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AEM - 202

AEM 202

Agri-Business and Entrepreneurship Development


(3 Credits)

Block III
Commodity and Future Marketing
Unit 1 :

Commodity Markets

3-20

Unit 2 :

Introduction to Commodity Exchanges

21-38

Unit 3 :

Futures Exchange and Risk Management

39-54

Unit 4 :

Ware house Receipts and Collateral Management

55-69

Post Graduate Diploma in Agricultural Extension Management (PGDAEM)

Published by
National Institute of Agricultural Extension Management (MANAGE),
Rajendranagar, Hyderabad 500 030, Andhra Pradesh, India
First Published: 2008
MANAGE, 2008
All rights reserved . No part of this work may be reproduced in any form, by mimeograph or any
other means without permission in writing from the MANAGE.
Shri K.V. Satyanarayana, IAS
Director General
National Institute of Agricultural Extension Management (MANAGE),
Rajendranagar, Hyderabad 500 030
Andhra Pradesh, India
Program Coordinators
Dr. M.N. Reddy, Director (Agri. Extn. & Commn.) & Principal Coordinator (PGDAEM)
Ph. Off: (040) 24014527, email: mnreddy@manage.gov.in
Dr. N. Balasubramani, Assistant Director (Agri. Extn.)
Ph. Off: (040) 24016702-708 Extn. 275, email: balasubramani@manage.gov.in

Course Coordinator
Dr. Vikram Singh, Director (OB)
National Institute of Agricultural Extension Management (MANAGE),
Rajendranagar, Hyderabad 500 030, Andhra Pradesh, India
Ph. Off: (040) 24016690, email: vikrams@manage.gov.in
Contributors
This material was originally prepared for YASHADA, Pune. The intellectual copy right of this material
belongs to YASHADA, Pune

Agri-Business and Entrepreneurship Development

AEM - 202

Unit 1
Commodity Markets
Structure
1.0

Objectives

1.1

Commodity markets

1.2

Classification of markets

1.3

Market players and motives

1.4

Motives of market participants

1.5

Forward and backward linkages in markets

1.6

Regulation of commodity markets

1.7

Recent innovation in commodities markets

1.8

Let us sum up

1.9

Key words

1.10 Further readings


1.11 Check your progress

1.0 Objectives
Agriculture occupies a very important place in the economic life of our country. It is the backbone
of our economic system. India is primarily an agricultural country. The fortunes of the economy are, even
now, dependent on the course of agricultural production. Commodity markets have been serving the
livelihood in the Indian economy. There were different kinds of markets based on products, nature of
competition, time etc. This Unit will help you to understand the following concepts viz:

Post Graduate Diploma in Agricultural Extension Management (PGDAEM)

Commodity Markets

Classification of markets,

Market motives,

Market participants and

Forward and backward linkages.

1.1. Commodity Markets


1.

What are commodities?


A commodity is anything for which there is demand, but which is supplied without qualitative

differentiation across a given market.


2.

Characteristics of Commodities

They are essential things that are produced and consumed in large quantities.

Physical goods that have a value attached to them and hence can be called asset classes.

They are often used as inputs in the production of other goods or services.

The prices are determined as a function of their market as a whole.

There is little differentiation between commodity coming from one producer and the same
commodity from another producer.

Generally they do not have brands, if branded they are called as products

Include physical substances, such as food, grains, and metals, which are interchangeable
with another product of the same type, and which investors buy or sell.

3.

How are commodities different from other assets?

Commodities are bulky in nature

They are perishable especially agro products

Commodities are physical assets - have added storage costs

They are goods, which have logistics problem - as they are bulky and as their production and
consumption centers are far apart

They have wide variations in quality and hence certain grades are taken as standards

Commodity Markets

4.

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Markets
The term market means not a particular place in which things are bought and sold but the whole

of any region in which buyers and sellers are in such a free intercourse with one another that the prices
of the same goods tend to equality, easily and quickly.

1.2 Classification of Markets


There are different kinds of markets, which have been classified, based on the following aspects

Classification of markets based on:

Functioning

Stage

Scale

Time

Place

Products sold

Competition

1.

Regulated

1.

Wholesale

1.

Physical

1.

Perfect

2.

Unregulated

2.

Retail

2.

Electronic

2.

Imperfect

1.

Primary

1.

Spot

1.

Consumer

2.

Secondary

2.

Forwards

2.

Industrial

3.

Futures

monopoly, duopoly and Oligopoly


The description of different kinds of markets is given below
1.

Based on Functioning

Based on the functioning, markets are placed in two categories


a.

Regulated Markets: These are markets in which business is done in accordance with the
rules and regulations framed by the statuary market organization representing different sections
involved in markets. The marketing costs in such markets are standardized and marketing
practices are regulated.

Important features of regulated markets


i)

Method of sale: in regulated markets, the sale of agricultural produce is undertaken either
by open auction or by the close tender method.
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Post Graduate Diploma in Agricultural Extension Management (PGDAEM)

ii)

Weighment of produce: Weighment of the produce is done by a licensed standard weights


and platform scale.

iii) Grading: the produce in the regulated markets is expected to be sold only after grading.
iv) Licensing of market functionaries: all the market functionaries , from the hamals (loaders)
to traders, working in the regulated markets have to obtain license from market committee.
b.

Unregulated Markets: these are the markets in which business is conducted without any set
rules and regulations. Traders frame the rules for the conduct of the business and run the
market. These markets suffer from many ills, ranging from non-uniform charges for marketing
functions to imperfections in the determination of prices.

2.

Based on the Stage of Marketing

Based on the marketing, the markets are divided into three categories
a.

Primary Markets
They are markets where most of the raw materials / materials are sold without much processing.

They lie near the origin of commodities. In primary markets, the producers of goods sell their farm
products to the wholesalers and their agents.
b.

Secondary Markets
These markets are mostly far away from the primary centers of production and located at the

consumption centers. This is the market where the wholesalers sell their goods to the retailers for onward
selling to the consumer. The middlemen buy goods from producers and manufacturers and sell to the
retailers.
c.

Terminal Market
This is the market where goods are purchased for final use or consumption. The retailers sell

their goods to consumers. This market is one where the produce is either finally disposed of to the
consumers or processors, or assembled for exports. In these markets, merchants are well organized
and use modern methods of marketing.
The main objectives of setting up Terminal Markets are
i)

To link the farmers to the markets by shortening the supply chain of perishables and enhance
their efficiency and thus increase farmers income,

ii)

Provide professionally managed competitive alternative marketing structures that provide multiple
choices to farmers for sale of their agricultural produce,
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Commodity Markets

iii)

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To drive reforms in the agricultural marketing sector resulting in accelerated development of


marketing and post harvest infrastructure including cool chain infrastructure in the country
through private sector investment.

iv)

To bring transparency in the market transactions and price fixation for agricultural produce and
through provision of backward linkages to enable the farmers to realise higher price and thus
higher income to the farmers.

3.

Based on scale/volume of business

a.

Retail Markets
These markets cater to the needs of the general public who are consumers of the products.
Largely small-scale transactions take place at retail level. Retailers are scattered all over mostly
in residential areas. In short retail refers to a market where goods are sold in small quantity
directly to the consumer.

b.

Wholesale Market
This market sells primarily to traders such as caterers and small shopkeepers. Members of the

public however, are not necessarily excluded. Large-scale transactions take place. Whole sale shops are
mostly concentrated in a particular location in a town/city. It is the market where the middlemen buy the
goods in bulk from the producers and manufacturers. Wholesaling is normally characterized by a system
of delivery by the wholesaler to the customer and the extension of credit facilities against bulk purchases.
4.

Based on Time

a.

Futures Market
This is an auction market in which participants buy and sell commodity/future contracts for

delivery on a specified future date. Futures exchanges act as a platform facilitating and regulating trade.
A futures contract is an agreement between two parties to buy or sell a specified and standardized
quantity and quality of an asset at a certain time in the future at a price agreed upon. It is a market in
which the buyers and sellers make agreement for delivery of goods in future. The contract is made on a
certain date but the goods will be delivered in future. Eg: MCX
b.

Forward Market
Forward contract is an agreement between two parties to buy or sell an asset at a future date for

a price agreed upon by both. Contracts are booked in advance, to mitigate risk. Contracts are signed
by the buyers and sellers and they have their own set of norms. Forward trade may not involve the
activity of an Exchange.
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Post Graduate Diploma in Agricultural Extension Management (PGDAEM)

c.

Spot Market
Commodities are physically bought and sold here so these are called physical markets. In this

market, delivery is taken immediately. Cash settlement is done within a maximum of 11 days. The spot
market is a ready market where the sellers on the spot physically hand over goods to the buyers. There is
an exchange of goods for money at the same time.
5.

Based on Place

a.

Electronic Market
These are markets wherein the buyers and sellers do not meet. They are also called as virtual

markets / online market place eg e-bay. In Futures exchanges also, now trading is taking place
electronically
b.

Physical Markets
A market in which commodities, such as grain, gold, crude oil etc. are bought and sold for cash

and delivered immediately. This is also called cash market or spot market.
6.

Based on Products sold

a.

Industrial Markets
This involves the sale of goods between businesses. They are not aimed directly at the consumer.
Eg: primary market where the raw materials and inputs are obtained eg: cement.

b.

Consumer Market
Here, the products and services are bought by individuals for their own or family use. This

can be broadly classified into:

7.

1.

Fast-Moving Consumer Goods (FMCG) - high volume, low unit value

2.

Consumer durables - low volume but high unit value

3.

Soft goods eg: clothes, shoes

4.

Services - e.g. hairdressing, dentistry

Based on Competition
Based on competition the markets are classified into perfect and imperfect markets

a.

Perfect Markets: A perfect market is one in which the following condition will hold good

There is a large number of buyers and sellers


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All the buyers and sellers in the market have perfect knowledge

Prices at any one time are uniform over a geographical area plus or minus the cost
of supplies.

b.

Imperfect Markets: The markets in which the conditions of perfect completion are lacking are
characterized as imperfect markets. The following are the situations based on the imperfections:
i.

Monopoly: It is a persistent situation where there is only one provider of a product or


service in a particular market. Monopolies are characterized by a lack of economic competition for the good or service that they provide and a lack of viable substitute goods.

ii.

Oligopoly: It is a market form in which a market or industry is dominated by a small


number of sellers (oligopolists).
i. Duopoly: This is a specific type of oligopoly where only two producers exist in one
market

1.3 Market Players and Motives


There are different kinds of participants in the markets, which are listed below. Their activities
vary slightly according to the markets they operate and they also carry different names according to the
place of operation. eg. speculators, hedgers & arbitragers in futures market.

Buyers

Sellers

Stockists

Trade facilitators / brokers

1.

Buyer

A person who buys commodities or products

Buyers are classified as consumer / industrial buyer

The buying behaviour varies with time, place etc.,

2.

Seller

A person who has goods to offer for willing buyers to buy.

Post Graduate Diploma in Agricultural Extension Management (PGDAEM)

3.

Stockist

A trader who buys goods at lower levels and stores it for some time and sells when prices
improve.

They take advantage of the price variation

4.

Brokers

Intermediaries who operate between buyers and sellers

They facilitate trade and take some part of the price margin

1.4 Motives of Market Participants


The market participants have different kinds of motives to meet physical requirement. The different
kinds of motives are listed below

Investment motive

Speculative motive

Arbitrage motive

1.

Investment motive
A trader who is neither a producer nor a consumer of a produce, but operates in the markets for

profit motive is an investor. He works in the market by buying goods and selling it at a later period or in
a different market and gains from the price differences. Investment may be subdivided into 1) speculative
and 2) arbitrage motive
2.

Speculative motive
A speculator buys, holds and sells commodities in the market to profit from the fluctuations in the

market. Risk involved is more when a person operates with a speculative motive.
3.

Arbitrage motive
Arbitrage is the practice of taking advantage of a price differential between two or more markets,

time periods etc Eg. a person buying in the spot market and selling in the futures market or vice-versa

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1.5 Forward and Backward Linkages in Markets


The markets are linked with two types of linkages namely backward and forward linkages
1.

Backward linkage

a.

Contract Farming

b.

Corporate Farming

a.

Contract Farming
Contract farming has been prevalent in various parts of the country for commercial crops like

sugarcane, cotton, tea, coffee, etc. The concept has, however, gained importance in recent times in
the wake of economic liberalization. The main feature of contract farming is that farmers grow
selected crops under a buy back agreement with an agency engaged in trading or processing.
There are many success stories on contract farming such as potato, tomato, groundnut and
chilli in Punjab, Safflower in Madhya Pradesh, oil palm in Andhra Pradesh, seed production contracts
for hybrids seed companies in Karnataka, cotton in Tamil Nadu and Maharashtra etc. which helped
the growers in realization of better returns for their produce.
In our country contract farming has considerable potential where small and marginal farmers
can no longer be competitive without access to modern technologies and support. The contractual
agreement with the farmer provides access to production services and credit as well as knowledge of
new technology. Pricing arrangements can significantly reduce the risk and uncertainty of the market
place.
Small-scale farmers are frequently reluctant to adopt new technologies because of the possible
risks and costs involved. In contract farming, private agribusiness firms normally offer improved
methods and technologies because they have a direct economic interest in improving farmers
production to meet their needs. In many instances, the larger companies provide their own extension
support to contracting farmers to ensure that production is according to the specification. The farmer
learns many skills through contract farming like record keeping, improved methods of applying
chemicals, fertilizers and knowledge of the importance of quality and of the demands of export
markets.
In view of the above, contract-farming arrangements need to be encouraged widely. This
would require arrangement for registration of sponsoring companies and recording of contract
farming agreements, in order to check unreliable and spurious companies. A dispute resolution
mechanism needs to be set up near to farmers which can quickly settle issues, if any, arising between
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Post Graduate Diploma in Agricultural Extension Management (PGDAEM)

the farmers and the company under a quasi-judicial manner. The farmers while raising the contracted
crops, run the risk of incurring debt and consequent displacement from land in the event of crop failure.
Farmers need to be indemnified from such displacement by law.
Eg: PepsiCo has emerged as one of the biggest providers of high quality seeds (especially tomatoes,
chillies and potatoes) for which farmers have to pay up front. The company recently imported 15,000
citrus plants from California, which are being distributed in Punjab. The idea is to try and develop Punjab
as a major citrus exporter.
b.

