarily for consumption. To begin with.2) . Examples of consumption assets are commodities such as copper. For pricing consumption assets. However. Note however that investment assets do not always have to be held exclusively for investment. oil. 6. If instead he buys the asset in the forward market. it involves opportunity costs. we look at the cost-of-carry model and try to understand the pricing of futures contracts on investment assets. or buying it in the forward market. we treat the forward and the futures market as one and the same. If he buys it in the spot market today. For pricing purposes. we need to review the arbitrage arguments a little differently. This forms the basis for the cost-of-carry model where the price of the futures contract is defined as: F = S-C where: F Futures price S Spot price C Holding costs or carry costs The fair value of a futures contract can also be expressed as: F = S(l + r)T where: r Percent cost of financing (6. has a number of industrial uses.78 Pricing commodity futures examples of investment assets. these assets do have to satisfy the requirement that they are held by a large number of investors solely for investment. silver. The buyer who needs an asset in the future has the choice between buying the underlying asset today in the spot market and holding it. However the costs of holding the asset are now incurred by the seller of the forward contract who charges the buyer a price that is higher than the price of the asset in the spot market. As we will learn.1) (6. It is not usually held for investment.2 The cost of carry model We use arbitrage arguments to arrive at the fair value of futures. and pork bellies. A futures contract is nothing but a forward contract that is exchange traded and that is settled at the end of each day. we can use arbitrage arguments to determine the futures prices of an investment asset from its spot price and other observable market variables. for example. He incurs the cash outlay for buying the asset and he also incurs costs for storing it. As we saw earlier.
equation 6.43.40 and the three-month interest rate is 5% per annum. Consider a three-month forward contract on a stock that does not pay dividend.71828 (6.2 uses the concept of discrete compounding. the arbitrager delivers the share and receives 0 0 0 Rs.50 at the end of the three month period.2. If F < S(1 + r)T or F > S(1 + r)T. Suppose that the forward price is relatively high at Rs. In the case of commodity futures. To understand the pricing of commodity futures.2 The cost of carry model T Time till expiration 79 Whenever the futures price moves away from the fair value. . Pricing of options and other complex derivative securities requires the use of continuously compounded interest rates. We consider the strategies open to an arbitrager in two extreme situations. the holding cost is the cost of financing minus the dividends returns.25 −4 .00 . buy one share in the spot market. 1.43. We begin with a forward contract on an asset that provides the holder with no income and has no storage or other costs.Rs. the holding cost is the cost of financing plus cost of storage and insurance purchased. In the case of equity futures. We know what are the spot and futures prices.40.6. for example. there would be opportunities for arbitrage. but what are the components of holding costs? The components of holding cost vary with contracts on different assets.a forward contract. Most books on derivatives use continuous compounding for pricing futures too. Equation 6. the logic for pricing a futures contract is exactly the same as the logic for pricing a forward contract.43. The sum of money required to pay off the loan is 4 e 0. Assume that the price of the underlying stock is Rs. By following this strategy. At the end of three months.05 ×0. let us start with the simplest derivative contract .2 is expressed as: F . At times the holding cost may even be negative. An arbitrager can borrow Rs.SerT where: r Cost of financing (using continuously compounded interest rate) T Time till expiration e 2.3) So far we were talking about pricing futures in general. Then we introduce real world factors as they apply to investment commodities and later to consumption commodities. arbitrage would exist. When we use continuous compounding. However. We use examples of forward contracts to explain pricing concepts because forward contracts are easier to understand. and sell the stock in the forward market at Rs. the arbitrager locks in a profit of Rs. where interest rates are compounded at discrete intervals.43. annually or semiannually.40 from the market at an interest rate of 5% per annum.50 = Rs.5 .
40.1 Pricing futures contracts on investment commodities In the example above we saw how a futures contract on gold could be priced using arbitrage arguments and the cost-of-carry model. Therefore. 7086 .7263. there exists arbitrage. What is the cost of financing for a month? e 0.1 × 5 9 0 3 65 = Rs. Similarly if the forward price is less than Rs. 1. Let us take the example of a futures contract on a commodity and work out the price of the contract.7086. What is the spot price of gold? The spot price of gold. What are the holding costs? Let us assume that the storage cost = 0.80 Pricing commodity futures 2. S= Rs.50 there will be no arbitrage. The proceeds of the short sale grow to 4 e 0. if the one-month contract was for a 100 kgs of gold instead of 10 gms.40. eventually driving the forward price down to Rs.50. In the example we considered. the gold contract was for 10 grams of gold.7086.80 s If the contract was for a three-month period i. At a forward price of Rs.1 gives the indicative warehouse charges for accredited warehouses/ vaults that will function as delivery centres for contracts that trade on the NCDEX.05 ×0.50 at the end of three months. in the process making a net gain of Rs.25 − 4 .e. Arbitragers will buy the asset in the forward market.80 365 F = Se rT = 7 000 e = R .15 × 30 365 3. and take a long position in a three-month forward contract.40.5 0 0 0 in three months. In this case the fair value of the futures. Suppose that the forward price is relatively low at Rs.50. Hence we ignored the storage costs. eventually pushing the forward price up to Rs. Under such a situation. invest the proceeds of the short sale at 5% per annum for three months.75 6. the arbitrager pays Rs. At the end of the three months. Now let us try to extend this logic to a futures contract on a commodity.40. 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-ofcarry. This is the fair value of the forward contract. Let us first try to work out the components of the cost-of-carry model. 2.39.2. there exists arbitrage. An arbitrager can short one share for Rs. the cost of financing would increase the futures price. Table 6. Warehouse charges include .80 plus the holding costs. the futures price would be 0. 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. then it would involve non-zero holding costs which would include storage and insurance costs.39. If the cost of financing is 15% annually.40. 1. The same arguments hold good for a futures contract on an investment asset.7000/ 10 gms.15 × 30 F =7 0 e 00 0.50. We see that if the forward price is greater than Rs. works out to be = Rs.50. expiring on 30th March. arbitragers will sell the asset in the forward market. The spot price of gold is Rs. However.40. The price of the futures contract would then be Rs.7000/ 10 gms. takes delivery of the share under the terms of the forward contract and uses it to close his short position.
and a per unit per week charge. For most of the day.6000 per 10 grams and the risk-free rate is 7% per annum. It was the ultimate test of the efficiency of the margining system in the futures market. the US market saw a breakdown in this classic relationship between spot and futures prices.1987 a fixed charge per deposit of commodity into the warehouse. At one point. the futures price is very close to S(X + r)T. and the variable storage costs are Rs.76 (6. the futures price of a commodity that is an investment asset is given by F = SerT Storage costs add to the cost of carry. the New York Stock Exchange placed temporary restrictions on the way in which program trading could be done. We saw that in the absence of storage costs.2 The cost of carry model 81 Under normal market conditions. Suppose the fixed charge is Rs. 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. Assume that the payment is made at the beginning of the year. If U is the present value of all the storage costs that will be incurred during the life of a futures contract. The per unit charges include storage costs and insurance charges. 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. it follows that the futures price will be equal to F = (S + U)erT 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.3170 to store one kg of gold for a year(52 weeks). futures traded at significant discount to the underlying index. on October 19.1987.1987. Box 6. the highlight of the whole episode was the fact that inspite of huge losses. 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.55 per week. On the next day.6. However.4) . Assume further that the spot gold price is Rs. The result was that the breakdown of the traditional linkages between stock indexes and stock futures continued.07 x 1 = 646904. This was largely because delays in processing orders to sell equity made index arbitrage too risky. it costs Rs. there were no defaults by futures traders. October 20.9: The market crash of October 19. F.310 per deposit upto 500 kgs.
50.50 We see that the three-month futures price of a kg of gold would be Rs.310 per deposit upto 500 kgs.82 Pricing commodity futures Table 6.6000 per 10 grams and the risk-free rate is 7% per annum. The one-year futures price for 10 grams of gold would be about Rs.25 = 611635. Now let us consider a three-month futures contract on gold. 6.medium 310 610 110 110 110 110 110 110 110 110 55 per kg 1 per kg 13 per MT 30 per MT 18perMT 42 per MT 26 per MT 25 per MT 6 per Bale 6 per Bale We see that the one-year futures price of a kg of gold would be Rs.1 NCDEX . What would the price of three month gold futures if the delivery unit is one kg? F = (S + U)erT = (600000 + 310 + 715)e0.6116.6.11.) Gold Silver Soy Bean Soya oil Mustard seed Mustard oil RBD Palmolein CPO Cotton .904. Suppose we have F > (S+U)erT (6. the arbitrage arguments used to determine futures prices need to be reviewed carefully. The threemonth futures price for 10 grams of gold would be about Rs.1025 to store one kg of gold for three months(13 weeks). and the variable storage costs are Rs.5) To take advantage of this opportunity.2 Pricing futures contracts on consumption commodities We used the arbitrage argument to price futures on investment commodities.55 per week. Assume further that the spot gold price is Rs.6469.76. For commodities mat are consumption commodities rather than investment assets.07 x 0.46.) (Rs.long Cotton . We make the same assumptions the fixed charge is Rs.6. Assume that the storage costs are paid at the time of deposit. It costs Rs.2.635.indicative warehouse charges Commodity Fixed charges Warehouse charges per unit per week (Rs. an arbitrager can implement the following strategy: .
because of its consumption value .3 The futures basis The cost-of-carry model explicitly defines the relationship between the futures price and the related spot price.6. Take a long position in a forward contract.(S + U) erT at the expiration of the futures contract. they will find it profitable to trade in the following manner: 1. 2. equation 6. They are reluctant to sell these commodities and buy forward or futures contracts because these contracts cannot be consumed. The difference between the spot price and the futures price is called the basis. Short a forward contract on one unit of the commodity. When they observe the inequality in equation 6. As arbitragers exploit this opportunity. the spot price will decrease and the futures price will increase until equation 6. the basis reduces to zero. for commodities like cotton or wheat that are held for consumption purpose.not because of its value as an investment. F<=(S+U) erT That is the futures price is less than or equal to the spot price plus the cost of carry. 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. do so.6 does not hold good. However. (67) 6. We see that as a futures contract nears expiration. many investors hold the commodity purely for investment. Individuals and companies who keep such a commodity in inventory.5 does not hold good. 2. This happens because if the futures price is above the spot price during the delivery period it gives rise to a clear arbitrage . This means that for investment assets. As arbitragers exploit this opportunity. This would result in a profit at maturity of (S + U) erT . the spot price will increase and the futures price will decrease until Equation 6.6) In case of investment assets such as gold and silver. save the storage costs.3 The futures basis 83 1. Suppose next that F < (S+U)erT (6. Therefore there is unlikely to be arbitrage when equation 6. In short. this argument cannot be used. for a consumption commodity therefore.6.4 holds good. If we regard the futures contract as a forward contract.F relative to the position that the investors would have been in had they held the underlying commodity. Sell the commodity.6 holds good. This means that there is a convergence of the futures price to the price of the underlying asset. and invest the proceeds at the risk-free interest rate. this strategy leads to a profit of F .
then there is an arbitrage opportunity. As the time to expiration of a contract reduces. If it is not. In case of such arbitrage the trader can short his futures contract. the basis reduces . At a later stage we shall look at how these arbitrage opportunities can be exploited. In the case of consumption assets. 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. .84 Figure 6. This will lead to a profit equal to the difference between the futures price and spot price. the basis is zero.1 Variation of basis over time Pricing commodity futures The figure shows how basis changes over time. we need to factor in the benefit provided by holding the physical commodity. • Transactions costs are very important in the business of arbitrage. 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. The closing price for the April gold futures contract is the closing value of gold in the spot market on that day. the basis reduces. the futures price and the spot price converge. 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. 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. Towards the close of trading on the day of settlement.1). opportunity for traders. Nuances • As the date of expiration comes near.there is a convergence of the futures price towards the spot price(Figure 6. • There is nothing but cost-of-carry related arbitrage that drives the behaviour of the futures price in the case of investment assets. buy the asset from the spot market and make the delivery. On the date of expiration.
the basis_ _ 1. Reduces to half •• •• •• . Solved problems Q: The________model is used for pricing futures contracts. 6050. Most investors 4. Q: An investment asset is an asset that is held for consumption purposes by_ 1.3 The futures basis 85 Note: The pricing models discussed in this chapter give an approximate idea about the true future price. Large investors 2. Large investors 2.40 .6000 per 10 grams? The money can be invested at 10% p. Time-value •• Q: What is the fair value of one month futures if the spot value of gold is Rs. Q: As the a futures contract nears expiration. The correct answer is number 2.40. 3. Some investors A: The correct answer is number 3.• A: The fair value is 6025e01x00833 = 6075.25 1. All investors 3. 1. 2. Remains unchanged 4.00 3 6075. 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. 6090. Most investors 4. and warehousing cost are Rs.6. All investors 3.00. Reduces A: The correct answer is number 2. 6025. Black & Scholes 2.a. 3. Some investors A: The correct answer is number 3.30 4 . Q: An investment asset is an asset that is held for investment purposes by_ 1. Increases 2. Cost-of-carry A: The correct answer is number 2. Miller 4.
•• set 4. Selling the underlying asset and buying futures •• set 4. Selling futures 2. Buying the underlying asset 3. Q: When the futures price happens to be lower than the fair value of the futures contract. Selling futures and buying the underlying asA: The correct answer is number 3.86 Pricing commodity futures Q: When the futures price happens to be higher than the fair value of the futures contract. Selling futures 2. Selling futures and buying the underlying asA: The correct answer is number 4. Buying the underlying asset 3. arbitragers profit by 1. arbitragers profit by 1. Selling the underlying asset and buying futures .
it must have all three kinds of participants . extractors. speculation and arbitrage. who are influenced by the commodity prices. The confluence of these participants ensures liquidity and efficient price discovery on the market. Hedgers could be government institutions. If . 1. 1. This risk might relate to the price of wheat or oil or any other commodity that the person deals in.Chapter 7 Using commodity futures For a market to succeed. By selling his crop forward.1 Basic principles of hedging When an individual or a company decides to use the futures markets to hedge a risk.1 Hedging Many participants in the commodity futures market are hedgers. trading companies and even other participants in the value chain. that it makes the outcome more certain.. To hedge. the gain on the futures position offsets the loss on the commodity.000 for each 1 rupee increase in the price of a commodity over the next three months and will lose Rs.hedgers. 7.000 for each 1 rupee decrease in the price of a commodity over the same period. Hedging does not necessarily improve the financial outcome. 1. The futures position should lead to a loss of Rs. speculators and arbitragers.00. the company should take a short futures position that is designed to offset this risk. Take the case of a company that knows that it will gain Rs.1. ginners.00. processors etc. indeed. In this chapter we look at the use of commodity derivatives for hedging. for instance farmers. What it does however is. Commodity markets give opportunity for all three kinds of participants. 1.00. 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.000 for each 1 rupee decrease in the price during this period. it could make the outcome worse. the objective is to take a position that neutralises the risk as much as possible. private corporations like financial institutions. he obtains a hedge by locking in to a predetermined price.000 for each 1 rupee increase in the price of the commodity over the next three months and a gain of Rs. 7. They use the futures market to reduce a particular risk that they face.00. If the price of the commodity goes down.
