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Commodity Futures A Commodity futures is an agreement between two parties to buy or sell a specified and standardized quantity of a commodity

at a certain time in future at a price agreed upon at the time of entering into the contract on the commodity futures exchange. The need for a futures market arises mainly due to the hedging function that it can perform. Commodity markets, like any other financial instrument, involve risk associated with frequent price volatility. The loss due to price volatility can be attributed to the following reasons:

Consumer Preferences: - In the short-term, their influence on price volatility is small since it is a slow process permitting manufacturers, dealers and wholesalers to adjust their inventory in advance.

Changes in supply: - They are abrupt and unpredictable bringing about wild fluctuations in prices. This can especially noticed in agricultural commodities where the weather plays a major role in affecting the fortunes of people involved in this industry. The futures market has evolved to neutralize such risks through a mechanism; namely hedging.

The objectives of Commodity futures:  Hedging with the objective of transferring risk related to the possession of physical assets through any adverse moments in price. Liquidity and Price discovery to ensure base minimum volume in trading of a commodity through market information and demand supply factors that facilitates a regular and authentic price discovery mechanism. 

Maintaining buffer stock and better allocation of resources as it augments reduction in inventory requirement and thus the exposure to risks related with price fluctuation declines. Resources can thus be diversified for investments.

Price stabilization along with balancing demand and supply position. Futures trading leads to predictability in assessing the domestic prices, which maintains stability, thus safeguarding against any short term adverse price movements. Liquidity in Contracts of

This would make funding easier and less stringent for banks to commodity market players. a company that knows that it is due to buy an asset in the future can hedge by taking long futures position. for instance farmers. Commodity markets give opportunity for all three kinds of participants. processors etc. A company that wants to sell an asset at a particular time in the future can hedge by taking short futures position. private corporations like financial institutions. They use the futures market to reduce a particular risk that they face. As we said.hedgers. Hedgers Many participants in the commodity futures market are hedgers. speculators and arbitragers. certainty and transparency in purchasing commodities facilitate bank financing. By selling his crop forward. which in turn would eliminate the risks associated with running the business of trading commodities. Similarly. Participants of Commodity Derivatives For a market to succeed. ginners. Hedging does not necessarily improve the financial outcome. Hedgers could be government institutions. This is known as long hedge. indeed.  Flexibility. This risk might relate to the price of any commodity that the person deals in. or is likely to own the asset and expects to sell it at some time in the future. a short hedge is appropriate when the hedger already owns the asset. Predictability in prices of commodity would lead to stability. that it makes the outcome more certain. A long hedge is appropriate when a . he obtains a hedge by locking in to a predetermined price. it must have all three kinds of participants . The confluence of these participants ensures liquidity and efficient price discovery on the market. What it does however is.the commodities traded also ensures in maintaining the equilibrium between demand and supply. This is called a short hedge. trading companies and even other participants in the value chain. extractors. 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.. A short hedge is a hedge that requires a short position in futures contracts. who are influenced by the commodity prices. There are basically two kinds of hedges that can be taken. it could make the outcome worse.

arbitrage helps to equalise prices and restore market efficiency.company knows it will have to purchase a certain asset in the future and wants to lock in a price now. a customer must open a futures trading account with a commodity derivatives broker. An entity having an opinion on the price movements of a given commodity can speculate using the commodity market. commodities are bulky products and come with all the costs and procedures of handling these products. The buying cheap and selling expensive continues till prices in the two markets reach equilibrium. Buying futures simply involves putting in the margin money. While the basics of speculation apply to any market. With the purchase of futures contract on a commodity. This activity termed as arbitrage. speculating in commodities is not as simple as speculating on stocks in the financial market. To trade commodity futures on the NCDEX. Hence. Speculators If hedgers are the people who wish to avoid price risk. For a speculator who thinks the shares of a given company will rise. This enables futures traders to take a position in the underlying commodity without having to actually hold that commodity. they should sell at the same price. If the price of the same asset is different in two markets. The commodities futures markets provide speculators with an easy mechanism to speculate on the price of underlying commodities. These are the people who takes positions in the market & assume risks to profit from price fluctuations in fact the speculators consume market information make forecasts about the prices & put money in these forecasts. it is easy to buy the shares and hold them for whatever duration he wants to. This states that in a competitive market. speculators are those who are willing to take such risk. there will be operators who will buy in the market where the asset sells cheap and sell in the market where it is costly. However. if two assets are equivalent from the point of view of risk and return. 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). F = (S + U)erT Where: r = Cost of financing (annualised) T = Time till expiration . Arbitrage A central idea in modern economics is the law of one price.

