You are on page 1of 104

CONTENTS

TOPIC
1

Evolution of commodity exchanges


Evolution of Commodity Exchanges
Leading Commodity Exchanges
Commodity exchanges in Developing Economies

Commodity exchanges in India


Evolution of Commodity Markets in India
List of Commodity Exchanges in India
List of commodities in which futures trading is permitted

Introduction to Derivatives
Traditional markets
Emergence and growth of derivatives markets
What are derivatives?
Forward and Future contracts
Forwards v/s Futures in a nutshell
Swaps
Options
Options Glossary

Futures market functioning


Trading
Placing the Order
Methods of Trading
Kinds of Orders
Kinds of Margins
Pricing of Futures
Closing out the positions
Clearing and Settlement
Clearing House
Functions of a clearing house
Processes of a clearing house
Proposed Systems and Regulations at NCDEX Clearing
house
Settlement Methods
Proposed Systems and Regulations at NCDEX
Accredited Warehouse, R&T Agents, Assayers
Clearing and Settlement at NCDEX in a nutshell

Characteristics of commodity trading


Hedging
Hedging Strategies
Hedge Ratio

PAGE
3
3
4
5
6
6
6
9
11
11
12
12
13
17
18
19
22
24
24
24
24
25
27
28
30
31
31
31
32
33
34
37
41
44
44
45
45

Advantages of Hedging
Limitations of Hedging
Basis Risk
Speculation
Arbitrage
Cash and Carry Arbitrage
6

NCDEX and its functioning


Objectives
Promoters
Governance
Membership
Commodities Traded
Institutional Tie-Up

Regulatory provisions
Forward Contract (Regulation) Act
Forward Markets Commission (FMC)
Functions of FMC
Powers of The Commission
Regulatory measures of FMC
Securities Contracts (Regulation) Act
Agricultural Markets
Proposed rules and regulations of NCDEX

Sample Problems and Answers


Multiple Choices
Fill in the blanks
Problems
Answers

47
47
48
49
49
50
51
51
51
51
52
52
52
54
54
54
54
55
55
55
56
57
64
64
71
72
79

Frequently Asked Questions

81

10

Economic Benefits of Futures trading

93

11

Glossary of Futures Terms

94

1. EVOLUTION OF COMMODITY EXCHANGES

Most of the commodity exchanges, which exist today, have their origin in the late 19 th and
earlier 20th century. The first central exchange was established in 1848 in Chicago under
the name Chicago Board Of Trade. The emergence of the derivatives markets as the
effective risk management tools in 1970s and 1980s has resulted in the rapid creation of
new commodity exchanges and expansion of the existing ones. At present, there are major
commodity exchanges all over the world dealing in different types of commodities.
Commodity Exchange
Commodity exchanges are defined as centers where futures trade is organized In a wider
sense, it is taken to include any organized market place where trade is routed through one
mechanism, allowing effective competition among buyers and among sellers - this would
include auction-type exchanges, but not wholesale markets, where trade is localized, but
effectively takes place through many non-related individual transactions between different
permutations of buyers and sellers.
Role of Commodity Exchanges
Exchanges can concentrate on the trade in futures and options contracts, or they could
primarily function as centers for facilitating physical trade. They act as a focal point for trade
transactions, and increase the security of these transactions.
Well-organized commodity exchanges form natural reference points for physical trade, and
in this way, they help the price discovery process. If a commodity exchange manages to link
different warehouses in the country, this allows trade to take place more efficiently.
Evolution of Commodity Exchanges
The creation of exchanges goes back to the late 19th century with the development of
national and international market places. The main rationale, was the reduction of transaction
costs, the major potential for it lying in organizing a physical market place, where buyers and
sellers could be sure of finding a ready market .
One of the factors that led to the creation of the Chicago Board of Trade, over a century old
and still one of the world's largest commodity exchanges, was that farmers coming to Chicago
at times found no buyers, and had to dump their cereals unsold in Lake Michigan, adjoining the
city. These old exchanges are located mainly in developed countries. However, a few were
created in developing countries, too. The Buenos Aires Grain Exchange in Argentina, founded in
1854, is one of the oldest in the world.
We're now seeing the onset of a new phase in the evolution of commodity exchanges, driven
by technology. Established traditional exchanges seem convinced that the Internet is
providing them with unprecedented opportunities. This is equally true for commodity
exchanges in developing countries - Technology has made it possible for them to offer new
products at a lower cost. They now need to grasp these possibilities.

Some of the leading commodity exchanges across the globe are:


United States Of America

Canada
Brazil

North and South America


Chicago Board of Trade (CBOT)
Chicago Mercantile Exchange
Minneapolis Grain Exchange
New York Cotton Exchange
New York Mercantile Exchange
Kansas Board of Trade
New York Board of Trade
The Winnipeg Commodity Exchange
Brazilian Futures Exchange
Commodities and Futures Exchange
Asia/Pacific

Australia

Sydney Futures Exchange Ltd.

Peoples Republic Of China

Beijing Commodity Exchange


Shanghai Metal Exchange
Hong Kong Futures Exchange

Hong Kong
Japan

Malaysia
New Zealand
Singapore
France
Italy
Netherlands
Russia

Spain

United Kingdom

Tokyo International Financial


Futures
Exchange
Kansai Agricultural Commodities Exchange
Tokyo Grain Exchange
Kuala Lumpur commodity Exchange
New Zealand Futures & Options Exchange
Ltd.
Singapore Commodity Exchange Ltd.
Europe
Le Nouveau Marche
MATIF
Italian Derivatives Market
Amsterdam Exchanges
Option Traders Combination
The Russian Exchange
MICEX/Relis Online
St. Petersburg Futures Exchange
The Spanish Options Exchange
Citrus Fruit and Commodity Futures Market
of Valencia
The London International Financial Futures
and Options Exchange
The London Metal Exchange

Commodity Exchanges in Developing Economies


Africa
Africa`s most active and important commodity exchange is the South African Futures
Exchange (SAFEX). It was informally launched in 1987. SAFEX only traded financial
futures and gold futures for a long time, but the creation of the Agricultural Markets
Division (as of 2002, the Agricultural Derivatives Division) led to the introduction of a range
of agricultural futures contracts for commodities, in which trade was liberalized, namely,
white and yellow maize, bread milling wheat and sunflower seeds.
Maize contracts are also traded on new exchanges in Zambia and Zimbabwe. Farmers
established the Zimbabwe Agricultural Commodity Exchange (ZIMACE) in 1994, in response
to the gradual liberalization of state-controlled agricultural marketing.
Asia
Chinas first commodity exchange was established in 1990 and at least forty had appeared
by 1993. The main commodities traded were agricultural staples such as wheat, corn and in
particularly soybeans.
In late 1994, more than half of China's exchanges were closed down or reverted to being
wholesale markets, while only 15 restructured exchanges received formal government
approval. At the beginning of 1999, the China Securities Regulatory Committee began a
nationwide consolidation process which resulted in three commodity exchanges emerging;
the Dalian Commodity Exchange (DCE), the Zhengzhou Commodity Exchange and the
Shanghai futures Exchange, formed in 1999 after the merger of three exchanges: Shanghai
Metal, Commodity, Cereals & Oils Exchanges.
The Taiwan Futures Exchange was launched in 1998
Malaysia and Singapore have active commodity futures exchanges. Malaysia hosts one
futures and options exchange. Singapore is home to the Singapore Exchange (SGX), which
was formed in 1999 by the merger of two well-established exchanges, the Stock Exchange
of Singapore (SES) and Singapore International Monetary Exchange (SIMEX).
Latin America
Latin Americas largest commodity exchange is the Bolsa de Mercadorias & Futuros, (BM&F)
in Brazil. Although this exchange was only created in 1985, it was the 8th largest exchange
by 2001, with 98 million contracts traded.
There are also many other commodity exchanges operating in Brazil, spread throughout the
country. They trade largely in commodities for immediate or forward delivery, but through
an electronic network (which links most of the countrys exchanges) they also make it
possible to trade in futures contracts.
Argentinas futures market Mercado a Termino de Buenos Aires, founded in 1909, ranks as
the worlds 51st largest exchange.
Mexico has only recently introduced a futures exchange to its markets. The Mercado
Mexicano de Derivados (Mexder) was launched in 1998.

2. COMMODITY EXCHANGES IN INDIA


EVOLUTION OF COMMODITY DERIVATIVE MARKETS IN INDIA

First organized futures market evolved in India by setting up of Bombay Cotton Trade
Association Ltd. in 1875.

Bombay Cotton Exchange Ltd. was established in 1893 following the widespread
discontent amongst leading cotton mill owners and merchants over the functioning of
Bombay Cotton Trade Association.

The Futures trading in oilseeds started in 1900 with the establishment of the Gujarati
Vyapari Mandali which carried on futures trading in groundnut, castor seed and cotton.

Futures trading in wheat was existent at several places in Punjab and Uttar Pradesh. But
out of all the most notable futures exchange for wheat was chamber of commerce at
Hapur set up in 1913.

Futures trading in bullion began in Mumbai in 1920.

Calcutta Hessian Exchange Ltd. was established in 1919 for Futures trading in rawjute
and jute goods. But organized futures trading in raw jute began only in 1927 with the
establishment of East Indian Jute Association Ltd. These two associations amalgamated
in 1945 to form the East India Jute & Hessian Ltd. to conduct organized trading in both
Raw Jute and Jute goods.

Enactment of Forward Contracts (Regulation) Act, 1952

Establishment of the Forwards Markets Commission (FMC) in 1953 under the Ministry
of Consumer Affairs and Public Distribution.

In due course several other exchanges were created in the country to trade in diverse
commodities.
COMMODITY EXCHANGES IN INDIA
A comprehensive list of the registered commodity exchanges in India is given below:
S.No.
1

EXCHANGE
Bhatinda Om & Oil Exchange Ltd. Bhatinda.

The Bombay Commodity Exchange Ltd.


Mumbai

The Rajkot Seeds oil & Bullion Merchants


Association Ltd.

PRODUCTS TRADED
Gur
Sunflower Oil
cotton (seed and oil)
Safflower (Seed, Oil and Oil cake)
Groundnut (Nuts and Oil)
Castor oil-Int'l
Castorseed
Sesamum (oil and Oilcake)
Rice Bran, Rice Bran Oil and Oilcake
Crude Palm Oil
Groundnut Oil
Castorseed

5
6
7

Rajkot
The Kanpur Commodity Exchange Ltd, Kanpur

The Meerut Agro Commodities Exchange Co.


Ltd., Meerut.
The Spices and Oilseeds Exchange Ltd.
Sangli, Maharashtra.
Ahmedabad Commodity Exchange Ltd.

Rapeseed/Mustardseed
Rapeseed/Mustardseed Oil
Rapeseed/Mustardseed oil-Cake
Gur
Turmeric
cottonseed
Castorseed
Gur
Pepper

8
9

Vijay Beopar Chamber Ltd., Muzaffarnagar


India Pepper & Spice Trade Association.
Kochi

10

Rajdhani Oils and Oilseeds Exchange Ltd.


Delhi

Gur
Rapeseed/Mustardseed
Sugar Grade - M

11

National Board of Trade.


Indore.

Rapeseed/Mustard seed/Oil/Cake
Soybean/Meal/Oil
Crude Palm Oil

12

The Chamber Of Commerce.


Hapur

Gur
Rapeseed/Mustardseed

13
14

The East India Cotton Association Mumbai


The Central India Commercial Exchange Ltd.
Gwaliar

Indian Cotton
Gur

15

The East India Jute & Hessian Exchange


Ltd.,
Kolkata.

Hessian
Sacking

16

First Commodity Exchange of India Ltd.


Kochi

Copra
Coconut oil
Copra cake

17

Bikaner Commodity Exchange Ltd.


Bikaner
The Coffee Futures Exchange India Ltd.
Bangalore.

No commodity is traded at present

18

Coffee

19

E sugarindia Limited.
Mumbai

Sugar

20

National Multi Commodity Exchange of India


Limited.
Ahmedabad

Gur
RBD Pamolein
Crude Palm Oil
Sunflower (Seed and Oil)
Rapeseed/Mustardseed (seed, oil and
oilcake)
Soy bean (Beans, oil and oilcake)
Copra
Cotton (Seed, oil and oilcake)
Safflower (seed, oil and oilcake)
Groundnut (Nuts, oil and oilcake)
Sugar
Sacking
Coconut (oil and oilcake)
Castor (seed, oil and oilcake)
Sesamum (Seed, Oil and oilcake)
Linseed (seed, oil and oilcake)
Rice Bran Oil
Pepper
Guarseed
Gram
Aluminium Ingots
Nickel
Vanaspati
Rubber
Copper
Zinc
Lead
Tin

COMMODITIES IN WHICH FUTURES TRADING IS PERMITTED


Govt. of India has the ultimate powers to decide the commodities in which futures trading
can be allowed. At present forward trading is allowed in the following commodities in India.
Commodity Group
Fibers and Manufacturers

Spices

Edible Oilseeds and Oil

Others

Metals

Products
Kapas,
Hessian
Indian Cotton
Staple Fiber Yarn
Sacking
Gram
Pepper
Turmeric
RBD Pamolein
Rapeseed/Mustard (seed, oil and cake)
Soy bean (beans, meal, oil and cake)
Copra
Cotton (seed, oil and cake)
Groundnut (nuts, oil and cake)
Castor oil-Int'l
Coconut (oil and cake)
Copra cake
Cottonseed oil
Sesamum (seeds, oil and cake)
Safflower (seed, oil and cake)
Rice Bran, Rice Bran Oil and cake
Sunflower (Seed, oil)
Crude Palm Oil
Vanaspati
Linseed (seed, oil and cake)
Gur
Potato
Sugar
Sugar Grade M
Sugar Grade - S
Coffee-Robusta Cherry AB
Raw Coffee Arabica Parchment
Raw Coffee Robusta Cherry
Coffee
Coffee-Plantation A.
Coffee-Robusta Cherry AB.
Raw Coffee Robusta Cherry.
Raw Coffee Arabica parchment
Rubber
Aluminium Ingots

10

Nickel
Copper
Zinc
Lead
Tin
Gold
Silver

11

3. INTRODUCTION TO DERIVATIVES
TRADITIONAL MARKETS
Traditional markets are the Cash and Carry markets. They are also called Spot markets. The
contract is called a Spot contract. A spot contract is an agreement where the seller agrees
to deliver an asset and a buyer agrees to pay for that asset on the spot. They are used in
all forms of business to transfer title to goods.
The advantage with the traditional markets is that the buyer can find the precise
commodity that suits him, pay the money and become the owner of the merchandise
immediately. However, transactions in traditional markets are inherently high-risk. The
following example is illustrative of this drawback of traditional markets.
Example: Company X has Poultry feed business and sells the feed in the retail market under
their own brand name.
The prices in the retail market fluctuate less and vary according to the competitor prices.
The raw material for the poultry feed consists of Soy meal, Maize, wheat bran and brokens,
oilcakes, etc. The prices of the raw materials vary according to the supply-demand situation
of the commodities like Soybean, Maize, Wheat etc. The production of these commodities is
in turn largely dependent on the vagaries of the monsoon.
The raw materials approximately constitute 70% of the cost of manufacturing the feed.
The profit margins at current price levels are 10% of the sales of the feed
The Company, in June (for example) needs to plan the buying of raw materials in the month
of December to manufacture the feed. In June the company anticipates the raw material
prices in December to be more or less similar as in the previous year.
However, in the month of December it finds that the cost of the raw materials have
increased by 20% from the previous year because of a bad monsoon resulting in fall in
production and the consequent supply shortage. The increase in raw material prices resulted
in increased cost of manufacturing of the feed and decreased profit margins for the
company.
This above example illustrates the need for a system, which can minimize the risk in the
traditional markets and protect the buyers and sellers from the unexpected price
fluctuations.
The Disadvantages of the traditional markets can thus be summed as follows:

Price uncertainty which makes it difficult to predict the market accurately

Lack of effective mechanism to eliminate the price risk which arises due to demand and
supply variations and uncertainties in the economic and market conditions

12

EMERGENCE AND GROWTH OF DERIVATIVES MARKETS


Derivatives have emerged out of spot contracts as an effective risk management tool.
There are evidences indicating that futures trading existed in Japan and China even in the
17th century.
In the mid 1800s Chicago was developing as a commercial center. Wheat farmers and
traders across the country used to assemble in Chicago to sell and buy wheat. There was a
heavy supply of wheat, but poor methods of grading and weighing almost left the farmers at
the mercy of the traders. As a result of this a central exchange was established in 1848 for
farmers and traders to deal in spot markets. Soon after this with the increase in trade,
farmers and traders started entering into forward contracts at a predetermined price to
minimize the risk. The first forward contract was recorded at CBOT (Chicago Board Of
Trade) in March 1851 for Maize corn to be delivered in June of that year. At that time the
forward contracts created confusion for the users as they were traded privately and were
not standardized. As a result of this, CBOT formalized grain trading by developing
standardized agreements called futures contracts in 1865.
For the next hundred years the derivatives segment grew steadily, but were still small
compared to spot markets. During the post 1970s derivatives started growing exponentially
in the USA. The key economic and technological factors that drove this growth were:

Breakdown of the Bretton woods system of fixed exchange rates in 1971 (Bretton
woods System- US dollar is the anchor of this system and the dollar was pegged to
gold. It was convertible to gold at the rate of $35 to an ounce. The currencies of all
other nations were pegged to US dollar, which could be revalued or devalued when
necessary. With the breakdown of this system, dollar was no longer convertible to
gold, which resulted in inflation and currency turmoil).

Oil price shocks in 1973

Excess government spending and high inflation in USA in 1970s

Exponential increase in the magnitude of world trade, capital flows and progressive
dismantling of tariff barriers.

Technological innovations like advancements in communication and information


technologies enabled effective implementation of derivatives

Implementation of financial innovations including 24 hours global trading and online


risk management systems.

WHAT ARE DERIVATIVES?