We will study these two hedges in detail.1 Payoff for buyer of a short hedge Using commodity futures The figure shows the payoff for a soy oil producer who takes a short hedge. the price of the commodity goes up. This is known as long hedge. the loss on the futures position is offset by the gain on the commodity. Irrespective of what the spot price of soy oil is three months later. A short futures position will give him the hedge he desires. Similarly. Let a look at a more detailed example to illustrate a short hedge. 7. This is called a short hedge.450 per MT. As we said.1. We assume that today is the . by going in for a short hedge he locks on to a price of Rs. He makes a gain if die dollar increases in value relative to the rupee and makes a loss if the dollar decreases in value relative to the rupee. a company that knows that it is due to buy an asset in the future can hedge by taking long futures position. For example. For example. A company that wants to sell an asset at a particular time in the future can hedge by taking short futures position.2 Short hedge A short hedge is a hedge that requires a short position in futures contracts. a short hedge is appropriate when the hedger already owns the asset.88 Figure 7. a short hedge could be used by a cotton farmer who expects the cotton crop to be ready for sale in the next two months. or is likely to own the asset and expects to sell it at some time in the future. an exporter who knows that he or she will receive a dollar payment three months later. There are basically two kinds of hedges that can be taken. A short hedge can also be used when the asset is not owned at the moment but is likely to be owned in the future.
455 per 10 Kgs. 10. making a gain of Rs. The company closes its short futures position at Rs. Table 7.1. or Rs.000 under its sales contract. 1680 .000 in total. Because April is the delivery month for the futures contract. the effect of the strategy would be to lock in a price close to Rs.1 gives the payoff for a short hedge.475 . Suppose the spot price for soy oil on January 15 is Rs.1 Hedging Table 7. 1. Rs.000 on its short futures position. The company closes its short futures position at Rs. 10000 for each 1 rupee increase in the price of oil over the next three months and lose Rs. Figure 7.465. The company realises Rs.10:00 am to 4:00 pm Closing session . making a loss of Rs.465 per 10 Kgs. 7. Case 2: The spot price is Rs. 2. A long hedge is appropriate when a company knows it will have to purchase a certain asset in the future and wants to lock in a price now.450 per 10 Kgs and the April soy oil futures price on the NCDEX is Rs. 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.4.4.1 gives the soy oil futures contract specification. A firm involved in industrial fabrication knows that it will require 300 kgs of silver on April 15 to meet a certain contract.4.Rs. The oil producer is therefore in a position where he will gain Rs.000 on its short futures position.10.465 or below Rs. per 10 Kgs Tick size 5paisa Trading hours 89 15th of January and that a refined soy oil producer has just negotiated a contract to sell 10. If the oil producers closes his position on April 15. The total amount realised from both the futures position and the sales contract is therefore about Rs.000 Kgs of soy oil. Suppose that it is now January 15.4.455 = Rs.475 on that date.465 per 10 Kgs.7. The company realises Rs.475 per 10 Kgs. On April 15.55. It has been agreed that the price that will apply in the contract is the market price on the 15th April.3 Long hedge Hedges that involve taking a long position in a futures contract are known as long hedges.465 = Rs.10 per 10 Kgs.455 on that date.475. 10000 for each one rupee decrease in the price of oil during this period. Let us look at how this works.465 per 10 Kgs. Case 1: The spot price is Rs. the futures price on April 15 should be very close to the spot price of Rs.000 under its sales contract.455. The spot price of silver is Rs.4:15 pm to 4:30 pm Unit of trading 1000 Kgs (=1 MT) Delivery unit 10000 Kgs (=10 MT) Quotation/ base value Rs.465 . or Rs.65. the spot price can either be above Rs.000 Kgs worth of April futures contracts (10 units). Rs.10 per 10 Kgs. The total amount realised from both the futures position and the sales contract is therefore about Rs.65.Rs.75.000 in total.1 Refined soy oil futures contract specification Trading system NCDEX trading system Monday to Friday Normal market hours .465 per 10 Kgs. The producer can hedge his exposure by selling 10.
10:00 am to 4:00 pm Closing session .000 to buy the silver from the spot market. If the fabricator closes his position on April 15. Irrespective of what the spot price of silver is three months later. On April 15.per kg of Silver with 999 fineness Tick size 5 paisa Trading hours per kg and the April silver futures price is Rs.2 Payoff for buyer of a long hedge Using commodity futures The figure shows the payoff for an industrial fabricator who takes a long hedge.4:15 pm to 4:30 pm Unit of trading 5Kgs Delivery unit 30Kgs Quotation/ base value Rs.1780 on that date. Case 1: The spot price is Rs.2 gives the payoff for the buyer of a long hedge. The fabricator pays Rs. by going in for a long hedge he locks on to a price of Rs.1730.1730 per kg. A unit of trading is 5 Kgs.1730 or below Rs. The company closes its long . the effect of the strategy would be to lock in a price close to Rs. Figure 7.34.2 Silver futures contract specification Trading system NCDEX trading system Monday to Friday Normal market hours . 1. the spot price can either be above Rs.90 Figure 7. Table 7. Because April is the delivery month for the futures contract. The fabricator can hedge his position by taking a long position in sixty units of futures on the NCDEX.2 gives the contract specification for silver.1780 per kg. Let us look at how this works.1730. Table 7. the futures price on April 15 should be very close to the spot price of Rs.1730 per kg.5.
Rs. Equation 7.15.5. Case 2: The spot price is Rs. But this would involve incurring interest cost and warehousing costs.1730 per MT. the futures contracts entered into were exactly for this amount of cotton.1) where: • • σS σF ∆ S: Change in spot price. since prices of silver rose in three months.5. In the examples above we assume that the futures position is closed out in the delivery month.Rs. but to lock on to a price to be paid in the future upfront.1730 .1780. if the hedgers exposure in the underlying was to the extent of 11 bales of cotton.000 to buy the silver from the spot market. For example. Note that the purpose of hedging is not to make profits. but would also have ended up buying silver at a much higher price. orRs.1780 . the company would have not only incurred interest and storage costs. 2. In most cases. delivery is not made even when the hedger keeps the futures contract until the delivery month.000intotal.50 per kg. Besides.40 per kg. The effective cost of silver purchased works out to be about Rs. if the prices of silver fell in April. The hedge has the same basic effect if delivery is allowed to happen. We were assuming here that the optimal hedge ratio is one.1730 = Rs.1 Hedging 91 futures position at Rs.19. during a period of time equal to the life of the hedge . orRs. on hind sight it would seem that the company would have been better off buying the silver in January and holding it.12. making a loss of Rs. Because April is the delivery month for the futures contract.000 on its long futures position. the futures price on April 15 should be very close to the spot price of Rs. S. In all other cases. 7.000intotal. The company closes its long futures position at Rs. h =ρ (7. or Rs. F.1. In the industrial fabricator example. we assumed that the hedger would take exactly the same amount of exposure in the futures contract as in the underlying asset. The effective cost of silver purchased works out to be about Rs. and the spot and futures market are perfectly correlated. a hedge ratio of one could be assumed. In situations where the underlying asset in which the hedger has an exposure is exactly the same as the asset underlying the futures contract he uses.19. one that minimizes the variance of the hedger's position.000 on its long futures position.5. So far in the examples we used.1690. or Rs. Hedgers with long positions usually avoid any possibility of having to take delivery by closing out their positions before the delivery period.1690 = Rs. making a gain of Rs. a hedge ratio of one may not be optimal.7.1 gives the optimal hedge ratio.1730 per MT.1690 on that date. during a period of time equal to the life of the hedge ∆ F: Change in futures price. The fabricator pays Rs. making or taking delivery can be a costly process. However.4 Hedge ratio Hedge ratio is the ratio of the size of position taken in the futures contracts to the size of the exposure in the underlying asset.1690 per MT.07.
• σS : Standard deviation of ∆S .
hedging also has other advantages: 1.92 • σR : Standard deviation of Using commodity futures ∆F ∆ S and ∆ F • ρ: Coefficient of correlation between • h : Hedge ratio Let us consider an example.64 × =6 0 4 11 . The standard deviation of the change in the cotton futures price over a threemonth period is 0. the hedge ratio works out to be 0. as shown in Equation 7. The unit of trading is 11 bales and the delivery unit for cotton on the NCDEX is 55 bales.3.6) (7.8.3) However. The company chooses to hedge by buying futures contracts on cotton.4) (7. Number of contracts Np = =1 =1 0 00 1 . that is if the cotton spot and futures were perfectly correlated. 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 in three months.1. A company knows that it will require 11.5) h = 640 Number of contracts = 0. Optimal hedge ratio = 0. . What is the optimal hedge ratio? How many cotton futures contracts should it buy? If the hedge ratio were one. For example.64 7.032. Suppose the standard deviation of the change in the price per Quintal of cotton over a three-month period is calculated as 0.0 00 11 (7. The futures market permits him to sell futures contracts to establish the approximate sale price at any time between the time he buys his calves for feeding and the time the fed cattle are ready to market.8 × 0. some four to six months later.0 0 4 (7.2) (7.5 Advantages of hedging Besides the basic advantage of risk management. a livestock feeder does not have to wait until his cattle are ready to market before he can sell them.5.64. Hedging stretches the marketing period. He can take advantage of good prices even though the cattle are not ready for market.7) N p = 0.7).000 bales of cotton it requires in three months.040 and the coefficient of correlation between the change in price of cotton and the change in the cotton futures price is 0. The company will hence require to take a long position in 140 units of cotton futures to get an effective hedge (Equation 7. in this case as shown in Equation 7.0 2 3 0.0 0 1 0 1 1 (7.
But in many cases. translate that to a price for the finished products. . long staple cotton and medium staple cotton. Hedging protects inventory values. a merchandiser with a large. this may not always be possible for a various reasons. For example. The hedger was then able to use the futures contract to remove almost all the risk arising out of price of the asset on that date. • The expiration date of the hedge may be later than the delivery date of the futures contract. The loss made during selling of an asset may not always be equal to the profits made by taking a short futures position. a jewelry manufacturer can determine the cost for gold. • The asset whose price is to be hedged may not be exactly the same as the asset underlying the futures contract. If a hedger has an underlying asset that is exactly the same as the one that underlies the futures contract. This could result in an imperfect hedge. even if the price of the commodity drops.1. For example. 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. or platinum as may be needed to make the products that will fill its orders. In reality. silver or platinum by buying a futures contract.6 Limitation of hedging: basis Risk In the examples we used above. For example. 7. in India we have a large number of varieties of cotton being cultivated. However.7. In our examples. unsold inventory can sell futures contracts that will protect the value of the inventory. Hedging permits forward pricing of products. The hedger was then able to use the perfect futures contract to remove almost all the risk arising out of price of the asset on that date. • The hedger may be uncertain as to the exact date when the asset will be bought or sold. The hedger was able to identify the precise date in the future when an asset would be bought or sold. 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. When this happens. silver.1 Hedging 93 2. This is called a rollover. It is impractical for an exchange to have futures contracts with all these varieties of cotton as an underlying. In reality. Often the hedge may require the futures contract to be closed out well before its expiration date. the manufacturer can use his capital to acquire only as much gold. he would get a better hedge. since the price of the farmers cotton and the price of the cotton underlying the futures contract do match perfectly. Having made the forward sales. Hedges can be rolled forward many times. 3. the hedge would not be perfect. the hedges considered were perfect. Hedging can only minimise the risk but cannot fully eliminate it. multiple rollovers could lead to short-term cash flow problems. the hedger was able to identify the precise date in the future when an asset would be bought or sold. This is because the value of the asset sold in die spot market and the value of the asset underlying the future contract may not be the same. This is called the basis risk. hedging is not quite this simple and straightforward. The NCDEX has futures contracts on two varieties of cotton. and make forward sales to stores at firm prices.
Suppose he buys a 1 kg of gold which costs him Rs.3 gives the contract specifications for gold futures.6400 per 10 grms. How can he trade based on this belief? In the absence of a deferral product.6.2. While the basics of speculation apply to any market.4:15 pm to 4:30 pm Unit of trading 100 gm Delivery unit 1kg Quotation/ base value Rs.00. Buying futures simply involves putting in the margin money.6150. He would like to trade based on this view.10:00 am to 4:00 pm Closing session . He makes a profit of Rs. he would have to buy gold and hold on to it. 7. Today a speculator can take exactly the same position on gold by using gold futures contracts.6000 per 10 gms in the spot market and he expects its price to go up in the next two-three months.00. it is easy to buy the shares and hold them for whatever duration he wants to. buy futures Take the case of a speculator who has a view on the direction of the price movements of gold. Suppose further that his hunch proves correct and three months later gold trades at Rs.40.94 Using commodity futures Table 7. Let us see how this works. This works out to an annual return of about 26 percent. We look here at how the commodity futures markets can be used for speculation.per 10 gms of gold with 999 fineness Tick size 5paisa 7. a customer must open a futures trading account with a commodity derivatives broker. Table 7. This enables futures traders to take a position in the underlying commodity without having to to actually hold that commodity. The commodities futures markets provide speculators with an easy mechanism to speculate on the price of underlying commodities. With the purchase of futures contract on a commodity. commodities are bulky products and come with all the costs and procedures of handling these products. speculating in commodities is not as simple as speculating on stocks in the financial market.000 on an investment of Rs.6. The unit of trading .000. Perhaps he knows that towards the end of the year due to festivals and the upcoming wedding season. For a speculator who thinks the shares of a given company will rise. Gold trades for Rs.000 for a period of three months.6000 per 10 gms and three-month gold futures trades at Rs. the prices of gold are likely to rise. However. Gold trades at Rs. 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). To trade commodity futures on the NCDEX.1 Speculation: Bullish commodity.3 Gold futures contract specification NCDEX trading system Trading system Monday to Friday Trading hours Normal market hours .2 Speculation An entity having an opinion on the price movements of a given commodity can speculate using the commodity market.
