AHL-IILM-CMS

Commodity Future Market

Financial Derivatives and Financial Engineering

Hitesh, Hunish, Rohit 10/25/2010

Commodity derivatives

Derivatives as a tool for managing risk first originated in the commodities markets. They were then found useful as a hedging tool in financial markets as well. In India, trading in commodity futures has been in existence from the nineteenth century with organised trading in cotton through the establishment of Cotton Trade Association in 1875. Over a period of time, other commodities were permitted to be traded in futures exchanges. Regulatory constraints in 1960s resulted in virtual dismantling of the commodities future markets. It is only in the last decade that commodity future exchange have been actively encouraged. However, the markets have been thin with poor liquidity and have not grown to any significant level. In this chapter we look at how commodity derivatives differ from financial derivatives. We also have a brief look at the global commodity markets and the commodity markets that exist in India.

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. However there are some features which are very peculiar to commodity derivative markets. In the case of financial derivatives, most of these contracts are cash settled. Even in the case of physical settlement, financial assets are not bulky and do not need special facility for storage. Due to the bulky nature of the underlying assets, physical settlement in commodity derivatives creates the need for warehousing. Similarly, the concept of varying quality of asset does not really exist as far as financial underlyings are concerned. However in the case of commodities, the quality of the asset underlying a contract can vary largely. This becomes an important issue to be managed. We have a brief look at these issues.

Physical settlement
Physical settlement involves the physical delivery of the underlying commodity, typically at an accredited warehouse. The seller intending to make delivery would have to take the commodities to the designated warehouse and the buyer intending to take delivery would have to go to the designated warehouse and pick up the commodity. This may sound simple, but the physical.

Commodity derivatives
Settlement of commodities is a complex process. The issues faced in physical settlement are enormous. There are limits on storage facilities in different states. There are restrictions on interstate movement of commodities. Besides state level octroi and duties have an impact on the cost of movement of goods across locations. The process of taking physical delivery in commodities is quite different from the process of taking physical delivery in financial assets. We take a general overview at the process flow of physical settlement of commodities. Later on we will look into details of how physical settlement happens on the NCDEX.

Delivery notice period

Unlike in the case of equity futures, typically a seller of commodity futures has the option to give notice of delivery. This option is given during a period identified as 'delivery notice period'. Such contracts are then assigned to a buyer, in a manner similar to the assignments to a seller in an options market. However what is interesting and different from a typical options exercise is that in the commodities market, both positions can still be closed out before expiry of the contract. The intention of this notice is to allow verification of delivery and to give adequate notice to the buyer of a possible requirement to take delivery. These are required by virtue of the fact that the

actual physical settlement of commodities requires preparation from both delivering and receiving members. Typically, in all commodity exchanges, delivery notice is required to be supported by a warehouse receipt. The warehouse receipt is the proof for the quantity and quality of commodities being delivered. Some exchanges have certified laboratories for verifying the quality of goods. In these exchanges the seller has to produce a verification report from these laboratories along with delivery notice. Some exchanges like LIFFE, accept warehouse receipts as quality verification documents while others like BMF-Brazil have independent grading and classification agency to verify the quality. 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,

including fiscal debts related to the stored goods. A provisional delivery order of the good to BM&F (Brazil), issued by the

warehouse.

been paid.

A warehouse certificate showing that storage and regular insurance have

Assignment
Whenever delivery notices are given by the seller, the clearing house of the exchange identifies the buyer to whom this notice may be assigned. Exchanges follow different practices for the assignment process. One approach is to display the delivery notice and allow buyers wishing to take delivery to bid for taking delivery. Among the international exchanges, BMF, CBOT and CME display delivery notices. Alternatively, the clearing houses may assign deliveries to buyers on some basis.

Exchanges such as COMMEX and the Indian commodities exchanges have adopted this method.