A derivative is a financial instrument whose value depends on the value of the underlying
variables. There are broadly 4 types of derivatives:

Forwards: A forward contract is a bilateral agreement in which the buyer and the seller
agree upon the delivery of a specified quality and quantity of an asset on a specified
future date at a price agreed today. These are not traded on the exchanges.

13

Futures: Future contracts are exchange-traded contracts to sell or buy financial


instruments or physical commodities for future delivery at an agreed upon price.
MEANING :WHICH PRICE EITHER SPOT OR

Swaps: The word Swap literally means an exchange. A Swap may be defined as a
contract whereby two parties (known as counter parties), exchange two different
streams of cash flows over a definite period of time, usually through an intermediary
like a financial institution. The nature of the exchange flows to be exchanged is defined
in the contract.

Options: An option is an agreement between two parties-one of whom is the buyer and
the other is the seller. An option gives the holder or buyer of the option the right but
not the obligation, to buy or sell an asset at a known fixed price at a given point in the
future. The seller in turn has the obligation (and not the right) to sell the asset to the
buyer. For assuming this obligation the seller charges a premium called Option premium
from the buyer.

In less than three decades of their coming into vogue, derivatives markets have become
part of the day-to-day life in trading for ordinary people in most parts of the world.
FORWARD AND FUTURE CONTRACTS
Forward Contracts
A forward contract is traded in the Over the Counter Market, usually between two financial
institutions or between a financial institution and client. One of the parties 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. The price in a forward contract is known as the
delivery price.
Future Contracts
Future contracts have evolved out of forward contracts and are exchange-traded versions
of forward contracts. In futures contract there is an agreement to buy or sell a specified
quantity of financial instrument/ commodity in a designated future month at a price agreed
upon by the buyer and seller. The contracts have certain standardized specifications with
the date and time of expiry of the contract.
Types of Future Contracts:
The common underlying for which the futures are construed, are:

Commodity Futures: Futures in which the underlying asset is a commodity. It can be


agricultural commodity like wheat, corn, soybeans, perishable commodities like pork or
even precious assets like gold, silver etc.

Financial futures: Futures in which the underlying assets are financial instruments like
money market paper, notes, bonds. Currency futures on major convertible currencies
like the US Dollar, Pound, Euro or Yen. Security futures such as single stock futures and
stock index futures.

14

Index Futures: The underlying asset is an Index. Most, of these contracts are for stock
indices. The more famous indices on which futures are traded are Standard and Poor
Composite 500,The New York Stock Exchange Index.

Long and Short Positions in a Forward/ Futures contract


Long Position

The party, who buys the contract, is considered, as assuming a long position in the
market with the expectation that price will go up. If the market goes down the party
with the long position tends to lose money.

The payoff from a long position in a forward contract for one unit of an asset is St K.
(Where, St is the spot price of the asset at the time of the maturity of the contract
and K is the delivery price)

Short Position

The party, who sells the contract, assumes a short position. Going short is selling off
expecting the price to go down. At the time of the maturity if the delivery price is
higher than the spot price the seller makes profit. If the delivery price is less than the
spot price at the time of maturity of the contract the seller incurs a loss.

The payoff from a short position in a forward contract for one unit of an asset is K St.
K is the delivery price and St is the spot price of the asset at the time of the maturity
of the contract.

Figure: Pay-off in Forward contracts


Forward contracts have linear/symmetric pay-off profiles, highlighting the fact that both
the buyer and the seller of these products have equal rights and obligations. Consequently,
the buyer pays no compensation to the seller, upfront. The pay-offs to the buyer and seller
are a linear function of the price of the underlying.

Buyers Pay
-off

Profit
Spot price (St)
of
the
commodity at
the time of
the maturity

Loss

Delivery
Price (k)

Sellers Payoff

15

K is the delivery price of the contract (the price at which the underlying commodity or
security moves from the seller to the buyer) and St is the spot price of the commodity at
the maturity of the contract. This is because the holder of the contract is obligated to buy
an asset worth St for K.

16

Forward and Futures contract


i) Characteristics
Forward Contracts

Forward contracts are OTC (Over the


Counter) contracts.
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 has to be settled by
delivery of the asset on expiration date.
In case, the party wishes to reverse the
contract, it has to compulsorily go to the
same counter party.

Future Contracts

Futures are essentially exchange traded.

Futures contracts are standardized in


terms of its various characteristics like
quantity, quality, settlement dates and
market conventions etc., for the easy and
convenient access by a large number of
market participants.

It is a price fixing contract. The


buyer/seller is obligated to take/give
delivery or closeout the positions at the
pre agreed price for the purpose of
settlement.

In futures market actual delivery of goods


takes place only in a very few cases.
Transactions are mostly squared up before
the due date and are settled by payment
of differences without any physical
delivery of goods taking place.

ii) Determining Prices


Forward Contracts

In principle the forward price for an asset would


be equal to the spot or the cash price at the time
of the transaction and the cost of carry. The cost
of carry includes all the costs incurred for
carrying the asset forward in time. Depending
upon the type of asset or commodity the cost of
carry takes into account factors including
payments and receipts for storage, transport
costs, interest payments, dividend receipts,
capital appreciation etc.

Future Contracts
Price discovery mechanism is similar.

Forward Price = Spot or the cash price + Cost of


Carry

17

iii) Functions of the markets


Forward Markets

Future Markets

Forward contract is a simple agreement to buy


or sell an asset at a certain future time for a
certain price. Since, the forward contract is
traded in over the counter market and not in
an exchange the market/exchange has no role
to play in a forward transaction.

Futures markets perform certain important


economic functions. They meet the needs of
three groups of future market users.
1.Those who wish to discover information
about the future prices of commodities.
2.Those who wish to speculate
3.Those who wish to hedge

iv) Advantages
Forward Markets

Future Markets

Forward contract has no


margin system. This means
the cost of entering into a
transaction for both the
buyer and the seller is zero.

Absence of credit risk. At any point of time the maximum


credit risk is limited to one-day movement in futures
prices.

High Liquidity: Futures market gives the participants the


option to come out of their positions at any time they
want.

High leverage: Futures are highly leveraged instruments,


which attracts large number of market participants who
ensure high liquidity at all times.

Price stabilization: In times of violent price fluctuations,


the futures mechanism enables to reduce the price
fluctuations

v) Limitations
Forward Markets

The contracts are private and are negotiated


bilaterally between the parties. Therefore,
there are no exchange guarantees.

The prices are not transparent, as there is no


reporting requirement.

The profit or loss is realized only on the


maturity date.

Settlement is only through actual delivery or


offsetting by cash delivery. Closing out is not
possible.

Future Markets

Futures are not versatile for


hedging
strategies
due
to
standardization of commodities.
This limitation is overcome by
options

Exact hedge is not possible.


Futures contracts cannot be
tailored to the particular needs of
firms and financial institutions.

18

FORWARDS VS FUTURES IN A NUTSHELL


Particulars

Forward Contracts

Future Contracts

Trading

Traded on a private basis


and bilaterally negotiated

Traded on the floor of an


exchange through open
outcry or electronically

Nature

Forward contracts are


customized by the two
counter parties as per their
requirements.

Future contracts are


exchange traded
standardized contracts.

Process

Private and negotiated


bilaterally between the
parties with no exchange
guarantees

Transaction takes place


through a clearing house
which provides protection
for both the parties

Margin Requirements

Involves no margin

Requires a margin to be
paid

Liquidity

Less liquid as the contract


prices are not transparent
and there is no reporting
requirement

More liquid as their prices


are transparent due to
standardization and market
reporting of volumes and
price

Settlement

By actual delivery or offset


with cash settlement. A
forward contract can be
reversed only

Usually by closing out


through offsetting of
positions.

Credit risk

Credit risk is substantial as


the contracts are not bound
by strict rules and
regulations

Credit risk is largely


eliminated by the use of
margins (initial, additional,
mark to market margins
etc.)

A typical futures price quotation will look like: (example taken from National Stock
Exchange, September 29th, 2003, mid-day)
Instrument
Type
FUTSTK

Underlying

Expiry
Date

High
Price

Low
Price

Prev
Close

Last
Price

TISCO

30OCT2003

277.25

267.10

269.05

276.65

Number
of
contracts
traded
8029

Turnover
in Rs.
Lakhs

Underlying
Value

39494.97

273.30

The underlying stock is Tisco. The expiry date of the futures is 3oth October. The last
price quoted for the futures was 276.65, whereas the spot price at that precise moment
was quoting at 273.30

19

SWAPS
A Swap is an agreement between two parties to exchange different cash flows in the future
usually through an intermediary like a financial institution.
The agreement defines the dates when the cash flows are to be paid and the way that they
are to be calculated. Usually the calculation of the cash flows involves the future values of
one or more market variables.
Swaps are the most versatile of derivative products. The development of the swap market
was an important milestone in the evolution of Indian markets in the 1980s. It has changed
fundamentally the way in which todays financier or bankers look at funding choices.
While forwards and futures are single period price fixing contracts which means
future/forward contract leads to exchange of cash flows on just one future date, swaps are
multi-period price-fixing contracts which means cash flow exchanges occur on several
future dates.
Swaps were developed essentially as OTC products; but today, a number of exchangerelated versions of swaps are available as well.
Example: A forward contract can be viewed as a simple example of a swap. Suppose it is
September 1, 2003 and a company enters into a forward contract to buy 1 kg of gold at
Rs.5,600 per 10 gms one year forward. The forward contract is, therefore, equivalent to a
swap agreement where the company pays a cash flow of Rs. 5,60,000 on September 1, 2004,
and receives a cash flow equal to 100 times S on the same date, where S is the market price
of 10 gms of gold.
It is necessary to distinguish financial swaps from foreign exchange swaps. In the case of
foreign exchange swaps, a currency is simultaneously bought and sold for two value dates.
One of these may be spot and the other may be forward or both the legs may relate to two
different forward rates. Swaps in the derivatives context, refers mostly to contracts
where two parties exchange two streams of cash flows over a definite period of time.
Foreign exchange swaps essentially involve short-term exchanges while financial swaps, are
essentially long term in nature.
Swaps fundamentally exist because different institutions have varied access to financial
markets and due to different needs. It is more advantageous to swap payments with
another party thus transforming ones liability, rather than to borrow directly in the market
of choice. Currency and interest rate swaps are techniques that transform the currency and
interest rate characteristics of a liability or an asset, from one form to another. Thus, swap
is a utility for transforming the characteristics of financial claims.
Swap also has Linear/Symmetric Pay-off profile like a forward/future contract. The payoff profile for a Swap would be similar to forward and futures contract. Refer to Figure: 1
under the section forward and futures contract for the pay-off profile

20

OPTIONS
There are two types of Options

Call Option: A Call option gives the buyer the right (option) to buy the underlying asset
by a certain date for a certain price. He can choose not to exercise the option. The
seller of the call option has an obligation to sell the asset.

Put Option. A Put option gives the buyer the right (option) to sell the underlying asset
by a certain date for a certain price. He can choose not to exercise the option. The
seller of the option has an obligation to buy the asset.

There are several specific terms used in the context of options. They are:
Buyer/Holder/Owner
This refers to the person who buys the option and as a result has the right (option) to
either buy/sell the underlying without the attendant obligation to do so.
Seller/Writer
The person who sells the option and as a result has only the obligation to either buy/sell the
underlying, having surrendered his rights to the contract for a price known as the option
premium.
Option Premium
Amount paid by a buyer to the seller for acquiring the right to buy or sell an underlying.
Alternately, it is the price received by the seller for surrendering his rights in an option
contract. It is usually paid upfront, i.e. at the time of entering into the option contract.
Strike price
The price at which the right to buy or sell the underlying is exercisable, which is agreed
upon upfront. It is also known as the exercise/agreed price.
Expiry Date
The date on which the options contract expires or becomes invalid.
Call Option
An option acquired to obtain the right to buy/call an underlying in the market.
Put Option
An option acquired to obtain the right to sell/put an underlying the market
American Option
In this type of option, the buyer can exercise the right (buy/sell) at any time during the life
of the option contract
European Option
In this type of option, the right can be exercised by the buyer only at the end of the life of
the option contract

21

Figure: Pay-off in a Call Option


Options are non-linear in their pay-offs to the buyer and seller. Since the rights and
obligations are skewed in favor of the buyer to the detriment of the seller, the latter is
compensated upfront, by way of a fee known as option premium. The pay-offs to the buyer
and seller are not linear vis--vis the price of the underlying/commodity.

Buyers Call
Option
Profit
Spot price of the
commodity at the time
of the maturity of the
contract
Loss

Strike
price

Sellers Call
Option

Figure: Pay
off in a Put Option

Buyers Put
Option
Profit
Spot price of the
commodity at the time
of the maturity of the
contract
Loss
Sellers Put
Option

Strike
price

The following example illustrates the pay-offs.


Example:
A trader wants to sell a commodity 8 weeks hence. The commodity is quoting at a price of
USD 300 per tonne. If the price, during the period, increases to USD 310 per tonne, the

22

trader would gain, if he buys today. However, if the price falls to USD 280 per tonne, he
would incur a loss, if he buys today.
The trader, instead, takes a put option on the same commodity at say, USD 300 per tonne
for the same date at a premium of USD 10. If the spot price indeed falls to USD 280, he
exercises his option. Thus he sells at USD 300 and buys in the spot market at USD 280 to
close his position. His gain will be the difference of the two prices the premium (USD 10 in
this example). The more the spot price falls, the more his gain.
However, if the spot price rises to say USD 315, he will choose not to exercise the sell
option. In fact, whenever the spot price rises above the put option price, he will choose not
to exercise the option, because he will incur a loss by buying in the spot market to square up
his position.
Thus, even in the worst case, his loss is limited to the options premium. All buyers of options
(call or put) can limit their losses, since they can choose not to exercise their option when
conditions are adverse. On the other hand when conditions are favorable, there is no limit to
their gains.
In a Call/Put option, if the buyer does not exercise the option (as it is only a right and not
an obligation) he only foregoes the option premium. Thus, his loss is restricted to only the
premium, whereas his potential profits are unlimited. In the case of the seller, since he is
obligated to sell the option and cannot choose not to do so, his profit is what he gains from
the option premium, while his loss could be unlimited.
Call Buyer

Call Seller

Pays premium

Collects premium

Has right to exercise, resulting in


long futures position
Time works against call buyer

Has obligation if assigned, resulting


in a short position in the underlying
futures contract

Has no performance bond requirement

Time works in favor of call seller


Has performance bond requirement

Put Buyer

Put Seller

Pays premium

Collects premium

Has right to exercise, resulting in


short futures position
Time works against put buyer

Has obligation if assigned, resulting


in a long position in the underlying
futures contract

Has no performance bond requirement

Time works in favor of put seller


Has performance bond requirement

23

OPTIONS GLOSSARY
Call
Gives the holder the right to buy a futures contract at the strike price.
Delta
A measurement of the rate of change of an option premium with respect to a price change
in the underlying futures contract. Delta is always expressed as a number between -1 and +1.
Exercise
The process whereby the option buyer asserts his right and goes long the underlying
futures (in the case of exercising a call) or short the underlying futures (in the case of
exercising a put). Only option buyers can exercise options. Options sellers have the
obligation to take the opposite and possibly adverse futures position to the buyers and for
this risk they receive the premium.
Expiration Date
This is last day on which an option can be exercised into the underlying futures contract.
After this point the option will cease to exist, the buyer cannot exercise and the seller has
no obligation.
In-the-Money
An option is said to be in-the-money when the underlying futures price is greater than a
call options strike price or less than a put options strike price.
Intrinsic Value
The amount the futures price is higher than a calls strike; or the amount the futures price
is below a puts strike:
For calls:
Futures price Strike price = Intrinsic Value (amount must be positive or 0)
For puts:
Strike price Futures price = Intrinsic Value (amount must be positive or 0)
Offset
A trader may offset a position if they wish to take profits before expiration or limit losses
on the downside. A buyer can offset an option by instructing their broker to sell the option
before expiration. An option seller can offset a position by buying back or covering a short
position.
Out-of-the-money
An option is said to be out-of-the-money when the underlying futures price is less than a
call options strike price or greater than a put options strike.
Premium
The price that the buyer of an option pays and the seller of an option receives for the
rights conveyed by an option.
Put
Gives the buyer the right to sell a futures contract at the strike price.
Strike (or Exercise) Price
The price at which the underlying futures contract will be bought (in the case of calls) or
sold (in the case of puts); the price at which the option buyer may buy or sell the underlying

24

futures contract.
Tick
Each exchange establishes the minimum increment that the price of a product can fluctuate
upward or downward. This is known as the tick, and a tick's value varies with each product.
Time Value
The part of the option price that is not intrinsic value; the amount option traders are willing
to pay over intrinsic value, given the amount of time left to expiration for the futures to
advance in the case of calls, or decline in the case of puts:
Options Premium Intrinsic Value = Time Value

25

4. FUTURES MARKET FUNCTIONING


The functioning of futures market consists of three important steps. They are trading,
clearing and settlement.
TRADING
The various aspects in trading are:
a) Placing the order
b) Methods of trading
c) Kinds of orders
d) Kinds of margins
e) Pricing of futures
f) Closing out the positions
a) Placing the order
In futures market an order should contains specifications such as buy or sell, the number of
contracts, the month of contract, type and quality of the commodity, the exchange, the
price specification and the period of validity. Usually, orders are placed, by telephone, with
brokers representing users and producers. If an order is executed the client receives a
confirmation. The investor who agrees to buy assumes a long futures position and the
investor who agrees to sell assumes a short futures position.
b) Methods of Trading
The trading in futures exchanges is carried out through two methods. They are
i) Open outcry
ii) Electronic trading
Open Outcry:
Open outcry trading is a face-to-face and highly activated form of trading used on the
floors of the exchanges. In open outcry system the futures contracts are traded in pits. A
pit is a raised platform in octagonal shape with descending steps on the inside that permit
buyers and sellers to see each other. Normally only one type of contract is traded in each
pit like a Eurodollar pit, Live Cattle pit etc.
Each side of the octagon forms a pie slice in the pit. All the traders dealing with a certain
delivery month trade in the same slice. The brokers, who work for institutions or the
general public stand on the edges of the pit so that they can easily see other traders and
have easy access to their runners who bring orders.
The trading process consists of an auction in which all bids and offers on each of the
contracts are made known to the public and everyone can see the markets best price. To
place an order under this method, the customer calls a broker, who time-stamps the order
and prepares an office order ticket. The broker then sends the order to a booth on the
exchange floor called brokers floor booth. There, a floor order ticket is prepared, and a

26

clerk hand delivers the order to the floor trader for execution. In some cases, the floor
clerk may use hand signals to convey the order to floor traders. Large orders typically go
directly from the customer to the brokers floor booth. The floor trader, standing in a
central location i.e. trading pit, negotiates a price by shouting out the order to other floor
traders, who bid on the order using hand signals. Once filled, the order is recorded manually
by both parties in the trade. At the end of each day, the clearing house settles trades by
ensuring that no discrepancy exists in the matched-trade information.
Electronic Trading:
Electronic trading systems have become increasingly popular in the past decade. The driving
factor for the rise in the popularity of these systems is their potential to improve
efficiency and lower the cost of transactions. In addition, electronic trading systems make
exchanges available to remote investors in real time, which is an important benefit in the
present situation of increased trading from remote locations.
Electronic trading is an automated trade execution system with three key components
1.Computer terminals, where customer orders are keyed in and trade confirmations are
received.
2. A host computer that processes trade.
3. A network that links the terminals to the host computer.
Customers may enter orders directly into the terminal or phone in the order to a broker.
With electronic order-matching systems, the host computer matches bids with offers
according to certain rules that determine an orders priority. Priority rules on most systems
include price and time of entry. In some cases, priority rules may also include order size,
type of order and the identity of the customer who placed the order.
In the simplest case, matching occurs when a trader places a buy order at a price equal to
or higher than the price of an existing sell order for the same contract. The host computer
automatically executes the order, so that trades are matched immediately. Trades are then
cleared immediately, as long as the host computer is linked to the clearing house.
After hours Electronic trading system:
After-hours electronic trading first began in 1992 at CME (Chicago Mercantile Exchange).
This was introduced to meet the needs of an increasingly integrated global economy and to
have an access to the currency price protection around the clock. Electronic trading
systems are used in the open outcry exchanges after the day trading is over.
c) Kinds of orders
The orders (under an open outcry/ electronic system) can be placed in different ways,
including:

Market Order: This is the most common type of order. No specific price is mentioned.
Only the position to be takenlong/short is stated. When this kind of order is placed, it
gets executed irrespective of the current market price of that particular asset.
Market on Open: The order will be executed on the market open within the opening
range. This trade is used to enter a new trade, or exit an open trade .