25.000. Buying an asset in the futures market only require making margin payments. This works out to an annual return of 83 percent. He closes his long futures position at Rs.1. there will be operators who will buy in the market where the asset sells cheap and sell in the market where it is costly.4. To take this position. Simple arbitrage ensures that the price of a futures contract on a commodity moves correspondingly with the price of the underlying commodity. he pays a margin of Rs. 7. He close out his short futures position at Rs. on the day of expiration.3 Arbitrage A central idea in modern economics is the law of one price. commodity futures form an attractive tool for speculators.000.15.000. Three months later gold trades at Rs. He sells ten two-month cotton futures contract which is for delivery of 550 bales of cotton. if two assets are equivalent from the point of view of risk and return. Three months later. so will the futures price.6.2 Speculation: Bearish commodity. 7. there wasn't much he could do to profit from his opinion.000. Hence. Because of the leverage they provide. Let us understand how this works.20. If the price of the same asset is different in two markets. the futures price converges to the spot price (else there would be a risk-free arbitrage opportunity). Today all he needs to do is sell commodity futures. This activity termed as arbitrage. The value of the contract is Rs.6400 in the process making a profit of Rs.6400 per 10 gms.3. How can he trade based on this opinion? In the absence of a deferral product. As we know. So does the price of cotton futures. arbitrage helps to equalise prices and restore market efficiency.50.3 Arbitrage 95 is 100 gms and the delivery unit for the gold futures contract on the NCDEX is 1 kg. The buying cheap and selling expensive continues till prices in the two markets reach an equilibrium.000.000. so will the futures price. If the commodity price falls. Now take the case of the trader who expects to see a fall in the price of cotton.1.2.000 on an initial margin investment of Rs. This states that in a competitive market. He buys one kg of gold futures which have a value of Rs.50. sell futures Commodity futures can also be used by a speculator who believes that there is likely to be excess supply of a particular commodity in the near future and hence the prices are likely to see a fall. If the commodity price rises. making a profit of Rs.20. if his hunch were correct the price of cotton falls. F = where: r Cost of financing (annualised) T Time till expiration (S+U)erT (7. He pays a small margin on the same. they should sell at the same price.7.8) .00. involves the simultaneous purchase and sale of the same or essentially similar security in two different markets for advantageously different prices.
To capture mispricings that result in overpriced futures. On the futures expiration date.96 U Present value of all storage costs Using commodity futures In the chapter on pricing. (We assume that fixed charge is Rs. However. Buy 10 kgs of gold on the cash/ spot market at Rs.60. 1. sell 10 gold futures contract at Rs. mispricing would result in both.251. we discussed that the cost-of-carry ensures that futures prices stay in tune with the spot prices of the underlying assets.55 per kg per week for 13 weeks).600 per gram in the spot market. .50. Pay (310 + 7150) as warehouse costs.000.00. Sell the gold for Rs.1.1 Overpriced commodity futures: buy spot.310 per deposit upto 500 kgs.07.000 held in hand.625 and seem overpriced. gold trades for Rs. Equation 7.749. This is termed as cash-and-carry arbitrage.60.000. the arbitrager must sell futures and buy spot. 8. that exploiting an arbitrage opportunity involves trading on the spot and futures market.60.00. it makes sense to arbitrage.62. From the Rs. buying the spot and holding it or selling the spot and investing the proceeds. even if there exists a mispricing. He could make riskless profit by entering into the following set of transactions.615 in the spot market. the spot and the futures price converge.61. 1. 7. borrow Rs. and the variable storage costs are Rs. whereas to capture mispricings that result in underpriced futures.51.8 gives the fair value of a futures contract on an investment commodity. the arbitrager must sell spot and buy futures. 7.50.50. in the case of consumption assets which are held primarily for reasons of usage.460 at 6% per annum to cover the cost of buying and holding gold.62.000. arbitrage opportunities arise. In the real world.3. 5. Take delivery of the gold purchased and hold it for three months. sell futures An arbitrager notices that gold futures seem overpriced.98. return the borrowed amount plus interest of Rs. Now unwind the position. Say gold closes at Rs. 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. 6. The result is a riskless profit of Rs. In the case of investment commodities. How can he cash in on this opportunity to earn riskless profits? Say for instance. a person who holds the underlying may not want to sell it to profit from the arbitrage. Simultaneously. 3. 2. Three month gold futures on the NCDEX trade at Rs. On day one. Futures position expires with profit of Rs. Remember however. 4. one has to build in the transactions costs into the arbitrage strategy. Whenever the futures price deviates substantially from its fair value.000.
60.97. He should__ 1. he could make riskless profit by entering into the following set of transactions.7150 saved by way of warehouse costs for three months 6%. 8. 4. sell mustard seed futures 4. The result is a riskless profit of Rs. This is termed as reverse-cash-and-carry arbitrage. Suppose the price of gold is Rs. 1.605 and seem underpriced. buy silver A: The correct answer is number 3. The futures position expires with a profit of Rs. 5. exploiting arbitrage involves trading on the spot market. 6. 7. sell silver futures 4. Three month gold futures on the NCDEX trade at Rs. sell index futures •• . 3.000 plus the Rs. 1.60. Solved problems Q: A speculator thinks that the price of mustard seed will rise. sell 10 kgs of gold in the spot market at Rs. Now unwind the position. On the futures expiration date. it makes sense for you to arbitrage. sell spot An arbitrager notices that gold futures seem underpriced.000 on the spot market. Buy back gold at Rs.600 per gram in the spot market. buy three-month gold futures on NCDEX at Rs.50.936. sell mustard seed A: The correct answer is number 1.7.00.000. 3. As we can see.60.00.2 Underpriced commodity futures: buy futures. As more and more players in the market develop the knowledge and skills to do cash-and-carry and reverse cash-and-carry.000.60.3 Arbitrage 97 7.00. If he happens to hold gold.000.3. sell index futures •• 3.50. The gold sales proceeds grow to Rs. Simultaneously. the spot and the futures price of gold converge. How can he cash in on this opportunity to earn riskless profits? Say for instance.615 per gram. On day one. buy mustard seed futures 2. If the returns you get by investing in riskless instruments is more than the return from the arbitrage trades. Q: A speculator thinks that the price of silver will fall.47. we will see increased volumes and lower spreads in both the cash as well as the derivatives market.61. buy silver futures 2.936. It is this arbitrage activity that ensures that the spot and futures prices stay in line with the cost-of-carry. He should___ 1. Invest the Rs. 2. gold trades for Rs.
98 Q: A long hedge should be taken by a person who 1. Wants to buy the underlying asset in the fufuture. 2. Sell the underlying asset in the future A: The correct answer is number 1.
Using commodity futures
3. Expects to own the underlying asset in the ture 4. None of the above ••
Q: A short hedge should be taken by a person who 1. Wants to buy the underlying asset in the futoday. ture. 3. Wants to sell the underlying asset
2. Wants to sell the underlying asset in the future. 4. None of the above A: The correct answer is number 2. ••
Q: A farmer who has just sown wheat can hedge his position by_ _ 1. buying wheat futures 2. selling wheat futures A: The correct answer is number 2. 3. buying index futures 4. selling the wheat ••
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 1. Selling 10 units of April futures. 2. Buying 10 units of April futures. 3. Selling 100 units of April futures. 4. Buying 100 units of April futures.
A: The producer needs to take a short hedge to the extent of 10,000 Kgs of soy oil. One trading unit is for 1000 Kgs of soy oil. He gets the hedge by selling 10 units of April futures. The correct answer is number 1.
Q: On the 15th of January a 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. 2. Buying 60 units of April silver futures. 3. Buying 30 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 fufutures. 2. Selling 2550 units of three-month cotton fufutures. 3. Buying 2550 units of three-month cotton tures. 4. Selling 600 units of three-month cotton tures.
A: One trading unit is for 11 bales of cotton. The hedge ratio is 0.85. The company obtains a hedge by Buying
33 ,000 × 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 2. (-)2,500 3. (+)25,000 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 1000 . The correct a profit of Rs.250 per 10 gms. His total profit from the position 10 answer is number 3. • •
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 2. (-)1,500 3. (-)15,000 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 of Rs.150 per 10 gms. His total profit from the position is is number 4.
×1000 . The correct answer
m.trading cum clearing members and professional clearing members. where orders match automatically. Each TCM can have more than one user.2 Entities in the trading system There are two entities in the trading system of NCDEX . It supports an order driven market and provides complete transparency of trading operations. The trade timings on the NCDEX are 10. 8. it is an active order.Chapter 8 Trading In this chapter we shall take a brief look at the trading system for futures on NCDEX. However. Order matching is essentially on the basis of commodity. . to 4. When any order enters the trading system. a trade is generated. It tries to find a match on the other side of the book. Trading cum clearing members (TCMs): Trading cum clearing members are members of NCDEX. After hours trading has also been proposed for implementation at a later stage. The exchange assigns an ID to each TCM. 1. Time stamping is done for each trade and provides the possibility for a complete audit trail if required. They can trade and clear either on their own account or on behalf of their clients including participants. time and quantity.00 a. the best way to get a feel of the trading system is to actually watch the screen and observe how it operates.00 p. provides a fully automated screen-based trading for futures on commodities on a nationwide basis as well as an online monitoring and surveillance mechanism. the order becomes passive and gets queued in the respective outstanding order book in the system. The NCDEX system supports an order driven market. All quantity fields are in units and price in rupees.1 Futures trading system The trading system on the NCDEX. The number of users allowed for each trading member is notified by the exchange from time to time. If it does not find a match. If it finds a match. The exchange notifies the regular lot size and tick size for each of the contracts traded from time to time.m. its price. 8. The exchange specifies the unit of trading and the delivery unit for futures contracts on various commodities .
It is the responsibility of the TCM to maintain adequate control over persons having access to the firm's User IDs. . In some cases. The client code should be alphanumeric and no special characters can be used. 8. The floor trader. The broker then sends the order to a booth on the exchange floor called broker's floor booth.e.2. a floor order ticket is prepared. All the traders dealing with a certain delivery month trade in the same slice.10: The open outcry system of trading Each user of a TCM must be registered with the exchange and is assigned an unique user ID. The unique TCM ID functions as a reference for all orders/ trades of different users. Open outcry trading is a face—to-face and highly activate form of trading used on the floors of the exchanges. 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. who time-stamps the order and prepares an office order ticket. They carry out risk management activities and confirmation/ inquiry of trades through the trading system. both for themselves and/ or on behalf of their clients. The PCM membership entitles the members to clear trades executed through Trading cum Clearing Members (TCMs). The same client should not be allotted multiple codes. All clients trading through a member are to be registered clients at the member's back office. some still follow the open outcry method. 2. The brokers. trading pit. the order is recorded manually by both parties in the trade. This ID is common for all users of a particular TCM.102 Trading While most exchanges the world over are moving towards the electronic form of trading. To place an order under this method. Professional clearing members: Professional clearing members are members of NSCCL. and a clerk hand delivers the order to the floor trader for execution. Once filled. standing in a central location i. A pit is a raised platform in octagonal shape with descending steps on the inside that permit buyers and sellers to see each other. 3. the customer calls a broker. who bid on the order using hand signals. Normally only one type of contract is traded in each pit like a Eurodollar pit. Large orders typically go directly from the customer to the broker's floor booth. A unique client code is to be allotted for each client. 2. There. the floor clerk may use hand signals to convey the order to floor traders. negotiates a price by shouting out the order to other floor traders.1 Guidelines for allotment of client code The trading members are recommended to follow guidelines outlined by the exchange for allotment and use of client codes at the time of order entry on the futures trading system: 1. At the end of each day. Box 8. the clearing house settles trades by ensuring that no discrepancy exists in the matched-trade information. In open outcry system the futures contracts are traded in pits. Each side of the octagon forms a pie slice in the pit. 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. Live Cattle pit etc.
sunflower. soya oil. Table 8. coffee. Pure Silver New Delhi 3. . Expeller Rapeseed Mustard Oil Jaipur 7. Rapeseed Mustard Seed Jaipur 6. tea. crude palm oil and RBD palmolein. Pure Gold Mumbai 2. wheat. the contracts shall expire on the previous trading day.3 give the futures contract specifications for gold and long staple cotton.3 Contract specifications for commodity futures Table 8. two-month and three-month expiry cycles. and in agri commodities. castor (seed. Refined Soya Oil Indore 5.3 Contract specifications for commodity futures NCDEX plans to trade in all the major commodities approved by FMC (Forwards Market Commission) but in a phased manner. In the first phase.1 gives the list and symbols of underlying commodities on which futures contracts are available. edible oil products like groundnut. zinc and nickel) and commodity indices like agri commodity index and metal commodity index. soybean. If the 20th of the expiry month is a trading holiday. trading has commenced in cotton (long and medium staple). Figure 8. In the second phase NCDEX plans to offer the following commodities for trading . rape/ mustard oil. Table 8. under the category of bullion.1 Commodity futures contract and their symbols 1. Crude Palm Oil Kandla 9. base metals (aluminium. 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.8. it has already started trading in gold and silver. J34 Medium Staple Cotton Bhatinda 10. RBD Palm Olein Kakinada 8. oil and cake).2 and Table 8. All contracts expire on the 20th of the expiry month. S06 L S Cotton Ahmedabad 103 GLDPURMUM SLVPURDEL SYBEANIDR SYOREFTDR RMSEEDJPR RMOEXPJPR RBDPLNKAK CRDPOLKDL COTJ34BTD COTS06ABD 8.rice. Soybean Indore 4. New contracts will be introduced on the trading day following the expiry of the near month contract. 8.1 shows the contract cycle for futures contracts on NCDEX. copper. rape/ mustardseed.4 Commodity futures trading cycle NCDEX trades commodity futures contracts having one-month.
Not less than 995 fineness bearing a serial number and identifying stamp of a refiner approved by NCDEX. 15% of open interest) Client-wise: Max (Rs.2 Gold futures contract specification Trading system Trading hours NCDEX trading system Monday to Friday Normal market hours . The settlement price for less than 999. These conditions are broadly divided into the .9 fineness (called "Pure Gold" in trade circles) 5 paisa Limit 10%. January 2004 contract opens on 21st October 2003.4:15 pm to 4:30 pm 100 gms lKg Rs.9 fineness will be calculated as: (Actual fineness/ 999. if 20th happens to be a holiday then previous working day.e.com None At any date. List of approved refiners will be available with the exchange and also on its web site: www. 20th day of the delivery month.104 Table 8.9) * Settlement price Trading Unit of trading Delivery unit Quotation/ base value Tick size Price band Quality specification Quantity variation No.100 crore. Member-wise: Max (Rs. Limits will not apply if the limit is reached during final 30 minutes of trading.9. 3 concurrent month contracts will be active. 3 months prior to the contract month i.10:00 am to 4:00 pm Closing session . per 10 gms of Gold with 999.ncdex. There will be a total of twelve month contracts in a year.5 Order types and trading parameters An electronic trading system allows the trading members to enter orders with various conditions attached to them as per their requirements. 10% of Open interest) The discount will be given for the fineness below 999. of active contracts Delivery center Opening date Due date Position limits Premium/ Discount 8. Mumbai Trading in any contract month will open on the 21st day of the month.200 crore.