Corporate Farming
Corporate farming refers to direct ownership or leasing in of farmland by business organizations

in order to produce for their captive processing requirements or for the open market.
Eg:, Jamnagar Farms Pvt. Ltd.- a subsidiary of Reliance Industries (Mukesh Ambani group)
with 7500 acres of farm land which has mango occupying 450 acres that makes it the largest
mango orchard in Asia. The farm was originally set up as an environmental protection measure
near its refinery. Now, it is being seen as a profitable venture in itself.
2.

Forward linkage
Forward linkage means the dealings with retail chains and processors. The most essential things

in forward linkages are

Quantity and consistency in supply,

Competitive pricing of the produce,

Market knowledge, and

Farmers ability to build their associations, which are very much required.

Retailers buying process


Retail buying is the recent procurement strategy adopted by major retailers, i.e. they will not
agree with any pre-agreed price with farmer, however they give the prevailing market rate through
their collection centers in villages/taluk place. They directly buy the produce on cash and cheque
payments, some retail companies buy directly from existing open markets.
Eg: Relaince Retail buying of vegetables through their collection centers for their outlets.
3.

Challenges for Commodities Markets

Encourage the retail companies to evolve sourcing models and meanwhile proactively prepare
farmer group to establish linkage with retailers.
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Necessary infrastructure in order to provide, Multi commodity service, preserving quality,


enhancing agri produce shelf life etc

Improved market access for farmers both in the national and overseas markets

Increase bargaining power of farmers by building their own associations

Introduce de-intermediation process into the current marketing system

Forward linkage of farmers and backward linkage of retail chain etc.

1.6 Regulation of Commodity Markets


Commodity markets are regulated at national and international level by the following organizations.
1.

India

a.

APMC

b.

State Marketing Board

c.

Forward Markets Commission (FMC)

2.

International

a)

WTO

b)

United Nations Conference on Trade and Development (UNCTAD)

1.a APMC (Agricultural Produce Marketing Committee) Act


The Act provides improved regulation in marketing of agricultural produce, development of an
efficient marketing system, promotion of agri-processing and agricultural export and the establishment
and proper administration of markets for agricultural produce in the States. The modified APMC Act
has been made specifically responsible for:

Ensuring complete transparency in pricing system and transactions taking place in market area

Providing market-led extension services to farmers

Ensuring payment for agricultural produce sold by farmers on the same day

Promoting agricultural processing including activities for value addition in agricultural produce

Publicizing data on arrivals and rates of agricultural produce brought into the market area for
sale.

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Post Graduate Diploma in Agricultural Extension Management (PGDAEM)

Setup and promote public private partnership in the management of agricultural markets

Compulsory registration of all contract farming sponsors, recording of contract farming


agreements, resolution of disputes, if any, arising out of such agreement, exemption from
levy of market fee on produce covered by contract farming agreements and to provide for
indemnity to producers title/ possession over his land from any claim arising out of the
agreement

Provision made for direct sale of farm produce to contract farming sponsor from farmers
field without the necessity of routing it through notified markets

Provision made for imposition of single point levy of market fee on the sale of notified
agricultural commodities in any market area and discretion provided to the State Government
to fix graded levy of market fee on different types of sales

Licensing of market functionaries is dispensed with and a time bound procedure for registration
is laid down. Registration for market functionaries provided to operate in one or more than
one market areas

Commission agency in any transaction relating to notified agricultural produce involving an


agriculturist is prohibited and there will be no deduction towards commission from the sale
proceeds payable to agriculturist seller

Provision made for the purchase of agricultural produce through private yards or directly
from agriculturists in one or more than one market area

Provision made for the establishment of consumers/ farmers market to facilitate direct sale
of agricultural produce to consumers

Provision made for resolving of disputes, if any, arising between private market/ consumer
market and Market Committee

Market Committee permitted to use its funds among others to create facilities like grading,
standardization and quality certification; to create infrastructure on its own or through public
private partnership for post harvest handling of agricultural produce and development of
modern marketing system

1.b State Agricultural Marketing Board


The Board acts as a liaison agency between the Market Committees and the Government for all
round development of agricultural marketing in the State. The State Agricultural Marketing Board has

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been made specifically responsible for setting up of a separate marketing extension cell in the Board to
provide market-led extension services to farmers
(i)

Promoting, grading, standardization and quality certification of notified agricultural produce


and for the purpose to set up a separate Agricultural Produce Marketing Standards Bureau

(ii) Funds of the State Agricultural Marketing Board permitted to be utilized for promoting either
on its own or through public private partnership, for the following
a)

Market survey, research, grading, standardization, quality certification, etc.

b)

Development of quality testing and communication infrastructure

c)

Development of media, cyber and long distance infrastructure relevant to marketing of


agricultural and allied commodities

1.c Forward Markets Commission


It is a regulatory authority for all Commodity Derivatives Exchanges in India, which is overseen by
the Ministry of Consumer Affairs and Public Distribution, Government of India. It is a statutory body set
up in 1953 under the Forward Contracts (Regulation) Act, 1952.
The key functions of FMC are given below
(a) To advise the Central Government in respect of the recognition or the withdrawal of recognition
from any association or in respect of any other matter arising out of the administration of the
Forward Contracts (Regulation) Act 1952.
(b) To keep forward markets under observation and to take such action in relation to them, as it
may consider necessary, in exercise of the powers assigned to it by or under the Act.
(c) To collect whenever the Commission thinks it necessary, to publish information regarding the
trading conditions in respect of goods to which any of the provisions of the act is made
applicable, including information regarding supply, demand and prices, and to submit to the
Central Government, periodical reports on the working of forward markets relating to such
goods;
(d) To make recommendations generally with a view to improving the organization and working
of forward markets;
(e) To undertake the inspection of the accounts and other documents of any recognized association
or registered association or any member of such association whenever it considerers it
necessary.
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Post Graduate Diploma in Agricultural Extension Management (PGDAEM)

2.a

United Nations Conference on Trade and Development (UNCTAD)


The United Nations Conference on Trade and Development (UNCTAD) was established in 1964

as a permanent intergovernmental body, UNCTAD is the principal organ of the United Nations General
Assembly dealing with trade, investment and development issues.

To maximizing the trade and development prospects of developing countries and economies in
transition,

Assisting them in their beneficial integration into the globalizing and liberalizing world economy
and the international trading system, and

Aims to strengthen human, institutional and policy-making capacities by formulating and


implementing national trade policy frameworks conducive to economic, human and social
development and poverty alleviation, as well as in participating effectively in multilateral,
regional and sub regional trade negotiations.

To develop Comprehensive computer-based information system on trade control measures


that uses UNCTADs database.

2.b

World Trade Organization (WTO)


WTO is the only international body dealing with the rules of trade between nations.

The main functions of WTO can be described in very simple terms. These are

To oversee implementation and administering of WTO agreements

To provide a forum for negotiations

To provide a dispute settlement mechanism and

Expand the production of and trade in goods and services.

1.7 Recent Innovation in Commodities Markets


1.

Safal Market
This was the initiative by NDDB, which came into existence in April 2003 with setting up of a full-

fledged trading platform for Fruits and Vegetables at Bangalore. It has been formed to establish an
alternative market set-up that operates parallel to mandis to stimulate production, raise quality standards,
reduce losses etc

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Reasons for NDDBs debut into the F&V sector could be

Dominated by small farmers, who were unable to effectively bargain in the Mandis and get
remunerative prices

APMC Act emphasises on regulation and restrictions on marketing activity which create a
situation which is disadvantageous to growers

Mandi operations were poorly designed - inefficient & lack transparency

2.

E-Choupal
E-Choupal is an initiative of ITC Limited (a large diversified group in India) to link directly with

rural farmers for the procurement of agricultural/aquaculture produce like soya, coffee, and prawns.
E-Choupal was conceived to tackle the challenges posed by the unique features of Indian agriculture,
characterized by fragmented farms, weak infrastructure and the involvement of numerous
intermediaries. Traditionally, these commodities are being procured in mandis (major agricultural
marketing centres in rural areas of India), where the middleman used to make most of the profit.
These middlemen used unscientific means to judge the quality of the product, the price difference in
the payout for good quality and inferior quality was less and hence there was no incentive for the
farmers to produce good quality yield. With e-choupal, role of the middleman was restricted.
ITC Limited has now established computers and Internet access in key rural areas where the
farmers can directly negotiate the sale of their produce with ITC Limited. The PCs and Internet access
at these centers enable the farmers to obtain information on mandi prices, good farming practices
and place orders for agricultural inputs like seeds and fertilizers. This helps farmers in improving the
quality of produce, and also helps in realizing a better price. Each ITC Limited kiosk having an
access to Internet is run by a sanchalaka trained farmer. The computer housed in a farmers house
is linked to the Internet via phone lines or by a VSAT connection and serves an average of 600
farmers in 10 surrounding villages within about a 5 km radius. The sanchalak bears some operating
cost but in return gets commissions for the e-transactions done through his eChoupal. The warehouse
hub is managed by middle-men called samyojaks. The samyojak acts as a local commission agent
for ITC Limited.
The system saves procurement costs for ITC Limited. The E-Choupal model is quite different
from the other models, as the farmers do not pay for the information and knowledge they get from
E-Choupals.

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Post Graduate Diploma in Agricultural Extension Management (PGDAEM)

ITC Limited has extracted value in four steps through E-Choupal


(a) Elimination of non-value adding activities
(b) Differentiating product through identity preservation
(c)

Value added products traceable to farm practices

(d) E-market place and support services to future exchange.


3.

Metro Cash & Carry


Cash and Carry is a new initiative in wholesaling in which services of credit and delivery are

replaced with discounts. Metros Cash & Carrys business model brings together small, medium and
large-sized producers, farmers, agricultural cooperatives and manufacturers, with the dispersed
community of hotels, restaurants, caterers, traders, retailers and small to medium business enterprises,
under one roof. They buy directly from producers and manufacturers and sell to business customers
at wholesale centers. This way, they shorten the supply chain and thereby eliminate the high costs
associated with a fragmented supply chain. They also cut costs and wastage by building modern
trade infrastructure and implementing modern IT-based systems, which improve efficiency. By
aggregating the demand of small and medium businesses, they are able to buy in bulk quantities at
lower costs, a part of which is passed on to the customers.

1.8 Let us Sum Up


The fortunes of the economy are, even now, dependent on the course of agricultural production.
Commodity markets have been serving the livelihood in the Indian economy.
A commodity is anything for which there is demand, but which is supplied without qualitative
differentiation across a given market. The markets in which the commodities are trading are called
as commodities markets. There are different kinds of commodities markets, which have been classified
based on functioning, stage, scale of business, time and nature of business transaction, place and
area, products sold and competition.
In the markets, largely there are four kinds of participants, namely buyers, sellers, stockists
and trade facilitators. The market participants have investment, speculative and arbitrage motives.
The markets are bound with forward and backward linkages. The backward linkages consist
of contract farming and corporate farming models. In contract farming the farmers grow selected
crops under a buy back agreement with an agency engaged in trading or processing. Corporate
farming involves the direct ownership or leasing in of farmland by business organizations to produce
for their captive processing requirements or for the open market. Dealing with retail chains and
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processing units are termed as forward linkages. Under the changing scenario, commodity markets are
facing many challenges such as increased infrastructure requirement, market access to farmer, improving
the bargaining power of farmers, introduction of de-intermediation process. To pace up the challenges,
market functionaries have been introducing innovations in marketing such as E-Choupal, Cash and
Carry markets and Safal market.

1.9 Key Words


Arbitrage: 1) A transaction that generates a risk-free profit; 2) a leveraged speculative transaction;
and 3) the activity of engaging in either of the above two forms of arbitrage transactions.
Auction: An auction is the process of buying and selling goods by offering them up for bid, taking bids,
and then selling the item to the winning bidder. In economic theory, an auction is a method for determining
the value of a commodity that has an undetermined or variable price.
Buyer: A buyer is any person who contracts to acquire an asset in return for some form of consideration.
Contract: It is a legally binding exchange of promises or agreement between parties that the law will
enforce. It is an agreement between two or more competent parties to do, or not to do, some legal
act for a legal consideration.
Fast moving consumer goods: Fast Moving Consumer Goods (FMCG), also known as Consumer
Packaged Goods (CPG), are products that have a quick turnover and have a relatively low cost.
Though the absolute profit made on FMCG products is relatively small, they generally sell in large
numbers and so the cumulative profit on such products can be large.
Futures contract: It is a standardized contract, traded on a futures exchange, to buy or sell a certain
underlying instrument at a certain date in the future, at a specified price. The future date is called the
delivery date or final settlement date. The pre-set price is called the futures price. The price of the
underlying asset on the delivery date is called the settlement price.
Investment: It is the purchase of capital equipment. i.e. the purchase of machines, equipment, factories
etc. that firms need to enable them to produce.
Liberalisation: It refers to a relaxation of previous government restrictions, usually in areas of social or
economic policy.
Price: The amount of money, or other goods, that one has to give up to buy a good or service.
Sales: Sales are the activities involved in providing products or services in return for money or other
compensation. It is an act of completion of a commercial activity.
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Post Graduate Diploma in Agricultural Extension Management (PGDAEM)

1.10 Further Readings


Acharya S and N.L.Agarwal, 2005 Agricultural Marketing in India, Oxford & IBH Publishing Co Pvt.
ltd, New Delhi.
Various issues of Commodityindia.com
www.wto.org
www.agmarknet.nic.in
www.dgft.gov.in
www.unctad.org
www.fmc.gov.in

1.11 Check Your Progress


1.

Define commodity and markets.

2.

How do you classify the commodities markets?

3.

What are the kinds of markets existing under time mode?

4.

What are the major primary markets for different agricultural commodities

5.