27

Market on Close: The order will be executed on the market close. The fill price will
be within the closing range, which may, in some markets, be substantially different
from the settlement price. This trade is also used to enter a new trade, or exit an
open trade.

Limit Order: An order to buy or sell a stated amount of a commodity at a specified


price, or at a better price, if obtainable at the time of execution. The disadvantage is
that the order may not get filled at all if the price for that day does not reach the
specified price.

Stop-Loss Order: A stop-loss order is an order, placed with the broker, to buy or sell a
particular futures contract at the market price if and when the price reaches a
specified level. Futures traders often use stop orders in an effort to limit the amount
they might lose if the futures price moves against their position. Stop orders are not
executed until the price reaches the specified point. When the price reaches that point
the stop order becomes a market order. Most of the time, stop orders are used to exit
a trade. But, stop orders can be executed for buying/selling positions too. A buy stop
order is initiated when one wants to buy a contract or go long and a sell stop order
when one wants to sell or go short. The order gets filled at the suggested stop order
price or at a better price
Example: A trader wants to purchase a crude oil futures contract at Rs.750 per barrel.
He wishes to limit his loss to Rs.50 a barrel. A stop order would then be placed to sell an
offsetting contract if the price falls to Rs 700 per barrel. When the market touches
this price, stop order gets executed and the trader would exit the market.

Day Order: Day orders are good for only one day, the day the order is placed.
Example: A trader wants to go long on September 1, 2003 in Refined Palm oil in a
commodity exchange. A day order is placed at Rs.340/10 kg. If the market does not
reach this price the order does not get filled even if the market touches Rs.341 and
closes. In other words day order is for a specific price and if the order does not get
filled that day, one has to place the order again the next day.

Good Till Cancelled (GTC) Order: It is an open order to buy or sell that remains active
until the order gets filled in the market, or is cancelled by the person who placed the
order.
Example: A trader wants to go long on Refined Palm oil when the market touches
Rs.400/10kg. The order exists until it is filled up, even if it takes months for it to
happen. The order is always open until the order is cancelled or the contract expires.

Fill or Kill Order: This order is a limit order that is sent to the pit to be executed
immediately and if the order is unable to be filled immediately, it gets canceled.

All or None Order: All or None order (AON) is a limit order, which is to be executed in
its entirety, or not at all. Unlike a fill-or-kill order, an all-or-none order is not cancelled
if it is not executed as soon as it is represented in the exchange. An all-or-none order
position can be closed out with another AON order

Spread Order: A simple spread order involves two positions, one long and one short.
They are taken in the same commodity with different months (calendar spread) or in

28

closely related commodities. Prices of the two futures contract therefore tend to go up
and down together, and gains on one side of the spread are offset by losses on the
other. The spreaders goal is to profit from a change in the difference between the two
futures prices. The trader is virtually unconcerned whether the entire price structures
moves up or down, just so long as the futures contract he bought goes up more (or down
less) than the futures contract he sold.

OCO Order: It is called One cancels the Other (OCO) order. An order placed so as to
take advantage of price movement, which consists of both a Stop and a Limit price. Once
one level is reached, one half of the order will be executed (either Stop or Limit) and
the remaining order canceled (either Limit or Stop). This type of order would close the
position if the market moved to either the stop rate or the limit rate, thereby closing
the trade and at the same time, canceling the other entry order.
Example: A trader has a buy position at Rs.14,000/tonne on Soybean. He wishes to have
both stop and limit orders in order to fill the order in a particular price range. A stop
order is placed at Rs. 14,100/tonne and a limit order at Rs.13,900/tonne. If the market
trades at Rs.13,900/tonne, the limit order gets filled and the stop order is immediately
gets cancelled. The trader exits the market at Rs.13,900/tonne

d) Kinds of Margins
Margin is the deposit money that needs to be paid to buy or sell each contract. The margin
required for a futures contract is better described as performance bond or good faith
money. The margin levels are set by the exchanges based on volatility (market conditions)
and can be changed at any time. The margin requirements for most futures contracts range
from 2% to 15% of the value of the contract.
The different types of margins in futures that a trader has to maintain are:

Initial Margin: The amount that must be deposited by a customer at the time of
entering in to a contract is called Initial margin. This margin is meant to cover the
largest potential loss in one day. The margin is a mandatory requirement for parties who
are entering into the contract.

Maintenance Margin: A trader is entitled to withdraw any balance in the margin account
in excess of the initial margin. To ensure that the balance in the margin account never
becomes negative, a maintenance margin, which is somewhat lower than the initial
margin, is set. If the balance in the margin account falls below the maintenance margin,
the trader receives a margin call and is requested to deposit extra funds to bring it to
the initial margin level within a very short period of time. The extra funds deposited are
known as a variation margin. If the trader does not provide the variation margin, the
broker closes out the position by offsetting the contract.

Additional margin: In case of sudden higher than expected volatility, the exchange calls
for an additional margin, which is a preemptive move to prevent breakdown. This is
imposed when the exchange fears that the markets have become too volatile and may
result in some payments crisis, etc.

Mark-to-Market Margin: At the end of each trading day, the margin account is adjusted
to reflect the traders gain or loss. This is known as marking to market the account of

29

each trader. All futures contracts are settled daily reducing the credit exposure to
one-days movement. Based on the settlement price, the value of all positions is markedto-the-market each day after the official close. I.e. the accounts are either debited or
credited based on how well the positions faired in that days trading session. If the
account falls below the maintenance margin level the trader needs to replenish the
account by giving additional funds. On the other hand, if the position generates a gain,
the funds can be withdrawn (those funds above the required initial margin) or can be
used to fund additional trades.

Just as a trader is required to maintain a margin account with a broker, a clearing house
member is required to maintain a margin account with the clearing house. This is known
as clearing margin. In the case of clearing house member, there is only an original margin
and no maintenance margin. Clearing house and clearing house margins has been
discussed further in detail under the section Clearing and Settlement

e) Pricing of Futures
In futures contract the price is predetermined. The seller knows how much he is going to be
paid and the buyer knows how much he is going to pay at a future date. As futures contracts
are standardized according to quantity, quality and location, it is price that is the only
factor on which buyers and sellers can bargain. The price in futures market is determined
by a mechanism called Price discovery.
Price discovery
It is the process of arriving at a figure in which one person buys and another sells a futures
contract for a specific expiration date. In an active futures market, the process of price
discovery continues from the markets opening until its close. The prices are freely and
competitively derived. Future prices are therefore considered to be superior to the
administered prices or the prices that are determined privately. Further the low
transaction costs and frequent trading encourages wide participation in futures markets
lessening the opportunity for control by a few buyers and sellers.
In an active futures markets the free flow of information is vital. Futures exchanges act as
a focal point for the collection and dissemination of statistics on supplies, transportation,
storage, purchases, exports, imports, currency values, interest rates and other pertinent
information. Any significant change in this data is immediately reflected in the trading pits
as traders digest the new information and adjust their bids and offers accordingly. As a
result of this free flow of information, the market determines the best estimate of today
and tomorrows prices and it is considered to be the accurate reflection of the supply and
demand for the underlying commodity. Price discovery facilitates this free flow of
information, which is vital to the effective functioning of futures market.
Interpretation of Price charts and tables:
Example: CBOT Corn Futures Prices on Thursday, September 4, 2003.
Corn (CBT) 5,000 bushel (bu); cents per bu.
Contract
Months

Open

High

Low

Settle

Lifetime
High

Lifetime
Low

Open
Interest

30

Sept

262.75

263.50

261.50

262.00

270.50

238.00

33922

Dec

266.25

267.50

264.75

266.75

268.00

235.50

141307

Estimated Volume 38,000; volume Wed 38,592; open interest 348,967 + 987

The first line of the table: Corn (CBT) 5,000 bu; cents per bu This indicates that the
table applies to the Chicago Board of Trade (CBT) corn contract, the contract size is
5,000 bushels, and the prices shown in the table are in units of cents per bushel.

Opening Price: The open or opening price is the price or range of prices for the days
first trades, registered during the period designated as the opening of the market or
the opening call.

Closing price: The closing price is the price or range of prices at which the commodity
futures contracts are traded during the brief period designated as the market close or
on the closing call (i.e. last minute of the trading day).

Highest price: The word high refers to the highest price at which a commodity futures
contract is traded during the day.

Lowest price: Low refers to the lowest price at which a commodity futures contract is
traded during the day.

Settlement Price: This is abbreviated as settle in most of the pricing tables. There will
be many trades occurring in the last few minutes. Settlement price is computed from
the range of closing prices. Settlement price is important to calculate the daily gains,
losses and margin requirements. It is used by the clearing house to calculate the market
value of outstanding positions held by its members.

Change: The change refers to the change in settlement prices from the previous days
close to the current days close.

Lifetime high and low: They refer to the highest and lowest prices recorded for each
contract from the first day it traded to the present.

Open interest: It refers to the number of outstanding contracts for each maturity
month.

In the line at the bottom of the table, Est. vol. indicates the estimated volume of
trading for that day. Vol. Wed. indicates the trading volume for the previous day. Open
Int. refers to the total open interest for all contract months combined at the end of
the days trading session. Then the figure +987 indicates an increase of 987 contracts
from the open interest of the previous day.

Price Charts:
The price movements on any particular day can be shown in Bar charts, in the following
manner.
HIGH
CLOSE

OPEN

31
LOW

Closing price is considered as the most important price for that days transaction as it
indicates the trend in the market i.e. either bullish (bulls expects the prices to go up) or
bearish (bears expect the prices to go down)
Patterns of Futures Prices:
As the maturity date approaches the futures prices show different patterns. Based on
these patterns the markets can be predicted
Normal Markets: Markets where the prices increase as the time to maturity increases.
Inverted markets: Markets where the price is a decreasing function of the time to
maturity.
Convergence of futures price to spot price:
As the delivery month of a future contract approaches the futures prices converges to the
spot price of the underlying asset. When the delivery period is reached the futures price
equals or is very close to the spot price. This happens because if the futures price is above
the spot price during the delivery period it gives rise to a clear arbitrage opportunity for
traders. In case of such arbitrage the trader can short his futures contract, buy the asset
from the spot market and make the delivery. This will lead to a profit equal to the
difference between the futures price and spot price. As traders start exploiting this
arbitrage opportunity the demand for the contract will increase and futures prices will fall
leading to the convergence of the future price with the spot price. If the futures price is
below the spot price during the delivery period all parties interested in buying the asset will
take a long position. The trader would buy the contract and sell the asset in the spot market
making a profit equal to the difference between the future price and the spot price. As
more traders take a long position the demand for the particular asset would increase and
the futures price would rise nullifying the arbitrage opportunity
f) Closing out the Positions
The futures contracts are squared-off before the delivery date. Most of the traders
choose to closeout their positions prior to the delivery period specified in the contract.
Closing out means taking opposite positions of trade from the original one.
Continuing from Example 1: The Mumbai investor who bought the December soybean futures
on September 2, 2003 can close out the position by selling (i.e. going short) one December
futures contract on any date before the agreed upon delivery date. The Indore investor
who sold the Soybean futures can closeout by buying one December contract at any time
before the Delivery date. The investors total gain or loss is determined by the change in
the futures prices between the date of entering in to the contract and date of closing out
the contract.

32

CLEARING AND SETTLEMENT


INTRODUCTION
Most of the futures contracts do not lead to the actual physical delivery of the underlying
asset. The settlement is by closing out, physical delivery or cash settlement. All these
settlement functions are taken care of by an exchange-clearing house, called clearing
house/ corporation, in futures transactions.
Clearing House
A clearing house is a system by which exchanges guarantee the faithful compliance of all
trade commitments undertaken on the trading floor or electronically over the electronic
trading systems. The main task of the clearing house is to keep track of all the transactions
that take place during a day so that the net position of each of its members can be
calculated. It guarantees the performance of the parties to each transaction. It is
responsible for

Effecting timely settlement

Trade registration and follow up

Control of the evolution of open interest

Financial clearing of the payment flow

Physical settlement (by delivery) or financial settlement (by price difference) of


contracts

Administration of financial guarantees demanded by the participants.

Functions of clearing house


Clearing house has a number of members, who are mostly financial institutions responsible
for the clearing and settlement of commodities traded on the exchanges. The margin
accounts for the clearing house members are adjusted for gains and losses at the end of
each day (in the same way as the individual traders keep margin accounts with the broker).
In the case of clearing house members only the original margin is required (and not
maintenance margin). Everyday the account balance for each contract must be maintained at
an amount equal to the original margin times the number of contracts outstanding. Thus
depending on a days transactions and price movement the members either need to add
funds or can withdraw funds from their margin accounts at the end of the day. The brokers
who are not the clearing members need to maintain a margin account with the clearing house
member through whom they trade in the clearing house.

33

Processes of a clearing house


Members
Trading ReportStatement of
commitments

Checking

Input

Trading Room
Price informationCommitments information

Clearing Section-Report on
Margins In-out

Computer Processing

Statement of Margins
Margin RequiredMargin Deposited

Margin required
or refundable

Output

Payment

Statement of Account for


Daily Settlement
Daily clearing account (Mark
to Market)

Exchange Trading
fee

Exchange Tax

Liability Reserve

Special Security
Fund
Amount to be paid or received

Margin required is to be paid by cash or


substitutable securities. Margin Refundable is
to be returned on request

To be made through account


transfer at the contracted bank by
noon of 2 business days after the
date of the statement

(The narrative above describes the general functions of a clearing house. NCDEX has only
trading cum clearing members and Professional Clearing members. The specific differences
are highlighted in NCDEX manual on rules and regulations)

34

Proposed Systems and Regulations at NCDEX


CLEARING AND SETTLEMENT PROCESS
CLEARING HOUSE
REGULATION OF CLEARING HOUSE
NCDEX shall prescribe the process from time to time for the functioning and operations of
the Clearing House and to regulate the functioning and operations of the Clearing House for
the settlement of non-depository deals.
EXCHANGE TO MAINTAIN CLEARING HOUSE
The Exchange shall maintain a Clearing House, which shall function as per the instructions,
and supervision of the Exchange. The Clearing House shall act as the common agent of the
members for clearing contracts between members and for delivering commodities to and
receiving commodities from members in connection with any of the contracts and to do all
things necessary or proper for carrying out the foregoing purposes.
CLEARING HOUSE TO DELIVER COMMODITIES AT DISCRETION
The Clearing House is entitled at its discretion to deliver commodities, which it has received
from a member under these Regulations to another member who is entitled under these
Regulations to receive delivery of commodities of a like kind or to instruct a member to give
direct delivery of commodities which he has to deliver.
NO LIEN ON CONSTITUENTS COMMODITIES
When a member is declared a defaulter neither the Exchange nor the creditors of the
defaulter shall be entitled to any lien on the commodities delivered by him to the Clearing
House on account of his Constituents.
CLEARING CODE AND FORMS
A member shall be allotted a Clearing Code, which must appear on all forms used by the
member connected with the operation of the Clearing House. The Clearing Forms and
Formats to be used by the members shall be as prescribed by the Clearing House.
SIGNING OF CLEARING FORMS
The member or his Clearing Assistant shall sign all Clearing Forms.
SPECIMEN SIGNATURES
A member shall file with the Clearing House specimens of his own signature and of the
signatures of his Clearing Assistants. The member and his Authorized Representative in the
presence of an officer of the Exchange or of the Clearing House shall sign the specimen
signature card.
PROVISIONS REGARDING MEMBERS OF THE CLEARING HOUSE
CLEARANCE BY MEMBERS ONLY
Clearing Members including Professional Clearing Members only shall be entitled to clear and
settle contracts through the Clearing House.
CHARGES FOR CLEARING

35

The Exchange shall from time to time prescribe the scale of clearing charges for the
clearance and settlement of transactions through the Clearing House.
CLEARING HOUSE BILLS
The Clearing House shall periodically render bills for the charges, fees, fines and other
dues payable by members to the Exchange which would also include the charges for the use
of the property as well as the charges, fines and other dues payable on account of the
business cleared and settled through the Clearing House and debit the amount payable by
members to their accounts. All such bills shall be paid within a week of the date on which
they are rendered.
LIABILITY OF THE CLEARING HOUSE
The only obligation of the Clearing House shall be to facilitate the delivery and payment in
respect of commodities, transfer deed and any other documents between members.
Settlement Methods
A contract can be settled in three ways

By physical delivery of the underlying asset

Closing out by offsetting positions

Cash settlement.