10% of Open interest) Will be given on the basis of Staple Length (at 0. Limits will not apply if the limit is reached during final 30 minutes of trading. 'Superfine'. 3 months prior to the contract month i. 3 concurrent month contracts will be active.5 mm intervals) & grade combinations. The exchange will communicate the premium/ discounts applicable before the settlement date. 15% of open interest) Client-wise: Max (Rs. 'Fully Good'.5 At any date. Main/ Base Variety: Shankar-6 Staple Length: 27-30 mm (Basis: 29 mm) Micronaire: 3. 105 Unit of trading Delivery unit Quotation/ base value Tick size Price band Quality specification No.8. 'Extra Superfine'.7 Quintal (=11 bales) 93.e.10:00 am to 4:00 pm Closing session .5 Order types and trading parameters Table 8. There will be a total of twelve month contracts in a year.40 crore. January 2004 contract opens on 21st October 2003. per Quintal 5paisa Limit 10%. Min: 21 G/ Tex Grade: 'Good to Fully Good'. 'Fine'.5 (Basis: 3. Member-wise: Max (Rs. if 20th happens to be a holiday then previous working day. Ahmedabad Trading in any contract month will open on the 21st day of the month.20 crore.3 Long staple cotton futures contract specification Trading system NCDEX trading system Trading hours Monday to Friday Normal market hours .4-4. % Max: 8.5 Quintals (=55 bales) Rs. Moisture.7-4. of active contracts Delivery center Opening date Due date Position limits Premium/ Discount . (Basis: 'Fine') Crop: Current Year Crop in which the delivery date falls (current year for Shankar-6 is defined as from 1st Nov of one year to 31st Oct of the subsequent year).4:15 pm to 4:30 pm 18. 20th day of the delivery month.2) Strength.
a near-month. The order types and conditions are summarised below. following categories: • Time conditions • Price conditions • Other conditions Several combinations of the above are possible thereby providing enormous flexibility to users. If the order is not executed during the day. it spans trading days. a middle-month and a farmonth. 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. good till date order and spread order. immediate or cancel order.Good till day order: A day order.341 and closes.Good till cancelled (GTC): A GTC order remains in the system until the user cancels it. If the market does not reach this price the order does not get filled even if the market touches Rs.106 Figure 8. • Time conditions . Consequently. Of these. once more making available three index futures contracts for trading. A day order is placed at Rs. at any given point of time.340/ 10 kg. three contracts are available for trading . The days counted are inclusive of the day on which the order is . good till day order. 2004 in refined palm oil on the commodity exchange. the system cancels the order automatically at the end of the day. one has to place the order again the next day. As the January contract expires on the 20th of the month. . stop loss order. Example: A trader wants to go long on March 1. a new three-month contract starts trading from the following day.1 Contract cycle Trading The figure shows the contract cycle for futures contracts on NCDEX. the order types available on the NCDEX system are regular lot order. As can be seen. if not traded on the day the order is entered. Each day counted is a calendar day inclusive of holidays. as the name suggests is an order which is valid for the day on which it is entered. good till cancelled order. In other words day order is for a specific price and if the order does not get filled that day.
The disadvantage is that the order may not get filled at all if the price for that day does not reach the specified price.Market price: Market orders are orders for which no price is specified at the time the order is entered (i. The maximum days allowed by the system are the same as in GTC order. an all-or-none order is not cancelled if it is not executed as soon as it is represented in the exchange. • Price condition . which is to be executed in its entirety. and the unmatched portion of the order is cancelled immediately. When the price reaches that point the stop order becomes a market order. For the stop-loss sell order. . it gets cancelled. stop orders are used to exit a trade.All or none order: All or none order (AON) is a limit order. When this kind of order is placed. stop orders can be executed for buying/ selling positions too. A stop order would then be placed to sell an offsetting contract if the price falls to Rs 700 per barrel.400/ 10kg.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.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. . 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. it gets executed irrespective of the current market price of that particular asset. When the market touches this price.50 a barrel. Stop orders are not executed until the price reaches the specified point. .8. Example: A trader wants to go long on refined palm oil when the market touches Rs. placed with the broker. 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. the order is cancelled from the system. Only the position to be taken long/ short is stated. the system determines the price.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. 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.750 per barrel. . to buy or sell a particular futures contract at the market price if and when the price reaches a specified level. An all-or-none order position can be closed out with another AON order.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. He wishes to limit his loss to Rs. even if it takes months for it to happen. stop order gets executed and the trader would exit the market. • Other conditions . Partial match is possible for the order. For such orders.Stop-loss: A stop-loss order is an order. Futures traders often use stop orders in an effort to limit the amount they might lose if the futures price moves against their position. the trigger price has to be greater than the limit price. failing which the order is cancelled from the system.e. price is market price). At the end of this day/ date. 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. or not at all. Unlike a fill-or-kill order. Theoritically. But. . if obtainable at the time of execution. . the order exists until it is filled up. whichever is earlier. or at a better price.Limit order: An order to buy or sell a stated amount of a commodity at a specified price. Most of the time.
The trader is virtually unconcerned whether the entire price structure moves up or down. . or exit an open trade. If the market trades at Rs.13. cancelling the other entry order. 14. An order placed so as to take advantage of price movement. 14.900/ tonne. .5 8. The spreaders goal is to profit from a change in the difference between the two futures prices. one long and one short.5. the limit order gets filled and the stop order is immediately gets cancelled. A stop order is placed at Rs. which may. The tick size in respect of all futures contracts admitted to dealings on the NCDEX is 5 paise. 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. This trade is used to enter a new trade.One cancels the other order : It is called one cancels the other order (OCO). This type of order would close the position if the market moved to either the stop rate or the limit rate. which consists of both a stop and a limit price. The fill price will be within the closing range. .11: After hours electronic trading system . 8.13. thereby closing the trade and at the same time. He wishes to have both stop and limit orders in order to fill the order in a particular price range. be substantially different from the setdement price.Market on close: The order will be executed on the market close. Prices of the two futures contract therefore tend to go up and down together.Spread order: A simple spread order involves two positions.900/ tonne.5. This trade is also used to enter a new trade. or exit an open trade.100/ tonne and a limit order at Rs.000/ tonne on Soybean. in some markets. .13. Example: A trader has a buy position at Rs. Called Globex.108 Trading After-hours electronic trading first began in 1992 at CME (Chicago Mercantile Exchange). just so long as the futures contract he bought goes up more (or down less) than the futures contract he sold. and gains on one side of the spread are offset by losses on the other.Market on open: The order will be executed on the market open within the opening range. The lot size currently applicable on individual commodity contracts is given in Table 8.Trigger price: Price at which an order gets triggered from the stop-loss book. Once one level is reached. .2 Tick size for contracts The tick size is the smallest price change that can occur for the trades on the exchange. Box 8. The trader exits the market at Rs.900/ tonne. one half of the order will be executed (either stop or limit) and the remaining order cancelled (either limit or stop). They are taken in the same commodity with different months (calendar spread) or in closely related commodities.Limit price: Price of the orders after triggering from stop-loss book. . Typically electronic trading systems are used in the open outcry exchanges after the day trading is over.1 Permitted lot size The permitted trading lot size for the futures contracts on individual commodities is stipulated by the exchange from time to time.
000 Grams (gm) 1.10% from the base price.5. The base price of me contracts on all subsequent trading days is the daily settlement price of the futures contracts on the previous trading day. the exchange may. the exchange can approve such order.8. operating price ranges on the NCDEX are kept at +/.5 Order types and trading parameters Table 8.3 Quantity freeze All orders placed by members have to be witiiin the quantity specified by the exchange in this regard. In respect of orders which have come under price freeze. at its discretion.300 Bales 3.500 kilograms (Kgs) 300 Metric Tonnes (MT) 300 Metric Tonnes (MT) 300 Metric Tonnes (MT) 300 Metric Tonnes (MT) 300 Metric Tonnes (MT) 300 Metric Tonnes (MT) 3.5. The exchange can approve or . in exceptional cases. 8. the members are required to confirm to the exchange that there is no inadvertent error in the order entry and mat the order is genuine.5 Price ranges of contracts In order to prevent erroneous order entry by trading members. the member is required to confirm to the exchange that there is no inadvertent error in the order entry and mat the order is genuine. 8. These spot prices are polled across multiple centers and a single spot price is determined by the bootstrapping method.5.300 Bales 109 8. Orders exceeding me range specified are not executed and he pending with the exchange as a price freeze. Any order exceeding tiiis specified quantity will not be executed but will he pending with the exchange as a quantity freeze. not allow the orders that have come under quantity freeze for execution for any reason whatsoever including non-availability of exposure limits.4 gives the quantity freeze for each commodity contract.4 Commodity futures: Quantity freeze unit Instrument Asset Quantity Type Asset Symbol Freeze Unit FUTCOM FUTCOM FUTCOM FUTCOM FUTCOM FUTCOM FUTCOM FUTCOM FUTCOM FUTCOM GLDPURMUM SLVPURDEL SYBEANTDR SYOREFIDR RMSEEDJPR RMOEXPJPR RBDPLNKAK CRDPOLKDL COTJ34BTD COTS06ABD 30. On such confirmation. the base price is the previous days' closing price of the underlying commodity in the prevailing spot markets. However. In respect of orders which have come under quantity freeze.4 Base price On introduction of new contracts. Table 8.
Unless specifically notified by the exchange. there will be no price ranges applicable in the last half hour of normal market trading. 8.110_____________________________________________________________________Trading disapprove such orders solely at its own discretion.5. These keys have been provided to facilitate faster operation of the system and enable quicker trading on the system.6 Order entry on the trading system The NCDEX trading system has a set of function keys built into the trading front-end. The function keys can be operated from the keyboard of the user. The set of function keys enable the following: • Buy open • Sell open • Order cancellation • Order modification • Exercise/ Position liquidation • Outstanding orders • Quick order cancel • Spread order entry • Market watch setup • Trade modify • Trade cancel • Client master maintenance • Market by order • Market by price • Activity log • Security list/ portfolio setup • Portfolio offline order entry • Spread market by price • Previous trades • Contract description • Alphabetical sorting of contracts .
5 Order types and trading parameters Table 8./ 10 Kg Rs./Kg Rs./ 10 GM Rs./20Kg Rs./ 10 Kg Rs./ Quintal 111 Delivery Delivery Lot Unit 1 30 10 10 10 10 10 10 55 55 KG KG MT MT MT MT MT MT Bales Bales • Spread order status • Spread activity log • Snap quote • Online offline order entry • Message log • Market movement • Full message display • Market inquiry • Spread outstanding orders • Net position upload • Order status • Liquidity schedule • Buy close • Sell close ./ 10 Kg Rs.5 Commodity futures: Lot size and other parameters Instrument Asset Market Quantity Price Type Asset Symbol Lot Unit Unit FUTCOM FUTCOM FUTCOM FUTCOM FUTCOM FUTCOM FUTCOM FUTCOM FUTCOM FUTCOM GLDPURMUM SLVPURDEL SYBEANIDR SYOREFIDR RMSEEDJPR RMOEXPJPR RBDPLNKAK CRDPOLKDL COTJ34BTD COTS06ABD 100 5 1 1 1 1 1 1 11 11 GM Kg MT MT MT MT MT MT Bales Bales Rs./ Quintal Rs./ Quintal Rs.8./ 10 Kg Rs.
Based on the settlement price. Just as a trader is required to maintain a margin account with a broker. This is imposed when the exchange fears that the markets have become too volatile and may result in some payments crisis. a maintenance margin. This margin is meant to cover the largest potential loss in one day. there is only an original margin and no maintenance margin. The margin is a mandatory requirement for parties who are entering into the contract. The extra funds deposited are known as a variation margin. etc. the accounts are either debited or credited based on how well the positions fared in that day's trading session. if the position generates a gain. This is known as marking to market the account of each trader. there are different types of margins that a trader has to maintain. If the balance in the margin account falls below the maintenance margin. The margin requirements for most futures contracts range from 2% to 15% of the value of the contract. a clearing house member is required to maintain a margin account with the clearing house. • Mark-to-Market margin (MTM): At the end of each trading day. the funds can be withdrawn (those funds above the required initial margin) or can be used to fund additional trades. If the trader does not provide the variation 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. which is somewhat lower than the initial margin. On the other hand.112 Trading 8. If the account falls below the maintenance margin level the trader needs to replenish the account by giving additional funds. All futures contracts are settled daily reducing the credit exposure to one day's movement. At this stage we look at the types of margins as they apply on most futures exchanges. the value of all positions is marked-to-market each day after the official close. which is a preemptive move to prevent breakdown. • Maintenance margin: A trader is entitled to withdraw any balance in the margin account in excess of the initial margin. • Initial margin: The amount that must be deposited by a customer at the time of entering into a contract is called initial margin. the broker closes out the position by offsetting the contract. . The margin required for a futures contract is better described as performance bond or good faith money. • Additional margin: In case of sudden higher than expected volatility. In the case of clearing house member.6 Margins for trading in futures Margin is the deposit money that needs to be paid to buy or sell each contract. In the futures market. i. the exchange calls for an additional margin. the margin account is adjusted to reflect the trader's gain or loss. Clearing house and clearing house margins have been discussed further in detail under the chapter on clearing and settlement. is set. We will discuss them in more details when we talk about risk management in the next chapter. This is known as clearing margin.e. The margin levels are set by the exchanges based on volatility (market conditions) and can be changed at any time. To ensure that the balance in the margin account never becomes negative.
Trading on a nationwide basis. 2.7 Charges 113 8.one Lakh trade done. members are required to remit Rs. Trading by open-outcry .8. NCDEX then forwards the mandate form to BJPL. 3. Rate of charges: The transaction charges are payable at the rate of Rs. 1. 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. BJPL sends the log-in ID and password to the mailing address as mentioned in the registration form. 5. it is found that open interest is maximum in near month expiry contracts. Based on studies carried out in international exchanges. The important provisions are listed below: The billing for the all trades done during the previous month will be raised in the succeeding month. Online monitoring and surveillance 4. does not provide 1. Registration with BJPL and their services: Members have to fill up the mandate form and submit the same to NCDEX. mechanism.6 per Rs. This rate is subject to change from time to time. A fully automated screen-based trading. the billing details can be viewed on the website upto a maximum period of 12 months. A: The correct answer is number 4.7 Charges Members are liable to pay transaction charges for the trade done through the exchange during the previous month. the futures market is a zero sum game i.000 as advance transaction charges on registration. 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. The members can then log on through the website of BJPL and view the billing amount and the due date. Besides. 6. Finally. 2. 4.50. The total number of outstanding contracts (long/ short) at any point in time is called the "Open interest". Solved Problems Q: The trading system on the NCDEX.e. Collection process: NCDEX has engaged the services of Bill Junction Payments Limited (BJPL) to collect the transaction charges through Electronic Clearing System. This Open interest figure is a good indicator of the liquidity in every contract. Penalty for delayed payments: If the transaction charges are not paid on or before the due date. Advance email intimation is also sent to the members. » » 3. a penal interest is levied as specified by the exchange. the total number of long in any contract always equals the total number of short in any contract. Adjustment against advances transaction charges: In terms of the regulations.