Difference between commodity and financial derivatives

Any seller/ buyer who has given intention to deliver/ been assigned a delivery has an option to square off positions till the market close of the day of delivery notice. After the close of trading, exchanges assign the delivery intentions to open long positions. Assignment is done typically either on random basis or first-in-first out basis. In some exchanges (CME), the buyer has the option to give his preference for delivery location. The clearing house decides on the daily delivery order rate at which delivery will be settled. Delivery rate depends on the spot rate of the underlying adjusted for discount/ premium for quality and freight costs. The discount/ premium for quality and freight costs are published by the clearing house before introduction of the contract. The most active spot market is normally taken as the benchmark for deciding spot prices. Alternatively, the delivery rate is determined based on the previous day closing rate for the contract or the closing rate for the day.

Delivery
After the assignment process, clearing house/ exchange issues a delivery order to the buyer. The exchange also informs the respective warehouse about the identity of the buyer. The buyer is required to deposit a certain percentage of the contract amount with the clearing house as margin against the warehouse receipt. The period available for the buyer to take physical delivery is stipulated by the exchange. Buyer or his authorised representative in the presence of seller or his

representative takes the physical stocks against the delivery order. Proof of physical delivery have been affected is forwarded by the seller to the clearing house and the invoice amount is credited to the seller's account. In India if a seller does not give notice of delivery then at the expiry of the contract the positions are cash settled by price difference exactly as in cash settled equity futures contracts. 2.1.2 Warehousing One of the main differences between financial and commodity derivative is the need for warehousing. In case of most exchange-traded financial derivatives, all the positions are cash settled. Cash settlement involves paying up the difference in prices between the time the contract was entered into and the time the contract was closed. For instance, if a trader buys futures on a stock at Rs.100 and on the day of expiration, the futures on that stock close Rs.120, he does not really have to buy the underlying stock. All he does is take the difference of Rs.20 in cash. Similarly the person, who sold this futures contract at Rs.100, does not have to deliver the underlying stock. All he has to do is pay up the loss of Rs.20 in cash. In case of commodity derivatives however, there is a possibility of physical settlement. This means that if the seller chooses to hand over the commodity instead of the difference in cash, the buyer must take physical delivery of the underlying asset. This requires the exchange to make an arrangement with warehouses to handle the settlements. The efficacy of the commodities settlements depends on the warehousing system available. Most international commodity exchanges used certified warehouses (CWH) for the purpose of handling physical settlements. Such CWH are required to provide storage facilities for participants in the commodities markets.

Commodity derivatives The New York Cotton Exchange has specified the asset in its orange juice futures contract as "U.S Grade A, with Brix value of not less than 57 degrees, having a Brix value to acid ratio of not less than 13 to 1 nor more than 19 to 1, with factors of color and flavour each scoring 37 points or higher and 19 for defects, with a minimum score 94". The Chicago Mercantile Exchange in its random-length lumber futures contract has specified that "Each delivery unit shall consist of nominal 'i y- is of random lengths from 8 feet to 20 feet, grade-stamped Construction Standard, Standard and Better, or #1 and #2; however, in no case may the quantity of Standard grade or #2 exceed 50%. Each deliver unit shall be manufactured in California, Idaho, Montana, Nevada, Oregon, Washington, Wyoming, or Alberta or British Columbia, Canada, and contain lumber produced from grade-stamped Alpine fir, Englemann spruce, hem-fir, lodgepole pine, and/ or spruce pine fir". The advantage of this system is that a warehouse receipt becomes a good collateral, not just for settlement of exchange trades but also for other purposes too. In India, the warehousing system is not as efficient as it is in some of the other developed markets. Central and state government controlled warehouses are the major providers of agri-produce storage facilities. Apart from these, there are a few private warehousing being maintained. However there is no clear regulatory oversight of warehousing services. 2.1.3 Quality of underlying assets A derivatives contract is written on a given underlying. Variance in quality is not an issue in case of financial derivatives as the physical attribute is missing. When the underlying asset is a commodity, the quality of the underlying asset is of prime

importance. There may be quite some variation in the quality of what is available in the marketplace. When the asset is specified, it is therefore important that the exchange stipulate the grade or grades of the commodity that are acceptable. Commodity derivatives demand good standards and quality assurance/ certification procedures. A good grading system allows commodities to be traded by specification. Currently there are various agencies that are responsible for specifying grades for commodities. For example, the Bureau of Indian Standards (BIS) under Ministry of Consumer Affairs 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 are other agencies like EIA, which specify standards for export oriented commodities.