Closing out
Most of the contracts are settled by closing out. In closing out, the opposite transaction is
effected to close out the original futures position. A buy contract is closed out by a sale
and a sale contract is closed out by a buy.
Cash settlement
When a contract is settled in cash it is marked to the market at the end of the last trading
day and all positions are declared closed. The settlement price on the last trading day is set
equal to the closing spot price of the underlying asset ensuring the convergence of future
prices and the spot prices.
At NCDEX
After the trading hours on the expiry date, based on the available information, the
matching for deliveries would take place firstly, on the basis of locations and then randomly
keeping in view the factors such as available capacity of the vault/warehouse, commodities
already deposited and dematerialized and offered for delivery and any other factor as may
be specified by the Exchange from time to time. Matching done by aforesaid process shall
be binding on the Clearing Members. After completion of the matching process, Clearing
Members would be informed of the deliverable / receivable positions and the unmatched
positions. Unmatched positions shall have to be settled in cash. The cash settlement would
be only for the incremental gain / loss as determined on the basis of Final Settlement Price.
Physical Delivery
When a contract comes to settlement, the exchange provides alternatives like delivery
place, month and quality specifications.

36

Trading period, Delivery date etc. are all defined as per settlement calendar

Member is bound to give Delivery information. If he fails to give information, it is


Closed out with Penalty as decided by the Exchange

Member can choose for an alternative mode of Settlement by providing Counter


party Clearing Member and Constituent. The Exchange will not be responsible for or
guarantee settlement for such deals.

Settlement Price is calculated and notified by the Exchange

The delivery place is very important for commodities with significant transportation costs.
The exchange also specifies the precise period (date and time) during which the delivery
can be made. For many commodities the delivery period may be an entire month. The party
in the short position (seller) gets the chance to make choices from these alternatives. The
Exchange collects delivery information. The price paid is normally the most recent
settlement price (with a possible adjustment for the quality of the asset and the delivery
location). Then the exchange selects a party with an outstanding long position to accept
delivery.
At NCDEX
As and when the Buyers intend to take physical delivery of the commodities, held by them
in their respective Demat accounts, they would make such requests to their respective
depository participant (DP) with whom they hold the Demat account. The DP will upload
such requests to the specified Depository who will in turn forward the same to the R&T
Agent concerned. After due verification of the authenticity, the R&T Agent will forward
delivery details to the warehouse who in turn will arrange to release the commodities after
due verification of the identity of recipient.
NCDEX contracts provide a standardized description for each commodity. The description
is given in terms of quality parameters specific to the commodities. At the same time, it is
realized that with commodities, there could be some amount of variances in quality/ weight
etc, due to natural causes, which are beyond the control of any person. Hence, NCDEX
contracts also provide tolerance limits for variances.
A delivery will be treated as good delivery and accepted if the delivery comes within the
tolerance limits. However, to allow for the difference, the concept of premium and discount
has been introduced. The goods that come to the authorized warehouse for delivery would
be tested and graded as per the prescribed parameters. The premium and discount rates
would apply depending on the level of variation. The price payable by the party taking
delivery would then be adjusted as per the premium/ discount rates fixed by the Exchange.
This ensures that some amount of leeway is given for delivery, but at the same time, the
buyer taking delivery does not face windfall loss/ gain due to the quantity/ quality variation
at the time of taking delivery. This, to some extent, mitigates the difficulty in delivering
and receiving exact quality/ quantity of commodity.
An example of a contract specification at NCDEX is provided below:
Contracts: Soyabean
Trading system
Trading hours
Unit of trading

NCDEX Trading System


Monday to Friday 10:00 am to 4:00 pm
10 Quintal (=1 MT)

37

Quotation/Base Value
Tick size
Delivery unit
Quantity variation
Quality specification
Delivery center
No. of active contracts
Opening of contracts

Due date
Closing of contract
Price band

Rs per Quintal
Re 0.05
100 Quintal (=10 MT)
+/- 2%
Moisture:
10%
Max
Sand/Silica:
2%
Max
Damaged:
2%
Max
Green Seed: 7% Max
Indore
3 concurrent month contracts
Trading in any contract month will open on the 21st
day of the month, 3 months prior to the contract
month i.e. December 2003 contract opens on 21st
September 2003
20th day of the delivery month, if 20th happens to
be a holiday then previous working day
All open positions will be settled as per general and
product specific regulations
Limit 10% or as specified by Exchange from time to
time. Limits will not apply if the limit is reached
during final 30 minutes of trading
Member-wise: Max (Rs. 40 crore, 15% of open
interest)

Position limits
Client-wise: Max (Rs. 20 crore, 10% of open
interest)

38

Proposed Systems and Regulations at NCDEX pertaining to Accredited


warehouse, Registrar and Transfer Agent and Assayer

ACCREDITED WAREHOUSE
The Exchange shall specify accredited warehouse(s) through which delivery of a specific
commodity shall be effected and which shall facilitate for storage of commodities.
PROCESS AND PROCEDURES FOR ACCREDITED WAREHOUSE
The Exchange shall specify from time to time the processes, procedures, and operations
that every accredited Warehouse, Constituents, Depository Participants and R & T Agents
shall be required to follow for the participation, functioning and operations of the
accredited warehouse.
FUNCTIONS OF ACCREDITED WAREHOUSE
(a) Earmark separate storage area as specified by the Exchange for the purpose of storing
commodities to be delivered against deals made on the Exchange. The Warehouse(s)
shall also meet the specifications prescribed by the Exchange for storage of
commodities.
(b) Ensure and co-ordinate for grading of the commodities received at the Warehouse
before they are being stored.
(c) Store commodities in line with their grade specifications and validity period and shall
facilitate maintenance of identity. On expiry of such validity period of the grade for
such commodities, the Warehouse(s) shall segregate such commodities and store them
in a separate area so that the same are not mixed with commodities which are within
the validity period as per the grade certificate issued by the approved Assayers
DUTIES OF ACCREDITED WAREHOUSE
(a) Shall use uniform and standard description of commodities and units of measurement in
respect of the commodities stored pertaining to the Constituent of the Exchange.
(b) Shall strictly adhere to the Warehousing norms stipulated for a commodity in particular
or group of commodities in general by the Exchange.
(c) Shall ensure that necessary steps and precautions are taken to ensure that the quantity
and the grade of the commodity are maintained during the storage period.
(d) Shall maintain the records for the commodities deposited with it by the Constituents, in
electronic form in the manner and in the system as prescribed by specified Depository.
Warehouse(s) shall avail the services of a Registrar & Transfer (R&T) agent approved
and appointed by the Exchange for the above purpose. The Warehouse shall facilitate
the uploading of instructions by the R&T agent using the system connected to the
depository for the creation of electronic records of the Commodities received by the
Warehouse in the Depository Clearing System. The Warehouse shall execute and
complete necessary documentation with the R&T agent and the Depository in this
regard.

39

(e) Unless and until expressly consented by the Exchange, the Warehouse shall not assign,
shift, transfer and relocate the commodities held by it pertaining to the Constituents
of the Exchange. The Warehouse(s), however, is/are entitled to move the commodities
within the area earmarked in the warehouse for storing the commodities pertaining to
the Constituents of the Exchange.
VERIFICATION OF COMMODITIES STORED IN WAREHOUSE
The Exchange will verify itself or through any agencies / experts, at any time, the
commodities deposited by the Constituents and/or warehouse facilities in general or for
compliance of the warehousing norms stipulated by the Exchange for the specific
commodities.
RELEASE OF COMMODITIES STORED IN WAREHOUSE
As and when the Buyers intend to take physical delivery of the commodities, held by them
in their respective Demat accounts, they would make such requests to their respective
depository participant (DP) with whom they hold the Demat account. The DP will upload
such requests to the specified Depository who will in turn forward the same to the R&T
Agent concerned. After due verification of the authenticity, the R&T Agent will forward
delivery details to the warehouse who in turn will arrange to release the commodities after
due verification of the identity of recipient.
CHARGES FOR WAREHOUSE SERVICES
Warehouse(s) shall charge from the Constituents of the Exchange, storage and other
charges as may be mutually agreed in advance between the Exchange and Warehouse(s)
from time to time. For the purpose of operational convenience, the DPs who will be opening
the Demat account for the Constituents will arrange to collect the storage charges from
them and pay the same to the Warehouse at agreed periodic intervals. The Warehouse(s) is
entitled to levy all incidental charges such as insurance; assaying, handling charges or any
such charges directly from the Constituent depositing the commodities as may be
applicable. The Exchange shall not be responsible in any manner for payment of any of the
charges of Warehouse.
The Exchange may also explore the possibility of availing the services of Collateral
Management Agent (CMA), who can offer the warehousing facilities for the Constituents of
the Exchange. In such a case the Constituents shall be required to shift their holdings in
the warehouses approved / identified by such CMA.
REGISTRAR AND TRANSFER AGENT(R&T AGENT)
APPROVED R&T AGENT
The Exchange shall specify Approved R&T Agent(s) through which commodities shall be
dematerialized and which shall facilitate for dematerialization / re-materialization of
commodities in the manner as prescribed by the Exchange from time to time.
PROCESS AND PROCEDURES FOR R&T AGENT
The Exchange shall specify from time to time the processes, procedures, and operations
that every accredited warehouse, Depository Participants and Constituents shall be
required to follow for the participation, functioning and operations of the R&T Agent. The

40

Regulations relating to the R&T Agent shall be deemed to form a part of any settlement
process so provided.
FUNCTIONS OF R&T AGENT
(a) Establish connectivity with approved warehouse(s) and support them with physical
infrastructure.
(b) Verify the information regarding the commodities accepted by the accredited
warehouse and assign the identification number (ISIN) allotted by the Depository in
line with the grade/validity period.
(c) Further process the information, and ensure the credit of commodity holding to the
Demat account of the Constituent.
(d) Ensure that the credit of commodities goes only to the Demat account of the
Constituents held with the Exchange empanelled DPs
(e) On receiving request for Re-materialization (physical delivery) through the depository,
R&T Agent(s) shall arrange for issuance of authorization to the relevant warehouse for
the delivery of commodities.
MAINTENANCE OF RECORDS AND CO-ORDINATION ACTIVITIES
R&T Agent(s) shall maintain proper records of beneficiary position of Constituents holding
dematerialized commodities in Warehouse(s) and in the Depository for a period and also as
on a particular date. R&T Agent(s) shall furnish the same to the Exchange as and when
demanded by the Exchange.
R&T Agent(s) shall also co-ordinate with DPs and Warehouse(s) for billing of charges for
services rendered on periodic intervals.
R&T Agent(s) shall also reconcile Dematerialized commodities in the Depository and Physical
commodities at the Warehouse(s) on periodic basis and co-ordinate with all parties
concerned for the same.
ASSAYER
APPROVED ASSAYER
The Exchange shall specify Approved Assayer(s) through which grading of commodities
received at approved warehouse(s) for delivery against deals made on the Exchange can be
availed by the Constituents of Clearing Members.
PROCESS AND PROCEDURES FOR ASSAYER
The Exchange shall specify from time to time the processes, procedures, and operations
that every Warehouse, Constituents and R&T Agent shall be required to follow for the
participation, functioning and operations of the Assayer. The Regulations relating to the
approved Assayer shall be deemed to form a part of any settlement process so provided.
FUNCTIONS OF ASSAYERS
(a) Inspect the Warehouse(s) identified by the Exchange on periodic basis to verify the
compliance of technical / safety parameters detailed in the Warehousing Accreditation

41

norms of the Exchange by the Warehouse(s). The compliance certificate so given by the
Assayer would form the basis of Warehouse accreditation by the Exchange.
(b) Make available grading facilities to the Constituents in respect of the specific
commodities traded on the Exchange at specified warehouse. The Assayer shall ensure
that the grading to be done, in a certificate format prescribed by the Exchange from
time to time, in respect of specific commodity shall be as per the norms specified by
the Exchange in the respective Contract specifications
(c) Grading certificate so issued by the Assayer would specify the grade as well as the
validity period up to which the commodities would retain the original grade, and the time
up to which the commodities are fit for trading subject to environment changes at the
warehouses.
DUTIES OF ASSAYER(S)
(a) The issuance of the certificate of compliance by the Assayer would imply that in the
event of deterioration of quality of the commodity before the expiry of the validity
period assigned by the Assayer, the Assayer would make good the losses that may be
incurred. However, the Exchange shall not liable for any losses arising out of such cases.
(b) Assayer(s) shall not allow to store any commodity that does not meet the grading norms
and parameters specified by the Exchange and that the Assayer(s) shall make available
to the Constituents the grading certificate when the commodities are allowed to be
stored in the warehouses.
(c) Assayer(s) shall ensure that it shall at all given times maintain properly records in
respect of grading of specific commodities and validity period of the commodity in
electronic form along with the details with regard to the certificate issued by them
from time to time.
INSPECTION OF GRADING FACILITIES
The Exchange reserves the right to physically verify / inspect itself or through any
agencies / experts, at any time, the grading facilities and processes of the approved
Assayers as and when felt necessary.

42

CLEARING AND SETTLEMENT AT NCDEX IN A NUTSHELL


NCDEX has tied-up with NSCCL for clearing the trades
Settlement guarantee fund would be maintained and managed by NCDEX.
Contracts settlement
All open contracts not intended for delivery and non-deliverable positions at client level
would be cash settled.
Settlement period
All contracts settling in cash would be settled on the following day after the contract
expiry date. All contracts materializing into deliveries would settle in a period of 2-7 days
after the expiry. The exact settlement day would be specified for each commodity.
Are deliveries compulsory?
No. The buyer and the seller have to give delivery information. Deliveries would be matched
randomly at client level. Contracts not assigned delivery would be settled in cash
Would additional margins be levied for deliverable positions?
Yes
Settlement in commodity futures market
For open positions on the expiry day of the contract, the buyer and the seller can give
intentions for delivery. Deliveries would take place in electronic form. All other positions
would be settled in cash.
Taking physical delivery
Any buyer intending to take physicals would have to put a request to its Depository
Participant, who would pass on the same to the registrar and the warehouse. On a specified
day, the buyer would go to the warehouse and pick up the physicals.
Getting the electronic balance for the physical holdings
The seller intending to make delivery would have to take the commodities to the designated
warehouse. These commodities would have to be assayed by the Exchange specified assayer.
The commodities would have to meet the contract specifications with allowed variances. If
the commodities meet the specifications, the warehouse would accept them. Warehouses
would then ensure updating the receipt in the depository system giving a credit in the
depositor's electronic account.
Seller giving an invoice to the buyer
The seller would give the invoice to its clearing member, who would courier, the same to the
buyer's clearing member.
Accrediting warehouses
NCDEX would prescribe the accreditation norms, comprising of financial and technical
parameters, which would have to be met by the warehouses. NCDEX would take
assayer's/Structural Engineer's certificate confirming the compliance of the technical
norms by the warehouses.
Whether the accredited warehouses would be dedicated warehouses?
In case of grains/seeds, warehouses would earmark a definite storage capacity within the
warehouse premises for members of NCDEX, while in case of oils, specified tankers would
be earmarked for NCDEX participants.
Warehousing charges
The warehouse concerned would decide the warehousing charges. However, the warehouse
charges would be made available on NCDEX website
Health checks and inventory verification

43

The assayers and or other experts on behalf of NCDEX would carry out surprise health
checks and inventory verification.
Sales tax
Prices quoted for the futures contracts would be basis warehouse and exclusive of sales tax
applicable at the delivery center. For contracts materializing into deliveries, sales tax would
be added to the settlement amount. The sales tax would be settled on the specified day
after the payout.
How would the buyer give a declaration for re-sale in case of last point collection of
tax?
The buyer intending to take delivery would give declaration for re-sale at the time of giving
intention for delivery. Accordingly the seller would issue the invoice, exclusive of sales tax.
The declaration form duly signed by the buyer would be forwarded through the buyer's
clearing member to the seller's clearing member within a specified time after pay-in and
payout.
Uniformity in delivered grades / varieties
The exchange will specify, in its contract description, the particular grade / variety of a
commodity that is being offered for trade. A range will be specified for all the properties
and only those grades / varieties, which fall within the range, will be accepted for delivery.
In case the properties fall within the range, but differ from the benchmark specifications,
the Exchange will specify a premium / rebate
Premium / rebates for the difference in quality
These would be pre-defined and made available on the website. The settlement obligation
would be impacted on account of the premium / rebates in case of deliverable positions. The
parameters which would be considered for premium / rebate computation as well as the
methodology would be specified by NCDEX
Certifying / assaying agencies.
NCDEX is looking at following assayers: SGS India Pvt. Limited, Geo-Chem Laboratories, Dr.
Amin Superintendents & Surveyors Pvt Ltd., Calib Brett and Stewart. Only certificates
given by specified assayers by NCDEX will be accepted. All the certificates issued will have
time validity
What happens when the commodities reach the validity date?
Those commodities will not be available for delivery on the clearing corporation. Hence the
deliverable electronic balance would be automatically reduced. Warehouse would place the
commodities in a separate area, indicating that they are not available for electronic trading.
Would commodities be accepted without assayer's certificate?
No
Can commodities be re-deposited in the warehouse after the validity period of the
assayer's certificate?
Yes, provided they are re-validated by the assayer.
Transaction charges
Rs.6/- per Rs100,000/-, i.e. 0.006% of the trade value.
Procedure for handling bad delivery / part delivery?
Partial delivery as well as bad delivery would be considered as default. Penalties would be
levied.
How would disputes be resolved?
Any disputes in regard to the quality / quantity will be referred to the Arbitration

44

committee set up for the purpose.