Long staple cotton Ahmedabad A: The correct answer is number 2. A: The correct answer is number 2.114_____________________________________________________________________Trading Q: Order matching on the NCDEX happens on the basis of 1. All of the above •• Q: COTS06ABD is the symbol for 1. •• . Once every two weeks. 2. 3. At the end of each week. One day horizon 2. Six-month •• Q: Billing to members for the all trades done on the NCDEX will be raised 1. Quantity 4. 3. 3. One week horizon A: The correct answer is number 1. Two-month A: The correct answer is number 4. Three-month 4. Medium staple cotton Bhatinda 2. At the end of each day. Commodity 2. Small staple cotton Aurangabad 4. 3. One month horizon •• Q: NCDEX does not trade commodity futures contracts having___expiry cycles 1. 4. None of the above •• Q: Initial margin is meant to cover the largest potential loss over a 1. Price and time A: Correct answer is number 4. 3. One hour horizon 4. One-month 2. In the succeeding month.
200 3.00.0 .420 4. What is the value of his open long position? Unit of trading is 100 gms and delivery unit is one Kg 1.7.000 A: One trading unit is for 100 gms.000. in 1428. What is the value of his open long position? Unit of trading is 100 gms and delivery unit is one Kg 1. i. 10 units 2.7. 28 units A: Futures price of 10 gms of gold is Rs. He has to take a position 1 .7. Q: A trader requires to take a long gold futures position worth Rs.65. Rs.700 per gram. He has to buy 14 units of gold 70 0 •• futures contracts.7.57 gms of gold gms. 10 Q: A trader requires to take a long gold futures position worth Rs. Two month futures trade at Rs. How many units must he purchase to give him the hedge? 1.e.20.100 ×100 × 20 The correct answer is number 4.500 4. 100 units 3. Rs.42.700 per gram.000 units 4.6.0 0 0 0 0 .6. 14. Rs.7. position is 10 Q: A trader sells 20 units of gold futures at Rs. This means gold futures cost Rs. 10.000 2. The value of his long gold futures 5.000 per 10 gms.100 per 10 gms.000. 14. Unit of trading is 100 gms and delivery unit is one Kg.500 ×100 ×10 The correct aanswer is number 1. 1.000 3.8. Rs. 10.1. Rs. Unit of trading is 100 gms and delivery unit is one Kg. To take .000 2.1.7. Rs. Rs.00. Rs. 14 units 4.6. He has bought 20 units.000 A: One trading unit is for 100 gms.50.7 Charges 115 Q: A trader buys 10 units of gold futures at Rs.000 units A: Futures price of 10 gms of gold is Rs. 10 units 2. 20 units 3. The value of his long gold futures position is 7.000 per 10 gms.00. Roughly how many units must he purchase to give him the hedge? 1. He has bought 10 units. Two month futures trade at Rs. .000 as part of his hedging strategy.000 as part of his hedging strategy. The correct answer is number 3.500 per 10 gms.65. This means gold futures cost Rs. .
•• .a position in 1000 gms of gold he has to buy 10 units of gold futures contracts. The correct answer is number 1.
100 units 3.000.000 units 4.7. To take a position in 1000 gms of gold he has to sell 10 units of gold futures contracts.7.000 units A: Futures price of 10 gms of gold is Rs. 10.7.116____________________________________________________________________Trading Q: A trader requires to take a short gold futures position worth Rs. Two month futures trade at Rs. How many units must he sell to give him the hedge? 1.00. •• . This means gold futures cost Rs.000 as part of his hedging strategy. 10 units 2. 1.000 per 10 gms.700 per gram. The correct answer is number 1. Unit of trading is 100 gms and delivery unit is one Kg.
in the case of clearing house members only the original margin is required (and . It guarantees the performance of the parties to each transaction. The settlement is done by closing out open positions. 6. All these settlement functions are taken care of by an entity called clearing house or clearing corporation. The clearing house has a number of members. 3. Typically it is responsible for the following: 1. 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. physical delivery or cash settlement.Chapter 9 Clearing and settlement Most futures contracts do not lead to the actual physical delivery of the underlying asset. who are mostly financial institutions responsible for the clearing and settlement of commodities traded on the exchange. Control of the evolution of open interest. On the NCDEX. 4. 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. 2. Financial clearing of the payment flow. Administration of financial guarantees demanded by the participants. Physical settlement (by delivery) or financial settlement (by price difference) of contracts. Trade registration and follow up. 9. The settlement guarantee fund is maintained and managed by NCDEX. 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).1 Clearing Clearing of trades that take place on an exchange happens through the exchange clearing house. National Securities Clearing Corporation Limited (NSCCL) undertakes clearing of trades executed on the NCDEX. 5. Effecting timely settlement.
This position is considered for exposure and daily margin purposes..1. the matching for deliveries takes place firstly. clearing members are informed of the deliverable/ receivable positions and the unmatched positions. A TCM's open position is arrived at by the summation of his clients' open positions. reporting of balances and other operations as may be required by NCDEX from time to time.118 Clearing and settlement not maintenance margin).2 Clearing banks NCDEX has designated clearing banks through whom funds to be paid and/ or to be received must be settled. at the member level without any set-offs between clients. commodities already deposited and dematerialized and offered for delivery etc. The clearing bank will debit/ credit the clearing account of clearing members as per instructions received from NCDEX. keeping in view the factors such as available capacity of the vault/ warehouse. Clearing members must authorise their clearing bank to access their clearing account for debiting and crediting their accounts as per the instructions of NCDEX. Everyday the account balance for each contract must be maintained at an amount equal to the original margin times the number of contracts outstanding. based on the available information. A clearing member having funds obligation to pay is required to have clear balance in his clearing account on or before the stipulated pay-in day and the stipulated time. Proprietary positions are netted at member level without any set-offs between client and proprietary positions. Unmatched positions have to be settled in cash. for settling funds and other obligations to NCDEX including payments of margins and penal charges. After completion of the matching process. 9. Client positions are netted at the level of individual client and grossed across all clients.e. Thus depending on a day's transactions and price movement. The clearing mechanism essentially involves working out open positions and obligations of clearing members. The cash settlement is only for the incremental gain/ loss as determined on the basis of final settlement price. but can withdraw funds from this account only in his self-name. in the contracts in which they have traded. The brokers who are not the clearing members need to maintain a margin account with the clearing house member through whom they trade in the clearing house 9. A clearing member can deposit funds into this account. Matching done by this process is binding on the clearing members. the members either need to add funds or can withdraw funds from their margin accounts at the end of the day. in contracts in which they have traded. Every clearing member is required to maintain and operate a clearing account with any one of the designated clearing bank branches.1 Clearing mechanism Only clearing members including professional clearing members (PCMs) are entitled to clear and settle contracts through the clearing house. The following banks have been designated . on the basis of locations and men randomly. The open positions of PCMs are arrived at by aggregating the open positions of all the TCMs clearing through him.1. after the trading hours on the expiry date. The clearing account is to be used exclusively for clearing operations i. At NCDEX.
e. Canara Bank. daily settlement price is computed as per the methods prescribed by the exchange from time to time. in the absence of trading for a contract during closing session. All open positions in a futures contract cease to exist after its expiration day. 9.3 Depository participants Every clearing member is required to maintain and operate a CM pool account with any one of the empanelled depository participants.2 Settlement 119 as clearing banks . for effecting and receiving deliveries from 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.1 Settlement mechanism Settlement of commodity futures contracts is a little different from settlement of financial futures which are mostly cash settled. On the NCDEX. • 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. created during the day or closed out during the day. 9. The CM pool account is to be used exclusively for clearing operations i. 9.ICICI Bank Limited. However. are marked to market at the daily settlement price or the final settlement price at the close of trading hours on a day. when the member holds an open position. The possibility of physical settlement makes the process a little more complicated. UTI Bank Limited and HDFC Bank Limited. the MTM settlement which happens on a continuous basis at the end of each day.2. it is the difference between the entry value and daily settlement price for that day. Daily mark to market settlement Daily mark to market settlement is done till the date of the contract expiry. All the open positions of the members are marked to market at the end of the day and the profit/ loss is determined as below: • On the day of entering into the contract. either brought forward. This is done to take care of daily price fluctuations for all trades. • Final settlement price: Final settlement price is the closing price of the underlying commodity on the last trading day of the futures contract. All positions of a CM. • On any intervening days.. it is the difference between the daily settlement price for that day and the previous day's settlement price. .2 Settlement Futures contracts have two types of settlements.1.9. and the final settlement which happens on the last trading day of the futures contract.
The MTM profit/ loss shows that he makes a total profit of Rs. The profit/ loss made by him however gets added/ deducted from his initial margin on a daily basis. The MTM profits/ losses get added/ deducted from his initial margin on a daily basis. The spot prices are collected from members across the country through polling. The profit/ loss made by him however gets added/ deducted from his initial margin on a daily basis.2003 Dec 17.2003 Dec 19.6435 per Quintal on December 15.120 per Quintal of trading. Date Dec 15.2 explains the MTM margins to be paid by a member who sells December expiration long staple cotton futures contract at Rs.2244.120 per Quintal. The polled bid/ ask prices are bootstrapped and the mid of the two bootstrapped prices is taken as the final settlement price. So upon closing his position. The MTM profit/ loss per unit of trading shows at he makes a total loss of Rs. The member closes the position on December 19. On the expiry date of a futures contract. i. So upon closing his position.7 Quintals = 11 bales) on December 15. the final settlement price is the spot price on the expiry day. Table 9.7 Quintals) and each contract is for delivery of 55 bales of cotton. he makes a total loss of Rs.1 MTM on a long position in cotton futures Clearing and settlement A clearing member buys one December expiration long staple cotton futures contract at Rs.6435 per Quintal (18.120 Table 9.e. The responsibility of settlement is on a trading cum clearing member for all trades done on his own account and his client's trades. Table 9. The member closes the position on December 19.2244 on the short position taken by him.2003 Settlement price 6320 6250 6312 6310 6315 MTM -115 -70 +62 -2 +5 • On the expiry date if the member has an open position. (18.7 x 120) on the long position taken by him.6435 per Quintal on December 15. members are required to submit delivery information . 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 19.1 explains the MTM margins to be paid by a member who buys one unit of December expiration long staple cotton contract at Rs.2003 Dec 18. The unit of trading is 11 bales(18.2003 Dec 16. it is the difference between the final settlement price and the previous day's settlement price. A professional clearing member is responsible for settling all the participants trades which he has confirmed to the exchange. The unit of trading is 11 bales and each contract is for delivery of 55 bales of cotton. Final settlement On the date of expiry. he makes a total profit of Rs.
by placing at the exchange. The MTM profits/ losses get added/ deducted from his initial margin on a daily basis.2003 Dec 19.9. may be closed out forthwith or any time thereafter by the exchange to the extent possible. A detailed report containing all matched and unmatched requests is provided to members through the extranet. It can also take additional measures like. the outstanding positions of such clearing member and/ or trading members and/ or constituents. bye-laws and regulations of NCDEX and attracts penal charges as stipulated by NCDEX from time to time. for which no delivery information is submitted with final settlement obligations of the member concerned and settled in cash. matches the information and arrives at a delivery position for a member for a commodity. .2003 Settlement price MTM 6320 +115 6250 +70 6312 -62 6310 +2 6315 -5 through delivery request window on the trader workstations provided by NCDEX for all open positions for a commodity for all constituents individually.6435 on December 15.2003 Dec 18. failure to submit delivery information for open positions attracts penal charges as stipulated by NCDEX from time to time. Non-fulfilment of either the whole or part of the settlement obligations is treated as a violation of the rules. Pursuant to regulations relating to submission of delivery information. invoking bank guarantees or fixed deposit receipts. without any notice. clearing and settling through such clearing member. NCDEX on receipt of such information. imposing penalties. The unit of trading is 11 bales and each contract is for delivery of 55 bales of cotton. 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. NCDEX also adds all such open positions for a member. Date Dec 15.2003 Dec 16. The member closes the position on December 19. 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. collecting appropriate deposits.2003 Dec 17.2 MTM on a short position in cotton futures 121 A clearing member sells one December expiration long staple cotton futures contract at Rs.2 Settlement Table 9. Further. NCDEX can also initiate such other risk containment measures as it deems appropriate with respect to the open positions of the clearing members. realizing money by disposing off the securities and exercising such other risk containment measures as it deems fit or take further disciplinary action.
Clearing and settlement
9.2.2 Settlement methods
Settlement of futures contracts on the NCDEX can be done in three ways - by physical delivery of the underlying asset, by closing out open positions and by cash settlement. We shall look at each of these in some detail. On the NCDEX all contracts settling in cash are settled on the following day after the contract expiry date. All contracts materialising into deliveries are settled in a period 2-7 days after expiry. The exact settlement day for each commodity is specified by the exchange.
Physical delivery of the underlying asset
For open positions on the expiry day of the contract, the buyer and the seller can announce intentions for delivery. Deliveries take place in the electronic form. All other positions are settled in cash. When a contract comes to settlement, the exchange provides alternatives like delivery place, month and quality specifications. Trading period, delivery date etc. are all defined as per the settlement calendar. A member is bound to provide delivery information. If he fails to give information, it is closed out with penalty as decided by the exchange. A member can choose an alternative mode of settlement by providing counter party clearing member and constituent. The exchange is however not responsible for, nor guarantees settlement of such deals. The settlement price is calculated and notified by the exchange. The delivery place is very important for commodities with significant transportation costs. The exchange also specifies the precise period (date and time) during which the delivery can be made. For many commodities, the delivery period may be an entire month. The party in the short position (seller) gets the opportunity to make choices from these alternatives. The exchange collects delivery information. The price paid is normally the most recent settlement price (with a possible adjustment for the quality of the asset and the delivery location). Then the exchange selects a party with an outstanding long position to accept delivery. As mentioned above, after the trading hours on the expiry date, based on the available information, the matching for deliveries is done, firstiy, on the basis of locations and then randomly keeping in view factors such as available capacity of the vault/ warehouse, commodities already deposited and dematerialized and offered for delivery and any other factor as may be specified by the exchange from time to time. After completion of the matching process, clearing members are informed of the deliverable/ receivable positions and the unmatched positions. Unmatched positions have to be settled in cash. The cash settlement is done only for the incremental gain/ loss as determined on the basis of the final settlement price. Any buyer intending to take physicals has to put a request to his depository participant. The DP uploads such requests to the specified depository who in turn forwards the same to the registrar and transfer agent (R&T agent) concerned. After due verification of the authenticity, the R&T agent forwards delivery details to the warehouse which in turn arranges to release the commodities after due verification of the identity of recipient. On a specified day, the buyer would go to the warehouse and pick up the physicals. The seller intending to make delivery has to take the commodities to the designated
warehouse. These commodities have to be assayed by the exchange 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
Closing out by offsetting positions
Most of the contracts are settled by closing out open positions. In closing out, the opposite transaction is effected to close out the original futures position. A buy contract is closed out by a sale and a sale contract is closed out by a buy. For example, an investor who took a long position in two gold futures contracts on the January 30, 2004 at 6090, can close his position by selling two gold futures contracts on February 27, 2004 at Rs.5928. In this case, over the period of holding the position, he has suffered a loss of Rs.162 per unit. This loss would have been debited from his margin account over the holding period by way of MTM at the end of each day, and finally at the price that he closes his position, that is Rs.5928 in this case.