Global commodities derivatives exchanges

Globally commodities derivatives exchanges have existed for a long time. Table 2.1 gives a list of commodities exchanges across the world. The CBOT and CME are two of the oldest derivatives.

Table 2.1 The global derivatives industry Country United States of America Exchange Chicago Board of Trade (CBOT) Chicago Mercantile Exchange New York Cotton Exchange New York Mercantile Exchange New York Board of Trade Canada Brazil Australia People's Republic Of China Hong Kong Japan The Winnipeg Commodity Exchange Brazilian Futures Exchange Commodities and Futures Exchange Sydney Futures Exchange Ltd. Beijing Commodity Exchange Shanghai Metal Exchange Hong Kong Futures Exchange Tokyo International Financial Futures Exchange Kansai Agricultural Commodities Exchange Tokyo Grain Exchange Malaysia New Zealand Singapore France Italy Netherlands Russia Kuala Lumpur commodity Exchange New Zealand Futures& Options Exchange Ltd. Singapore Commodity Exchange Ltd. Le Nouveau Marche MATIF Italian Derivatives Market Amsterdam Exchanges Option Traders The Russian Exchange MICEX/ Relis Online St. Petersburg Futures Exchange Spain The Spanish Options Exchange Citrus Fruit and Commodity Futures Market of Valencia United Kingdom The London International Financial Futures Options exchange The London Metal Exchange

Global Commodities derivatives exchanges

exchanges in the world. The CBOT was established in 1848 to bring farmers and merchants together. Initially its main task was to standardise the quantities and qualities of the grains that were traded. Within a few years the first futures-type contract was developed. It was know as the to-arrive contract. Speculators soon became interested in the contract and found trading in the contract to be an attractive alternative to trading the underlying grain itself. In 1919, another exchange, the CME was established. Now futures exchanges exist all over the world. On these exchanges, a wide range of commodities and financial assets form the underlying assets in

various contracts. The commodities include pork bellies, live cattle, sugar, wool, lumber, copper, aluminium, gold and tin. We look at commodity exchanges in some developing countries.

Africa
Africa's most active and important commodity exchange is the South African Futures Exchange (SAFEX). It was informally launched in 1987. SAFEX only traded financial futures and gold futures for a long time, but the creation of the Agricultural Markets Division (as of 2002, the Agricultural Derivatives Division) led to the introduction of a range of agricultural futures contracts for commodities, in which trade was liberalised, namely, white and yellow maize, bread milling wheat and sunflower seeds.

Asia
China's first commodity exchange was established in 1990 and at least forty had appeared by 1993. The main commodities traded were agricultural staples such as wheat, corn and in particularly soybeans. In late 1994, more than half of China's exchanges were closed down or reverted to being wholesale markets, while only 15 restructured exchanges received formal government approval. At the beginning of 1999, the China Securities Regulatory Committee began a nationwide consolidation process which resulted in three commodity exchanges emerging; the Dalian Commodity Exchange (DCE), the Zhengzhou Commodity Exchange and the Shanghai futures Exchange, formed in 1999 after the merger of three exchanges: Shanghai Metal, Commodity, Cereals & Oils Exchanges. The Taiwan Futures Exchange was launched in 1998. Malaysia and Singapore have active commodity futures exchanges. Malaysia hosts one futures and options exchange. Singapore is

home to the Singapore Exchange (SGX), which was formed in 1999 by the merger of two well-established exchanges, the Stock Exchange of Singapore (SES) and Singapore International Monetary Exchange (SIMEX).