Who are all the different kinds of participants in commodities markets?

6.

Explain the linkages in the commodities markets?

7.

What is corporate farming? Explain with an example?

8.

Give a brief description about the contract farming?

9.

Explain the following terms


a. Terminal markets
b. Futures markets
c. Electronic markets

10. How do you classify the markets based on competition?


11. What are the challenges faced by the commodities market?
12. Explain the recent innovations in commodities markets?

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Unit 2
Introduction to Commodity Exchanges
Structure
2.0

Objectives

2.1. Introduction to derivatives


2.2. Instruments available for trading
2.3

Commodity exchanges and futures trading

2.4

Evolution of futures trading

2.5

Commodity exchanges at global and national level

2.6

Exchange transactions

2.7

Let us sum up

2.8

Key words

2.9

Further readings

2.10 Check your progress

2.0 Objectives
On completing this unit you will be able to

Understand the meaning of derivatives

Futures contract and exchanges

Evolution of futures trading

Commodity exchanges in India

Structure and members of commodity exchanges and

How to trade in the commodity exchanges

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Post Graduate Diploma in Agricultural Extension Management (PGDAEM)

2.1. Introduction to Derivatives


In the world of liberalization it is most indispensable to predict the future. It becomes more
requisite for agriculture, which faces more flux than other sectors. So the Government of India
introduced commodity futures trading in India through commodity exchanges.
Derivative is a product whose value is derived from the value of one or more underlying variables or
assets in a contractual manner. The underlying asset can be equity, forex, commodity or any other
asset.
Derivative markets can broadly be classified as commodity derivative market and financial
derivatives markets. As the name suggests, commodity derivatives markets trade contracts for which
the underlying asset is a commodity. It can be an agricultural commodity like wheat, soybeans,
rapeseed, cotton, etc or precious metals like gold, silver, etc. Financial derivatives markets trade
contracts that have a financial asset or variable as the underlying. The main types of derivatives are
futures, forwards, options, and swaps.
a.

Futures
utures: A futures contract is an agreement between two parties to buy or sell the underlying
asset at a future date at a future price. Futures contracts differ from forward contracts in the
sense that they are standardized and exchange traded.

b.

Options
Options: There are two types of options - calls and puts. Calls give the buyer the right but not
the obligation to buy a given quantity of the underlying asset, at a given price on or before a
given future date. Puts give the buyer the right, but not the obligation to sell a given quantity
of the underlying asset at a given price on or before a given date.

c.

Warrants
arrants: Options generally have lives of up to one year, the majority of options traded on
options exchanges having a maximum maturity of nine months. Longer dated options are
called warrants and are generally traded over the counter.

d.

Swaps
Swaps: Swaps are private agreements between two parties to exchange cash flows in the
future according to a prearranged formula. They can be regarded as portfolios of forward
contracts.

2.2. Instruments available for Trading


In recent years, derivatives have become increasingly popular due to their applications for
hedging, speculation and arbitrage. Before we study about the applications of commodity derivatives,
we will have a look at some basic derivative products. There are three derivative contracts namely
forward, futures and options trading.
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Introduction to Commodity Exchanges

a.

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Forward contracts
A forward contract is an agreement to buy or sell an asset on a specified date for a specified

price. 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. The other party assumes a short
position and agrees to sell the asset on the same date for the same price. Other contract details like
delivery date, price and quantity are negotiated bilaterally by the parties to the contract. The forward
contracts are normally traded outside the exchanges.
The salient features of forward contracts are

They are bilateral contracts and hence exposed to counter party risk.

Each contract is custom designed, and hence is unique in terms of contract size, expiration
date and the asset type and quality

The contract price is generally not available in public domain

On the expiration date, the contract has to be settled by delivery of the asset

If the party wishes to reverse the contract, it has to compulsorily go to the same counter party,
which often results in high prices being charged.

b.

Futures contract
A futures contract is an agreement between two parties to buy or sell an asset at a certain time

in the future at a certain price. But unlike forward contracts, the futures contracts are standardized and
exchange traded. To facilitate liquidity in the futures contracts, the exchange specifies certain standard
features of the contract. It is a standardized contract with standard underlying instrument, a standard
quantity and quality of the underlying instrument that can be delivered, (or which can be used for reference
purposes in settlement) and a standard timing of such settlement. A futures contract may be offset prior
to maturity by entering into an equal and opposite transaction. Majority of the futures transactions are
offset this way.
The standardized items in a futures contract are:

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
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Post Graduate Diploma in Agricultural Extension Management (PGDAEM)

Distinction between futures and forwards


Futures

Forwards

Trade on an organized exchange

OTC in nature

Standardized contract terms hence more liquid

Customized contract terms hence less liquid

Requires margin payments

No margin payment

Follows daily settlement

Settlement happens at end of period

Futures Terminology
Spot price
price: The price at which an asset trades in the spot market.
Futures price:
price The price at which the futures contract trades in the futures market.
Contract cycle:
cycle The period over which a contract trades. The commodity futures contracts on the
exchanges have one-month, two-months and three-months expiry cycles.
Expiry date:
date It is the date specified in the futures contract. This is the last day on which the contract
will be traded, at the end of which it will cease to exist.
Delivery unit:
unit The amount of asset that has to be delivered under one contract. For instance, the
delivery unit for futures on Long Staple Cotton on the NCDEX is 55 bales. The delivery unit for the
Gold futures in MCX contract is 1 kg.
Basis
Basis: Basis can be defined as the futures price minus the spot price. There will be a different basis for
each delivery month for each contract. In a normal market, basis is positive. This reflects that futures
prices normally exceed spot prices.
Cost of carry:
carry The relationship between futures prices and spot prices can be summarized in terms of
what is known as the cost of carry. This measures the storage cost plus the interest that is paid to
finance the asset less the income earned on the asset.
Initial margin:
margin The amount that must be deposited in the margin account at the time a futures
contract is first entered into is known as initial margin.
Marking
-to
-market (MTM): In the futures market, at the end of each trading day, the margin account
Marking-to
-to-market
is adjusted to reflect the investors gain or loss depending upon the futures closing price. This is
called marking to market.
Maintenance margin: This is somewhat lower than the initial margin. This is set to ensure that the
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balance in the margin account never becomes negative. If the balance in the margin account falls
below the maintenance margin, the investor receives a margin call and is expected to top up the
margin account to the initial margin level before trading commences on the next day.
Short position: The sale of a security or commodities futures not owned by the seller at the time of the
trade. Short sales are usually made in anticipation of a decline in the price.
Long PPosition:
osition: Owning a commodity with an anticipation of increase in prices.
c.

Options trading
An option gives the holder of the option the right to do something but the holder does not have

the obligation to exercise this right. In contrast, in a forward or futures contract, the two parties have
committed themselves to the act of buying and selling. Whereas it costs nothing (except margin
requirements) to enter into a futures contract, the purchase of an option requires an up front payment.

2.3 Commodity Exchanges and Futures Trading


A commodity exchange is an association or a company or any other body corporate that is
organizing futures trading in commodities.
A commodity futures contract is a contractual agreement between two parties to buy or sell a
specified quantity and quality of commodity at a certain time in future at a certain price agreed at the
time of entering into the contract on the commodity futures exchange.
1.

Structure of Commodities exchange

A Commodities Exchange is formed with the following objectives

To create a platform for the market participants

To bring professionalism and transparency into commodity trading

To inculcate best international practices like de-modularization, technology platforms, low cost
solutions and information dissemination without noise etc. into the trade

To provide nation wide reach and consistent offering

To bring together the entities that the market can trust

2.

Exchange membership
Membership of exchanges is open to any person, association of persons, partnerships, cooperative

societies, companies etc. that fulfills the eligibility criteria set by the exchange. All the members of the
exchange have to register themselves with the competent authority before commencing their operations.
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Post Graduate Diploma in Agricultural Extension Management (PGDAEM)

The members of Exchanges fall into two categories, Trading cum Clearing Members (TCM) and Professional
Clearing Members (PCM).
a.

Trading cum Clearing Member - An individual or corporate can be admitted by the


Commodity Exchange as a Trading-Cum-Clearing Member (TCM) conferring upon them a right
to trade and clear through the clearing house of the Commodity Exchange. Moreover, the member
may be allowed to make deals for themselves (proprietary positions) besides trading on
behalf of registered approved / authorized users and to clear/ settle them.

b.

Professional Clearing Member (PCM) - Any Financial Institution or Bank, which is registered
as PCM is conferred the right only to clear and settle trades through the clearing-house of the
exchange. They may clear and settle trades of such members of the exchange who choose to
do so through that PCM.

3.

Participants in the futures trading


There are three types of participants in futures trading namely hedgers, speculators, and

arbitragers.
a.

Hedgers
Hedgers: a person who makes investment in order to reduce the risk of adverse price
movements in a commodity, by taking an offsetting position in a related commodity, such as
long and short position is called as hedger. Hedgers could be government institutions, private
corporations like financial institutions, trading companies and even other participants in the
value chain, for instance farmers, extractors, ginners, processors etc., who are influenced by
the commodity prices.

b.

Speculators
Speculators: Speculators are participants who wish to bet on future movements in the price
of an asset. Futures and options contracts can give them leverage; that is, by putting in small
amounts of money upfront, they can take large positions on the market. As a result of this
leveraged speculative position, they increase the potential for large gains as well as large
losses.

c.

Arbitragers: Arbitragers work at making profits by taking advantage of discrepancy between


prices of the same product across different markets. If, for example, they see the futures price
of an asset getting out of line with the cash price, they would take offsetting positions in the
two markets to lock in the profit.

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2.4 Evolution of Futures Trading


History of modern futures trading begins in 1848, the Chicago Board of Trade (CBOT) the
worlds first modern futures exchange was formed. Trading was originally in forward contracts; the
first contract (on corn) was written on March 13, 1851. In 1865, standardized futures contracts were
introduced. Today, the futures markets have far outgrown their agricultural origins.
Organized futures market evolved in India by the setting up of Bombay Cotton Trade
Association Ltd. in 1875. Futures trading in Raw Jute and Jute Goods began in Calcutta with the
establishment of the Calcutta Hessian Exchange Ltd., in 1919. Later East Indian Jute Association Ltd
was set up in 1927 for organizing futures trading in Raw Jute. The most notable amongst them was
the Chamber of Commerce at Hapur, which was established in 1913. Futures market in Bullion
began at Mumbai in 1920 and later similar markets came up at Rajkot, Jaipur, Jamnagar, Kanpur,
Delhi and Kolkata.
After independence, the Constitution of India brought the subject of Stock Exchanges and
futures markets in the Union list. As a result, the responsibility for regulation of commodity futures
markets devolved on Govt. of India. A Bill on forward contracts was referred to an expert committee
headed by Prof. A.D.Shroff and Select Committees of two successive Parliaments and finally in
December 1952 Forward Contracts (Regulation) Act, 1952, was enacted.
After the introduction of economic reforms since June 1991 and the consequent gradual
trade and industry liberalization in both the domestic and external sectors, the Govt. of India appointed
in June 1993 one more committee on Forward Markets und Chairmanship of Prof. K.N. Kabra. The
Committee recommended that futures trading be introduced in Basmati Rice, cotton, Jute, oilseeds,
silver and onions.
The liberalized policy being followed by the Government of India and the gradual withdrawal
of the procurement and distribution channel necessitated setting in place a market mechanism to
perform the economic functions of price discovery and risk management.
The National Agriculture Policy announced in July 2000 and the announcements of Honble
Finance Minister in the Budget Speech for 2002-2003 were indicative of the Governments resolve to
put in place a mechanism of futures trade/market. As a follow up the Government issued notifications
on 1.4.2003 permitting futures trading in the commodities, with the issue of these notifications
futures trading is not prohibited in any commodity. Options trading in commodity are, however
presently prohibited.

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Post Graduate Diploma in Agricultural Extension Management (PGDAEM)

Forward Market Commission (FMC) is a regulatory authority for all Commodity Derivatives
Exchanges in India, which is overseen by the Ministry of Consumer Affairs and Public Distribution,
Government of India. It is a statutory body set up in 1953 under the Forward Contracts (Regulation)
Act, 1952.
The functions of the FForward
orward Markets Commission are as follows:
(a) To advise the Central Government in respect of the recognition or the withdrawal of recognition
from any association or in respect of any other matter arising out of the administration of the
Forward Contracts (Regulation) Act 1952.
(b) To keep forward markets under observation and to take such action in relation to them, as it
may consider necessary, in exercise of the powers assigned to it by or under the Act.
(c) To collect whenever the Commission thinks it necessary, to publish information regarding the
trading conditions in respect of goods to which any of the provisions of the act is made
applicable, including information regarding supply, demand and prices, and to submit to the
Central Government, periodical reports on the working of forward markets relating to such
goods;
(d) To make recommendations generally with a view to improving the organization and working
of forward markets;
(e) To undertake the inspection of the accounts and other documents of any recognized association
or registered association or any member of such association whenever it considerers it
necessary.

2.5 Commodity Exchanges at Global and National level


1.

Commodity Exchanges at National level


The Government, in order to make the commodities market more transparent and efficient,

accorded approval for setting up of national level multi commodity exchanges. Accordingly three
national level exchanges are there which deal in a wide variety of commodities and which allow
nation-wide trading. They are
a.

National Commodities Derivatives Exchange (NCDEX)

b.

Multi Commodity Exchange (MCX)

c.

National Multi Commodity Exchange (NMCE)

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Introduction to Commodity Exchanges

Today commodity exchanges are offering spectacular growth opportunities and advantages to a
large cross section of the participants including Producers / Processors, Traders, Corporate, Regional
Trading Centers, Importers, Exporters, Cooperatives and Associations.
a.

National Commodities Derivatives Exchange (NCDEX)


NCDEX is a nation-level, technology driven de-mutualized on-line commodity exchange with an

independent Board of Directors and professionals. It is a professionally managed by ICICI Bank, LIC,
NABARD and (NSE). NCDEX is a public limited company incorporated on April 23, 2003 under the
Companies Act, 1956.