Clearing bankers
Following banks have agreed to act as clearing bankers:
Canara Bank
HDFC Bank
ICICI Bank
UTI Bank
Depository participants
NCDEX has approached

Bank of Baroda

Canara Bank

Global Trust Bank

HDFC Bank

ICICI Bank

IDBI Bank

Indusind Bank

UTI Bank

45

5. CHARACTERISTICS OF COMMODITY TRADING


Commodity trading gives opportunity to the traders for investment and risk management
through different strategies like hedging, speculation and arbitrage. In this section these
aspects have been discussed for a futures market. Most of those who participate in the
futures or options markets can be categorized broadly into one of two groups hedgers
and speculators depending on whether they are trying to transfer or accept risk. Brokers
are intermediaries who carry out buying and selling instructions from hedgers or
speculators.
Hedgers
Hedgers are market participants who want to transfer risk. They can be producers or
consumers. A producer hedger wants to transfer the risk that prices will decline by the
time a sale is made. A consumer hedger wants to transfer the risk that prices will increase
before a purchase is made.
Speculators
Speculators include investors and traders who want to profit from price changes. They
accept the price risks and rewards that hedgers wish to avoid. Speculators try to make
money by buying futures contracts at a low price and selling back at a higher price or selling
high and buying back lower. They take on the risk of an adverse price direction and its
effect on their account. Speculators provide risk capital and depth to the market place and
make it possible for hedgers to use the futures market to reduce risk (They dont do this,
intentionally. They are in the market for profits, but the nature of the market is such that
they become de-facto risk capital providers).

Buyers and sellers of the actual commodities use the futures market as a form of risk
management. They use futures to protect themselves against adverse price changes.
Speculators accept the price risks and rewards that hedgers wish to avoid. Speculators
include investors and traders who want to profit from price changes.
A. HEDGING
Commodity trading involves sizable price risks (due to volatile prices in the cash markets),
which may affect the value of the underlying commodity. Hedging is a strategy used in the
futures markets to protect ones asset from adverse price changes and minimize risks.
Hedging does not necessarily improve the financial outcome, indeed it could make the
outcome worse. What it does however is, that it makes the outcome more certain. Hedgers
could be Government institutions, private corporations like financial institutions, trading
companies and even other participants in the value chain for instance farmers, extractors,
ginners, processors etc., who are influenced by the commodity prices.
Example:
A company orders a commodity at a price of USD 300 per tonne. The commodity will be
delivered after 8 weeks to the receiving port. If the price, during the period, increases to
USD 310 per tonne, the company would have made a gain. However, if the price falls to USD
280 per tonne, the company would incur a loss. The company hedges its position by taking a
put option on the same commodity at say, USD 300 per tonne for the same date. If the

46

price indeed falls to USD 280, the company exercises its option and offsets its losses (The
company buys an equivalent amount in the spot market and gains USD 20 per tonne. This
offsets the losses due to fall in price during the delivery period). If the prices, on the
other hand go up to say, USD 310 per tonne, the company will choose not to exercise the
option and will lose only the premium. The option premium is thus an insurance against losses.
A company that wants to sell an asset at a particular time in the future can hedge by taking
short futures position. This is known as futures hedge. If the price of the asset goes down,
the company does not fare well on the sale of the asset but makes a gain on the short
futures position. If the price of the asset goes up, the company gains from the sale of the
asset but takes a loss on the futures position. Similarly, a company that knows that it is due
to buy an asset in the futures can hedge by taking long futures position. This is known as
long hedge
Example:
A poultry farmers objective is to raise and sell broiler birds at a price that would give him
the most profit. His risk is declining broiler prices. To offset (minimize) this risk, he could
sell futures contracts. If broiler prices fall, he could then buy back the futures contracts
at a price lower than he previously sold them. The subsequent gain on this futures
transaction would help offset his cash loss, thus minimizing his risk. (In this case, if he sold
futures and prices rose, he would lose money on the futures transaction, but gain on the
spot transaction).
Whereas the broiler farmer is the futures seller in this example, the futures buyer could
be a risk taker a speculator who thinks that broiler prices are going to rise, or a
commercial user such as a poultry processor, who needs broiler birds and would be
adversely affected by higher prices. A speculator is willing to accept risk in hopes of
generating a profit. The commercial user is using futures to offset the risk of possible
higher bird prices.
Hedging strategies
The hedging strategies are short and long. A hedger takes a closed position where he has an
asset and liability on the same maturity date.
Selling Hedge (Short) Selling futures contracts to protect against possible declining
prices of commodities that will be sold in the future. At the time the cash commodities are
sold, the open futures position is closed by purchasing an equal number and type of
futures contracts as those that were initially sold.
Example. If a company knows that it is due to sell an asset at a particular time in the
future, it hedges by taking a short futures position. If the price of the asset goes down the
sale results in a loss to the company but it makes a gain on the short futures market. If the
price of the asset goes up the company gains from the sale of the asset but makes a loss on
the short futures position.
Purchasing (Long) Hedge Buying futures contracts to protect against a possible increase in
the price of cash commodities that will be purchased in the future. At the time the physical
commodities are bought, the open futures position is closed by selling an equal number and

47

type of futures contracts as those that were initially purchased. This is also referred to as
a buying hedge.
Hedge Ratio
The Hedge Ratio is defined as the ratio of the size of the position taken in futures contract
to the size of the exposure.
Let,
S be the change in spot price, S during the life of the hedge
F be the change in futures price, P during the life of the hedge
S be the standard deviation of S
F be the standard deviation of F
be the coefficient of correlation between S and F
h be the hedge ratio
When the hedger is long on the assets and short on futures (short hedge), the change in
value of the hedgers position during the life of the hedge is
S - h F
For a long hedge, it is

h F - S

The variance, V, of the change in the value of hedged position is given by


V = (S)2 + (h)2 (F)2 - 2 h S) (F)
The variance is minimized when
h = (S/ F)
If these two are perfectly correlated, ie., = 1, h = (S/ F)
When the futures price mirrors the spot price perfectly, S = F and h = 1.0
Example:
A company will buy 100,000 tons of soy-bean in three months. The standard deviation of the
change in price per ton over a three- month period has been calculated as 0.072. The
company hedges by buying futures contracts. The standard deviation of the change in
futures price is 0.08 over a three-month period. The coefficient of correlation between the
three month change in spot prices and futures prices is 0.9. The optimal hedge ratio will be
h = 0.9 x 0.072/ 0.08 = 0.81
If one futures contract is for 1000 tons, the company needs to buy
0.81 x 100,000/ 1000 = 81 contracts

48

Variance
of
position

Hedge ratio, h
h*

Dependence of variance of hedgers position on hedge ratio

Advantages of hedging

Hedging stretches the marketing period.

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.

Hedging protects inventory values.

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.

Hedging permits forward pricing of products.

Example.: A jewelry manufacturer can determine the cost for gold, silver or platinum by
buying a futures contract, translate that to a price for the finished products, and make
forward sales to stores at firm prices. Having made the forward sales, the
manufacturer can use its capital to acquire only as much gold, silver, or platinum as may
be needed to make the products that will fill its orders.
Limitations of hedging
Hedging-using futures does not work perfectly in practice. The limitations are

Hedging can only minimize the risk but cannot fully eliminate it. For Example. The
loss made during selling of an asset is not equal to the profits made by going short.
This is because the underlying value of the asset and the future contract vary

The hedge may require the futures contract to be closed out well before its
expiration date

49

Limitation also exists that the underlying hedged product and the contract
specification might not be exactly the same grade

50

Roll Over
Hedges can be rolled forward. When the expiration date of the hedge is later than the
delivery dates of the future contracts, the hedger closes out the futures contracts
entered into and takes the same position in futures contracts with a later delivery date.
Hedges can be rolled forward many times. However, multiple rollovers could lead to shortterm cash flow problems.
Basis Risk
The limitations of hedging give rise to basis risk. The basis in a hedging situation is defined
as the difference between the current cash price and the futures price of the same
commodity. Unless otherwise specified, the price of the nearby futures contract month is
used to calculate the basis.
Basis = Spot price of asset to be hedged less futures price of contract
When the spot price increases by more than the futures price, the basis increases which is
referred to as strengthening of the basis. When the futures price increases by more than
the spot price the basis declines. This is referred as weakening of the basis.
Example of Hedging
A farmer intends to plant 10 acres of Soybean in June and is willing to forward sell 50 per
cent of his anticipated production before planting (expected yield is 400 kgs/acre and
estimated total production is 4 tons). Only a portion of the expected crop is hedged due to
production uncertainty. Delivery is expected in mid-September. The farmer estimates basis
to be Rs. 25/tonne under the November contract price in mid-September. The farmer
places an order to sell 2 November futures contracts (2 tonnes) on June 15. This is
referred to as a forward pricing hedge.
The farmer delivers and sells the harvested soybean crop on September 15. Also on
September 15, the farmer buys back the 2 November soybean futures contracts at the
current price of Rs.14,250/tonne, offsetting his/her position in the futures market.
Date

Market Price

November Futures

Basis

June 15

implied Rs.14,000/t

Rs. 14,025/t

anticipated Rs.25/tonne

Forward Price Hedge: Soybean seed


Date

Action

Cash Position

Futures Position

Basis

June 15

Plant Soybean
Sell 50% of
expected
Production on
Nov. futures

Expect 4 tons
production.
Hedge 2 tons at
expected
price of Rs. 14,000/t
(Rs.14,025-basis
Rs.25/t)

Sell 2 November
Futures contract @
Rs. 14,025/t

anticipated
Rs.25/t

September

Sell cash
Soybean seed

Sell 2 tons

Buy 2 November
soybean

Rs. 25/t

51

15

Offset
futures
position

@Rs.13,700/t

@ Rs.13,725/t

Gains/losses

Loss: Rs.300/t
(relative to
expectation)

Gain: Rs.300/t

no change

Final Outcome:
The net price received on the 4 tonnes of Soybean hedged is Rs.14,000/t. (Rs.13,700/ton
from the cash sale plus a Rs. 300/ton gain on the futures position).
If all 4 tonnes of production are sold on September 15, the average price for the total crop
is Rs.13,850/t. (average of Rs.14,000/t for the hedged portion and Rs.13,700/t for the unhedged portion).
B. SPECULATION
The price of any commodity in the market is a function of the demand and supply. If
supplies fall short prices tend to increase and vice versa. Often the estimation of demand
and supply is the major challenge faced by the market. The traders who speculate are called
Speculators. Speculation is the process of buying or selling something now based on
anticipations of future price changes. Speculators buy (or sell) futures at a time when its
price is low (or high) and sell later (or buy) when the price is higher (or lower). Speculators
are risk takers and they add liquidity and capital to the futures markets. If the price
changes are temporary, speculation reduces fluctuations, reduces risk and enhances
efficiency. The main objective of speculators is to make profit in the trade and not to
minimize risk unlike Hedgers
Positions
Speculators take open positions- i.e. they will have either an asset or liability.
Long position: Buy futures, expecting higher futures price at later date
Short Position: Sell futures, expecting lower futures price at later date.
C. ARBITRAGE
Arbitrage is the process of buying something at a place where its price is low and selling it
where its price is high. Arbitragers try to profit from differencein prices of identical goods
in different locations.
Example: The shares of a particular stock are trading at Rs.410 and Rs 420 in Ahmedabad
and Mumbai stock exchanges simultaneously. An arbitrager will purchase the scrip in
Ahmedabad and sell it in Mumbai to generate a riskless profit of Rs 10 per share.
In arbitrage as both the trades are done simultaneously there is no investment. But in an
efficient market, arbitrage opportunities would not exist. Even though they exist they
cannot last long as arbitrage itself reduces the price differentials. As arbitrageurs start
buying goods from the low price locations it raises the prices of goods and as they sell the

52

scrip in a high price location it lowers the price of goods thereby nullifying any arbitrage
opportunities.
In reality, if such arbitrage opportunities do exist (at first glance), the prospective
arbitrageur would do well to check the hidden transaction costs. In most cases he would
find that such hidden costs nullify the apparent arbitrage opportunity.
Cost-of-carry
This is the cost to carry a storable good forward in time. The carrying charges are of four
basic kinds

Cost of warehousing

Cost of insurance

Transportation costs (moving the goods from origin to the appropriate destination
for delivery).

Financing cost

Cash and carry arbitrage


A trader can buy goods for cash and carry it through to the expiration of the futures
contract. Let us see an example to understand this:
Example
Spot price of gold per 10 gms Rs 5,100/Future price of gold per 10 gms (for delivery in one year) Rs 5,500/Interest rate per annum 6.5%
The trader borrows Rs 5,100 for 1 year at 6.5%. He buys 10 gms of gold in the spot market
for Rs 5,100 and sells a futures contract for delivery one year hence.
At the end of 1 year, he delivers 10 gms of gold against the futures and realizes Rs 5,500/-.
He also repays the loan of Rs 5,100/- and the interest amount of Rs 331/- (total Rs 5431/-).
Thus, he gets a total profit of Rs 69/In the above example, we have assumed that there is only financing charge applicable. When
attempting arbitrage at significant volumes of goods, the trader would have to worry about
storage costs and insurance. The arbitrage opportunity may still exist. However, as
discussed earlier, the market would react to changes in interest rates, insurance premiums
and storage costs and the gaps would close very quickly.
Reverse cash and carry arbitrage
This happens when the spot price is too high. In the above example, let us suppose that the
spot price was Rs 5,200/- instead of Rs 5,100/-.
The trader would now sell 10 gms of gold short, lend Rs 5,200/- for 1 year and buy one gold
future for delivery of 10 gms one year hence.

53

At the end of 1 year, he collects the proceeds from the loan (Rs 5,200/- + interest Rs
338/-), accepts delivery on the futures contract of 10 gms gold (pays out Rs 5,500/-) and
uses the gold from futures delivery to repay the short sale. He thus profits by Rs 38/In the end the market ensures that the future price equals the spot price and the cost of
carry to close out the arbitrage opportunities.

6. NCDEX AND ITS FUNCTIONING


National Commodity and Derivatives Exchange Ltd. (NCDEX) is a public limited company
registered under the Companies Act, 1956 with the Registrar of Companies, Maharashtra in
Mumbai on April 23,2003.
A. OBJECTIVES OF NCDEX

To create a world class commodity exchange platform for the market participants.

To bring professionalism and transparency in to the commodity trading.

To inculcate international best practices like demutualisation, technology platforms, low


cost solutions and information dissemination without noise etc. into our trade.

To provide nation wide reach and consistent offering.

To bring together the names that market can trust.

B. PROMOTERS
NCDEX is promoted by a consortium of Institutions. They are

ICICI Limited

Life Insurance Corporation of India (LIC)

National Bank for agriculture and Rural Development (NABARD)

National Stock Exchange of India Ltd. (NSE)

The consortium brings to the table:

Institution building expertise

Commitment to the Agricultural sector

Nationwide reach

Ability to bring in capital

Technology and risk management skills.

C. GOVERNANCE
Board of Directors

54

NCDEX is run by an independent Board of Directors. Promoters do not participate in the


day to day activities of the Exchange.
The directors are appointed in accordance with the provisions of the Articles ofAssociation
of the company.
The board is responsible for managing and regulating all the operations of the exchange and
commodities transactions.
It formulates the rules and regulations related to the operations of the exchange.
Board appoints Executive committee and other committees for the purpose of managing
activities of the exchange.
Executive Committee
The executive committee consists of Managing Director of the exchange who would be
acting as the Chief Executive of the Exchange, and also other members appointed by the
board.
Other Committees
Apart from the executive committee the board has constitute committee like Membership
committee, Audit Committee, Risk Committee, Nomination Committee, Compensation
Committee and Business Strategy Committee which help the Board in policy formulation.
D. MEMBERSHIP
Membership of NCDEX as trading cum clearing members (TCM) is open to any person,
association of persons, partnerships, co-operative 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.
The members of NCDEX falls in to 2 categories:
TCMs
Trading Cum Clearing Members
Members
who
carry
out
the
transactions (Trading, Settling and
Clearing) on their own account and also
on their clients account.
Membership criterion for TCMs
Net worth-Rs.50 lakh
Interest free deposit-Rs.15 lakh
Minimum collateral-Rs.15 lakh
Annual Charges-Rs.50,000

PCMs
Professional Clearing Members
Members who carry out the settlement
and clearing for their clients who have
traded through a TCM
Membership criterion for PCMs
Net worth-Rs.50 crore
Interest free deposit-Rs.25 lakh
Minimum collateral-Rs25 lakh
Annual Charges-Rs.1,00,000

E. COMMODITIES THAT ARE TRADED ON NCDEX


NCDEX plans to trade in all the major commodities approved by FMC (Forwards Market
Commission) but in a phased manner.
Commodities traded in 1st phase

55

NCDEX has approval from FMC to trade in the following commodities in the first phase

Bullion- Gold, Silver

Agri
commodities-Cotton
(long
and
medium
staple),
Soybean,
Rape/Mustardseed, Rape/Mustard oil, Crude Palm Oil and RBD Palmolein.

Soyaoil,

Commodities planned to be offered for trading in 2 nd phase

Rice, wheat, Coffee, Tea.

Edible oil products like Groundnut, Sunflower, Castor (Seed, Oil and cake)

Base metals (Aluminium, Copper, Zinc and Nickel)

Commodity indices-Agri commodity index, Metal commodity index.