Latin America
Latin America's largest commodity exchange is the Bolsa de Mercadorias & Futures, (BM&F) in Brazil. Although this exchange was only created in 1985, it was the 8th largest exchange by 2001, with 98 million contracts traded. There are also many other commodity exchanges operating in Brazil, spread throughout the country. Argentina's futures market Mercado a Termino de Buenos Aires, founded in 1909, ranks as the world's 51st largest exchange. Mexico has only recently introduced a futures exchange to its markets. The Mercado Mexicano de Derivados (Mexder) was launched in 1998.

Evolution of the commodity market in India

Bombay Cotton Trade Association Ltd., set up in 1875, was the first organised futures market. Bombay Cotton Exchange Ltd. was established in 1893 following the widespread discontent amongst leading cotton mill owners and merchants over functioning of Bombay Cotton Trade Association. The Futures trading in oilseeds started in 1900 with the establishment of the Gujarati Vyapari Mandali, which carried on futures trading in groundnut, castor seed and cotton. Futures trading in wheat was existent at several places in Punjab and Uttar Pradesh. But the most notable futures exchange for wheat was chamber of commerce at Hapur set up in 1913. Futures trading in bullion began in Mumbai in 1920. Calcutta Hessian Exchange Ltd. was established in 1919 for futures trading in rawjute and jute goods. But organised futures trading in raw jute began only in 1927 with the establishment

of East Indian Jute Association Ltd. These two associations amalgamated in 1945 to form the East India Jute & Hessian Ltd. to conduct organised trading in both Raw Jute and Jute goods. Forward Contracts (Regulation) Act was enacted in 1952 and the Forwards Markets Commission (FMC) was established in 1953 under the Ministry of Consumer Affairs and Public Distribution. In due course, several other exchanges were created in the country to trade in diverse commodities.

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

Table 2.3 Registered commodity exchanges in India Exchange Product traded Bhatinda Om & Oil Exchange Ltd. The Bombay Commodity Exchange Ltd. Gur Sunflower oil Cotton (Seed and oil) Safflower (Seed, oil and oil cake) Groundnut (Nut and oil) Castor oil, Castorseed Sesamum (Oil and oilcake) Rice bran, rice bran oil and oilcake Crude palm oil The Rajkot Seeds oil & Bullion Merchants Association, Ltd. Castorseed The Kanpur Commodity Exchange Ltd. The Meerut Agro Commodities Exchange Co. Ltd. The Spices and Oilseeds Exchange Ltd.Sangli Ahmedabad Commodities Exchange Ltd. Vijay Beopar Chamber Ltd., Muzaffarnagar India Pepper & Spice Trade Association, Kochi Rajdhani Oils and Oilseeds Exchange Ltd., Delhi Rapeseed/ Mustardseed oil and cake Gur Turmeric Cottonseed, Castorseed Gur Pepper Gur, Rapeseed/ Mustardseed Sugar Grade-M National Board of Trade, Indore Rapeseed/ Mustard seed/ Oil/ Cake Soybean/ Meal/ Oil, Crude Palm Oil The Chamber of Commerce, Hapur The East India Cotton Association, Mumbai The Central India Commercial Exchange Ltd., Gwaliar The East India Jute & Hessian Exchange Ltd., Kolkata First Commodity Exchange of India Ltd., Kochi Gur, Rapeseed/ Mustardseed Cotton Gur Hessian, Sacking Copra, Coconut oil & Copra cake Groundnut oil

The Coffee Futures Exchange India Ltd., Bangalore National Multi Commodity Exchange of India Limited, Ahmedabad

Coffee Gur, RBD Pamohen Crude Palm Oil, Copra Rapeseed/ Mustardseed, Soy bean Cotton (Seed, oil, oilcake) Safflower (seed, oil, oilcake) Groundnut (seed, oil, oilcake) Sugar, Sacking, gram Coconut (oil and oilcake) Castor (oil and oilcake) Sesamum (Seed,oil and oilcake) Linseed (seed, oil and oilcake) Rice Bran Oil, Pepper, Guarseed Aluminium ingots, Nickel, tin Vanaspati, Rubber, Copper, Zinc, lead