Important Commodities traded at NCDEX


Commodity

Unit of price

Unit of trading

quotation

Yield/Re.
Movement

Precious metals
Gold

10gm

100gm

10.00

Kilo gold

10gm

1000gm

100.00

1kg

5KG

5.00

Soya oil

10KG

1000kg

100.00

Cotton-l

1T

11 bales

18.70

Mustard

20KG

1000kg

50.00

Mustard oil

10KG

1000kg

100.00

Palmolein oil RBD

10KG

1000kg

100.00

Pepper

1T

1000kg

10.00

Chana

1T

10000kg

100.00

Guar seeds

1T

10000kg

100.00

Rubber

1T

1000kg

10.00

Silver
Agricultural products

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Post Graduate Diploma in Agricultural Extension Management (PGDAEM)

b.

Multi Commodity Exchange (MCX)


MCX an independent and de-mutulised multi commodity exchange established on November

2003. It has permanent recognition from Government of India for facilitating online trading, clearing
and settlement operations for commodity futures markets across the country. Key shareholders of
MCX include Financial Technologies (I) Ltd., State Bank of India & associates, Fidelity International,
National Stock Exchange of India Ltd. (NSE) and National Bank for Agriculture and Rural Development
(NABARD).

Important Commodities traded at MCX


Commodity

Unit of price
quotation

Unit of trading

Yield/Re.
Movement

Gold-m

10gm

100gm

10.00

Gold

10gm

1000gm

100.00

Silver-m

1kg

5kg

5.00

Silver

1kg

30kg

30.00

1t

10 t

10.00

Soya oil

10kg

1000kg

100.00

Crude palm oil

10kg

1000kg

100.00

Rbd palmolein

10kg

1000kg

100.00

Castor seed

100kg

1t

10.00

Castor oil

10kg

1t

100.00

Ground nut oil

10kg

1t

100.00

Gaur seed

100kg

5t

50.00

Black pepper

100kg

1t

10.00

Rubber

100kg

25 t

250.00

Kapas

20kg

4t

200.00

Steel long

1t

25 t

25.00

Steel flat

1t

25 t

25.00

Copper

1kg

1t

1000.00

Nickel

1kg

250kg

250.00

Tin

1kg

500kg

500.00

Precious metals

Agricultural products
Soya

Industrial metals

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Introduction to Commodity Exchanges

c.

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National Multi Commodity Exchange of India Limited


National Multi Commodity Exchange of India Limited (NMCEIL) is the first de-mutualized,

Electronic Multi-Commodity Exchange in India. On 25th July, 2001, it was granted approval by the
Government to organize trading in the edible oil complex. It has operationalized from November
26, 2002. It is being supported by Central Warehousing Corporation Ltd., Gujarat State Agricultural
Marketing Board and Neptune Overseas Limited. It got its recognition in October 2002.
Apart from these national exchanges there are other regional commodities exchanges in
India, which are listed below. Most of these commodity exchanges are offline and commodity specific.
Registered commodity exchanges in India

Bhatinda Om & Oil Exchange Ltd.

The Bombay Commodity Exchange Ltd.

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

National Board of Trade, Indore

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

The Coffee Futures Exchange India Ltd., Bangalore

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Post Graduate Diploma in Agricultural Extension Management (PGDAEM)

2.

Global Commodities Exchanges

a.

Chicago Board of TTrade


rade
Chicago Board of Trade was established in 1948 and has been trading in agricultural produce,

interests, metals and US treasuries, soya complex, wheat and corn prices across the world are
referenced here. It has both electronic as well as open cry system of trading. It trades both in futures
as well as options.
b.

New Y
ork Board of TTrade
rade (NYBO
T)
York
(NYBOT)
New York Board of Trade (NYBOT) is the worlds largest commodities exchange for Coffee,

Sugar, Cotton and Frozen Concentrated Orange Juice. The exchange was founded as the New York
Cotton Exchange in 1870. NYBOT also facilitates trades in foreign currencies and derivative indices
for equities.
c.

Chicago Mercantile Exchange (CME)


Chicago Mercantile Exchange (CME) is the largest futures exchange in US. The exchange

trades in interest rates, equities, foreign exchange and agricultural commodities. It has both open cry
as well as electronic trading systems. Agricultural commodities traded on the exchange include dairy
products (butter, milk cheese) and live stock futures.
d.

London Metal Exchange (LME)


London Metal Exchange trades in Metals and non-ferrous metals like aluminum, copper,

lead, nickel, tin and zinc. Consumers as well as producers of metals use the official prices of LME for
their long-term contracts pricing. There are over 400 LME approved warehouse in some 32 locations
covering USA, Europe, the middle & the Far East. (At the moment there is none in India)., The
exchange has both open outcries as well as electronic system for trade.
e.

New Y
ork Mercantile Exchange (NYMEX)
York
New York Mercantile Exchange in its current form was created in 1994 by the merger of the

former New York Mercantile Exchange and the Commodity Exchange of New York (COMEX). Together
they represent one of worlds largest exchanges for precious metals and energy.
f.

Tokyo Commodity Exchange (T


OCOM)
(TOCOM)
Tokyo Commodity Exchange (TOCOM) is the largest exchange in Japan and second largest

commodity exchange in the world for futures and options. Crude oil, gasoline, kerosene, gas oil,
gold, silver, aluminum, platinum and rubber are the commodities that are actively traded.
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Introduction to Commodity Exchanges

e.

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Dubai Gold & Commodity Exchange (DGCX)


Dubai Gold & Commodity Exchange (DGCX) was formed in Dubai by joint participation of

Dubai government as well as MCX and FTIL. Dubai has an advantage of its location of serving all
time zones.
f.

Dubai Mercantile Exchange (DME)


Dubai Mercantile Exchange (DME) is a joint venture between a Dubai holding, the New York

Mercantile Exchange (NYMEX) and the Oman Investment Fund (OIF). It is a premier international
energy futures and commodities exchange in the Middle East.

2.6 Exchange Transactions


There are three components in exchanges transaction viz: trading, clearing and settlement.
1.

Trading
The trading system on the electronic exchanges provide a fully automated screen based trading

for futures on commodities on a nationwide basis as well as an online monitoring and surveillance
mechanism, which is called as terminal. It supports an order driven market and provides complete
transparency of trading operations. The system supports an order driven market, where orders match
automatically. Order matching is essentially on the basis of commodity, its price, time and quantity. All
quantity fields are in specified units and price in rupees. The exchange specifies the unit of trading and
the delivery unit for futures contracts on various commodities. The exchange notifies the regular lot size
and tick size for each of the contracts traded from time to time. When any order enters the trading
system, it is an active order. It tries to find a match on the other side of the book. If it finds a match, a
trade is generated. If it does not find a match, the order becomes passive and gets queued in the
respective outstanding order book in the system. Electronic recording is done for each trade and this
provides the possibility for a complete audit trail if required.
a.

How to invest/trade in commodities exchange


The following diagram should give an investor/trader clear understanding of how to go about

investing/trading in commodities market. The prerequisite for trading in commodities markets are

a.1 Client code


code: The client who is interested to trade in commodity exchanges has to open a
trading account with a commodity broker by signing the client agreement form. The broker
in turn submits the details to the TCM and PCM of the exchanges. The validity of client
agreement will be verified in the exchanges and specific client code is allotted to trade in the
exchanges.
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Post Graduate Diploma in Agricultural Extension Management (PGDAEM)

a.2. Depositing initial margin


An initial amount has to be deposited by a customer at the time of entering into a contract, which
is termed as initial margin. The initial margin will differs based on the commodities. The exchanges fix the
margin for each commodity and it is a small percentage (5-6%) of the value of the lot.

Procedure for opening client-trading account


NCDEX/MCX

Commodity Broker, TCM/PCM Member of the Exchange

BROKER

BROKER

BROKER

Client opens trading account, by signing Client Agreement with the Broker

CLIENT

CLIENT

CLIENT

CLIENT

CLIENT

CLIENT

a.3 Trading process


The next step is trading in the exchange terminal. The client has to place his trade with broker
through NCDEX/MCX terminals. The trade placed at brokers terminal is submitted to the exchange
terminal. When any order enters the trading system, it is an active order. It tries to find a match on the
other side of the book. If it finds a match, a trade is generated. From the exchange terminal the trade
confirmation is sent to the broker and broker in turn gives the trade confirmation to the client.
a.4 Pay
-in / PPay
ay
ay-in
ay--out

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Introduction to Commodity Exchanges

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NCDEX/MCX

PAY-IN

PAY-OUT
BROKER

CLIENT

Daily exchanges calculate the difference of the entry value and closing price of the particular
date. If the difference is positive the exchanges credit that particular amount into the client account.
In case the difference is negative, the exchanges deduct that particular amount from the credit
account. If the account does not have balance then pay in request is sent to the clients.
2.

Clearing
National Securities Clearing Corporation Limited (NSCCL) undertakes clearing of trades executed

on the exchanges. The settlement guarantee fund is maintained and managed by exchanges. Only
clearing members including Professional Clearing Members (PCMs) are entitled to clear and settle contracts
through the clearinghouse. At exchanges, after the trading hours on the expiry date, based on the
available information, the matching for deliveries takes place firstly, on the basis of locations and then
randomly, keeping in view the factors such as available capacity of the vault/ warehouse, commodities
already deposited and dematerialized and offered for delivery etc. Matching done by this process is
binding on the clearing members. After completion of the matching process, clearing members are
informed of the deliverable/ receivable positions and the unmatched positions. Unmatched positions
have to be settled in cash. The cash settlement is only for the incremental gain/ loss as determined on the
basis of final settlement price.
3.

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 Exchanges, 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 CM (Clearing Member) with the respective clearing bank. All positions of a CM, either
brought forward created during the day or closed out during the day, are marked to market at the
daily settlement price or the final settlement price at the close of trading hours on a day. On the date
of expiry, the final settlement price is the spot price on the expiry day. The responsibility of settlement
35

Post Graduate Diploma in Agricultural Extension Management (PGDAEM)

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 the exchanges for all open positions for
a commodity for all constituents individually. Exchanges on receipt of such information match the
information and arrive at a delivery position for a member for a commodity.
The seller intending to make delivery takes the commodities to the designated warehouse. These
commodities have to be assayed by the exchange specified assayer. The commodities have to meet the
contract specifications with allowed variances. If the commodities meet the 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 then gives the invoice to his clearing member, who
would courier the same to the buyers clearing member. On an appointed date, the buyer goes to the
warehouse and takes physical possession of the commodities.

2.7 Let us Sum Up


The agricultural sector in India is facing more flux in prices than other sector. So the government
of India introduced commodity futures trading in India through commodity exchanges. A commodity
exchange is an association or a company or any other body corporate that is organizing futures
trading in commodities. The members of Exchanges are Trading cum Clearing Members (TCM) and
Professional Clearing Members (PCM). While the participants of futures trading are hedgers,
speculators, and arbitragers.
Organized futures market evolved in India by the setting up of Bombay Cotton Trade
Association Ltd. in 1875. The consequent gradual trade and industry liberalization in both the
domestic and external sectors emphasized the need for futures trading and on 1.4.2003 the
Government permitted futures trading in the commodities. The national commodity exchanges in
India are National Commodities Derivatives Exchange (NCDEX), Multi Commodity Exchange (MCX)
and National Multi Commodity Exchange (NMCE)
Globally, the major commodity exchanges are New York Mercantile Exchange, Chicago
Board of Trade, New York Board of Trade, Chicago Mercantile Exchange and London Metal Exchange.
Exchange transactions involve trading, clearing and settlement. To start trading the participant has to
create trading account in exchange and has to place the trades at broker terminals. The exchanges
undertake the pay in and pay out of trades executed. National Securities Clearing Corporation
Limited (NSCCL) undertakes clearing of trades executed on the exchanges. At last the contracts are
settled.
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2.8 Key Words


Contract expiration: Derivatives contracts expire on a predetermined date and time up to which the
contract is available for trading. This is notified by the exchange in advance. The contract expiration
period will not exceed twelve months or as the exchange may specify from time to time.
Contract Specification - Contract specification is a document, which provides detailed guidelines
and parameters of any relevant commodity traded on the exchange. The contract ensures the standards
of commodity futures through various parameters such as trading details, contract duration or expiry
date, quality parameters, delivery mode and its details. It includes every possible detail for the successful
execution of the trade conducted on the exchange. These include trading lot, price quote, order size,
tick size, limits of daily price, margin and open positions, delivery centers, settlement price and
procedure, tender / delivery period, taxation, legal obligation, etc.
Delivery - The tender and receipt of the actual commodity, the cash value of the commodity or of
a delivery instrument covering the commodity (e.g., warehouse receipts) used to settle a futures
contract.
Lot size: The permitted trading lot size for the futures contracts on individual commodities is stipulated
by the exchange from time to time. The lot size currently applicable on individual commodity contracts.
Mark-to-Market (MTM)- At the end of every trading day, the margin account of the trader / client
is adjusted to reflect the participants gain or loss. The price changes on the close of every trading
day may result in some gain or loss as compared to the previous days closing price. These price
variations are netted into the daily margin account. This process is known as marking to the market.
Outcry: Open outcry trading is a face to face and highly activate form of trading used on the floors
of the exchanges.
Over-the-Counter (OTC): Trading is to trade financial instruments such as stocks, bonds,
commodities or derivatives directly between two parties. It is contrasted with exchange trading, which
occurs via corporate-owned facilities constructed for the purpose of trading
Pay in - It refers to the transfer of funds from the buyer-members settlement account to the exchange
before he takes delivery of the commodity from the exchange specified warehouse.
Payout - It refers to the transfer of funds to the selling-members settlement account from the
exchange, after the buyer lifts the commodity.
Tic Size: It is the minimum jump in the price.
Trading cycle: Trading cycle for each commodity/ derivative contract has a standard period,
during which it will be available for trading.
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Post Graduate Diploma in Agricultural Extension Management (PGDAEM)

Trading hours: The exchange announces the normal trading hours/ open period in advance from time
to time. In case necessary, the exchange can extend or reduce the trading hours by notifying the members.
Unit of price quotation: Unit of price quotation is the price shown on the trading screen.
Unit of trading: Unit of trading or lot size or contract size is all unanimous. Lot size is the minimum size
of the derivatives, futures or options contract.
Yield / Rupee = Lot Size (Unit of Trading)/ Unit of price quotation.