F. INSTITUTIONAL TIE-UP FOR THE FUNCTIONING


NCDEX has tied up with institutions of repute in their field for carrying out the functions
related to the exchange efficiency.
Assayers
for
certification
commodities
Discussions with
SGS India
Geo Chem
Dr.Amin Laboratories
Stewart Assayers

of

the

Clearing corporation
NSCCL (National securities and Clearing
Corporation Limited)

Depository Participants
Discussions with
Bank of Baroda
Canara Bank
Global Trust Bank
HDFC Bank
ICICI Bank
IDBI Bank
Indusind Bank
UTI Bank
Clearing Banks
Canara Bank
ICICI bank
UTI bank
HDFC bank

Warehouses
Commodity

Location

Warehouses currently identified

Crude Palm Oil

Kandla

CRPL(Chemicals and Resins Pt. Ltd)

RBD Palmolein

Kakinada

IMC Ltd.

Refined Soy Bean Oil


Mumbai
Expeller Rapeseed Mustard
Jaipur
Oil
Rapeseed-Mustard

Jaipur

Soy Bean

Indore

IMC Ltd.
Sree Ram Fats
CWC
(Central
Corporation)
MPSWC(MP
State
Corporation)

Warehousing
Warehousing

56

Cotton: Long staple

Cotton: Medium Staple

Ahmedabad

Bathinda

CWC
PAICO(Punjab
Agricultural
Industrial Corporation)

and

Note: this is an initial list and is subject to change in future depending on business
requirements.

57

7. REGULATORY PROVISIONS
THE FORWARD CONTRACTS (REGULATION) ACT:
The Forward Contracts (Regulation) Act, 1952, a Central Act, governs commodity
derivatives trading in India. The Act defines various forms of contract. The Act envisages a
three-tier regulation.

Exchange: The exchange which organizes forward trading in regulated commodities can
prepare its own Articles of Association, Rules and Regulations, byelaws and regulate
trading on a day-to-day basis.

FMC (Forward Markets Commission): The commission approves the rules and byelaws
of the exchange and provides a regulatory oversight. It also acquires concurrent powers
of regulation while approving the rules and byelaws or by making such rules and byelaws
under the delegated powers.

Central Government: Ministry of Consumer affairs and Public Distribution under the
Govt. of India is the ultimate regulatory authority. Only those associations, which are
granted recognition by the Government, are allowed to organize forward trading in
regulated commodities. Government has the power to suspend trading, call for
information nominate directors on the Boards of the Exchanges; supersede Board of
Directors of the Exchange etc. Central Govt. has delegated most of these powers to
FMC.

FORWARD MARKETS COMMISSION (FMC)


The Forward Markets Commission (FMC) regulates commodity futures trading in India. It is
a statutory body set up under the Ministry of Consumer Affairs and Public Distribution in
1953 under the Forward Contracts (Regulation) Act, 1952.
FUNCTIONS OF FMC
As per the Forward Contracts (Regulation) Act 1952, the functions of the FMC are
(a) To advise the Central Government in respect of the recognition of or the withdrawal of
recognition from any association or in respect of any other matter arising out of the
administration of this Act
(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 this Act
(c) To collect and whenever the Commission thinks it necessary publish information
regarding the trading conditions in respect of goods to which any of the provisions of this
Act is made applicable, including information regarding supply, demand and prices, and to
submit to the Central Government periodical reports on the operation of this Act and 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

58

(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
considers it necessary, and
(f) To perform such other duties and exercise such other powers as may be assigned to the
Commission by or under this Act, or as may be prescribed.
POWERS OF THE COMMISSION
As per the Forward Contracts (Regulation) Act 1952, the powers of the FMC are:
(1) The Commission shall, in the performance of its functions, have all the powers of a civil
court under the Code of Civil Procedure, 1908 (5 of 1908), while trying a suit in respect of
the following matters, namely:
(a) Summoning and enforcing the attendance of any person and examining him on
oath;
(b) Requiring the discovery and production of any document;
(c) Receiving evidence on affidavits;
(d) Requisitioning any public record or copy thereof from any office;
(e) Any other matters which may be prescribed.
(2) The Commission shall have the power to require any person, subject to any privilege
which may be claimed by that person under any law for the time being in force, to furnish
information on such points or matters as in the opinion of the Commission may be useful for,
or relevant to any matter under the consideration of the Commission and any person so
required shall be deemed to be legally bound to furnish such information within the meaning
of Sec. 176 of the Indian Penal code, 1860 (45 of 1860).
(3) The Commission shall be deemed to be a civil court and when any offence described in
Sections. 175, 178, 179, 180 or Sec. 228 of the Indian Penal Code, 1860 (45 of 1860), is
committed in the view or presence of the Commission, the Commission may, after recording
the facts constituting the offence and the statement of the accused as provided for in the
Code of Criminal Procedure, 1898 (5 of 1898) forward the case to a Magistrate having
jurisdiction to try the same and the Magistrate to whom any such case is forwarded shall
proceed to hear the complaint against the accused as if the case had been forwarded to him
under Section 482 of the said Code.
(4) Any proceeding before the Commission shall be deemed to be a judicial proceeding
within the meaning of Sections. 193 and 228 of the Indian Penal Code, 1860 (45 of 1860).
REGULATORY MEASURES OF FMC
To inculcate the best practices and to promote financial integrity, market integrity and
transparency into our trade FMC has imposed some regulations on the commodity exchanges
like

Daily mark to market margining

Time stamping of trades

Novation of contracts and creation of trade/ settlement guarantee fund

59

Back-office computerization for the existing single commodity Exchange and online
trading for the new Exchanges

Demutualisation for the new Exchanges

SECURITIES CONTRACTS (REGULATION) ACT


The Securities Contracts (Regulation) Act 1956 governs and regulates transactions in
securities. The functions of The Securities and Exchange Board of India (SEBI) are
regulating the business in the stock exchanges and any other securities market; performing
such functions and exercising such powers under the provisions of Securities Contracts
(Regulation) Act 1956, as may be delegated to it by the Central Government, levying fees or
other charges; conducting research for the above purposes; and performing such other
functions as may be prescribed.
The role of FMC in the commodities markets is similar to the role of SEBI in the stock
markets. The major area of difference is that while the SEBI is required to conduct
research into the different areas relating to the stock exchanges and the securities
market, the FMC is required to collect and publish information regarding supply, demand and
prices of commodities.
The finance ministry has recently amended two main clauses of the Securities Contracts
(Regulation) Rules, 1957 of the Securities Contracts (Regulation) Act 1956, which would
substantially widen participation in commodity futures market. Through a notification issued
in August 2003, the ministry has amended rule 8 (1)(f) of the SC(R) Rules, 1957 that
permits stock brokers to trade in commodity derivatives also. However, stock brokers will
be permitted to trade in commodity derivatives only through a separate subsidiary that
meets all the requisite norms set out by the Forward Markets Commission (FMC), the
commodity futures market regulator.
Further, to allow banks and other entities, the notification indicates that rule 8 (4) also has
been amended to permit banks under the second schedule of the Reserve Bank of India Act,
1934, and other entities, like the Export Import (EXIM) Bank of India, National Bank for
Agriculture and Rural Development (Nabard) and the National Housing Bank (NHB), to trade
in commodity futures.
Their respective statutes prevent these entities from trading in commodity futures.
AGRICULTURAL MARKETS
At present, though agricultural production is largely free from controls, the same is not
true of agricultural markets.
Essential Commodities Act, 1955 (ECA): The Essential Commodities Act provides for the
control of the production, supply and distribution of, and trade and commerce in certain
commodities if it is felt necessary or expedient by the Central Government so to do for
maintaining or increasing supplies of any essential commodity or for securing their equitable
distribution and availability at fair prices. In a liberalized economy, repeal of ECA would
facilitate free, unrestricted movement and storage of agricultural commodities (food
grains, edible oils, cotton or sugar) across the country.
Agricultural Produce Marketing Act (APMC):
Under this Act, State Governments alone are empowered to initiate the process of setting
up of markets for agri-products within a defined area. Currently, the Act places

60

restrictions on farmer from entering into direct marketing/contract with any


processor/manufacturer/bulk purchaser as the produce was required to be canalised
through regulated market. However, State Governments except Maharashtra and Madhya
Pradesh have formulated their own Acts in their legislatures to allow contract farming. The
Govt. of Karnataka has taken the initiative in playing the role of facilitator by providing for
the establishment of an Integrated Produce Market to be owned and managed by NDDB
for marketing of fruits, vegetables and flowers in the state.
NCDEX RULES AND REGULATIONS (PROPOSED)
These proposed regulations pertain to trading and other activities on the exchange. NCDEX
has prepared a complete manual covering all aspects of the exchange functioning. It deals
with rules and regulations on the following topics
Jurisdiction
Definitions
Approved commodity
Approved office
Approved user
Approved workstation
Authorised person
Books of accounts, records and documents
Branch office
Buyer
Clearing bank
Clearing corporation/ house
Clearing member
Closing buy transaction
Closing sell position
Clearing delivery
Constituent
Common pool facility
Contract month
Daily settlement price
Derivatives contract
Delivering member
Deliverable quantity
Expiration day
Final settlement price
Futures contract
Last trading day
Long position
Market type
Member
Member-constituent agreement
Members open position
Notification, notice or communication

61

Outstanding obligation
Professional clearing member
Receiving member
relevant authority
Rules and bye laws
Seller
Settlement calendar
Settlement date
Short position
Trading cycle
Trading member
Trading system
Trade type
User
Underlying commodities
Dealings on the exchange
Trading system
Trading members and users
Trading days
Trading hours
Trading cycle
Contract expiration
Trading parameters
Market types / trade types / settlement periods / transaction types
Failure of trading members' terminal
Dealings in derivatives contracts
Dealings in derivatives contracts
Trade operations
Margin requirements
Order management
Order type, Order attributes, Modification and cancellation of
orders, Order validation, Matching rules
Contract note
Brokerage
Margin from the constituents
Conduct of business by trading members
Office related procedure
Supervision
Procedures to be followed, Internal inspections, Written approval,
Qualifications investigated

62

Relation with the constituents


Guidelines governing relationship between trading member and constituent
General principles
Trading principles
General guidelines
Unfair trading practices
Records, annual accounts & audit
Records
Annual accounts and audit
Inspection
Inspection authority
Notice
Obligations of a trading member on inspection
Submission of report
Collection and dissemination of information
Types of deals
Deals, transactions, dealings and contracts
Extension or postponement of contracts by the exchange
Measures to meet emergencies
Procedure for settlement of deals
Eligibility of deals for settlement
Last day of trading
Delivery
Through clearing house, Outside clearing house, Early pay-in,
Additional credit/debits
Procedure for payment of sales tax/vat
Registration with sales tax authorities, Payment of sales tax/vat,
Information submission relating to sales tax/vat to the exchange,
Raising of invoice and determination of sale value, Disputes relating
to incorrect sales tax/vat information / documents for commodities
delivered / received, Failure to submit sales tax information,
Maintenance of records
Penalties for defaults
Process of dematerialization
Validity date
Process of re-materialization
Delivery through the depository clearing system
Payment through the clearing bank
Privity of contract
Contracts subject to change in settlement procedure
Clearing days and scheduled times
Alteration of clearing and clearing days and times
Clearing and settlement process
Settlement obligations statements for trading clearing members
Settlement obligations statements for professional clearing members

63

Delivery and receipt statements


Clearing members
Delivery of commodities
Depository deals
Mode of funds payment
Receipt of commodities
Depository deals
Mode of receipt of funds
Death of a clearing member
Delivery units
Prescribed delivery units
Deliverable grades
Assayers certificate
Delivery in part
Delivery subject to special agreement between buyer and seller constituents
Delivery when complete
Delivery when not complete
Closing out
Delivering member debited
Penalty for bad delivery
Depository delivery
Delivery units
Transfer duties and charges
Delivery in part
Closing out on refusal to accept delivery
Non-delivery and non-payment
Notice of non-delivery and non-payment
Non-delivery and non-payment by clearing member / banks / institutions
Failure to deliver
Closing-out on failure to deliver
Closing-out on failure to pay
Disabling of a member
Declaration of default
Deliveries due to the defaulter
Penalty for failure to give or take delivery
Withholding of commodities and funds
Withheld commodities and funds - how dealt with
Closing-out of contracts
Closing-out when effected
Closing-out in specific cases
Closing out for deals settled through the clearing house
Closing-out without notice
Closing-out contracts with deceased member
Compliance before closing-out
Closing-out how effected

64

Closing-out clearing members responsibility


Deferment by the relevant authority
Suspension or postponement of closing-out
Closing-out against defaulter
Charges for closing-out
Loss arising from closing-out
Profit arising from closing -out
Default if closing -out loss and damage not paid
Clearing bank
Exchange to regulate
Functions of clearing bank
Members to have account with the clearing bank
Clearing bank to act as per the instructions of the exchange
Clearing bank to inform exchange of default in funds settlement
Members to authorize the clearing bank to act as per the instructions
received from the exchange
Clearing account(s) of exchange in the clearing bank
Depository clearing system
Exchange to regulate
Clearance by members only
Functions of depository clearing system
Depository, Depository participants, Ring and other accounts,
Specified depository
Clearing members to have account with a depository participant
Specified depository to act as per the instructions of the exchange
Members to authorize depository participants
Clearing account(s) of exchange with the specified depository
Notices and directions
Clearing number id
Exchange to deliver commodities at discretion
Charges for clearing
Exchange bills
Liability of the exchange
Clearing house
Regulation of clearing house
Exchange to maintain clearinghouse
Clearing house to deliver commodities at discretion
No lien on constituents commodities
Clearing code and forms
Signing of clearing forms
Specimen signatures

65

Provisions regarding members of the clearing house


Clearance by members only
Trading members responsibility
Notices and directions
Charges for clearing
Clearing house bills
Liability of the clearing house
Liability of the exchange
Clearing and other forms
Clearing forms, special returns and other forms
Clearing number and clearing forms
Signing of clearing forms
False or misleading statements
Accredited warehouse
Process and procedures for accredited warehouse
Functions of accredited warehouse
Warehouse(s) to offer services
Duties of accredited warehouse
Verification of commodities stored in warehouse
Release of commodities stored in warehouse
Charges for warehouse services
Registrar and transfer agent( R & T agent)
Approved r&t agent
Process and procedures for r&t agent
Functions of r&t agent
Services by r&t agent
Maintenance of records and co-ordination activities
Assayer
Approved assayer
Process and procedures for assayer
Functions of assayers
Services by assayer
Duties of assayer(s)
Inspection of grading facilities
Arbitration
Definitions
Seat of arbitration
Jurisdiction of courts
Reference of the claim, difference or dispute
Criteria and procedure for selection of persons eligible to act as arbitrators

66

Procedure for appointment of arbitrators


Vacancy in the office of the arbitrator
Deposit towards cost of arbitration
Procedure for arbitration
Requirement for hearings
Notice of hearing
Adjournment of hearing
Arbitral award on agreed terms
Making of arbitral award
Interest
Arbitration fees and charges, costs, etc.
Administrative assitance, which may be provided by the exchange
Mode of communication
Conflict between rules, bye laws and regulation
Modifications
Forward contract regulation act
Savings

67

8. SAMPLE PROBLEMS AND ANSWERS


(Solutions are given at the end of this chapter)
A. Multiple Choices
1) An agreement where the seller agrees to deliver an asset and a buyer agrees to pay for
that asset immediately is called
a) Futures contracts
b) Forwards contract
c) Spot contract
d) Options
2)
a)
b)
c)
d)

Derivative markets emerged out of traditional markets to address the need for
Effective transactions
Effective risk management
Immediate delivery of the assets
None of the above

3)
a)
b)
c)
d)

Forward contracts are generally traded


Over the counter
In the exchange
Both a and b
None of the above

4)
a)
b)
c)
d)

Futures contracts differ from forwards in being


Exchange traded
OTC traded
In both exchange traded and OTC traded
None of the above

5) A Futures contract can be settled by


i) By physical delivery of the underlying asset
ii) Closing out by offsetting positions
iii) Cash Settlement
a) All of the above
b) Only i and ii
c) Only i and iii
d) Only ii and iii
6)
a)
b)
c)
d)

Credit risk for the counter-party is higher in which of the following contracts
Futures contracts
Forwards contracts
Options
All of the above

68

7) In which of the following the prices are not transparent, as there is no requirement for
reporting?
a) Forward contracts
b) Futures contracts
c) Both a and b
d) None of the above
8) The theoretical price of a Forward/Futures contract is determined by taking into
account
a) Spot price
b) Cost of carry
c) Both a and b
d) None of the above
9) Forward contracts provide the opportunity to speculate.
a) True
b) False
10)
a)
b)
c)
d)

A long position is taken when the spot prices are expected to


Increase
Decrease
Stay neutral
None of the above

11) When a party sells a contract, it is assumed to take a


a) Long position
b) Short position
c) Out position
d) None of the above
12)
a)
b)
c)
d)

If a trader is long in the market and spot prices go up it means


The trader will make money
The trader will lose money
Neither gains nor loses.
None of the above

13)
a)
b)
c)
d)

The payoff from a long position in a forward contract for one unit of an asset is
Delivery price less Spot price
Spot price less Delivery price
Spot price plus delivery price
None of the above

14) A buyer is short in a futures/forward contract. At the time of the maturity of the
contract if the delivery price is less than the spot price the buyer makes a
a) Loss
b) Profit

69

c) No profit, No loss
d) None of the above
15) A trader wants to sell an asset. He anticipates the asset price at the time of the sale to
fall. What is the position he should take in the futures market?
a) Go Short
b) Go Long
c) Enter into a forward contracts
d) None of the above
16)
a)
b)
c)
d)

Which of the following contracts have a nonlinear payoff profile?


Forward contracts
Futures contracts
Options
All of the above

17)
a)
b)
c)
d)

In a falling market one can


Profit by going short on the futures
Profit by going long on the futures
Both a and b
None of the above.

18)
a)
b)
c)
d)

Can a forward contract be settled by closing out?