National Commodity & Derivatives Exchange Limited

Soy Bean, Refined Soy Oil Mustard Seed Expeller Mustard Oil RBD Palmolein Crude Palm Oil Medium Staple Cotton Long Staple Cotton

DIFFERENT TYPES OF COMMODITIES TRADED World-over one will find that a market exits for almost all the commodities known to us. These commodities can be broadly classified into the following:

DIFFERENT SEGMENTS IN COMMODITIES MARKET

The commodities market exits in two distinct forms namely the Over the Counter (OTC) market and the Exchange based market. Also, as in equities, there exists the spot and the derivatives segment. The spot markets are essentially over the counter markets and the participation is restricted to people who are involved with that commodity say the farmer, processor, wholesaler etc. Derivative trading takes

place through exchange-based markets with standardized contracts, settlements etc.

LEADING COMMODITY MARKETS OF INDIA

The government has now allowed national commodity exchanges, similar to the BSE & NSE, to come up and let them deal in commodity derivatives in an electronic trading environment. These exchanges are expected to offer a nation-wide anonymous, order driven, screen based trading system for trading. The Forward Markets Commission (FMC) will regulate these exchanges. Consequently four commodity exchanges have been approved to commence business in this regard. They are:

BENEFITS TO INDUSTRY FROM FUTURES TRADING Hedging the price risk associated with futures contractual

commitments. Spaced out purchases possible rather than large cash purchases and its storage. Efficient price discovery prevents seasonal price volatility. Greater flexibility, certainty and transparency in procuring

commodities would aid bank lending. Facilitate informed lending. Hedged positions of producers and processors would reduce the risk of default faced by banks. * Lending for agricultural sector would go up with greater transparency in pricing and storage. Commodity Exchanges to act as distribution network to retail agrifinance from Banks to rural households. Provide trading limit finance to Traders in commodities Exchanges.

BENEFITS TO EXCHANGE MEMBER Access to a huge potential market much greater than the securities and cash market in commodities.

Robust, scalable, state-of-art technology deployment. Member can trade in multiple commodities from a single point, on real time basis. Traders would be trained to be Rural Advisors and Commodity Specialists and through them multiple rural needs would be met, like bank credit, information dissemination, etc.

WHY COMMODITY FUTURES? One answer that is heard in the financial sector is "we need commodity futures markets so that we will have volumes, brokerage fees, and something to trade''. We have to look at futures market in a bigger perspective -- what is the role for commodity futures in India's economy? In India agriculture has traditionally been an area with heavy government intervention. Government intervenes by trying to maintain buffer stocks, they try to fix prices, and they have import-export restrictions and a host of other interventions. Many economists think that we could have major benefits from liberalization of the agricultural sector. In this case, the question arises about who will maintain the buffer stock, how will we smoothen the price fluctuations, how will farmers not be vulnerable that tomorrow the price will crash when the crop comes out, how will farmers get signals that in the future there will be a great need for wheat or rice. In all these aspects the futures market has a very big role to play.

If we think there will be a shortage of wheat tomorrow, the futures prices will go up today, and it will carry signals back to the farmer making sowing decisions today. In this fashion, a system of futures markets will improve cropping patterns. Next, if I am growing wheat and am worried that by the time the harvest comes out prices will go down, then I can sell my wheat on the futures market. I can sell my wheat at a price, which is fixed today, which eliminates my risk from price fluctuations. These days, agriculture requires investments -- farmers spend money on fertilizers, high yielding varieties, etc. They are worried when making these investments that by the time the crop comes out prices might have dropped, resulting in losses. Thus a farmer would like to lock in his future price and not be exposed to fluctuations in prices. The third is the role about storage. Today we have the Food Corporation of India, which is doing a huge job of storage, and it is a system, which - in my opinion -- does not work. Futures market will produce their own kind of smoothing between the present and the future. If the future price is high and the present price is low, an arbitrager will buy today and sell in the future. The converse is also true, thus if the future price is low the arbitrageur will buy in the futures market. These activities produce their own "optimal" buffer stocks, smooth prices. They also work very effectively when there is trade in agricultural commodities; arbitrageurs on the futures market will use imports and exports to smooth Indian prices using foreign spot markets. In totality, commodity futures markets are a part and parcel of a program for agricultural liberalization. Many agriculture economists understand the need of liberalization in the sector. Futures markets are an instrument for achieving that liberalization.