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.
Clearing and settlement
9.2.3 Entities involved in physical settlement
Physical settlement of commodities involves the following three entities - an accredited warehouse, registrar & transfer agent and an assayer. We will briefly look at the functions of each.
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.
Approved registrar and transfer agents (R&T agents)
The exchange specifies approved R&T agents through whom commodities can be dematerialized and who facilitate for dematerialization/ re-materialization of commodities in the manner prescribed by the exchange from time to time. The R&T agent performs the following functions:
1. Establishes connectivity with approved warehouses and supports them with physical infrastructure. 2. 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.
The difference is settled in cash on a T+l basis. Therefore. The compliance certificate so given by the assayer forms the basis of warehouse accreditation by the exchange. 2. and the time up to which the commodities are fit for trading subject to environment changes at the warehouses. It specifies the initial margin requirements for each futures contract on a daily basis. The open positions of the members are marked to market based on contract settlement price for each contract. 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. They are required to furnish the same to the exchange as and when demanded by the exchange. 4. 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. The PCMs and TCMs in turn collect the initial margin from the TCMs and their clients respectively. A member is alerted of his position to enable him to adjust his exposure or bring in additional capital. Make available grading facilities to the constituents in respect of the specific commodities traded on the exchange at specified warehouse. security deposits) are quite stringent. 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.9. It also follows value-at-risk (VaR) based margining through SPAN. The salient features of risk containment mechanism are: 1. . the requirements for membership in terms of capital adequacy (net worth.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. 3. Position violations result in withdrawal of trading facility for all TCMs of a PCM in case of a violation by the PCM. 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. NCDEX charges an upfront initial margin for all the open positions of a member. The financial soundness of the members is the key to risk management. R&T agents also do the job of co-ordinating with DPs and warehouses for billing of charges for services rendered on periodic intervals. 3. 9. Assayers perform the following functions: 1.3 Risk management NCDEX has developed a comprehensive risk containment mechanism for the its commodity futures market. 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. 2.
at any point of time.4.4 Margining at NCDEX In pursuance of the bye-laws. For client positions: These are netted at the level of individual client and grossed across all clients. the exchange has defined norms and procedures for margins and limits applicable to members and their clients.2 Initial margin This is the amount of money deposited by both buyers and sellers of futures contracts to ensure performance of trades executed.4. Initial margin requirements are based on 99% VaR (Value at Risk) over a one-day time horizon. 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. The margining system for the commodity futures trading on the NCDEX is explained below. rules and regulations. Initial margin includes SPAN margins and such other additional margins that may be specified by the exchange from time to time. Initial margin requirements for a member for each contract are as under: 1. up to client level. 9.3 Computation of initial margin The Exchange has adopted SPAN (Standard Portfolio Analysis of Risk) system for the purpose of real-time initial margin computation. The most critical component of risk containment mechanism for futures market on the NCDEX is the margining system and on-line position monitoring. For proprietary positions: These are netted at member level without any set-offs between client and proprietary positions. 9. at the member level without any set-offs between clients. 2. A separate settlement guarantee fund for this segment has been created out of the capital of members. . The objective of SPAN is to identify overall risk in a portfolio of all futures contracts for each member. used by NCDEX under license obtained from CME. Initial margin is payable on all open positions of trading cum clearing members. 9. and is payable upfront by the members in accordance with the margin computation mechanism and/ or system as may be adopted by the exchange from time to time.1 SPAN SPAN is a registered trademark of the Chicago Mercantile Exchange. The actual position monitoring and margining is carried out on-line through the SPAN (Standard Portfolio Analysis of Risk) system.126 Clearing and settlement 5. 9.4.
3 Calculating outstanding position at TCM level Account Number of Number of units bought units sold Proprietary CUent A Client B Net outstanding position 3000 2000 1000 1500 1000 127 Outstanding position Long 2000 Long 500 Short 1000 3500 Table 9. he bought 3000 trading units and sold 1000 trading units within the day. 2. he sold 1000 trading units.4 Minimum margin percentage on commodity futures contracts Commodity Minimum margin percentage Pure gold Mumbai Pure silver New Delhi J34 medium staple cotton Bhatinda S06 L S cotton Ahmedabad Soybean Indore Refined soya oil Indore Rapeseed mustard seed Jaipur Expeller rapeseed mustard oil Jaipur Crude palm oil Kandla RBD palm olein Kakinada 4 4 3 3 4 4 4 4 4 4 Consider the case of a trading member who has proprietary and client-level positions in a April 2004 gold futures contract. 3. These may change from time to time as specified by the exchange. The minimum margin percentages for various commodities are given in Table 9.9. And on account of client B. he bought 2000 trading units at the beginning of the day and sold 1500 units an hour later.3 gives the total outstanding position for which the TCM would be margined. various parameters as given below will be specified from time to time: 1. For the purpose of SPAN margin. Table 9.4. On account of client A. 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 .4 Margining at NCDEX Table 9. On his proprietary account. Price scan range: Price scan range will be four standard deviations (4 sigma) as calculated for VaR purpose for the prices of futures contracts. 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.
In addition. 2. Mode of payment of initial margin: Margins can be paid by the members in cash. 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. by placing counter orders in respect of the outstanding position of members. The near month position is the buy/ sell position on the calendar-spread position that expires first. 4. bye-laws and regulations of the exchange and attracts penal charges as stipulated by NCDEX from time to time.4 Implementation aspects of margining and risk management We look here at some implementation aspects of the margining and risk management system for trading on NCDEX. 3 trading days prior to expiration of the near month contract. without any notice.4. The exchange can take additional measures like imposing penalties. 9. Margins are charged on all open calendar spread positions at 2% on the higher value of the near month or the far month position. The far month position is the buy/ sell position on the calendar-spread position that expires next. The member is not allowed to trade once the exposure limits have been exceeded on the exchange. A calendar spread position is treated as nonspread (naked) positions in the far month contract. invoking bank guarantees/ fixed deposit receipts. 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. to the extent possible. (a) Liquid networth: Liquid networth is computed as effective deposits less initial margin payable at any point in time. 1. The trader workstation of the member is disabled and trading permitted only on enhancement of exposure limits by deposit of additional capital. or in collateral security deposits in the form of bank guarantees. The liquid networth maintained by the members at any point in time cannot be less than Rs. can be closed out forthwith or any time thereafter at the discretion of the Exchange. . collecting appropriate deposits. However. 3. Payment of initial margin: The initial margin is payable upfront by members.128 Clearing and settlement exchange. or at such rate as may be specified by the exchange from time to time. as may be specified by the exchange from time to time. The outstanding positions of such members and/ or constituents clearing and settling through such members. 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. 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. 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. fixed deposits receipts and approved Government of India securities. Such action is final and binding on the members and/ or constituents. realizing money by disposing off the securities and exercising such other risk containment measures as it deems fit.25 lakh (referred to as minimum liquid net worth) or such other amount. The reduction of the spread position starts five days before the date of expiry of the near month contract.
Intra-day price limit: The maximum price movement during a day can be +/.e.10% of the previous day's settlement price prescribed for each commodity. For the purpose of computing effective deposits. This is in addition to the initial margin. In addition. rules and regulations. trading in that particular contract will be suspended and normal trading will resume after the cooling period. 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. by placing counter orders in respect of their outstanding positions. contracts are treated as open position of one third of the value of the far month futures contract. 10. 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.5 or as may be prescribed by the exchange from time. can be closed out forthwith or any time thereafter. as the case may be. must inform the exchange as per the procedure. fixed deposit receipts and Government of Indian securities. Imposition of additional margins and close out of open positions: As a risk containment measure. the outstanding positions of such members and/ or constituents. This is calculated as the higher of a specified percentage of the total open interest in the commodity or a specified value. the exchange may require the members to make payment of additional margins as may be decided from time to time. without any notice. there will be a cooling period of 15 minutes. . Open interest is the total number of open positions in that futures contract multiplied by its last available traded price or closing price. 6. (c) Method of computation of exposure limits: Exposure limits is specified as a multiple of the liquid net worth. i. If the price hits the intra day price limit (at upper side or lower side). 5. (d) Exposure limits for calendar spread positions: In case of calendar spread positions in futures. 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. 8. Such requests may be considered by the exchange subject to the bye-laws. cash equivalents mean bank guarantees. at any point of time. 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.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. 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. bye-Laws and regulations of the exchange and attracts penal charges as stipulated by NCDEX. The multiple is as specified in Table 9. 9. to the extent possible.9. which are or may have been imposed. 7. a member can have an exposure limit of x times his liquid net worth. clearing and settling through such members. The base price when trading resumes after cooling period will be the last traded price before the commencement of cooling period. 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. 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. During the cooling period. at the discretion of the exchange. There would be no cooling period if the price hits the intra day limit during the last 30 minutes of trading. over and above their deposit requirement towards initial margin and/ or other obligations.
9.6 gives the number of days for physical settlement on various commodities. it can make an intra-day margin call if the intra day price limit has been reached. the market price changes sufficiently. Table 9. it is the difference between the final settlement price and the previous day's settlement price. Intra-day margin call: The exchange at its discretion can make intra day margin calls as risk containment measure if. delivery margins are calculated as i\ days VaR margins plus additional margins. Delivery margin: In case of positions materialising into physical delivery. the exchange can withdraw any or all of the membership rights of members including the withdrawal of trading . 12. for example. There is a mark up on the VaR based delivery margin to cover for default. (b) On any intervening days. it is the difference between the entry value and daily settlement price for that day. For example. N days refer to the number of days for completing the physical delivery settlement. in its opinion. (c) On the expiry date if the member has an open position.5 Exposure limit as a multiple of liquid net worth Commodity Pure gold Mumbai Pure silver New Delhi J34 medium staple cotton Bhatinda S06 L S cotton Ahmedabad Soybean Indore Refined soya oil Indore Rapeseed mustard seed Jaipur Expeller rapeseed mustard oil Jaipur Crude palm oil Kandla RBD palm olein Kakinada Clearing and settlement Multiple 25 25 40 40 25 25 25 25 25 25 (a) Daily settlement price: The daily profit/ losses of the members are settled using the daily settlement price. as described hereunder or as may be prescribed by the exchange from time to time.130 Table 9. The number of days are commodity specific. The exchange at its discretion may make selective margin calls.5 Effect of violation Whenever any of the margin or position limits are violated by members. it is the difference between the daily settlement value for that day and the previous day's settlement price. which in the opinion of the exchange could result in an enhanced risk.4. or any other situation has arisen. (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. when the member holds an open position. The daily settlement price notified by the exchange is binding on all members and their constituents. only for those members whose variation losses or initial margin deficits exceed a threshold value prescribed by the exchange. 11.
4 Margining at NCDEX Table 9. realizing money by disposing off the securities. Q:______undertakes clearing and settlement of all trades executed on the NCDEX 1. Physical delivery. Carrying forward the position. 3. and exercising such other risk containment measures it considers necessary. NSDL 4. NSE 2. invoking bank guarantees/ fixed deposit receipts. Closing out open positions. This can be done without any notice to the member and/ or constituent. In addition. A: The correct answer is number 4. 2. The exchange can initiate further risk containment measures with respect to the open positions of the member and/ or constituent. 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. collecting appropriate deposits. These could include imposing penalties. Solved Problems Q: The settlement of futures contracts cannot be done by 1. Cash settlement. NCDEX •• 3. NSCCL A: The correct answer is number 2. without any notice. •• .9. 4.6 Number of days for physical settlement on various commodities Commodity Pure gold Mumbai Pure silver New Delhi J34 medium staple cotton Bhatinda S06 L S cotton Ahmedabad Soybean Indore Refined soya oil Indore Rapeseed mustard seed Jaipur Expeller rapeseed mustard oil Jaipur Crude palm oil Kandla RBD palm olein Kakinada Number of days for physical settlement 2 4 10 10 7 7 7 7 7 7 131 facilities of all members and/ or clearing facility of custodial participants clearing through such trading cum members.
•• Q: On expiry of a commodity futures contract. NCDEX •• Q: The clearing house of an exchange is responsible for 1. Financial clearing of the payment flow. •• Q: The exposure limit for each member is linked to the………of the member available with the exchange. 1. None of the above. Spot price of the underlying asset 2. the settlement price is the 1. 2. Control of the evolution of open interest. •• . Control of the evolution of open interest. NSDL 4. 3. 2. 3. A: The correct answer is number 1. A: The correct answer is number 2. 4. Spot price plus cost-of-carry 4. •• Q: The clearing house of an exchange is not responsible for 1. 4. Security deposits. 2. 3. Bank guarantees. Futures close price A: The correct answer is number 1.132 Clearing and settlement Q: The settlement guarantee fund for trades done on the NCDEX is maintained and managed by 1. 3. A: The correct answer is number 4. Financial clearing of the payment flow. Ensuring that the buyer and seller get the best price. Effecting timely settlement. NSCCL A: The correct answer is number 4. All of the above. Liquid net worth. 3. 4. Base capital. Effecting timely settlement. NSE 2.