The broker maintains an account of all dealing parties in which the daily profit or loss due to changes in the futures price is recorded. Whenever the futures price deviates substantially from its fair value. To capture mispricings that result in overpriced futures. in the case of consumption assets which are held primarily for reasons of usage. Which allows him to ask for physical delivery of the good from the warehouse. In the case of investment commodities. arbitrage opportunities arise. the arbitrager must sell futures and buy spot. But at present in India very few warehouses provide delivery for specific commodities. . However. good X in a ware house and gets a warehouse receipt. by when the buyer or seller either closes (square off) his account or give/take delivery of the commodity. The buyer should be able to take physical delivery at a location of his choice on presenting the warehouse receipt. the seller should be able to deposit the commodity at warehouse nearest to him and collect the warehouse receipt. A person can buy or sale a commodity future on an exchange based on his expectation of where the price will go. The second is futures trade. How Commodity market works? There are two kinds of trades in commodities. Following diagram gives a fair idea about working of the Commodity market. Futures have something called an expiry date. mispricing would result in both. A person deposits certain amount of say.U = Present value of all storage costs The cost-of-carry ensures that futures prices stay in tune with the spot prices of the underlying assets. The underpinning for futures is the warehouse receipt. buying the spot and holding it or selling the spot and investing the proceeds. But some one trading in commodity futures need not necessarily posses such a receipt to strike a deal. The above equation gives the fair value of a futures contract on an investment commodity. For commodity futures to work. The first is the spot trade. the arbitrager must sell spot and buy futures. in which one pays cash and carries away the goods. even if there exists a mispricing. Squiring off is done by taking an opposite contract so that the net outstanding is nil. a person who holds the underlying may not want to sell it to profit from the arbitrage. whereas to capture mispricings that result in underpriced futures.

The commodity trading system consists of certain prescribed steps or stages as follows: I.At this stage the following is the system implementedOrder receiving Execution Matching Reporting Surveillance Price limits Position limits II. Clearing: . Trading: . Traders need not visit a commodity market to speculate. With online commodity trading they could sit in the confines of their home or office and call the shots.This stage has following system in placeMatching Registration Clearing .Today Commodity trading system is fully computerized.

Settlement: . This transforms in to continuous price discovery . expert views and comments. Current Scenario in Indian Commodity Market Benefits of Commodity Futures Markets:The primary objectives of any futures exchange are authentic price discovery and an efficient price risk management. weather forecasts. the demand and supply equilibrium. hopes and fears.This stage has following system followed as followsMarking to market Receipts and payments Reporting Delivery upon expiration or maturity. Price Discovery:-Based on inputs regarding specific market information. Government policies. inflation rates. market dynamics. It is because of price discovery and risk management through the existence of futures exchanges that a lot of businesses and services are able to function smoothly. III. buyers and sellers conduct trading at futures exchanges. The beneficiaries include those who trade in the commodities being offered in the exchange as well as those who have nothing to do with futures trading. 1.- Clearing limits Notation Margining Price limits Position limits Clearing house.

smooth out the influence of changes in their input prices very easily. 5. importers etc. It is strategy of offering price risk that is inherent in spot market by taking an equal but opposite position in the futures market. the manufacturer can be caught between severe short-term price movements of oils and necessity to maintain price stability. The manufacturers can. Futures markets are used as a mode by hedgers to protect their business from adverse price change. The manufacturers have to ensure that the prices should be stable in order to protect their market share with the free entry of imports. 3.Export competitiveness: . processors. Hedging benefits who are involved in trading of commodities like farmers. Price Risk Management: . exporters. There would be no need to have large reserves to cover . merchandisers. 2. Predictable Pricing: . Import. 4. The purchases made from the physical market might expose them to the risk of price risk resulting to losses.The exporters can hedge their price risk and improve their competitiveness by making use of futures market. In the absence of futures market it will be meticulous. Futures contracts will enable predictability in domestic prices.Price instability has a direct bearing on farmers in the absence of futures market.The demand for certain commodities is highly price elastic. time consuming and costly physical transactions. as a result. The execution of trade between buyers and sellers leads to assessment of fair value of a particular commodity that is immediately disseminated on the trading terminal. A majority of traders which are involved in physical trade internationally intend to buy forwards. manufacturers. Benefits for farmers/Agriculturalists: . With no futures market. This could dent the profitability of their business.Hedging is the most common method of price risk management.mechanism. The existence of futures market would allow the exporters to hedge their proposed purchase by temporarily substituting for actual purchase till the time is ripe to buy in physical market. which could only be possible through sufficient financial reserves that could otherwise be utilized for making other profitable investments.