2.9 Further Readings


Derivatives FAQ by Ajay Shah and Susan Thomas
Options, futures and other derivatives by John Hull.
http://www.ncdex.com
http://fmc.gov.in

2.10 Check Your Progress


1.

What are commodity futures?

2.

Who is the watchdog of futures trading?

3.

Define TCM

4.

What are the benefits of commodity exchanges?

5.

Brief the structure of commodity exchanges?

6.

Explain the exchange transactions in brief?

7.

How commodity exchanges evolved into India?

8.

What are the commodities identified for trading?

9.

What are the benefits in futures trading in commodities?

10. How would contracts settle?


11. What happens when the commodities reach the validity date?
12. Explain pay in and pay out in the commodity futures?
13. What is NMCEIL and who are the promoters of NMCEIL ?
14. What are the key commodity exchanges in India
15. What do you mean by lot size?
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Unit 3
Futures Exchange and Risk Management
Structure
3.0

Objectives

3.1. Price risk


3.2

Causes of price risk

3.3. Methods of tackling price risks


3.4. Evaluation of methods for their efficiency and limitation
3.5. Hedging
3.6. Advantages of hedging
3.7

Basic principles of hedging

3.8. Limitation of hedging


3.9

Types of hedging

3.10 Hedge ratio


3.11 Let us sum up
3.12 Key words
3.13 Further readings
3.14 Check your progress

3.0 Objectives
This unit has been designed to help you to understand

Price risk, causes of price risks

Methods of handling price risk

Hedging, advantages and limitations of hedging


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Post Graduate Diploma in Agricultural Extension Management (PGDAEM)

Types of hedging-long hedge

Short hedge and cross hedge and hedge ratio

3.1 Price Risk


Risk has always been a part of agriculture. The rate of price volatility in agricultural produce
would create uncertainty and risks, which could hamper the performance of the agricultural sector
and negatively impact the income and welfare of the farmers. Besides, it will have a negative impact
on overall economic growth, income distribution and poverty alleviation. Therefore understanding
agricultural risks and the ways for managing it becomes important. Price volatility is perhaps the
most pressing issue facing the producers of primary commodities.
Agricultural production implies an expected outcome or yield to achieve the expected returns.
Variability in outcomes from those, which are expected, poses risks to the ability to achieve financial
goals. In this context Price risk is basically the risk that returns from the investment in physical
agricultural goods or commodities will be reduced or lost due to a fall in the future market price of
the commodity owned. Here it is important to understand the difference between risk and variability.
It is well known that agricultural prices vary from month to month and year to year. However, if the
variation were predictable, farmers would face no price risk. There are many numbers of risks that
are associated with the agricultural commodities, especially at the production, storage, transport,
marketing and processing stages. Hence it becomes important to identify the cause for price risks
and manage them.

3.2 Causes of Price Risks


a.

Production Risks
As the demand for agricultural products is inelastic, supply shocks caused due to production

variations are magnified in price variations. Agricultural production risks may be due to those arising
out of weather related factors, pests or diseases, farm and management practices, genetics, machinery
efficiency, quality of inputs and also due to risks from variable prices.
b.

Financial or Credit Risk


Farm credit has always been an important factor in improving agricultural productivity and

strengthening the rural economy. However, complicated operational mechanism of farm credit services,
high transaction costs, uncomfortable repayment schedules, higher interest rates, lower access to
credit, heavy reliance on money lenders, insolvency problems etc have increased the associated
price risks of the commodities.
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c.

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Institutional Risks
If Government policy framework may come unwarranted that would create a profound impact

on the prices. The government intervention sometimes instead of protecting may result in distortion
of trade, as it does not let the natural market forces of supply and demand in identifying the prices.
Eg. Reform measures like restriction on storage and movement of produces, direct price support
measures, subsidies etc.
d.

Market linked Risks


In a developing economy like India, wild swings in market prices due to supply and demand

factors arise due to nascent nature of such markets. Lack of participation, non-availability or low
dissemination of market information, infrastructure bottlenecks, market structure etc tend to increase
the price risks.

3.3 Methods of Tackling Price Risks


a.

Handling price risks


Price risks may be handled in any one of the following ways. They may be

1)

Retained holding the risk, that is taking no protection for the downside risk

2)

Avoided Risks can be avoided fully by going for a totally new venture

3)

Reduced risks can be reduced or mitigated by different possible ways in order to get some
assured income.

b.

Self-insurance

Here the farmers use the previous periods accumulated savings to protect
against uncertainties that they cannot control.
c.

themselves

Crop storage It is a means of avoiding seasonally low prices when there is expectation of
price fall in the season and adequate price rise later. However financial resources and storage
space are required which may limit the scope of this kind of risk management.

d.

Diversification It is the combining of different production processes so that low income in


one will be offset by higher income from other enterprises. It can include growing of different
crops or different types of the same crop, mixed farming with combining crops and livestock
etc.

e.

Taking credit The farmers may lean on to credit given by government banks, co-operative
societies, commercial banks, etc as well as money lenders. If collateral is insisted on advancing
of the loan then this measure may not be feasible for poor farmers.
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Post Graduate Diploma in Agricultural Extension Management (PGDAEM)

f.

Contract farming Contract farming is normally associated with vertical integration, where
an agribusiness firm coordinates all aspects of a producer from production to obtaining the
end produce. Here a stable market or price is guaranteed.

g.

Crop Insurance Insuring a crop against the risks basically gives protection against the
losses and also sometimes offers opportunity for gains.

h.

Hedging in futures
With the advent of futures, the use of futures and other derivative products to manage risk

has turned out to be one of the most important and practical innovations in evolving market economies.
Of all the measures intended to reduce risk in futures, hedging is a concept that gains utmost
importance and is used as a financial offset to cash market risks, prevalently. Here the risk averse
producers can buy protection from the risk taking speculators looking for profit.
Hedging is defined as, the establishing of a position in the futures market that is equal and
opposite the position, or intended position, in the cash market with an objective of transferring cash
price risk. Simply put, it involves establishing a position in the futures market that is equal and
opposite of a position in the physical or spot market, i.e. buying in futures markets the quantity sold
in spot markets and vice versa, thus offsetting any loss attained in one market by a gain in the other
market. It helps the participants who are associated with the produce (in this case the producers or
the farmers) to reduce the risks of unanticipated loss by locking in the futures price of a commodity
to their advantage in advance.

3.4. Evaluation of Methods for their Efficiency and Limitation


Any risk must be evaluated for its frequency of occurrence and its possible negative
consequences. All the above risk management measures or strategies while having the major
advantage of reducing or mitigating the risks, also have certain efficiencies and limitations of their
own.

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Strategy

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Advantages

Limitations

Self-insurance

Protects from risks

Crop Storage

Increased returns

Diversification

Reduces year to year


variations in income
Helps to cope with risks
Assured income as per the
conditions of the contract

Taking credit
Contract
farming

Crop
Insurance
Hedging

Covers against losses

Taken after risk occurs, results in reduction of


assets.

Crop damage during storage

Requires adequate financial resources to


meet storing costs
Capital investment required is increasingly
higher
Limited access of credit to most farmers

There are chances for either the farmers


orcontractors to default

The producer loses the opportunity of


benefiting from upside price potential

Contracts may not be consistent with the


producers goals and risk tolerance.
Operational inefficiencies delay the process

Protects against risks

Less awareness among producers or


farmers
If there is a chance for upside price
potential it cannot be taken advantage of.
Involves basis risk

3.5 Hedging
What is hedging?

Taking a position in the futures market that is opposite to a position in the physical market

Reduces or limits risks associated with unpredictable changes in price

The objective behind this mechanism is to offset a loss in one market with a gain in another

A temporary substitution of futures market transaction for a planned cash market transaction

Goals of Hedging
1.

Reducing the underlying volatility of your cash flows.

2.

Minimizing the probability of large losses.

Hedgers
Hedgers could be government institutions, private corporations like financial institutions, trading
companies and even other participants in the value chain, for instance farmers, extractors, ginners,
processors etc., who are influenced by the commodity prices.
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Post Graduate Diploma in Agricultural Extension Management (PGDAEM)

3.6 Advantages of Hedging


Besides the basic advantage of risk management, hedging also has other advantages:
a.

Hedging stretches the marketing period.


period For example, a livestock feeder does not have to
wait until his cattle are ready to market before he can sell them. The futures market permits him
to sell futures contracts to establish the approximate sale price at any time between the time he
buys his calves for feeding and the time the fed cattle are ready to market, some four to six
months later. He can take advantage of good prices even though the cattle are not ready for
market.

b.

Hedging protects inventory values


values. For example, a merchandiser with a large, unsold inventory
can sell futures contracts that will protect the value of the inventory, even if the price of the
commodity drops.

c.

Hedging permits forward pricing of products


products. For example, a jewelry manufacturer can
determine the cost for gold, silver or platinum by buying a futures contract, translate that to a
price for the finished products, and make forward sales to stores. Having made the forward
sales, the manufacturer can use his capital to acquire only as much gold, silver, or platinum as
may be needed to make the products that will its orders.

3.7 Basic Principles of Hedging


When an individual or a company decides to use the futures markets to hedge a risk, the objective
is to take a position that neutralizes the risk as much as possible. Take the case of a company that knows
that it will gain Rs.1,00,000 for each 1 rupee increase in the price of a commodity over the next three
months and will lose Rs.1,00,000 for each 1 rupee decrease in the price of a commodity over the same
period. To hedge, the company should take a short futures position that is designed to offset this risk. The
futures position should lead to a loss of Rs.1, 00, 000 for each 1 rupee increase in the price of the
commodity over the next three months and a gain of Rs.1,00,000 for each 1 rupee decrease in the price
during this period. If the price of the commodity goes down, the gain on the futures position offsets the
loss on the commodity. Irrespective of what the spot price of soy oil is three months later, by going in for
a short hedge he locks on to a price of Rs.450 per MT. the price of the commodity goes up, the loss on
the futures position is offset by the gain on the commodity. There are basically two kinds of hedges that
can be taken. A company that wants to sell an asset at a particular time in the future can hedge by taking
short futures position. This is called a short hedge. Similarly, a company that knows that it is due to buy
an asset in the future can hedge by taking long futures position. This is known as long hedge. We will
study these two hedges in detail in the next section.
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3.8 Limitation of Hedging


In the examples we used above, the hedges considered were perfect. The hedger was able to
identify the precise date in the future when an asset would be bought or sold. The hedger was then
able to use the futures contract to remove almost all the risk arising out of price of the asset on that
date. In reality, hedging is not quite this simple and straightforward. Hedging can only minimize the
risk but cannot fully eliminate it. The loss made during selling of an asset may not always be equal to
the products made by taking a short futures position. This is because the value of the asset sold in the
spot market and the value of the asset underlying the future contract may not be the same. This is
called the basis risk. In our examples, the hedger was able to identify the precise date in the future
when an asset would be bought or sold. The hedger was then able to use the perfect futures contract
to remove almost all the risk arising out of price of the asset on that date. In reality, this may not
always be possible for a various reasons.
The asset whose price is to be hedged may not be exactly the same as the asset underlying
the futures contract. For example, in India we have a large number of varieties of cotton being
cultivated. It is impractical for an exchange to have futures contracts with all these varieties of cotton
as an underlying. The NCDEX has futures contracts on two varieties of cotton, long staple cotton and
medium staple cotton. If a hedger has an underlying asset that is exactly the same as the one that
underlies the futures contract, he would get a better hedge. But in many cases, farmers producing
small staple cotton could use the futures contract on medium staple cotton for hedging. While this
would still provide the farmer with a hedge, since the price of the farmers cotton and the price of the
cotton underlying the futures contract do match perfectly, the hedge would not be perfect. The
hedger may be uncertain as to the exact date when the asset will be bought or sold. Often the hedge
may require the futures contract to be closed out well before its expiration date. This could result in
an imperfect hedge.
The expiration date of the hedge may be later than the delivery date of the futures contract.
When this happens, the hedger would be required to close out the futures contracts entered into and
take the same position in futures contracts with a later delivery date. This is called a rollover. Hedges
can be rolled forward many times. However, multiple rollovers could lead to short. term cash owned
problems.

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Post Graduate Diploma in Agricultural Extension Management (PGDAEM)

3.9 Types of Hedging


1.

Short Hedge
A Short hedge is a hedge that requires a short position in futures contracts. It is appropriate

when the hedger already owns the asset, or is likely to own the asset and expects to sell it at some
time in the future. For example, a short hedge could be used by a cotton farmer who expects the
cotton crop to be ready for sale in the next two months. Short hedgers are merchants and processors
who acquire inventories of the commodity in the spot market and who simultaneously sell an equivalent
amount of less in the futures market. The hedgers in this case are said to be long in their spot
transactions and short in the futures transactions.
a.

b.

Uses of short hedge strategy

To protect the price of finished products

To protect inventory not covered by forward sales

To protect prices of estimated production of finished products

Short hedge with basis risk


When futures price increased more than that of the spot price due to widening of the basis,

the hedger incurs a larger loss on short futures position and a smaller profit on the corresponding
cash position. But when the spot price increases more than that of the futures price due to narrowing
of basis, the hedger incurs a smaller loss on the futures position and a larger profit on the corresponding
cash position.
c.