25 per 10 gms on his futures position. He has bought ten futures contract.6050 per Quintal. The correct answer is number 1.30 per Quintal on his futures position. long staple cotton futures contracts at Rs. A loss of Rs. 1500 A: He makes a profit of Rs. The settlement price at the end of the day was Rs. 1500 4. A profit of Rs. One futures contract consists is for 18. •• . So he makes a profit of 30 * 18.6015 per Quintal. A profit of Rs.5000 A: Each unit of trading is 100 gms.500 3.500 2. This means he has a long position in 200 gms of gold. The unit of trading is 11 bales and each contract is for delivery of 55 bales.6020 per Quintal at the beginning of the day. He bought 3000 trading units at Rs.5000 4.e •• 10 Q: A trading member took proprietary positions in a March 2004 cotton futures contract.500. The correct answer is number 1.5610 3.5610 2.7 * 10 = Rs.5610. The settlement price at the end of the day was Rs. So he makes a profit of 20 × 200 = Rs. Long 5400 units 4. The unit of trading is 100 gms and each contract is for delivery of one kg of gold. AlossofRs. He has bought two units. the trading member has a long open position in 600 trading units.4 Margining at NCDEX 133 Q: A cotton trader bought ten one-month.7 Quintals. The correct answer is number 4.6025 per 10 gms. Long 3000 units 2. • • Q: A gold merchant bought two units of one-month gold futures contracts at Rs. AprofitofRs. He makes a profit of Rs. The trader's MTM account will show 1.6000 per Quintal and sold 2400 at Rs. i. What is the outstanding position on which he would be margined? 1. AprofitofRs. The trader's MTM account will show 1. Rs. A loss of Rs. Short 2400 units 3. AlossofRs.500.6000 per 10 gms at the beginning of the day.9. Long 600 units A: After netting.
6000 per Quintal and sold 2400 at Rs. (600 + 2000 +1000).1500) + 1000). i. and on account of client B. (3000 + (2000 . 3000 units 2. i. What is the outstanding position on which he would be margined? 1. The correct answer is number 3. the trading member has a proprietary open position in 600 trading units. On his proprietary account. 3600 units 4.6000 per 10 gms. What is the outstanding position on which he would be margined? 1. 3600 units 4.6020 per 10 gms.e. he bought 3000 trading units at Rs. he bought 3000 trading units at Rs. he sold 1000 trading units at Rs. On account of client A. 3000 units 2. 4500 units 3. he bought 2000 trading units at Rs.6012 per Quintal.6015 per Quintal. •• . 7500 units 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.134 Clearing and settlement Q: A trading member has proprietary and client positions in a March cotton futures contract.e. The correct answer is number 2. and on account of client B. •• Q: A trading member has proprietary and client positions in a April 2004 gold futures contract.5990 per Quintal.6012 per 10 gms and sold 1500 units at Rs. 8400 units 3. He would be margined on a net basis at the proprietary level and on a gross basis across clients. 1600 units A: After netting. he bought 2000 trading units at Rs. On account of client A. On his proprietary account. he sold 1000 trading units at Rs.5990 per 10 gms.
to ensure that futures prices are truly aligned with the prospective demand and supply conditions) and to protect and promote interest of customers/ non-members. It prescribes the following regulatory measures: .Chapter 10 Regulatory framework At present. In the absence of regulation. The resultant financial crisis in a futures market could create systematic risk. 1952. Forward Commission (Regulation) Act and various other legislations. Contracts Act. Regulation is also needed to ensure that the market has appropriate risk management system. unscrupulous participants could use these leveraged contracts for manipulating prices. settlement and management of the exchange so as to protect and promote the interest of various stakeholders. there are three tiers of regulations of forward/futures trading system in India. Forward Markets Commission(FMC) and commodity exchanges. thereby affecting interests of society at large. clearing. Stamp Act. particularly nonmember users of the market. they are subjected to various laws of the land like the Companies Act. Proper regulation is needed to create competitive conditions. market integrity (i. Under the Forward Contracts (Regulation) Act. This could have undesirable influence on the spot prices.. which are granted recognition by the central government (Department of Consumer Affairs. namely. Forward Markets Commission provides regulatory oversight in order to ensure financial integrity (i. All the exchanges.e. which impinge on their working. a major default could create a chain reaction. to prevent systematic risk of default by one major operator or group of operators). forward trading in commodities notified under section 15 of the Act can be conducted only on the exchanges. which deal with forward contracts. are required to obtain certificate of registration from the FMC. Ministry of Consumer Affairs. government of India. 10. In the absence of such a system.1 Rules governing commodity derivatives exchanges The trading of commodity derivatives on the NCDEX is regulated by Forward Markets Commission(FMC). Food and Public Distribution). The need for regulation arises on account of the fact that the benefits of futures markets accrue in competitive conditions. Regulation is also needed to ensure fairness and transparency in trading. Besides.e.
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. Limit on net open position as on the close of the trading hours. The FMC has also prescribed simultaneous reporting system for the exchanges following open out-cry system. and in some cases. 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. to ascertain the situation on the ground. 4. 10. The website of the commission also has a provision for the customers to make complaint and send comments and suggestions to the FMC. these have been divided into two main divisions pertaining to trading and clearing. except when a written consent is taken within three days time. also memberwise. The detailed bye laws. Skipping trading in certain derivatives of the contract. 3.1 Trading The NCDEX provides an automated trading facility in all the commodities admitted for dealings on the spot market and derivative market. By making further purchases/sales relatively costly. The FMC has also mandated all the exchanges following open outcry system to display at a prominent place in exchange premises.C(R) Act provides that a client's position cannot be appropriated by the member of the exchange. This measure is imposed only on the request of the exchange. For the sake of convenience. clearing and settlement. exchanges are governed by its own rules and bye laws(approved by the FMC). These steps facilitate audit trail and make it difficult for the members to indulge in malpractices like trading ahead of clients. In this section we have brief look at the important regulations that govern NCDEX. the F. whenever they visit exchanges. 2. The FMC is persuading increasing number of exchanges to switch over to electronic trading. The limit is imposed operator-wise.136 Regulatory framework 1. rules and regulations are available on the NCDEX home page. 10. Trading on the exchange is allowed only through . instead of merely attending meetings of the board of directors and holding discussions with the office-bearers. address. 5. which is more customer-friendly. Circuit-filters or limit on price fluctuations to allow cooling of market in the event of abrupt upswing or downswing in prices.2 Rules governing intermediaries In addition to the provisions of the Forward Contracts (Regulation) Act 1952 and rules framed thereunder. etc. closing the market for a specified period and even closing out the contract: These extreme measures are taken only in emergency situations. the name.2. the price rise or fall is sobered down. telephone number of the officer of the commission who can be contacted for any grievance. Some times limit is also imposed on intra-day net open position. This measure is also imposed on the request of the exchanges. Officers of the FMC have been instructed to meet the members and clients on a random basis. Besides these regulatory measures.
Trading days The exchange operates on all days except Saturday and Sunday and on holidays that it declares from time to time. These are stored by the system but get traded only once the market opens for trading on the following working day. trading members are provided a facility to place orders off-line i. 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. He does not have any title rights or interest whatsoever with respect to trading system. other than individuals or sole proprietorships. 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.e. Approved user shall be required to change his password at the end of the password expiry period. Any trade or transaction done by use of password of any approved user of the trading member. the member will install and use equipment and software as specified by the exchange at his own cost. In case of trading members. software and the information provided by the trading system. Each approved user is given a unique identification number through which he will have access to the trading system. 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. such certification program has to be passed by at least one of their directors/ employees/ partners / members of governing body. outside trading hours. For the purpose of accessing the trading system. which has been prescribed by the exchange. The cost of the equipment and software supplied by the exchange. The exchange has the right to inspect equipment and software used for the purposes of accessing the trading system at any time. installation and maintenance of the equipment is borne by the trading member. . Other than the regular trading hours. as may be specified by the relevant authority) from time to time • Authorised persons • Approved users Trading members have to pass a certification program. Each trading member is permitted to appoint a certain number of approved users as notified from time to time by the exchange.10. The trading member or its approved users are required to maintain complete secrecy of its password. The appointment of approved users is subject to the terms and conditions prescribed by the exchange. Trading members and users Trading members are entitled to appoint. An approved user can access the trading system through a password and can change the password from time to time. its facilities. (subject to such terms and conditions. will be binding on such trading member.2 Rules governing intermediaries 137 approved workstation(s) located at locations for the offlce(s) of a trading member as approved by the exchange.
The contract expiration period will not exceed twelve months or as the exchange may specify from time to time. position limits in respect of each commodity etc. Every trading member is required to specify the buy or sell orders as either an open order or a close order for derivatives contracts. Members can place orders on the trading system during these sessions. the exchange can at its discretion undertake to carry out on behalf of the trading member the necessary functions which the trading member is eligible for. Trading parameters The exchange from time to time specifies various trading parameters relating to the trading system. Only requests made in writing in a clear and precise manner by the trading member would be considered. Failure of trading member terminal In the event of failure of trading members workstation and/ or the loss of access to the trading system. rules and regulations. price steps in which orders shall be entered on the trading system. 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. Trading cycle for each commodity/ derivative contract has a standard period. within the regulations prescribed by the exchange as per these bye laws. the exchange can extend or reduce the trading hours by notifying the members. The exchange specifies the minimum disclosed quantity for orders that will be allowed for each commodity/ derivatives contract. In case necessary. This is notified by the exchange in advance.138 Regulatory framework The types of order books. Contract expiration Derivatives contracts expire on a pre-determined date and time up to which the contract is available for trading. from time to time. 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. It also prescribes the number of days after which Good Till Cancelled orders will be cancelled by the system. price limits. It specifies parameters like lot size in which orders can be placed. during which it will be available for trading. The trading member is accountable for the functions executed by the exchange on its behalf and has to indemnity the exchange against any losses or costs incurred by the exchange. Trading hours and trading cycle The exchange announces the normal trading hours/ open period in advance from time to time. . trade books.
2 Rules governing intermediaries 139 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. The exchange can impose upon any particular trading member or category of trading member any special or other margin requirement. The margin is charged so as to cover oneday loss that can be encountered on the position on 99% of the days. The exchange prescribes from time to time the commodities/ derivative contracts. 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. has to deposit a margin with exchange authorities. Trades generated on the system are irrevocable and 'locked in'. 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. which are likely to have effect of artificially. Additional margins may be levied for deliverable positions. the settlement periods and trade types for which margin would be attracted. The exchange specifies from time to time the market types and the manner if any. raising or depressing the prices of spot/ derivatives contracts. After the pay-out. deal in derivatives contracts in a fraudulent manner. in which trade cancellation can be effected. The margin has to be deposited with the exchange within the time notified by the exchange. The procedure for refund/ adjustment of margins is also specified by the exchange from time to time. every clearing member. On failure to deposit margin/s as required under this clause. the clearing house releases all margins. Unfair trading practices No trading member should buy. in respect of the trades in which he is party to. 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. take part either directly or indirectly in transactions. or indulge in any unfair trade practices including market manipulation.10. Where a trade cancellation is permitted and trading member wishes to cancel a trade. on the basis of VaR from the expiry of the contract till the actual settlement date plus a mark-up for default. 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. sell. it can be done only with the approval of the exchange. This includes the following: • Effect. The exchange also prescribes categories of securities that would be eligible for a margin deposit. Margin requirements Subject to the provisions as contained in the exchange bye-laws and such other regulations as may be in force. . as well as the method of valuation and amount of securities that would be required to be deposited against the margin amount. the exchange/clearing house can withdraw the trading facility of the trading member.
On the expiry date. accounts and records for the purpose of market manipulation. • Indulge in falsification of his books. • Delay the transfer of commodities in the name of the transferee. which are not genuine. which is calculated to create a false or misleading appearance of trading. bye laws and rules of the exchange. based on the available information. Delivery Delivery can be done either through the clearing house or outside the clearing house. After completion of the . the trading members/ clearing members have to give delivery information as prescribed by the exchange from time to time. Matching done is binding on the clearing members. execute a transaction with a constituent at a price other than the price at which it was executed on the exchange. 10. the deals have to be settled as per the settlement calendar applicable for such deals. commodities already deposited and dematerialized and offered for delivery and any other factor as may be specified by the exchange from time to time. the exchange provides a window on the trading system to submit delivery information for all open positions. on the basis of locations and then randomly keeping in view the factors such as available capacity of the vault/ warehouse. 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. resulting in reflection of prices. • Buy. during the trading hours.2 Clearing As mentioned earlier. If a trading member/ clearing member fails to submit such information during the trading hours on the expiry date for the contract.2. 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. in cash together with penalty as stipulated by the exchange.140 Regulatory framework • Indulge in any act. If the last trading day as specified in the respective commodity contract is a holiday. After the trading hours on the expiry date. • When acting as an agent. the last trading day is taken to be the previous working day of exchange.firstly. Last day of trading Last trading day for a derivative contract in any commodity is the date as specified in the respective commodity contract. On the expiry date of contracts. the matching for deliveries takes place . • 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.
fees. the exchange closes out the derivatives contracts and imposes penalties on the defaulting buyer or seller. however the seller is entitled to recover from the buyer. taxes. as the case may be. the sales tax and other taxes levied under the local state sales tax law to the extent permitted by law. Unmatched positions have to be settled in cash. The clearing members are allowed to deliver their obligations before the pay in date as per applicable settlement calendar. All matched and unmatched positions are settled in accordance with the applicable settlement calendar. In no event is the exchange/ clearing house liable for payment of sales tax/ VAT or any other local tax.10. Penalties for defaults In the event of a default by the seller or the buyer in delivery of commodities or payment of the price. clearing members are informed of the deliverable / receivable positions and the unmatched positions. The settlement for the defaults in delivery is to be done in cash within the period as prescribed by the exchange at the highest price from the last trading date till the final settlement date with a mark up thereon as may be decided from time to time. 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. as the case may be. whereby the clearing house can reduce the margin requirement to that extent. Procedure for payment of sales tax/VAT The exchange prescribes procedure for payment of sales tax/VAT or any other state/local/central tax/fee applicable to the deals culminating into sale with physical delivery of commodities. The cash settlement is only for the incremental gain/ loss as determined on the basis of the final settlement price. are registered with sales tax authorities of all such states in which the exchange has a delivery center for a particular commodity in which constituent has or is expected to have open positions. along with other details required by the exchange. It can also use the margins deposited by such clearing member to recover the loss. If the information provided by the buyer/ seller clearing members fails to match. Pay in/ Pay out for such additional obligations is settled on the supplemental settlement date as specified in the settlement calendar. levies etc.2 Rules governing intermediaries 141 matching process. government levies/ fees if any. sales tax. who intend to take or give delivery of commodity. All members have to ensure that their respective constituents. The exchange however. then the open position would be settled in cash together with penalty as may be stipulated by the exchange. The seller is responsible for payment of sales tax/VAT. The exchange specifies the parameters and methodology for premium/ discount. They have to mention their preferred identified counter-party and the deliverable quantity. is not be responsible or liable for such settlements or any consequence of such alternate mode of settlements. . from time to time for the quality/ quantity differential. Members have to maintain records/details of sales tax registration of each of such constituent and furnish the same to the exchange as and when required.