Since one of the objectives of futures exchange is to make available these prices as far as possible. There is a high degree of reluctance among banks to fund commodity traders.against unfavorable price fluctuations. Understanding Basis Basis = Spot price – Future price . Credit accessibility: . Even a small movement in prices can eat up a huge proportion of capital owned by traders. the market-determined price information disseminated by futures exchanges would be crucial for their production decisions. including the terms of quality standard: the quality certificates that are issued by the exchange-certified warehouses have the potential to become the norm for physical trade. 6. it is very likely to benefit the farmers. especially those who do not manage price risks. Also. This posses a huge obstacle in the smooth functioning and competition of commodities market. It ensures uniform standardization of commodity trade.The existence of warehouses for facilitating delivery with grading facilities along with other related benefits provides a very strong reason to upgrade and enhance the quality of the commodity to grade that is acceptable by the exchange. the interest rate is likely to be high and terms and conditions very stringent. which is possible through futures markets. due to the time lag between planning and production. The price information accessible to the farmers determines the extent to which traders/processors increase price to them. would cut down the discount rate in commodity lending. This would reduce the risk premiums associated with the marketing or processing margins enabling more returns on produce. If in case they do. Improved product quality: . 7. at times making it virtually impossible to pay back the loan. Storing more and being more active in the markets.The absence of proper risk management tools would attract the marketing and processing of commodities to high-risk exposure making it risky business activity to fund. Hedging.

In the market “lingo” one would say the basis is “50 under December. 150 Rs. one would say the basis is “50 over December.50 lower than the December futures price. The futures month is which to place a hedge.” Actually one can think of basis as “localizing” a future price. Local supply and demand conditions. such as grain quality. 50 higher than the December futures price. The futures market price represents the world price for commodity and is used as a benchmark in determining the value of commodity at the local level. Basis is the difference between the local cash price of a commodity and the price of a specific futures contract of the same commodity at any given point in time. Basis Movement . Interest/storage costs. 200 . When to use the future markets to hedge a purchase or sale.Rs. Because basis reflects local market conditions. the spot price is Rs. Resale bids.” On the other hand. local weather. When to accept a supplier’s offer or a buyer’s bid. Basis is used to determine:      The best time to buy or sell.A simple equation and the answer is a key to improving your profitability. Handling costs and profit margins. Spot price Dec futures price Basis Rs. 50 In this example. availability. it’s directly influenced by several factors including:     Transportation costs. if the spot price is Rs. need.

the cash price is becoming strong relative to futures. If the basis becomes more positive or less negative. National Bank of Agriculture and Rural Development (NABARD) and National Stock Exchange of India Limited (NSC). the basis is said to be weakening. Life Insurance Corporation of India (LIC). In this instance. In the instance. Major Commodities Exchange National Commodities & Derivatives Exchange Limited (NCDEX) National Commodities & Derivatives Exchange Limited (NCDEX) promoted by ICICI Bank Limited (ICICI Bank).The basis changes as the factors affecting cash or futures market change. Punjab National Bank (PNB). A weakening basis occurs when the cash price decreases relative to the futures over time. the cash price is becoming weak relative to the futures. Two terms used to describe a changing basis are strengthening and weakening. Credit Ratting Information Service of India Limited . A strengthening basis occurs when the cash price increases relative to the futures. and if the basis becomes less positive or more negative. the basis is said to be strengthening.

Meal     Pulses: Urad. Barley. Forward Contracts Regulation Act and various other legislations. NCDEX is also subjected to the various laws of land like the Companies Act. NCDEX is regulated by Forward Markets Commission (FMC). Indian parboiled Rice (IR-36/IR-64). Indian Farmers Fertilizer Cooperative Limited (IFFCO). Mustard seeds. Stamp Act. Yellow soybean. Masoor.Groundnut expeller Oil. It is committed 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. Coffee Arabica. Grain: Wheat. Mentha oil. Caster seed. Turmeric. NCDEX is a public limited company incorporated on 23 April 2003. Yellow peas. Mild steel Ingots. Indian raw Rice (ParmalPR-106). NCDEX currently facilitates trading of 57 commodities. Oil and Oil seeds: Cotton seed. Groundnut (in shell). Indian Pusa Basmati Rice. Silver. Tur. NCDEX is the only Commodity Exchange in the country promoted by national level institutions. Oil cake. Commodities Traded at NCDEX:   Bullion: Gold KG. Contracts Act. Refined soya oil. Brent. Pepper Plantation: Cashew. NCDEX is a national level technology driven on line Commodity Exchange with an independent Board of Directors and professionals not having any vested interest in Commodity Markets. Nickel Cathode. Aluminum Ingot. Yellow red maize Spices: Jeera. Minerals: Electrolytic Copper Cathode. Rape seeds. Chana. Cotton. Coffee Robusta . RBD Pamolein. professionalism and transparency. Crude Palm Oil. RM seed oil cake. Canara Bank and Goldman Sachs by subscribing to the equity shares have joined the promoters as a share holder of exchange.(CRISIL). NCDEX is located in Mumbai and offers facilities to its members in more than 550 centers throughout India. Zinc Metal Ingot.