Examples

The more detailed example to illustrate a short hedge is given below

Refined soy oil contract specifications


Unit of trading 1000 Kgs (=1 MT)
Delivery unit 10000 Kgs (=10 MT)
Quotation/ base value Rs. per 10 Kgs
Tick size 5 paisa
Refined soy oil producer has just negotiated a contract to sell 10,000 Kgs of soy oil on 15th
January. It has been agreed that the price that will apply in the contract is the market price on the
15th April. The oil producer is therefore in a position where he will gain Rs.10000 for each 1 rupee
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increase in the price of oil over the next three months and lose Rs.10000 for each one rupee decrease in
the price of oil during this period. Suppose the spot price for soy oil on January 15 is Rs.450 per 10 Kgs
and the April soy oil futures price on the NCDEX is Rs.465 per 10 Kgs. Eg: gives the soy oil futures
contract specification. The producer can hedge his exposure by selling 10,000 Kgs worth of April futures
contracts(10 units). If the oil producer closes his position on April 15, the effect of the strategy would be
to lock in a price close to Rs.465 per 10 Kgs.
Eg: gives the payoff for a short hedge. Let us look at how this works.
On April 15, the spot price can either be above Rs.465 or below Rs.465.
Case 1
1: The spot price is Rs.455 per 10 Kgs. The company realises Rs.4,55,000 under its sales
contract. Because April is the delivery month for the futures contract, the futures price on April 15 should
be very close to the spot price of Rs.455 on that date. The company closes its short futures position at
Rs.455, making a gain of Rs.465 - Rs.455 = Rs.10 per 10 Kgs, or Rs.10,000 on its short futures
position. The total amount realized from both the futures position and the sales contract is therefore
about Rs.465 per 10 Kgs, Rs.4,65,000 in total.
Case 2
2: The spot price is Rs.475 per 10 Kgs. The company realises Rs.4,75,000 under its sales
contract. Because April is the delivery month for the futures contract, the futures price on April 15 should
be very close to the spot price of Rs.475 on that date. The company closes its short futures position at
Rs.475, making a loss of Rs.475 - Rs.465 = Rs.10 per 10 Kgs, or Rs.10,000 on its short futures
position. The total amount realized from both the futures position and the sales contract is therefore
about Rs.465 per 10 Kgs, Rs.4,65,000 in total.
2.

Long Hedge
Hedges that involve taking a long position in a futures contract are known as long hedges.
Long hedge strategy is used by dealers, consumers, fabricators, traders and processors etc, who

have taken or will be taking an exposure in the physical market.


a.

Uses of long hedge

To protect increase in the cost of raw material

To replace inventory at a lower prevailing cost

To protect uncovered forward sale of finished products.

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Post Graduate Diploma in Agricultural Extension Management (PGDAEM)

b.

Long hedge with basis risk


When spot prices increase more than that of futures prices due to narrowing of the basis, the

hedger incurs smaller profit on the long futures position and larger loss on the corresponding cash
position. But when the futures price increased more than that of the cash price due to widening of the
basis, the hedger incurs larger profit on the long futures position and smaller loss on the corresponding
cash position.
c.

Examples
A long hedge is appropriate when a company knows it will have to purchase a certain asset

in the future and wants to lock in a price now. Suppose that it is now January 15. Arm 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
Eg: Payoff for buyer of a long hedge
This shows the payoff for an industrial fabricator who takes a long hedge. Irrespective of what
the spot price of silver is three months later, by going in for a long hedge he locks on to a price of
Rs.1730 per kg. Profit Loss 1730 Price of silver Long position in silver futures Short position in silver
Eg; Silver futures contract specification
Unit of trading 5 Kgs
Delivery unit 30 Kgs
Quotation/ base value Rs. per kg of Silver
Tick size 5 paisa per kg and the April silver futures price is Rs.1730. The fabricator can hedge his
position by taking a long position in sixty units of futures on the NCDEX. If the fabricator closes his
position on April 15, the effect of the strategy would be to lock in a price close to Rs.1730 per kg.
Eg; gives the payoff for the buyer of a long hedge. Let us look at how this works. On April 15,
the spot price can either be above Rs.1730 or belowRs.1730.
Case 1: The spot price is Rs.1780 per kg. The fabricator pays Rs.5,34,000 to buy the silver
from the spot market. Because April is the delivery month for the futures contract, the futures price on
April 15 should be very close to the spot price of Rs.1780 on that date. The company closes its long
hedging.
Futures position at Rs.1780, making a gain of Rs.1780 - Rs.1730 = Rs.50 per kg, or Rs.15,000
on its long futures position. The effective cost of silver purchased works out to be about Rs.1730 per
MT, or Rs.5,19,000 in total.
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Case 2
2:: The spot price is Rs.1690 per MT. The fabricator pays Rs.5,07,000 to buy the silver
from the spot market. Because April is the delivery month for the futures contract, the futures price on
April 15 should be very close to the spot price of Rs.1690 on that date. The company closes its long
futures position at Rs.1690, making a loss of Rs.1730 - Rs.1690 = Rs.40 per kg, or Rs.12,000 on
its long futures position. The effective cost of silver purchased works out to be about Rs.1730 per MT,
or Rs.5,19,000 in total.
Note that the purpose of hedging is not to make profits, but to lock on to a price to be paid in the
future upfront. In the industrial fabricator example, since prices of silver rose in three months, on hind
sight it would seem that the company would have been better off buying the silver in January and holding
it. But this would involve incurring interest cost and warehousing costs. Besides, if the prices of silver fell
in April, the company would have not only incurred interest and storage costs, but would also have
ended up buying silver at a much higher price.
In the examples above we assume that the futures position is closed out in the delivery month.
The hedge has the same basic effect if delivery is allowed to happen. However, making or taking
delivery can be a costly process. In most cases, delivery is not made even when the hedger keeps the
futures contract until the delivery month. Hedgers with long positions usually avoid any possibility of
having to take delivery by closing out their positions before the delivery period.
3.

Cross Hedging
Hedging as a price risk management tool is applicable for spot commodities that also have

active futures contracts. But for commodities that do not have futures market, cross hedging comes
to help. Cross hedging is the process of hedging a cash commodity in the futures market of a
different, but related, commodity. In this case, jowar or bajra are traded only in the cash or spot
markets, so they are hedged for risk exposure against that of a related but different commodity like
maize, which is actively traded in the futures market. Therefore, a cross-hedge utilizes information in
one market, in this case the NCDEX/ MCX maize futures market to predict the price of jowar in spot
markets.
Cross hedging will generally work well for reducing price risk if

The price of the commodity being cross hedged and the price of the futures commodity are
closely related and follow one another in a predictable manner, meaning hedged price risk
is less than unhedged price risk (it refers to the general price level variability)

Large enough quantities are being traded to meet cross hedged futures contract size
specifications.
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Post Graduate Diploma in Agricultural Extension Management (PGDAEM)

Here maize is used for cross hedging jowar because these prices follow each other closely as
they can be substituted in poultry feed rations. To explain in a detailed way we can say that the prices
of jowar/bajra and maize tend to move in similar patterns because people tend to purchase the
under priced commodity or sell the overpriced commodity. For instance, poultry owners will substitute
jowar / bajra for maize and vice-versa depending upon the price of maize relative to the jowar/bajra
price. That is if the maize prices in spot market go high then feed manufacturing industry will shift to
jowar and consequently prices of jowar will also go high. Thus the prices of Maize and jowar should
be positively correlated for hedging the price risk against the exposure. In this study we can see that
during the period from July to December the correlation coefficient between the jowar and maize
prices is 0.79. This substitution causes the two prices to converge toward each other, creating a
relatively stable price relationship.
Now if they are cross-hedged the producer of jowar can establish a price for their produce.
This may be done anytime before the planting of the crop, before the actual grain is sold into the
local cash market, after planting, or even after harvest (during storage).
a.

Limitations of Cross Hedging


Though cross hedging can greatly reduce the exposure to price risk it does not guarantee a

profit. Moreover hedging addresses only the price risk and not the production or other risks. The
hedging decision must still take into account production costs and market outlook.
Hedging could be imperfect at times due to differences in the actual selling price and the
closure of the contract. In short term, hedging may lead to a disadvantageous position, so, a longterm view has to be taken for evaluating the merits of hedging.
For many producers, deciding when and how to hedge is one of the most difficult aspects.
Since cross hedging appears to be complex from the farmers point of view, to hedge successfully,
producers must understand futures markets, cash markets, and the basic relationships. They must
trade in the futures market and will have to involve more people such as a commodity broker and a
lender in their market decision-making.
Margin money is required to maintain a position in the futures market. Also since this process
involves extra marketing cost, including brokerage commissions and interest on margin money it
demands adequate cash flow with the farmers.
Moreover the commodity exchanges in India are relatively new. So, the contracts, especially
far month contract may not exist or may not be active.

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3.10 Hedge Ratio


Hedge ratio is the ratio of the size of position taken in the futures contracts to the size of the
exposure in the underlying asset. So far in the examples we used, we assumed that the hedger would
take exactly the same amount of exposure in the futures contract as in the underlying asset.
For example, if the hedgers exposure in the underlying was to the extent of 11 bales of
cotton, the futures contracts entered into were exactly for this amount of cotton. We were assuming
here that the optimal hedge ratio is one. In situations where the underlying asset in which the hedger
has an exposure is exactly the same as the asset underlying the futures contract he uses, and the spot
and futures market are perfectly correlated, a hedge ratio of one could be assumed. Equation 1
gives the optimal hedge ratio, one that minimizes the variance of the hedgers position.
The hedge ratio is found out by using the equation
h* = *J (1)
M
Where,
J =Change in spot prices
M = Change in futures prices
J = Standard deviation of J
M = Standard deviation of M
=Coefficient of correlation between J and M
h*= Minimum variance Hedge ratio

Let us consider an example. A company knows that it will require 11,000 bales of cotton in
three months. Suppose the standard deviation of the change in the price per Quintal of cotton over
a three month period is calculated as 0.032. The company chooses to hedge by buying futures
contracts on cotton. The standard deviation of the change in the cotton futures price over a three
month period is 0.040 and the coefficient of correlation between the change in price of cotton and
the change in the cotton futures price is 0.8. The unit of trading is 11 bales and the delivery unit for
cotton on the NCDEX is 55 bales. What is the optimal hedge ratio? How many cotton futures
contracts should it buy?

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Post Graduate Diploma in Agricultural Extension Management (PGDAEM)

If the hedge ratio were one, that is if the cotton spot and futures were perfectly correlated, as
shown in Equation 3, the hedger would have to buy 1000 units (one unit of trading = 11 bales of
cotton) to obtain a hedge for the 11,000 bales of cotton it requires in three months.
Number of contracts =11000/11

(2)

Np-1 = 1000

(3)

However, in this case as shown in Equation 5, the hedge ratio works out to be 0.64. The
company will hence require to take a long position in 640 units of cotton futures to get an effective
hedge (7)
Optimal hedge ratio = 0.8 X 0.0325/0.040 (4)
h=0.64

(5)

Number of contracts = 0.64 X 11000/11

(6)

Np-1 = 640

(7)

3.11 Let us Sum Up


Risk has always been a part of agriculture. Price volatility is perhaps the most pressing issue
facing the producers of primary commodities. The different causes of price risks are production risks,
financial risks, institutional risks, and market-linked risks. There are different methods for handling
price risks. One among them is hedging in futures. Hedging is defined as, the establishing of a
position in the futures market that is equal and opposite the position, or intended position, in the
cash market with an objective of transferring cash price risk. The advantages of hedging are Hedging
stretches the marketing period, Hedging protects inventory values, Hedging permits forward pricing
of products.
There are two types of hedging short and long hedge. A short hedge is a hedge that requires
a short position in futures contracts. It is appropriate when the hedger already owns the asset, or is
likely to own the asset and expects to sell it at some time in the future.
Hedges that involve taking a long position in a futures contract are known as long hedges.
Long hedge strategy is used by dealers, consumers, fabricators, traders and processors etc, who
have taken or will be taking an exposure in the physical market. Cross hedging is the process of
hedging a cash commodity in the futures market of a different, but related, commodity.

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3.12 Key Words


Basis risk: It is the difference between the futures price and spot price (F-S) at an instance of time.
Delivery: The tender and receipt of the actual commodity, the cash value of the commodity or of a
delivery instrument covering the commodity (e.g., warehouse receipts) used to settle a futures contract.
Long position: It is buying the asset (with an intention of selling later).
Lot size: The permitted trading lot size for the futures contracts on individual commodities is stipulated
by the exchange from time to time. The lot size currently applicable on individual commodity contracts.
of buying later).
Payoff: The Profit & Loss from a long or short option position held to expiration is called the positions
payoff.
Short position: It is selling the asset without possessing the asset (with an intention
Tic Size: It is the minimum jump in the price.
Underlying asset: An underlying asset is the asset on which the price of a derivative depends. Most
traded derivatives (i.e. those traded on exchanges) are settled for cash, not by actual delivery of the
underlying.
Unit of price quotation: Unit of price quotation is the price shown on the trading screen.
Unit of trading: Unit of trading or lot size or contract size is all unanimous. Lot size is the minimum
size of the derivatives, futures or options contract.

3.13 Further Readings


Forward Markets Commission, 2000 Ministry of Food and Consumer Affairs, Government of India;
Forward trading and Forward Markets Commission,
Ministry of Food and Consumer Affairs, 1999 Government of India; Futures trading, commodity
exchanges and Forward Markets Commission, New Delhi.
Tomek, W G and Peterson, H H; 1995 Risk management in agricultural markets: A review, The
Journal of Futures Markets, Vol. 21 (10), 2001, pp.953-985. United Nations Conference on Trade
and Development, Feasibility study on a worldwide pepper futures contract, (UNCTAD/COM/64),
October.
Youssef, Frida; 2000 Integrated report on commodity exchanges and Forward Market Commission,
Report of the World Bank Project for the improvement of the commodities futures markets in India.
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Post Graduate Diploma in Agricultural Extension Management (PGDAEM)

www.nse-india.com
www.ncdex.com

3.14 Check Your Progress


1.

What is price risk?

2.

How to minimize price risk?

3.

What is hedging

4.

List out the advantages of hedging?

5.

What are the disadvantages of hedging?

6.

Explain the different types of hedging briefly.

7.

Define short hedge with an example?

8.

What is hedge ratio?

9.

Under what conditions we use long hedge?