On acceptance. For the depository. confirms the deposit of such commodity to the depository for giving credit to the demat account of the said constituent. commodities. the delivery of the commodity upon expiry of validity date is not considered as a good delivery. .142 Process of dematerialization Regulatory framework Dematerialization refers to issue of an electronic credit. the vault issues an acknowledgement to the constituent and sends confirmation in the requisite format to the R & T agent who upon verification. In case of precious metals. the commodity must be accompanied with the assayers' certificate. The vault/warehouse on receipt of such authorisation releases the commodity to the constituent or constituent's authorised person upon verifying the identity. In case of commodities (other than precious metals) the constituent delivers the commodity to the exchange-approved warehouses. Validity date In case of commodities having validity date assigned to it by the approved assayer. Process of rematerialisation Re-materialization refers to issue of physical delivery against the credit in the demat account of the constituent. to the depositor against the deposit of commodity. 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 commodity brought by the constituent is checked for the quality by the exchange-approved assayers before the deposit of the same is accepted by the warehouse. 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. the warehouse accepts the commodity and sends confirmation in the requisite format to the R & T agent who upon verification. Any person (a constituent) seeking to dematerialize a commodity has to open an account with an approved depository participant (DP). confirms the deposit of such precious metal to the depository for giving credit to the demat account of the said constituent. The vault accepts the precious metal. If the quality of the commodity is as per the norms defined and notified by the exchange from time to time. The exchange provides the list of approved DPs from time to time. The clearing member has to ensure that his concerned constituent removes the commodities on or before the expiry of validity date for such commodities. after verifying the contents of assayers certificate with the precious metal being deposited. are moved out of the electronic deliverable quantity. Such commodities are suspended from delivery. instead of a vault/ warehouse receipt. which have reached the trading validity date.
Settlement obligations statements for PCMs: The exchange/ clearing house generates and provides to each professional clearing member.10. The settlement obligation statement is deemed to have been confirmed by the said clearing member in respect of every and all obligations enlisted therein. the details of the corresponding buying/ selling constituent and such other details. 2. 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 pay-in and payout days and the scheduled time to be observed in connection with the clearing and settlement operations of deals in commodities/ futures contracts. Settlement obligations statements for TCMs: The exchange generates and provides to each trading clearing member. 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. 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. shall be offset by process of netting to arrive at net obligations. On respective pay-in day.2 Rules governing intermediaries 143 Delivery through the depository clearing system Delivery in respect of all deals for the clearing in commodities happens through the depository clearing system. 1. Clearing and settlement process The relevant authority from time to time fixes the various clearing days. the exchange generates delivery statement and receipt statement for each clearing member. The delivery and receipt statements are deemed to be confirmed by respective member to deliver and receive on account of his constituent. The delivery through the depository clearing system into the account of the buyer with the depository participant is deemed to be delivery. Delivery of commodities Based on the settlement obligations statements. Delivery has to be made in terms of the delivery units notified by the exchange. The delivery and receipt statement contains details of commodities to be delivered to and received from other clearing members. commodities as specified in the delivery and receipt statements. . clearing members effect depository delivery in the depository clearing system as per delivery statement in respect of depository deals. notwithstanding that the commodities are located in the warehouse along with the commodities of other constituents. Provided however that the deals of sales and purchase executed between different constituents of the same clearing member in the same settlement. Payment through the clearing bank Payment in respect of all deals for the clearing has to be made through the clearing bank(s).
we define the following: • Arbitrator means a sole arbitrator or a panel of arbitrators. proper courts within the area covered under the respective regional arbitration center have jurisdiction in respect of the arbitration proceedings falling/ conducted in that regional arbitration center. 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. arbitration In matters where the exchange is a party to the dispute. Depository clearing system The exchange specifies depository(ies) through which depository delivery can be effected and which shall act as agents for settlement of depository deals. Delivery units The exchange specifies from time to time the delivery units for all commodities admitted to dealings on the exchange. The clearing member cannot operate the clearing account for any other purpose. Clearing members are required to authorise the specified depositories and depository participants with whom they have a clearing account to access their clearing account for debiting and crediting their accounts as per instructions received from the exchange and to report balances and other credit information to the exchange. for the collection of margins by way of securities for all deals entered into through the exchange.3 Rules governing investor grievances. 10. For the purpose of clarity. whether or not there is a claim against such person. the civil courts at Mumbai have exclusive jurisdiction and in all other matters. for any other commodities movement and transfer in a depository(ies) between clearing members and the exchange and between clearing member to clearing member as may be directed by the relevant authority from time to time. which are to be received by a clearing member. Electronic delivery is available for trading before expiry of the validity date. . Every clearing member must have a clearing account with any of the Depository Participants of specified depositories.144 Regulatory framework Commodities. • Respondent means the person against whom the applicant lodges an arbitration application. for the collection of margins by way of commodities for deals entered into through the exchange. 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. Clearing Members operate the clearing account only for the purpose of settlement of depository deals entered through the exchange.
The statement of accounts. difference or dispute are to be referred to a panel of three arbitrators. Upon receipt of Form No. arbitration 145 If the value of claim. 2. the exchange forwards a copy of the statement of case and related documents to the respondent. If the value of the claim. then the arbitrator is appointed in the manner as specified in the regulation. 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. However. Copies of the relevant contract notes. 4.constituent agreement.I/IA. the exchange returns the deficient/ defective application to the applicant. to whom such agent of the member is affiliated. II/IIA containing list of names of the persons eligible to act as arbitrators. difference or dispute is up to Rs.25 Lakh on the date of application. the member. If the respondent fails to submit Form n/HA within the time period prescribed by the exchange. If the applicant fails to rectify the deficiency/ defect within the prescribed period.25 Lakh.3. The respondent then has to submit Form H/HA to the exchange within 7 days from the date of receipt. The respondent(s) should within 15 days from the date of receipt .1 Procedure for arbitration The applicant has to submit to the exchange application for arbitration in the specified form (Form No.10. 2. in such claim. Copies of member . The Applicant has to also submit to the exchange the following along with the arbitration form: 1. I/IA) along with the following enclosures: 1.3 Rules governing investor grievances. The statement of case (containing all the relevant facts about the dispute and relief sought). Form No. then such claim. Where any claim. 2. The date of receipt of communication of warehouse refusing to transfer the commodities in favour of the constituent. If any deficiency/ defect in the application is found. then they are to be referred to a sole arbitrator. which will be considered as a fresh application for all purposes and dealt with accordingly. is impeded as a party. the applicant has the right to file a revised application. 10. A cheque/ pay order/ demand draft for the deposit payable at the seat of arbitration in favour of National Commodity & Derivatives Exchange Limited. 3. difference or dispute arises between agent of the member and client of the agent of the member. the date of dispute is deemed to have arisen on 1. difference or dispute. whichever is later. The date of expiry of 5 days from the date of lodgment of dematerialized request by the constituent for transfer with the seller. In case the warehouse refuses or fails to communicate to the constituent the transfer of commodities. invoice and delivery challan. difference or dispute is more than Rs.
ni/IIIA If the respondent fails to submit Form III/niA within the prescribed time. In such a case the arbitrator proceeds to decide the matter on the basis of documents submitted by both the parties provided. submit to the exchange. waive the notice. then the arbitrator records the settlement in the form of an arbitral award on agreed terms. All fees and charges relating to the appointment of the arbitrator and conduct of arbitration proceedings are to borne by the parties to the reference equally or in such proportions as may be decided by the arbitrator. The applicant should within ten days from the date of receipt of copy of Form III/TIIA. if any. I/IA from the exchange. If the value of claim. which may have been raised by the respondent in its reply to the applicant. Notice for the first hearing is given at least ten days in advance. are awarded to either of the party in addition to the fees and charges. by their mutual consent.146 Regulatory framework of Form No. unless the parties. If after the appointment of an arbitrator. the arbitrator offers to hear the parties to the dispute unless both parties waive their right for such hearing in writing. if any. 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.25. Upon receiving Form No. the time and place of subsequent hearings of which the exchange gives a notice to the parties concerned. UMIIA from the respondent the exchange forwards one copy to the applicant. However the arbitrator for reasons to be recorded in writing may hear both the parties to the dispute. . The arbitrator determines the date. The costs. then the arbitrator can proceed with the arbitral proceedings and make the award ex-parte. • Copies of the relevant contract notes. IH/IIIA three copies in case of sole arbitrator and five copies in case of panel of arbitrators along with the following enclosures: • The statement of reply (containing all available defences to the claim) • The statement of accounts • Copies of the member constituent agreement. The exchange then forwards the reply to the respondent.000 or less. submit to the exchange in Form No.2 Hearings and arbitral award No hearing is required to be given to the parties to the dispute if the value of the claim difference or dispute is Rs. 10. as decided by the arbitrator. The exchange in consultation with the arbitrator determines the date. the time and place of the first hearing. a reply to any counterclaim. the parties settle the dispute.25. difference or dispute is more than Rs.3. invoice and delivery challan • 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.000.
Forward Markets Commission(FMC) A: The correct answer is number 4. Which of the following is not a measure prescribed? 1.10. Commodity exchanges 4. the civil courts at_______have exclusive jurisdiction. the FMC prescribes certain regulatory measures. Q: All the exchanges. are required to obtain certificate of registration from the 1. 3. Special margin deposits. 4. Commodity board of trading •• 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. bid order or ask order •• Q: In matters where the NCDEX is a party to the dispute. Delhi 2. call order or put order A: The correct answer is number 1. 3. arbitration 147 Solved Problems Q: Which of the following is not involved in regulating forward/futures trading system in India? 1. Commodity board of trading •• 3. Ahmedabad 4. Price determination •• 3. Q: To ensure financial integrity and market integrity. Circuit-filters or limit on price fluctuations. 1.3 Rules governing investor grievances. Forward Markets Commission(FMC) A: The correct answer is number 2. Limit on net open positions. 1. which deal with forward contracts. Open order or close order 2. Mumbai A: The correct answer is number 2. A: The correct answer is number 4. Government of India 2. 3. Calcutta •• . Government of India 2. take order or give order 4. 2. Commodity exchanges 4.
Warehouse •• 18.104.22.168. Rs. Rs. Respondent 2.000 2. the exchange in consultation with the_ determines the date. 3. Rs. Q: In the case of an arbitration. 1.000 4. Arbitrator 4.000 •• .000 A: The correct answer is number 1.00. 1. Rs. the _ time and place of the first hearing. Applicant A: The correct answer is number 3. 1.10.000 or less.148 Regulatory framework 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.
there is no liability for payment of sales tax. • It is the responsibility of the selling constituent to comply with the relevant local state sales tax laws and other local enactments. also provide for levy of additional tax. In many states. The present understanding of the implications are given below for reference. there would be liability for payment of sales tax. 4. Complying with any check-post regulations prescribed under the local sales tax. etc. The selling constituent will be responsible for the following: 1. • If the futures contract is closed out and settled between the constituents prior to the settlement date without actually buying or selling the commodities. In the case of settlements culminating into delivery. the sales tax laws.. Obtaining registration under the relevant state sales tax laws. payment of taxes and due compliance of laws. filing of returns. sales tax at the rates applicable in the state where the delivery center is located will be payable. The fact that delivery could happen across various states. entry tax or other municipal laws and ensuring that the prescribed documents accompany the goods. resale tax. and these states have different sales tax rules. 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. when the commodities are brought into the designated local area for lodging the same with the warehouse. turnover tax. which may or may not be recoverable from the buyer depending on the provisions of the local state sales tax law. octroi. Payment of entry tax.Chapter 11 Implications of sales tax The physical settlement in the case of commodities futures contracts involves issues concerned with sales tax. 2. • When the futures contract fructifies into a sale and culminates into delivery. 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. • 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. Liability for central sales tax if the commodities are moved from outside the state pursuant to a transaction of sale. makes the issue a little complicated. . 3. etc.
150 Implications of sales tax 5. 3. Obtaining registration under the relevant state sales tax laws based on the purchase of commodities. Sale A: The correct answer is number 3. • It is the responsibility of the buying constituent to comply with the applicable local state sales tax laws and other local enactments. 1. Buyer 4. Buyer A: The correct answer is number 4. Furnishing of duly completed declaration forms and certificates prescribed under the local sales tax. filing of returns. entry tax or other municipal laws to enable the buyer to avail of exemption or deduction as provided in the relevant laws. declaration forms and certificates prescribed under the local sales tax. payment of taxes and due compliance of laws. Clearing corporation 2. Seller •• Q: It is the responsibility of the___to comply with the relevant local state sales tax laws and other local enactments. 3. Warehouse 2. Exchange •• 3. Q: The issue of paying sales tax arises only when the futures contracts fructifies into a sale and culminates into_____of the underlying. The buying constituent will be responsible for the following: 1. Buyer and seller •• . 6. Warehouse A: The correct answer is number 2. entry tax or other municipal laws to enable the seller to avail of exemption or deduction as provided in the relevant laws. 1. 2. Furnishing of duly completed sales invoices. The selling constituent may move the commodities into the warehouse well in advance and ensure compliance of provisions of law. 1. Seller 4. the payment of sales tax is to be done in the state in which the___is situated. Delivery 4. Payment 2. Solved Problems Q: When the futures contract fructifies into a sale and culminates into delivery.
in . futures and other derivatives by John Hull. Derivative markets in India 2003 edited by Susan Thomas. Dubofsky. Kolb. Options.gov. Rubinstein on derivatives by Mark Rubinstein. http://www. Whaley Futures and options in risk management by Terry J.ncdex.151 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.Stoll and Robert E. options and swaps by Robert W. Watsham.com http://fmc. Futures. Introduction to futures and options markets by John Kolb Options and financial future: Valuation and uses by David A. • • • • • • • • • • • • Derivatives FAQ by Ajay Shah and Susan Thomas Escape to the futures by Leo Melamed Futures and options by Hans R.
10 assignment. 61 stock. 61 premium. 61 time value. 61 buyer. 61 european. 14 cost of carry. 77 hedge long. 61 call. 60 cost-of-carry. 10 spot price. 67 put.Index arbitragers. 57 futures. 105 price limit. 60 MTM. 60 baskets. 12 warrants. 60 option american. 13 forwards. 14 commodity. 76 delivery. 14 transaction forward. 68 margin initial. 12 spot. 10 long call. 106 settlement physical. 61 order day. 14 interest rate. 14 swaptions. 62 writer. 66 put. 104 GTC. 61 put. 61 in-the-money. 105 GTD. 19 derivatives exchange traded. 18 basis. 87 short. 17 short call. 60 maintenance. 14 currency. 62 out-of-money. 106 trigger. 105 stop-loss. 61 at-the-money. 14 . 69 speculators. 13 OTC. 61 intrinsic value. 105 IOC. 61 index. 60 swaps. 86 hedgers.
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