Silver Coins. Groundnut oil. Green Cottons. Mulberry raw Silk. Corporation Bank of India. Nickel. MCX deals with about 100 commodities. Crude Palm oil/ RBD Pamolein. Minerals:- Aluminum. Tur. Key share holders of MCX are Financial Technologies (India) Limited. Raw Jute. Yellow peas. Bombay Metal Exchange. Grain Bold. Indian 28 mm cotton. Silver. Iron/steel. Indian 31mm cotton. Sunflower Oil cake. Guar seeds. Commodities Traded at MCX:   Bullion:- Gold. Mulberry. Potato. Tin. Sunflower oil. Solvent Extractors Association of India. Chilli LCA334  Energy: Crude Oil. clearing and settlement operations for commodity futures market across the country. Coconut Oil Cake. Mustard/ Rapeseed oil. Medium Staple. Tamarind seed oil. Fibers and other: Guar Gum. Lead.   Pulses:- Chana. pulses Importers Association and Shetkari Sanghatana. Oil and Oil seeds:- Castor oil/castor seeds. . MCX facilitates online trading. Grains:- . Sugar. Bank of India and Cnnara Bank. State Bank of India. Soy seeds/Soy meal/Refined Soy Oil. Furnace oil Multi Commodity Exchange of India Limited (MCX) Multi Commodity Exchange of India Limited (MCX) is an independent and de-mutulized exchange with permanent reorganization from Government of India. having Head Quarter in Mumbai. Copper. Masur. Urad. Jute sacking bags. Lemon. Zinc. Guar. V-797 Kapas. MCX started of trade in Nov 2003 and has built strategic alliance with Bombay Bullion Association. . Copra. Union Bank of India.

Jeera. Gur and Sugar. Electricity Propane. The exchange is in existence since last 132 years and performs trades trough two divisions.    Spices:- Pepper. Poly Vinyl Chloride (PVC) Energy:- Brent Crude Oil. Potato. Middle East Sour Crude Oil. Platinum. Cinnamon. Rubber. JuteSacking. Mentha Oil.   Petrochemicals:- High Density Polyethylene (HDPE). RBOB Gasoline. Khandsari. the NYMEX division. Gasoline. etc. Bajara. Jute Goods. Clove. Palladium. Raw Jute. Wheat.Light sweet crude oil. Cardamom. Furnace Oil. Plantation:- Cashew Kernel. It is a primary trading forum for energy products and precious metals. medium staple. Kapas Khalli. Crude Oil. which deals in energy and platinum and the COMEX division. which trades in all the other metals. Chara or Berseem. Gaur seed and Guargum. Silver. Cotton (long staple. Natural Gas The New York Mercantile Exchange (NYMEX):The New York Mercantile Exchange is the world’s biggest exchange for trading in physical commodity futures. Commodities traded: . Natural Gas. Gold. Copper. Coconut. . Cotton Cloth. Aluminum. Fiber and others:- Kapas. Heating Oil. Coffee. Betel nuts. short staple). Red Chili. Ginger. Art Silk Yarn.Rice/ Basmati Rice. Barley. Maize. Areca nut. Polypropylene (PP). Cotton Yarn.

Tin. Commodities traded:. North American Special Aluminum Alloy (NASAAC). The exchange trades 24 hours a day through an inter office telephone market and also through a electronic trading platform. The primary focus of LME is in providing a market for participants from non-ferrous based metals related industry to safeguard against risk due to movement in base metal prices and also arrive at a price that sets the benchmark globally. Aluminum Alloy. The exchange was formed in 1877 as a direct consequence of the industrial revolution witnessed in the 19th century. .London Metal Exchange:The London Metal Exchange (LME) is the world’s premier non-ferrous market. Zinc. etc. with highly liquid contracts. Lead.Aluminum. Polypropylene. Copper. It is famous for its open-outcry trading between ring dealing members that takes place on the market floor. Nickel. Linear Low Density Polyethylene.