10. Differentiate between short and long hedge?


11. Explain the concept of cross hedge?

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Unit 4
Warehouse Receipts and Collateral Management
Structure
4.0

Objectives

4.1

Introduction to warehouses and warehousing

4.2

Functions of warehouses

4.3

Classification of warehouses

4.4

Warehouse receipt

4.5

Collateral management and its functions

4.6

Issues related to warehouse receipts: negotiability

4.7

Key features of the warehousing (Development and Regulation) Bill, 2005

4.8

Dematerialization of warehouse receipts and linkage of warehousing with futures trading

4.9

Let us sum up

4.10 Key words


4.11 Further readings
4.12 Check your progress

4.0 Objectives
In this unit you will learn about the following related concepts

Introduction to warehouses, warehousing and warehouse receipts

Functions of Warehouses

Classification of Warehouses

Warehouse Receipt and its uses

Collateral Management and its functions


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Post Graduate Diploma in Agricultural Extension Management (PGDAEM)

Issues related to Warehouse Receipts: Negotiability

Key features of the Warehousing (Development and Regulation) Bill, 2005

Dematerialization of Warehouse Receipts and linkage of warehousing with futures trading

4.1 Introduction to Warehouses and Warehousing


The production of most of the agricultural goods is seasonal, though their consumption takes
place throughout the year. This phenomenon has led to the growth of warehousing concept where
goods are physically stored till the time of consumption or sales. The warehousing concept has
assumed immense importance after the recent developments in the market like increase in futures
trading at the exchanges, increased role of banks and other institutions in agricultural trading in the
context of liberalization of the Indian markets in the WTO regime.
A warehouse is a location with adequate facilities where volume shipment are received from a
production center, broken down, reassembled into combinations representing a particular order or
orders, and shipped to the customers location or locations. In other words a warehouse is a scientifically
designed storage structure technically designed to protect the quality and quantity of the stored
produce.
Warehousing may be defined as a function, which involves assuming the responsibility for
quality and quantity of the stored goods in the warehouses. Thus warehousing involves the technical
aspects related to designing safe and sound structures as per the type of goods to be stored and the
prevailing conditions around the storage structures. Warehousing also involves having the knowledge
of safekeeping of grains while they are inside the warehouses through techniques like fumigation
and record keeping related to transfer of goods inside and outside the warehouses.

4.2 Functions of Warehouses


The functions of warehouse are as follows

Receive the Material

Store the Material properly: Provide the right and adequate storage and preserve the material
properly. Ensure that the materials do not suffer from damage, pilferage or deterioration.

Mixing/R
epacking of material
Mixing/Repacking

Deliver the material to right place

Keep the records perfectly in discipline


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Arranging transport

Arranging FFinance:
inance: The material stored in the warehouses are recognized as safe collaterals
by various banks and about 75% of the value of the produce may be financed. We would
discuss in detail about this function in later sections.

Price Stabilization and Market Intelligence: Warehouses provide an opportunity to the farmers
and the traders to store the produce when the prices are too low. They also sometimes
become information suppliers on the price trends through the data on offloading. Thus they
help the prices to stabilize through controlling excessive supplies in the market.

4.3 Classification of Warehouses


1.

On the basis of Type of Commodities Stored

a.

General W
arehouses: These are ordinary warehouses used for storage of most food grains,
Warehouses:
fertilizers, etc.

b.

Special Commodity W
arehouses: These are warehouses, which are specially constructed for
Warehouses:
the storage of specific commodities like cotton, tobacco, wool and petroleum products.

c.

Refrigerated W
arehouses/Cold Storages: These are warehouses in which low temperature is
Warehouses/Cold
maintained as per requirements and are meant for such perishable commodities as vegetables,
fruits, fish, eggs and meat.

2.

On the basis of Ownership

a.

Private warehouses: These are owned by individuals, large business houses or wholesalers
for the storage of their own stocks. They also store the products of others for a rent.

b.

Public warehouses: These are the warehouses, which are owned by the government and are
meant for the storage of goods. In India, Central Warehousing Corporation (CWC) and
State Warehousing Corporations (SWC) are the government organizations, which have the
mandate of building and operating warehouses all across the country. The CWC was
established as a statutory body in New Delhi on 2nd March 1957. CWC provides safe and
reliable storage facilities for about 120 agricultural and industrial commodities.
Separate warehousing corporations have been also set up in different States of the Indian
Union. The areas of operation of the State Warehousing Corporations are centers of district
importance. The total share capital of the State Warehousing Corporations is contributed
equally by the concerned State Govt. and the Central Warehousing Corporation.
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Post Graduate Diploma in Agricultural Extension Management (PGDAEM)

Apart from CWC and SWCs, the Food Corporation of India has also created storage facilities.
The Food Corporation of India is the single largest agency which as a capacity of 25.2
million tons.
c.

Bonded warehouses: These warehouses are specially constructed at a seaport or an airport


and accept imported goods for storage till the payment of customs by the importer of goods.
These warehouses are licensed by the government for this purpose. The goods stored in this
warehouse are bonded goods.

Capacity of Different Types of Warehouses in India


Sl No

Type of Warehouse

Capacity in Million Metric Tons

CWC

10.27

SWC

25

FCI

25.2

Private Warehouses available for hire (Estimated)

10

Private Warehouses used for self use(Estimated)

20

The extent of warehouse facilities available are very less in India as argued by experts in
commodity trading and there is a need to create further investment in the sector. The 11 th plan says
that a further capacity of 35 million tons should be created in the Warehousing sector.

4.4 Warehouse Receipt


A warehouse receipt is simply a document stating the ownership of a commodity. It is a
warrant issued by the warehouse to the person depositing the goods/produce in the warehouse
stating the following:
a)

Specified quantity, quality and grade of produce stored

b)

Warehouse location, storage fee etc.

c)

Date of Issue

d)

Approximate value of the produce indicating the present price

Warehouse receipts are issued by all approved warehouses after quality certification of the
stored goods.
The warehouse receipt can perform various functions. It converts agricultural produce or
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other inventory to a tradable warrant, which can be sold or used to raise a loan and even used for
delivery against a derivative instrument like futures contract.
Different banks have different guidelines for providing loans against the stored produce.
The amount of loan advanced depends on the market price, minimum support price and the
guidelines issued by the bank. The interest charged also depends on the norms of the bank for that
type of commodity. The other charges may involve collateral management charges and other fixed
charges as stipulated by the banks. By and large there are two systems prevalent:
1.

Hypothecation/Pledge of stocks
This system is prevalent mostly for the small private warehouses where the entire warehouse is

occupied with material belonging to a single entity. The material deposited in the warehouse is pledged
/Hypothecated as security. Once the loan is repaid after negotiations with the buyer, the borrower is free
to express his control over the stocks. This scheme is also popular as Produce Marketing Loan
a.

Storage receipts
It is a term closely associated with pledge financing, which is most common for Private gowdons/

private licensed warehouses. These receipts are issued by collateral managers of an agency known to
the bank who will have control over the commodity by lock-key method. In this way, the bank finances
the depositor only if the collateral manager approves the stock through the storage receipt.
2.

Warehouse receipt system


This is the most popular system where the financing is done based on warehouse receipt issued

by the warehouse. The warehouse receipt duly endorsed in favor of the Bank is to be deposited at the
bank and the material is released once the bank receives the payment from the buyer.
It is felt by various industry analysts that warehouse receipt-based funding has tremendous growth
potential in India. With the priority sector lending norms making it mandatory for banks to advance 18%
of loans to agriculture, warehouse-based receipt financing is being considered as the next big opportunity
in catering for the agricultural sector. The Planning Commission has also recently reinforced its commitment
to double the farm sectors growth from a low 2% per annum to 4% a year during the 11th Five Year
Plan. The government is now keen to break the logjam of low production and productivity of the farming
sector by beefing up infrastructure and irrigation sectors simultaneously. Therefore, in the near future
agricultural commodities will flow more steadily from farms. The management of these commodities will
prove to be both a challenge and an opportunity for banks and warehousing companies.

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Post Graduate Diploma in Agricultural Extension Management (PGDAEM)

4.5 Collateral Management and its Functions


The word collateral is synonymous with security or goods pledged against the loan advanced.
It may be defined as a third-party commitment accepted by the collateral taker to secure an obligation
of the collateral provider. In the context of warehouse based financing, the obligation is the amount
lent and the collateral is the goods stored. The need of collateral is intended to protect against
performance risk of counter party i.e. the risk of non-repayment of loan. Collateral Management
involves managing the collateral on behalf of the collateral taker.
The collateral is the only security, which provides protection against the financing done by the
financial institution in case of warehouse financing; collateral management has developed into a
highly specialized technique. Collateral management basically involves management of risk associated
with maintaining the value of the collateral. It therefore is associated not only with physically maintaining
the quality and quantity of the stored products in the warehouses but also mitigating risks associated
with fluctuations in prices of various commodities.
Thus collateral management deals with the following
1.

Storage and Preservation


Scientific storage and preservation is the first step towards keeping the quality and quantity of
the collateral.

2.

Testing and Certification


Timely testing helps to mitigate the quality risks that are ever-present in the commodities.

3.

Market Intelligence for Price Risk Management


Development of price prediction models based on information on spot and futures prices,
market arrivals and market trends to enable decisions on the timing of the sale.

4.

Price Risk Hedging


Minimization of the price risk exposure of the collateral through futures and options trading
at the national and international commodity exchanges.

5.

Developing Market Linkages


Prefixed buying and selling arrangements between buyers and sellers is also a very useful
technique to protect the collateral from any un-expected fall in the prices.

6.

Insurance
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7.

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Stock Documentation and Information repository


Collateral management is also very important when the warehouses are linked to commodity

exchanges. Collateral management ensures efficient and risk-free physical delivery systems. In the
recent past we have seen increased integration of collateral management and commodity exchanges.
Companies like National Bulk Handling Corporation (NBHC) and National Collateral Management
Services Limited (NCMSL) have developed as specialized agencies, which provide complete solutions
related to Collateral Management.

4.6 Issues related to Warehouse Receipts: Negotiability


Warehouse receipts can be negotiable or non-negotiable. A non-negotiable warehouse receipt
is made out to a specific party (a person or an institution). Only this party may authorize release of
goods from the warehouse. He may also transfer or assign the goods to another party, for example
a bank. The warehouse company must be so notified by the transferor before the transfer or assignment
becomes effective.
The non-negotiable warehouse receipt in itself does not convey title and, if it is in the name
of, for example, a trading firm, it needs to be issued in the name of or transferred to the bank in order
for the bank to obtain possession of goods. A security interest is much less attractive to a bank than
if it has what is called possessory collateral, i.e. it has direct recourse to the warehouse where the
goods are stored and in the event of a default or similar, it is easy for the bank to sell the commodities
in a shorter time frame.
Negotiable warehouse receipts can be traded, sold, swapped, used as collateral to support
borrowing, or accepted for delivery against a derivative instrument such as a futures contract.
To make the warehouse receipts enjoy a fully negotiable status there must be a regulatory regime in
force. The Warehousing (Development and Regulation) Bill, 2005 addresses the issues related to
negotiability of the Warehouse receipts in India.
1.

Preconditions for Viability of a Fully Negotiable Warehouse Receipt System


In order for a Negotiable Warehouse Receipt system to be viable, the economy within which

it operates must meet certain conditions. The legal system must support pledge instruments, such as
Warehouse Receipts, as secure collateral. The pertinent legislation must meet several conditions:

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Post Graduate Diploma in Agricultural Extension Management (PGDAEM)

2.

Warehouse Receipts must be functionally equivalent to stored commodities


The rights, liabilities, and duties of each party to a Warehouse Receipt (for example a farmer, a

bank, or a warehouseman) must be clearly defined;


3.

Warehouse Receipts must be freely transferable by delivery and endorsement


The holder of a Warehouse Receipt must be first in line to receive the stored goods or their

fungible equivalent on liquidation or default of the warehouse; and the prospective recipient of a
Warehouse Receipt should be able to determine, before acceptance, if there is a competing claim
on the collateral underlying the receipt.
4.

Existence of Reliable warehouse certification, guaranteeing basic physical and


financial standards
There must be a provision of a system of independent determination and verification of the

quantity and the quality of stored commodities, based on a national grading system. This should be
accompanied with an inspection mechanism of warehouses and stored commodities and the availability
of property and casualty insurance.
5.

The integrity of the system must be assured through performance guarantees.


A key prerequisite for the acceptability of Warehouse Receipts by the trade and by banks is

the existence of a performance guarantee for warehouses, assuring that the quantities of goods
stored match those specified by the Warehouse Receipt and that their quality is the same as, or better
than, that stated on the receipt. Without this guarantee, farmers and traders will be reluctant to store
their crops, and banks will be hesitant to accept Warehouse Receipts as secure collateral for financing
agricultural inventories.

4.7 Key features of the Warehousing (Development and Regulation)


Bill, 2005
Following are some of the key features of the Warehousing (Development and Regulation) Bill,
2005 which has been passed in the Parliament in early 2007:
1.

Context
Producers and traders stock various commodities such as food grain, pulses, sugar, metals and

oil in warehouses. The warehouse issues a receipt certifying that it is holding the specific commodity. The
receipt may be used as collateral to borrow money. The receipt can be transferred to a buyer of the
goods, who can take delivery from the warehouse. However, in India, trading in warehouse receipts
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(WRs) is limited as these are not considered negotiable instruments, i.e., they cannot be transferred from
one owner to another by endorsement and delivery.
A number of expert committees have deliberated on the possible methods and legislation required
to enable trading in these receipts, and related issues. The Warehousing (Development and Regulation)
Bill, 2005 seeks to make WRs negotiable, and establishes a structure to enable trading in these instruments.
For example, the proposed law would enable a farmer to store his produce in a warehouse, and sell it at
a later time by transferring the WR to a buyer or trader. The trader can subsequently sell the goods by
another transfer of the receipt, without physically moving the goods.
2.

Features
This Bill establishes minimum standards for WRs to make them negotiable. It establishes a

Warehouse Development and Regulatory Authority (WDRA) to regulate the WR system including
registering warehouses, providing for negotiability of WRs, and listing offences and penalties.
3.