WHAT MAKES COMMODITY TRADING ATTRACTIVE? A good low-risk portfolio diversifier A highly liquid asset class, acting as a counterweight to stocks, bonds and real estate. Less volatile, compared with, equities and bonds.

The NCDEX System Every market transaction consists of three components i.e. trading, clearing and settlement. A brief overview of how transactions happen on the NCDEXs market.

TRADING The trading system on the NCDEX provides a fully automated screen based trading for futures on commodities on a nationwide basis as well as online monitoring and surveillance mechanism. It supports an order driven market and provides complete transparency of trading operations. Order matching is essential on the basis of commodity, its price, time and quantity. All quantity fields are in units and price in rupees. The exchange specifies the unit of trading and the delivery unit for futures contracts on various commodities. The exchange notifies the regular lot size and tick size for each of the contracts traded from time to time. When any order enters the trading system, it is an active order. It tries to finds a match on the other side of the book. If it finds a match, a trade is generated. If it does not find a match, the order becomes passive and gets queued in the respective outstanding order book in the system. Time stamping is done for each trade and provides the possibility for a complete audit trail if required. NCDEX trades commodity futures contracts having one month, two month and three month expiry cycles. All contracts expire on the

20th of the expiry month. Thus a January expiration contract would expire on the 20th of January and a February expiry contract would cease trading on the 20th of February. If the 20th of the expiry month is a trading holiday, the contracts shall expire on the previous trading day. New contracts will be introduced on the trading day following the expiry of the near month contract.

CLEARING National Securities Clearing Corporation Limited (NSCCL) undertakes clearing of trades executed on the NCDEX. The settlement guarantee fund is maintained and managed by NCDEX. Only clearing members including professional clearing members (PCMs) only are entitled to clear and settle contracts through the clearing house. At NCDEX, after the trading hours on the expiry date, based on the available information, the matching for deliveries takes place firstly, on the basis of locations and then randomly, keeping in view the factors such as available capacity of the vault/warehouse, commodities already deposited and dematerialized and offered for delivery etc. Matching done by this process is binding on the clearing members. After completion of the matching process, clearing members are informed of the deliverable/ receivable positions and the unmatched positions. Unmatched positions have to be settled in cash. The cash settlement is only for the incremental gain/loss as determined on the basis of final settlement price.

SETTLEMENT Futures contracts have two types of settlements, the MTM settlement which happens on a continuous basis at the end of each day, and the final settlement which happens on the last trading day of the futures contract. On the NCDEX, daily MTM settlement and the final MTM settlement in respect of admitted deals in futures

contracts are cash settled by debiting/crediting the clearing accounts of CMs with the respective clearing bank. All positions of a CM, brought forward, created during the day or closed out during the day, are market to market at the daily settlement price or the final settlement price at the close of trading hours on a day. On the date of expiry, the final settlement price is the spot price on the expiry day. The responsibility of settlement is on a trading cum clearing member for all trades done on his own account and his clients trades. A professional clearing member is responsible for settling all the participants trades, which he has confirmed to the exchange. On the expiry date of a futures contract, members submit delivery information through delivery request window on the trader workstations provided by NCDEX for all open positions for a commodity for all constituents individually. NCDEX on receipt of such information matches the information and arrives at delivery position for a member for a commodity. The seller intending to make delivery takes the commodities to the designated warehouse. These commodities have to be assayed by the exchange specified assayer. The commodities have to meet the contract specifications with allowed variances. If the commodities meet the specifications, the warehouse accepts them. Warehouse then ensures that the receipts get updated in the depository system giving a credit in the depositors electronic account. The seller the gives the invoice to his clearing member, who would courier the same to the buyers clearing member. On an appointed date, the buyer goes to the warehouse and takes physical possession of the commodities.