Yes
No
Depends on the contract
None of the above

19)
a)
b)
c)
d)

In forward contracts profit or loss is realized


On the day of entering in to the contract
On the maturity date
Everyday by marking to market
All of the above

20) In futures contract the credit risk at any point of time is limited to the price movement
of
a) One day
b) Total contract period
c) On the maturity date
d) None of the above
21)The markets where the price decreases as the time to maturity increases are called as
a)
b)
c)
d)

Futures markets
Forward markets
Inverted markets
Normal markets

70

22) Options gives buyer of the option, the .to buy or sell and the seller
of the option, the to sell or buy a specified quantity of a commodity
at a specific price within a specified period of time
a) Right; Obligation
b) Obligation; Right
c) Both Right and Obligation
d) None of the above
23) What is Call Option?
a) The buyer is granted the right to buy (go long) the underlying asset
b) The buyer is granted the right to sell (go short) the underlying asset
c) Both a and b
d) None of the above
24) What is Put Option?
a) The buyer is granted the right to buy (go long) the underlying asset
b) The buyer is granted the right to sell (go short) the underlying asset
c) Both a and b
d) None of the above
25) When a commitment is made by a trader to purchase an asset, which is the suitable
option he has to purchase to hedge his position/ commitment?
a) Call option
b) Put Option
c) Both a and b
d) None of the above
26) When a commitment is made by a trader to sell an asset, what is the suitable option he
has to purchase to hedge his position/ commitment?
a) Call option
b) Put Option
c) Both a and b
d) None of the above
27) Options provide unlimited profit potential to the buyer with risk limited to the premium
paid to the seller
a) True
b) False
c) Depends on the contract
d) None of the above
28) Which one of the following strategies will allow the trader to profit from an asset, if
the market price for the asset increases?
a) Buying a call option
b) Buying a put option

71

c) Selling a futures contract


d) None of the above
29) The type of option in which the buyer can exercise the right (buy/sell) at any time
during the life of the option contract is called as
a) Call option
b) Put Option
c) American option
d) European Option
30) The contracts are traded in pits in
a) Open out cry system
b) Electronic trading
c) Both a and b
d) None of the above
31) The margin of a contract is like a good faith money
a) Yes
b) No
32) Marking to the market is
a) An order to buy or sell a futures contract of a given delivery month to be filled at the
best possible price.
b) To debit or credit the margin account of the buyer and seller at the end of the days
trade.
c) A range of prices at which buy and sell transactions take place before the markets
close.
d) The procedure for settling disputes between members or between members and
customers.
33) The period of rising market prices are called
a) Bull markets
b) Bear markets
c) Normal markets
d) Inverted markets
34) The period of falling market prices are called
a) Bull markets
b) Bear markets
c) Normal markets
d) Inverted markets
35)
a)
b)
c)

Which price indicates the trend of the market (either bullish or bearish)
Opening Price
Closing Price
High Price

72

d) Low Price
36) In this type of order no specific price is mentioned. Only the position to be taken
long/short is stated and the order gets executed at the current price on the floor of
exchange
a) Limit order
b) Stop order
c) Market order
d) All of the above
37) In a day order if the order does not get filled on that particular day, one has to place
the order again the next day for execution.
a) True
b) False
38) Hedging involves
a) Taking a futures position opposite to one's cash market position
b) Taking a futures position identical to one's cash market position
c) Taking a futures market position
d) Willingly taking a risk
39) The number of futures contracts required to buy or sell to provide the maximum offset
of risk is calculated using
a) Basis Risk
b) Hedge ratio
c) Swap ratio
d) None of the above
40) Incorrect matching of the offsetting investments in hedging gives rise to
a) Basis Risk
b) Price risk
c) Market risk
d) None of the above
41)
a)
b)
c)
d)

Hedgers
Protect their existing exposures
Willingly take risks
Profit from price differentials
All of the above

42) The process of selecting investments with higher risk in order to profit from an
anticipated price movement is called
a) Hedging
b) Speculation
c) Arbitrage

73

d) None of the above


43) The person who is willing to take risk and is expectation driven to make profits is known
as a
a) Hedger
b) Speculator
c) Arbitrageur
d) None of the above
44) The role of speculators in the market is to provide
a) Actual buyers and sellers of the commodity
b) Liquidity to the markets
c) Cash to the customers
d) None of the above
45) When would a speculator like to take the delivery of the commodity?
a) At the expiration date of the contract
b) 10 days before the expiry date
c) Never takes the delivery
d) At any point of time before the expiration date
46) A trader by identifying the market opportunities is buying the assets when their prices
are perceived to be low and storing them to sell later in anticipation of a better future
price. He is a
a) Hedger
b) Speculator
c) Arbitrageur
d) None of the above
47) The process of buying something at a place where its price is low and selling it where its
price is high is called
a) Hedging
b) Speculation
c) Arbitrage
d) Marking to the market
48) Arbitrageurs try to profit
a) By willingly taking risks
b) From price differentials
c) By protecting their existing exposures
d) By entering in to future contracts
49) The persons on the floor of exchange who trade for themselves are called
a) Brokers
b) Locals
c) Commission agents

74

d) All of the above


50) In calculating the clearing margins through gross basis the clearing house
a) Adds all the long and short positions entered in to by a client
b) Offsets the contracts against each other
c) Does it in both the ways
d) None of the above
51) Electronic trading systems have high efficiency and low transaction costs when
compared to the open outcry system.
a) True
b) False
B. Fill in the Blanks

52) An actual physical commodity that someone is buying or selling is called as


a a) financial asset b) physical asset c) asset
53) The financial instruments whose value is derived mathematically from the value of the
underlying are called a) futures b) options c) derivatives
54) What are the two main functions of a futures market?
.., a) price discovery and risk management b)
speculation and hedging c) hedging and risk management
55) Amount paid by a buyer to the seller for acquiring the right to buy or sell an underlying
in an options contract is called a) basis b) premium c) strike
price
56) The amount a futures market participant must deposit into his margin account at the
time he places an order to buy or sell a futures contract is calleda)
initial margin b) variation margin c) final margin
57) The extra funds deposited in to the margin account to adjust a days gains or losses are
called a) initial margin b) variation margin c) final margin
58) The generation of information about future value of a commodity or financial instrument
through the futures markets is called a) price discovery b) price search
c) hedging
59) The price at which the underlying commodity or security moves from the seller to the
buyer in a futures contract is called asa) basis price b) strike
price c) spot price

75

60) The total number of outstanding contracts for each maturity month for a given
commodity is called asa) closed interest b) interest c) open
interest
61) The system by which exchanges guarantee the faithful compliance of all trade
commitments undertaken on the trading floor or electronically over the electronic
trading systems is called as a) warehouse b) clearing house c)
assayer
62) All the members of the clearing house need to maintain a margin account with the
clearing house called asa) maintenance margin b) initial margin
c) clearing margin
63) The process by which the trader takes opposite position of trade from the original one
to square off the deal is called a) closing out b) speculation c)
hedging
64) The difference between the current cash price and the futures price of the same
commodity is called as a) basis b) arbitrage c) premium
65) The smallest allowable increment of price movement for a contract is called a
a) Tick b) basis risk c) hedge ratio
66) Part of the order-routing process in which the time of day is stamped on the order is
called a) Time stamping b) order stamping c) Tick
67) The traders who expect the market prices to go down are called as a)
bears b) bulls c) neither of the two
68) The markets where the prices increase as the time to maturity increases are called as
a) normal markets b) inverted markets c) perfect markets
69) The type of option where the right can be exercised by the buyer only at the end of the
life of the option contract is called ana) American option b) European
Option c) British option
70) The highest and lowest prices recorded for each contract from the first day it traded
to the present is referred as.a) 52 week high and low b) lifetime
high and low c) none of these
71) Futures trading in India are governed by Act. a) Forward Contract
Regulation Act, 1952 b) FMC Act, 1961 c) none of these
72) Statutory body which controls futures trading in India.a) Forward
Contract Regulator b) Forward Markets commission c) none of these

76

C. Problems

Futures
1.

A trader enters in to a short Soybean futures contract when the futures price is
Rs.11,300/tonne The contract is for the delivery of 50,000 tonnes. How much does the
trader gain or lose if the cotton price at the end of the contract is (a) Rs.11,200 per
tonne (b) Rs. 11,500 per tonne

Answer
a) In the first scenario of, the trader gains Rs.100/tonne This is because he would have
sold the contract at Rs.11,300 per tonne and bought at Rs. 11,200 per tonne to offset
his position when the contract expires. The total gain he would have made is Rs.50 lakhs
on the 50,000 tonnes
b) In the second scenario, the trader loses Rs.200/tonne. This is because he would have
sold the contract at Rs.11,300 per tonne and bought at Rs. 11,500 per tonne to offset
his position when the contract expires. The total loss he would have made is Rs.1 crore
on 50,000 tonnes
2. In July 2003, a palm oil processor decides to purchase crude palm oil in the month of
October 2003. The processor fears a potential fall in prices because of increase in
imports. So, he decides to hedge his purchase. He expects the basis to be
Rs.1000/tonne. The desired forward pricing objective is Rs 33,500/tonne. This is the
price at which he desires to purchase the crude oil in the month of October. The
November futures contract is trading at Rs.32,500/tonne
Determine how his objective will vary under the following scenarios when spot price of
oil increases and decreases
a) When basis is as predicted
b) When basis is larger than predicted
c) When basis is smaller than predicted
Answer
i) When Spot price is increasing
Month
a) When basis
predicted

Transaction
is

as

Buy November contract at


Rs. 32,500/tonne

Spot Price of oil


Rs. 33,500/tonne

Sell November contract at Buys crude palm oil from the spot
Rs.32,700/tonne
market at Rs.33,700/tonne
Effective Purchase price: Rs.33,700/tonne - Rs.200/tonne(on the sale of future contract)
= Rs.33,500/tonne. Profit objective has been achieved

77

Month
b) When basis is more than
predicted by Rs.500/tonne
i.e.
basis
is
now
Rs.1500/tonne

Transaction
Buy November contract at
Rs. 32,500/tonne

Spot Price of oil


Rs. 33,500/tonne

Sell November contract at Buys crude palm oil from the spot
Rs.32,700/tonne
market at Rs.34,200/tonne
Effective Purchase price: Rs.34,200/tonne - Rs.200/tonne(on the sale of future contract)
= Rs.34,000/tonne. The trader purchases the oil by Rs.500/tonne more than anticipated
c) When basis is less than Buy November contract at Rs. 33,500/tonne
predicted by Rs.400/tonne Rs. 32,500/tonne
i.e. the basis is now
Rs.1400/tonne
Sell November contract at Buys crude palm oil from the spot
Rs.32,700/tonne
market at Rs.31,300/tonne
Effective Purchase price: Rs.31,300/tonne Rs.200/tonne (on the sale of future contract)
= Rs.31,100/tonne. The trader purchases the oil cheaper by Rs.400/tonne than anticipated
ii) When Spot price is decreasing
Month
a) When
basis is
as predicted

Transaction
Buy November contract at Rs.
32,500/tonne

Spot Price of oil


Rs. 33,500/tonne

Sell November contract at Buys crude palm oil from the spot
Rs.32,300/tonne
market at Rs.33,300/tonne
Effective Purchase price: Rs.33,300/tonne + Rs.200/tonne (on account of loss from the sale of
future contract) = Rs.33,500/tonne. Profit objective has been achieved
b) When basis is more Buy November contract at Rs. Rs. 33,500/tonne
than
predicted
by 32,500/tonne
Rs.500/tonne i.e. basis is
now Rs.1500/tonne
Sell November contract at Buys crude palm oil from the spot
Rs.32,300/tonne
market at Rs.33,800/tonne
Effective Purchase price: Rs.33,800/tonne + Rs.200/tonne (on account of loss from the sale of
future contract)
= Rs.34,000/tonne. The trader purchases the oil by Rs.500/tonne more than anticipated
c) When basis is less than Buy November contract at Rs. Rs. 33,500/tonne
predicted
by 32,500/tonne
Rs.400/tonne i.e. the
basis
is
now
Rs.1400/tonne

78

Month

Transaction

Spot Price of oil


Sell November contract at Buys crude palm oil from the spot
Rs.32,300/tonne
market at Rs.30,900/tonne
Effective Purchase price: Rs.30,900/tonne + Rs.200/tonne (on account of loss from the sale of
future contract) = Rs.31,100/tonne. The trader purchases the oil cheaper by Rs.400/tonne than
anticipated
Thus, irrespective of whether the spot
be achieved provided the basis does
fluctuate because of location, time and
the more accurate hedging becomes and

II.

price increases/decreases the profit objective can


not fluctuate. More often than not, basis does
quality reasons. The more predictable the basis is,
vice-versa.

Options

3. If a trader takes a put option contract (say on NASDAQ) on 100 IBM shares with a
strike price of $120 and an expiration date of 3 months. The price of IBM stock after 3
months is $121.What will be the result? Gain or loss and how much?
Answer
The trader will lose only on the Option premium, as he would not exercise the option. The
option expires worthless. This is because after 3 months the price of IBM stock is more
than the strike price by $1. The trader will make profit on put option only when the strike
price is more than the stock/current price.
4. Mr.ShriRam an Indian investor wants to buy 100 shares in the month of December. To
hedge against price fluctuations he buys a Call option at a strike price of Rs.129/share
with a premium of Rs.10/share. How would ShriRams pay-off profile vary under the
following price scenarios in the month of December?
a) Rs.132/share
b) Rs.128/share
a) In the month of December, Mr.Shriram would exercise the option and buy 100 shares
for Rs.12,900. This would be his total purchase price.
He could thereafter sell the shares (if he wishes to) at Rs.13,200. The profit he would then
make is Rs. 290 per share (Rs.300 Rs. 10 per share). The total profit made is
Rs.29,000
b) In the month of December, Mr.Shriram would not exercise his right to buy the option,
as the market price is lesser than the strike price. He would lose on the option premium,
which is Rs.10/share. He would buy the shares directly from the market at Rs.
128/share. His total purchase price would be Rs.129/share (Rs.128+Rs.10 per share)
5. Mr. Rahul wants to sell 100 Reliance Industries in the month of November. To hedge
against price fluctuations he buys a Put option at a strike price of Rs. 130/share wherein
he pays a premium of Rs.2/share. How would Rahuls pay-off profile vary under the
following price scenarios in the month of November?

79

a) Rs.150/share
b) Rs.120/share
a) In the month of November, Rahul would not exercise his right to sell the option. The
option expires worthless. Instead he would sell the shares directly in the market at
Rs.150/share. He would forego a loss of Rs.2/share, which he has already paid upfront as
Option premium.
b) In the month of November, Rahul would exercise his right to sell the option. Rahul would
sell the 100 shares at the market price of Rs.120/share and exercise the Put option and
make a profit on the difference. He would make a profit of Rs 8/share after accounting for
the option premium.
6. In September with December futures at 70 cents/lb. a merchant seeking to hedge an
inventory purchase (Cotton) in the international market, buys a put on December futures
at a strike price of 70 cents for a premium of 1.7 cents/lb.
a) Why did the merchant buy a Put option?
b) Detail the gain/loss when the December spot prices are as follows.
66 cents/lb
70 cents/lb
71 cents/lb
72 cents/lb
Answer
a) A futures hedge protects against a price decline but eliminates the potential to benefit
from rising prices. A Put option also protects against a price decline, but allows the
merchant to benefit from rising prices.
b) Under the different price scenarios, a Put option minimizes risk as follows
Futures Price in
cents/lb

Gain/(Loss) on
Cotton
in
cents/lb

66
68
70
72
74
76

(4)
(2)
0
2
4
6

Gain/ (Loss) on
hedged
position
after
accounting
for the premium in
cents/lb
2.3
0.3
(1.7)
(1.7)
(1.7)
(1.7)

Net Gain (Loss) on


position in cents/lb

Hedged

(1.7)
(1.7)
(1.7)
0.3
2.3
4.3

7. In September a merchant sells cotton at 69 cents in the international market. He


covers the sale by the purchase of a call option. At the time of sale December futures

80

are at 70 cents. The Call option is purchased at a strike price of 70 cents for a premium
of 1.7 cents/lb.
a) Why did the merchant buy a Call option?
b) Detail the gain/loss when the December spot prices are as follows.
66 cents/lb
70 cents/lb
71 cents/lb
72 cents/lb
Answer
b) A futures hedge protects against a price decline but eliminates the potential to benefit
from falling prices. A Call option also protects against a price decline, but allows the
merchant to benefit from falling prices.
b) Under the different price scenarios, a Call option minimizes risk as follows
Futures Price in
cents/lb

Gain/(Loss) on
Cotton
in
cents/lb

Net Gain (Loss) on


position in cents/lb

4
2
0
(2)

Gain/ (Loss) on
hedged
position
after
accounting
for the premium in
cents/lb
(1.7)
(1.7)
(1.7)
0.3

66
68
70
72
74
76

(4)
(6)

2.3
4.3

(1.7)
(1.7)

Hedged

2.3
0.3
(1.7)
(1.7)

Margins
8. A trader has entered in to a short futures contract to sell July silver for Rs.8200 per
kg. The size of the contract is 500 kgs. The initial margin is Rs.40,000 and the
maintenance margin is Rs. 30,000.What changes in the price will lead to a margin call?
A. If the price falls below Rs.20 per kg the trader would get a margin call. If the market
touches a price of Rs.8180 per kg, the trader would have lost Rs.10,000 on 500 Kgs. The
initial margin would become Rs.10,000, which is the same as maintenance margin. If the
market price further falls, the trader would get a margin call.
9. A trader sold (short position) a futures contract at Rs.8100/kg on September 1,2003
and closed out his position by buying the contract at Rs.8000/kg on September 8, 2003.
The future prices for the above week are as follows. The contract size is 100 kgs
(Hypothetical)

81

Day
Sept 1
Sept 2
Sept 3
Sept 4
Sept 5
Sept 6
Sept 7
Sept 8

Future Prices in Rs/kg


8100
8007
8006.3
8004.2
8006.8
8002.4
7900
8000

Compute the traders Margin account and Margin Call if the Initial margin is
Rs.35,000/contract and maintenance margin is Rs.25,500/contract.
Answer
Day

1-Sep
2-Sep
3-Sep
4-Sep
5-Sep
6-Sep
7-Sep
8-Sep

Futures Price in Rs/Kg

8100
8007
8006.3
8004.2
8006.8
8002.4
7900
8000

Daily Gain/
Rs/Kg

-9300
-70
-210
260
-440
-10240
10000

(Loss)

in Margin
Account
Balance
Rs/Kg
35000
25700
25630
25420
35260
34820
24580
45000

Margin
Rs/Kg

Call

in

in

9580

10420

Thus, the trader would get margin call from the broker on September 4 and September 7
2003, when the margin account falls below Rs.25,500. It is then adjusted to the difference
between the initial margin and the current margin account.