Negotiable Warehouse Receipts


A WR is a document that is issued by the warehouse certifying that it is holding a certain amount

of goods as delivered to it by a depositor. A negotiable WR is transferable from person to person by


endorsement and delivery. It maintains its original worth because it is backed by the original goods
deposited. A non-negotiable WR is not transferable by endorsement.
The Bill establishes a framework for a negotiable warehouse receipts system for commodities. It
establishes a uniform WR that can be either in writing or in electronic form and that is fully negotiable. All
negotiable WRs must be issued by WDRA registered warehouses. Negotiability of a financial instrument
permits its ownership to be transferred by delivery of the instrument, or by endorsement (signing it) and
delivery. For example, the ownership of a Rs 10 currency note (which is a promissory note issued by the
Reserve Bank of India) is transferred by delivery, and that of a bearer cheque by endorsement and
delivery.
4.

The Role of Warehousemen


The warehouseman is the head of the warehouse and is responsible for storing the deposited

goods, issuing the WR, and delivering the deposited goods on retrieval of the receipt. Every warehouse
has to be registered with WDRA. The Bill outlines the role of the warehousemen, including liabilities,
duties, special powers to handle perishable and hazardous goods, as well as the lien of warehouse
on goods.

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Post Graduate Diploma in Agricultural Extension Management (PGDAEM)

5.

Regulatory Structure

The Bill establishes a Warehousing Development and Regulatory Authority (WDRA) to regulate
and promote the negotiable WR system. WDRA may constitute a Warehousing Advisory Committee,
which would consist of fifteen members who represent relevant interests.
WDRA may register Accreditation agencies, which would grant registration certificates to
warehouses.
6.

Penalties for Offences

The Bill seeks to penalize the warehouseman who knowingly issues a WR without taking actual
physical delivery of goods in his warehouse; who knowingly issues a duplicate WR without following the
proper procedure; who knowingly delivers goods without obtaining proper possession of the receipt; or
who fails to deliver the goods as agreed. It also imposes a fine of up to one lakh rupees, or imprisonment
for a term of up to three years, depending on the nature of the offence.
The Bill also seeks to penalise any depositor who knowingly declares the improper value of goods
to the warehouseman with imprisonment for a term of up to three years or with a fine of up to three times
the value of the goods or both.
7.

Advantages of Negotiable Warehouse Receipts

a)

High real interest rates are often linked to perceived risks, particularly when it concerns agriculture.
Secure and Negotiable Warehouse Receipts would reduce risk and lead to lower lending rates.
Collateralizing agricultural inventories through negotiable warehouse receipt system will lead to
an increase in the availability of credit, reduce its cost, and mobilize external financial resources
for the sector.

b)

Correctly structured Negotiable Warehouse Receipts provide secure collateral for banks by assuring
holders of the existence and condition of agricultural inventories.

c)

Warehouse Receipts contribute to the creation of cash and forward markets and thus enhance
competition. They can form the basis for trading commodities, since they provide all the
essential information needed to complete a transaction between a seller and a buyer. The
availability of negotiable warehouse receipts will thus both increase the volume of trade and
reduce transaction costs. Since buyers need not see the goods, transactions need not take
place at either the storage or the inspection location. With a functioning Warehouse Receipt
system, commodities are rarely, if ever, sold at the warehouse proper. A transaction can take
place informally or on an organized market or exchange. In either case, the Warehouse
Receipt forms the basis for the creation of a spot, or cash market. If transactions involve the
delivery of goods on a future date, Warehouse Receipts can form the basis for the creation of
a forward market and for the delivery system in a commodity futures exchange.
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d)

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A broader benefit of Warehouse Receipts is that they increase the confidence of participants,
particularly those in the private sector, in market transactions.

e)

A system of Negotiable Warehouse Receipts provides a way to reduce the need of government
agencies in procurement of agricultural commodities. Government intervention in agricultural
markets usually has two main objectives: to support prices, by buying directly from producers,
and to guarantee a measure of food security. In order to support prices, government can
accept Warehouse Receipts when prices drop below a support floor, rather than taking delivery
of physical inventories. Since Warehouse Receipts guarantee the existence of stocks,
governments can achieve their food - security
objectives by merely holding these receipts.

f)

Negotiable Warehouse Receipts can be combined with price-hedging instruments. This


combination provides lenders with secure collateral, in the form of Warehouse Receipts, and
puts a minimum risk on it, through the hedging operation.

4.8 Dematerialization of Warehouse Receipts and Linkage of


Warehousing With Futures Trading
The concept of dematerialization has been developed with a view to increasing the efficiency of
settlement of trades on stock exchanges and improving settlement efficiency. The concept involves holding
shares in electronic form with a depository and transacting the same on-line without any signatures.
With the increase in activity in the commodities futures market and establishment of national
level screen-based multi-commodities exchanges, need for an efficient settlement system in that
market is felt. Broadly, a commodity futures contract may be settled either by cash or by delivery of
the commodity depending upon the terms of the trade, demand of the buyer and rules of the exchange.
If the trade is expected to be settled by way of delivery of the commodity, the clearing house of the
commodity exchange will receive warehouse receipts from the seller instead of actual commodities
and pass such warehouse receipts over to the buyer. In case of national commodity exchanges,
buyers and sellers could operate from different parts of the country and if warehouse receipts are in
physical form, the warehouse receipts have to be delivered across the country from the seller to the
buyer, which could lead to systemic inefficiencies.
Either the original depositor or the holder in due course (transferee) can claim the commodities
from the warehouse for negotiable warehouse receipts. Warehouse receipts in physical form suffer
all the disadvantages of the paper form of title documents. Some of these limitations are as follows:
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Post Graduate Diploma in Agricultural Extension Management (PGDAEM)

Need for splitting the warehouse receipt in case the depositor has an obligation to transfer only
a part of the commodities

Need to move the warehouse receipt from one place to another with risk of theft/mutilation, etc.
if the transferor and transferee are at two different locations

Risk of forgery
Drawing lessons from the depository system for securities, depositories such as NSDL and CDSL

and national level multi-commodity exchanges have worked out a scheme to extend depository services
for settling trades in commodity futures. Investors trading in commodity futures may avail depository
services for receiving and delivering warehouse receipts.
A demat account for commodities has to be opened with empanelled DPs (Depository Participants).
Warehouses, that have entered into an agreement with depositories and commodity exchanges, can
issue depository eligible warehouse receipts. For example, NSDL has agreements with two multi-commodity
exchanges viz., National Commodity & Derivatives Exchange Limited (NCDEX) and Multi Commodity
Exchange of India Limited (MCX) and few warehouses that hold designated commodities in their custody.
The warehouse receipts in demat form can be used to give delivery and also physical delivery of goods
can be obtained against warehouse receipts credited in the demat account, through prescribed procedures.
In fact the smooth functioning of commodity exchanges is enabled through electronic warehouse
receipts increasing the association between the warehousing and futures trading. This is enabled through
the following:
a)

Ease in settlement of the contract through physical delivery

b)

With a good networking of warehouses, delivery can be taken at any location. This would
encourage hedge participation in the exchanges

c)

Better integration of spot and futures market increasing the efficiency of futures market

d)

Better information on crop fundamentals like stock positions helps to reduce risk of excess
volatility in prices

4.9 Let us Sum Up


A warehouse is a location with adequate facilities where volume shipment are received from
a production center, broken down, reassembled into combinations representing a particular order or
orders, and shipped to the customers location or locations. Warehousing involves the technical aspects
related to designing safe and sound structures as per the type of goods to be stored and the prevailing
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conditions around the storage structures as well as knowledge of safekeeping of grains while they are
inside the warehouses through techniques like fumigation and record keeping.
Warehouses are classified according to type of commodities stored as General Warehouses,
Special purpose Warehouses and Cold storages. On the basis of ownership they could be Private or
Public or Bonded Warehouses.
A warehouse receipt is a document stating the ownership of commodity. It specifies the
quantity, quality and grade of produce stored, warehouse location, storage fee and other details.
The warehouse receipt can perform various functions. As it converts agricultural produce or other
inventory to a tradable warrant, which can be sold or used to raise a loan and even used for delivery
against a derivative instrument like futures contract.
The Term Collateral Management refers to a third-party commitment accepted by the collateral
taker to secure an obligation of the collateral provider. Thus, collateral is the security, which provides
protection against the financing done by the financial institution. Collateral management basically
involves management of risk associated with maintaining the value of the collateral and deals with
aspects like Storage and Preservation,, Testing and Certification and other aspects related to price
risk management of commodities serving as collateral.
Negotiable warehouse receipts can be traded, sold, swapped, used as collateral to support
borrowing, or accepted for delivery against a derivative instrument such as a futures contract. The
Warehousing (Development and Regulation) Bill, 2005, which has been passed in the Parliament in
early 2007 has features that would create a regulatory framework for making the warehouse receipts
fully negotiable.
Negotiable warehouse receipts have many advantages such as low risk for the banker and
high credibility apart from efficient usage in delivery against a futures contract.
Recent advancements in dematerialization of Warehouse Receipts i.e. Holding Warehouse
Receipts in Electronic Form has solved problems of splitting the warehouse receipt, high risk of losing
the document and the risk of forgery. This has brought greater integration between warehousing and
futures trading.

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Post Graduate Diploma in Agricultural Extension Management (PGDAEM)

4.10 Key Words


Bonded warehouses: These warehouses are specially constructed at a seaport or an airport and
accept imported goods for storage till the payment of customs by the importer of goods.
Clearing house: A member of an exchange clearinghouse, responsible for executing client trades and
other financial commitments of customers.
Collateral : Commitment accepted by the collateral taker to secure an obligation of the collateral
provider.
Collateral Management: Collateral Management involves managing the collateral on behalf of
the collateral taker.
Dematerialization: Storing and transacting physical certificates in electronic form through a
depository. A Demat Account maintains record of electronic balances and transactions.
Depository: An agency, which maintains electronic balances of shares/warehouse deposits in
electronic form.
Hedging: It is an investment in order to reduce the risk of adverse price movements in a commodity,
by taking an offsetting position in a related commodity, such as long and short position.
Hypothecation: Charge in or upon any movable property, existing or future, created by a borrower
in favor of a secured creditor without delivery of possession of the movable property to such creditor.
Liberalization: Relaxation of government restrictions, usually in areas of social or economic policy.
Minimum support price (MSP): A price for various commodities declared by Central Government
at which it would purchase any quantity of the specified commodity from the farmers. MSP helps to
maintain the price of commodities above a certain level for the benefit of farmers.
Negotiability: The ability to be transferred to another party as a form of payment.
Pledge: A deposit of personal property as security for a debt.
Private warehouses: Warehouses owned by individuals, large business houses or wholesalers for
the storage of their own stocks or for rent.
Public warehouses: These are the warehouses, which are owned by the government and are
meant for the storage of goods for the public for a prescribed fee.
Refrigerated Warehouses/Cold Storages: These are warehouses in which low temperature is
maintained as per requirements and are meant for such perishable commodities as vegetables,
fruits, fish, eggs and meat.
Warehouse Receipt: A receipt issued by the warehouse to the person depositing the goods/produce
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Warehouse Receipts and Collateral Management

AEM - 202

in the warehouse stating details on quantity, quality and grade of produce stored.
Warehouse: Scientifically designed storage structure technically designed to protect the quality and
quantity of the stored produce.

4.11 Further Readings


Acharya S.S.and N.L.Agarwal, Agricultural Marketing in India, Oxford & IBH Publishing Co Pvt. ltd,
New Delhi, 2005
The Warehousing (Development And Regulation) Bill, 2005
Report of the Working Group on Warehouse Receipts & Commodity Futures. Department of Banking
Operations and Development Reserve Bank of India, Mumbai-April 2005
Various issues of Commodityindia.com
www.ficci.com
www.ncmsl.com
www.nbhcindia.com
www.nsdl.co.in
www.cdslindia.com

4.12 Check Your Progress


1.

Define warehousing. How is it different from simple storage?

2.

Discuss the functions of warehouses.

3.

How warehouses lead to Price Stabilization?

4.

What are the contents of a Warehouse receipt?

5.

What are the various methods of obtaining loan for produce stored in Warehouses?

6.

What are the functions of Collateral Management?

7.

What is the difference between a negotiable and non-negotiable Warehouse receipt? How is a
negotiable Warehouse receipt better?

8.

What are the penalties for various offences as per Warehousing (Development and Regulation)
Bill, 2005?

9.

How are warehouse receipts in demat form better than paper receipts?
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Post Graduate Diploma in Agricultural Extension Management (PGDAEM)

AEM 202: Agri-Business and Entrepreneurship Development (3 credits)

Block I :

Entrepreneurship

Unit 1

Enterpreneurship Development and Agri-Business Plan

Unit 2

Cash Management

BlockII :

Agri Business

Unit 1

Marketing Management in Agri Business

Unit 2

Rural Marketing

Unit 3

Procurement

Unit 4

Supply Chain Management (SCM)

Block III :

Commodity and Future Marketing

Unit 1

Commodity Markets

Unit 2

Introduction to Commodity Exchanges

Unit 3

Futures Exchange and Risk Management

Unit 4

Ware house Receipts and Collateral Management

Block IV :

Business Laws and Ethics

Unit 1

Business Laws and Ethics

Unit 2

Indian Contract Act, 1872

Unit 3

Sale of Goods Act, 1930

Unit 4

Indian Partnership Act, 1932

Unit 5

Companies Act, 1956

Unit 6

Negotiable Instrument Act, 1881

Unit 7

The Essential Commodities Act, 1955

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AEM - 202

Post Graduate Diploma in Agricultural Extension


Management (PGDAEM)

AEM 202
Agri-Business and Entrepreneurship Development
(3 Credits)

Block III
Commodity and Future Marketing

National Institute of Agricultural Extension Management


(An Organization of the Ministry of Agriculture, Govt. of India)
Rajendranagar, Hyderabad 500 030, Andhra Pradesh, India
www.manage.gov.in
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