82

ANSWERS
Multiple Choices
1) c
2) b
3) a
4) a
5) a
6) b
7) a
8) c
9) b
10) a
11) b
12) a
13) b
14) a
15) a
16) c
17) a
18) b
19) b
20) a
21) c
22) a
23) b
24) b
25) a
26) b
27) a
28) a
29) c
30) a
31) a
32) b
33) a
34) b
35) b
36) c
37) a
38) a
39) b
40) a
41) a

83

42) b
43) b
44) d (speculators are actually in the market to make profit for themselves, not for anybody
elses benefit- if liquidity gets created, it is only incidental)
45) c
46) b
47) c
48) b
49) b
50) a
51) a
Fill in the Blanks
52) b
53) c
54) a
55) b
56) a
57) b
58) a
59) b
60) c
61) b
62) c
63) a
64) a
65) a
66) a
67) a
68) a
69) b
70) b
71) a
72) b

84

9. FREQUENTLY ASKED QUESTIONS (FAQs)


1. What are the commodities that might be traded on a commodity exchange?
Commodities traded in an exchange might include
Agricultural products. Example Livestock and meat, Palm oil, Soybean oil, Corn etc
Metals. Examples: Gold, Silver, Bronze etc
Petroleum products. Example: Crude oil, Natural gas etc
2. What are cash commodities?
A cash commodity is an actual physical commodity that someone is buying or selling. They
are also referred to as actuals.
3. What are over the counter (OTC) and exchange traded derivatives?
Over the counter derivatives are Forward contracts, which are not traded in the exchanges.
Exchange traded derivatives are Futures, Swaps and Options
4. What are derivatives?
A derivative is a financial instrument whose value depends on the value of the underlying
variables. They are the financial abstractions whose value is derived mathematically from
the changes in the value of the underlying. There are broadly four kinds of derivatives:
Forwards, Futures, Swaps and Options
5. How derivatives are useful in risk management?
Derivatives are useful risk management tools, which protect the buyers and sellers of
commodities from unexpected price fluctuations in the traditional markets.
6. What is a forward contract?
Forward contracts are the bilateral agreements in which the buyer and the seller agree on
delivery of a specified quality and quantity of an asset on a specified future date at a price
agreed today. Forward contracts are traded privately and are not standardized.
7. What are the drawbacks of a forward contract?
Credit risk is high in forward contracts, which makes the parties wary of each other.
Consequently forward contracts are entered between parties who have good credit
understanding between them.
The contracts are private and are negotiated bilaterally between the parties. Therefore,
there are no exchange guarantees.
The prices are not transparent, as there is no reporting requirement.

85

8. What is a futures contract?


Futures are firm financial agreements to deliver (sell) or to take delivery (buy) of a
standardized quantity of an underlying commodity at a pre-established price at a specified
future date agreed on a regulated exchange.
They are standardized in terms of quantity, quality, delivery time and place.
9. What are the advantages of a futures contract?
Absence of credit risk makes futures contract an attractive tool of risk management.
Futures are exchange-traded products. The clearing house of the exchange takes the
credit risk in respect of all the transactions through the margin system. The profit/loss on
each transaction are settled at the end of the days trade. Thus at any point of time the
maximum credit risk is limited to only one-day movement in future prices.
The commodities traded in a futures market are standardized according to quality, quantity,
delivery time and place. Futures operate in highly liquid markets, which gives the option to
the participants to come out of their positions at any point of time.
10. What is the difference between forwards and futures contract?
Futures have evolved out of forward contracts and are the exchange-traded versions of
forward contracts. The credit risk is eliminated in futures contract through margin
payments by buyers and sellers. Settlement in futures contract need not necessarily be in
cash/physical delivery unlike in Forward contracts. The parties can close out their positions
by offsetting their current positions.
Example: A trader who is short (sell) on one contract can go long (buy) on another contract
and close out the first position before the expiry date of the contract.
11. What are the functions of a futures market?
Futures market performs important economic functions like Price discovery and risk
transfer. Price discovery is the process of generating the information to establish the
equilibrium prices, which reflects the current and prospective demand and supply situations.
This process helps the participants in trade to make better investment decisions. Risk
transfer is enabled through hedging (this was discussed in detail under Chapter: 3
Characteristics of commodity trading)
12. How is the price determined in a forward or futures contract?
In principle the forward/future price for an asset would be equal to the spot or the cash
price at the time of the transaction and the cost of carry. The cost of carry includes all the
costs incurred for carrying the asset forward in time. Depending upon the type of asset or
commodity the cost of carry takes into account the payments and receipts for storage,
transport costs, interest payments, dividend receipts, capital appreciation etc.
13. What is going long and going short in a futures contract?
Buying a contract is considered as going long and selling a contract is considered as going
short. A party goes long with the expectation that the prices may increase and a party goes
short with the expectation that the prices might decrease.

86

14. What are options?


An option is a contract that gives the buyer of the option the right (and not an obligation)
to buy or sell a futures contract at a certain price for a limited time. The seller of the
option is obligated to sell the futures contract at the exercise price. This is an important
distinguishing feature between futures and options. In futures the buyer and seller are
both obligated to buy or sell the underlying asset.
15. What are Call and Put options?
A Call option gives the holder/buyer the right, but not the obligation, to purchase the
underlying futures contract at the strike price on or before the expiration date. The seller
is obligated to sell the futures contract.
A Put option gives the holder/buyer the right but not the obligation to sell the underlying
futures contract at the strike price on or before the expiration date. The seller is
obligated to buy the futures contract in this case.
In a Call/Put option, if the buyer does not exercise the option (as it is only a right and not
an obligation to do so) he only foregoes the option premium. Thus, his loss is restricted to
only the premium, whereas his profits are unlimited. In the case of the seller, since he is
obligated to sell the option and cannot choose not to do so, his profit is what he gains from
the option premium, while his loss could be unlimited.
16. What is Option Premium?
Option premium is the amount paid by a buyer to the seller for acquiring the right to buy or
sell an underlying. It is the price received by the seller for surrendering his right in an
option contract. It is usually paid upfront at the time of entering into the option contract.
17. How do options differ from a futures contract?
An option gives the buyer the right but not the obligation to buy/sell the underlying where
as in futures contract the buyer is obligated to take the delivery.
In options the buyer pays an upfront payment called option premium to acquire the right.
The cost of entering into a futures contract is zero, as a premium need not be paid by the
buyer/seller unlike in Options.
18. What are Swaps? How do they differ from forward/futures contract?
A Swap is an agreement between two companies to exchange cash flows in the future usually
through an intermediary like a financial institution.
The agreement defines the dates when the cash flows are to be paid and the way that they
are to be calculated. Usually the calculation of the cash flows involves the future values of
one or more market variables.
19. What is an Order? What are the important types of orders?
An order is a requirement placed on the floor of the exchange by any interested party
(through a broker ) for execution of the contract. An order should contains specifications
such as buy or sell, the number of contracts, the month of contract, type and quality of the

87

commodity, the exchange, the price specification and the period of validity. The important
types of orders are
Market Order
Limit Order
Stop Loss Order
GTC Order
Day Order
20. What is a Market order?
In a market order no specific price is mentioned. Only the position to be taken, i.e.
long/short is stated. When this kind of order is placed, it gets filled at whatever the
current market price of that particular asset is.
21. What is a Limit order?
Limit order is an order to buy or sell a stated amount of a commodity at a specified price, or
at a better price. This order is placed when one wants to enter a new position, or exit an
open position at a specified price or better. The disadvantage is that the order may not
get filled at all if the price for that day does not reach the specified price. Limit order is
day order, which means they are good for only one day unless it is specified as a GTC order.
A Limit-GTC order means the order is good till it gets cancelled.
22. What is a stop order?
Stop orders are not executed until the price reaches a specific point. When the price
reaches that point the stop order becomes a market order. Most of the time stop orders
are used to exit a trade. But, stop orders can be executed for buying/selling positions too.
A "buy" stop order is initiated when one wants to buy a contract or go long and a "sell" stop
order when one wants to sell or go short. The order gets filled at the suggested stop order
price or at a better price.
23. What is a GTC order?
It is an order to buy or sell that remains active until the order gets filled in the market. It
is also called an open order.
24. What is a day order?
Day orders are good for only one day, i.e. the day on which the order is placed. If the order
does not get filled that day, the order has to be placed again the next day.
25. What is a Fill or Kill (FOK) Order?
This order is a limit order that is sent to the pit to be executed immediately and if the
order is unable to be filled right away, it is cancelled.
26. What is Spread Order?
A simple spread order involves two positions, one long and one short. They are taken in the
same commodity with different months (calendar spread) or in closely related commodities.
The spreaders goal is to profit from a change in the difference between the two futures
prices.

88

27. How an order gets filled up?


The broker executes an order only when the market trades through the mentioned price
and not at that particular price. In instances where the market does not touch the specified
price, the order gets executed at a price lower or above the specified one. This does not
apply in case of a market order where a specific price is not mentioned.
Example: A trader wishes to go long on Corn in the International Market. The current
market price is 275 cents per bushel. The trader wants to buy the contract only after the
market has gained some strength and reaches the price of 285 cents/bushel and above. He
would then place a Stop order to Buy 1 May Corn at 285 cents/bushel. When the market
trades at 285, the order becomes a market order and the trader gets the next best price.
If the market is trading at 284 and the next trade is at 286 , the order gets filled at
286- cents/bushel and not at 285 cents/bushel. This is because an order gets filled up at
a price the market traded through and not at that price
28. What is time stamping of the order?
It is a part of the order-routing process in which the time of day is stamped on an order.
An order is time-stamped twice once when it is received on the trading floor and again when
the order is completed.
29. What is the difference between a broker and a local?
Brokers execute trades for other people i.e. for financial, commercial institutions and the
general public and earn a fee for that. Locals trade for their own account and operate
independently.
30. What are the different trading methods followed?
Open-outcry and electronic trading are the most widely followed trading methods.
Open Outcry: Open outcry trading is a face-to-face and highly activated form of trading
used on the floors of the exchanges. In open outcry system the futures contract are traded
in pits on the floor of the exchange. This is the popular method of trading.
Electronic trading: Electronic trading is an automated trade execution system with three
key components.
Computer terminals, where customer orders are keyed in and trade confirmations
are received.
A host computer that processes trade.
A network that links the terminals to the host computer.
Electronic trading enables transactions to remote investors across the globe. It is cost
effective and efficient.
31. What is a tick?
The smallest allowable increment of price movement for a contract is called a tick.
32. What is a quotation?
The current price that is being offered for a particular security or commodity is called a
quotation.

89

33. What is margin money?


Margin money is the minimum balance that needs to be maintained in the exchange to buy or
sell a contract.
34. What is the objective of keeping the margins?
The basic aim of keeping margin is to cover the largest potential loss in one day. This system
of keeping margins eliminates the credit risk involved in the futures transactions.
35. What are the different types of margins?
The different types of margins are
Initial margin
Maintenance margin
Variation margin
36. What is initial margin?
It is the amount that must be deposited with the exchange by the buyer and seller at the
time of entering into a futures contract. This is mandatory on the part of the parties
entering into a contract.
37. What is the concept of maintenance margin?
A trader is entitled to withdraw any balance in the margin account in excess of the initial
margin. To ensure that the balance in the margin account never becomes negative, a
maintenance margin, which is somewhat lower than the initial margin, is required to be
maintained by the buyer and the seller in the contract.
38. What is a Margin call and Variation margin?
Margin call is a call given by the clearing house to a clearing member or from a brokerage
firm to a customer to replenish the account to the minimum required level, when the value
of the account falls below the maintenance margin. The extra funds deposited after the
margin call is given are known as variation margin. If the trader does not provide the
variation margin, the broker closes out the position by offsetting the contract.
39. What is price discovery in futures markets?
Price discovery is the process of generating information to arrive at the equilibrium price,
which reflects the current and prospective demand and supply position of the underlying
asset. This process helps people in making better estimates of futures prices and better
investment decisions.
40. What are the opening and closing prices?
The price at which the commodity opened for trading on a particular day is called an opening
price. Last price that is paid for the commodity before closing of the trade on a particular
day is called closing price.
41. What are the high and low prices?

90

Highest price at which a commodity futures contract traded on a particular day is called
high and the lowest price at which a commodity futures contract traded on a particular
day is called low.
42. What is settlement price?
The settlement price is determined by averaging the prices over the last few minutes of
trading. The price at which all client/member positions are marked to market at the end of
the day is the settlement price. This is also referred to as settle price.
43. What is an open interest?
Open interest represents the total number of outstanding or unliquidated contracts in a
commodity at the end of a trading day. A purchase and a sale are required to establish a
contract position. Thus the open interest is the total of either the outstanding purchases or
sales, not both.
44. What are bullish and bearish markets?
A period of rising market price is called a bullish market and a period of declining market
price is called a bearish market. Bulls expect the market prices to go up and bears expect
the market prices to go down. Closing price of a commodity indicates the trend of the
market (either bullish or bearish) for a particular day.
45. What is a clearing house?
Clearing house is an exchange, which is responsible for the faithful compliance of all trade
commitments undertaken on the trading floor through open outcry method or electronically.
It is responsible for settling trading accounts, clearing trades, collecting and maintaining
margin monies, regulating delivery, and reporting trading data.
46. Who are clearing members?
The members of an exchange/clearing house are called clearing members. These members
are responsible for the negotiation and settlement of commodities traded by brokerage
houses. Brokers who are not the members of the clearing house must channel their business
through a clearing member. All TCMs of NCDEX are members of the clearing house.
47. What is a clearing margin?
All the clearing house members are required to maintain a margin account with the clearing
house called as clearing margin. The margin account for the clearing house members is
adjusted for gains and losses at the end of each day (in the same way as the individual
traders keep margin accounts with the broker). In the case of clearing house members, only
the original margin (and not maintenance margin) is required to be maintained.
48. How is a contract settled in a futures market?
A futures contract can be settled in three ways
By physical delivery of the underlying asset
Closing out the transaction by offsetting the current positions
Through cash settlement.

91

49. What does closing out in a futures contract mean?


Closing out in a contract means taking an opposite position to close out the original futures
position. A buy contract is closed out by a sale and a sale contract is closed out by a buy.
50. What is hedging?
Hedging is a way of reducing some of the risk involved in holding an investment/asset.
Hedging is a way of insuring an investment against risk.
51. How hedging is helpful in risk management?
Hedging reduces the risk by taking an opposite position in the derivatives market to that of
the cash or underlying market. Hedging does not necessarily leads to a better outcome but
makes an outcome more certain .It protects an asset from adverse price changes and
stabilizes the total profits.
52. What are the different hedging strategies possible? What are their differences?
Hedging is possible both in Futures and Options. Hedging with options is dearer than
hedging with futures. This is because the Option premium is much higher and has to be paid
upfront by the buyer of the Option. In the case of futures such a premium need not be paid.
Hedging using futures
There are 2 types of hedging strategies- short and long.
Selling Hedge (Short) - It is selling futures contract to protect against possible declining
prices of commodities that would be sold in the future. At the time the cash commodities
are sold, the open futures position is closed by purchasing an equal number and type of
futures contract as those that were initially sold.
Purchasing (Long) Hedge It is buying futures contract to protect against a possible
increase in the price of cash commodities that would be purchased in the future. At the
time the physical commodities are bought, the open futures position is closed by selling an
equal number and type of futures contract as those that were initially purchased. This is
also referred to as a buying hedge.
Hedging using Options
There are two types of hedging strategies-Put and Call
Hedging using a Put option: When a trader wants to purchase an asset, he can purchase a Put
option to protect himself against any fall in prices and benefits from the rise in prices.
Hedging using a Call option: When a trader commits to sell an asset, he can purchase a Call
option to protect from any rise in prices and benefits from the fall in prices.
A futures hedge in the case of long/short hedge protects the trader against any fall/rise in
prices but eliminates the potential to benefit from rising/falling prices respectively
Hedging in the case of Put/Call option not only protects a trader from any fall/rise in price,
but also takes the benefit of rise/fall in prices respectively. This is because buyers in

92

options enjoy limited risk with unlimited profit potential. They can never lose more than the
option premium.
The major disadvantage in using options, as a hedge is that the buyer must pay premium in
full at the time of the purchase of the option.
54. What is a hedge ratio?
It is a ratio comparing the value of futures contract purchased or sold versus the value of
the cash commodity being hedged against. The hedge ratio is important for investors in
futures contract, as it would help to identify and minimize basis risk.
55. What is basis risk?
Basis is the difference between the cash price and the future price of a commodity
Basis is influenced by differences in both the cash and futures markets, which include
Location: The basis for a hedger located further away from the delivery point is
more volatile than for a hedger located nearer to the delivery point. This is because
the transportation costs would be higher for a hedger located farther from the
delivery point

Time (storage costs): Storage costs increase as the time of procurement increases.
Storage costs are higher in the future period than in the current period of delivery

Quality differences: Cash prices will usually be at a premium to futures prices for
commodities that are of higher grade. Similarly, cash prices for commodities of less
quality grade will usually be at a discount to futures prices.

To the degree that the relationship between cash and futures prices (the basis) is not
predictable, hedging effectiveness is reduced, or in other words, to the degree the basis is
predictable, hedging is effective.
56. What is speculation?
Speculation involves selecting investments with higher risk in order to profit from an
anticipated price movement. It is expectation driven and uses market opportunities to
increase ones profitability.
57. What is arbitrage?
Arbitrage is the simultaneous buying and selling of any underlying variable to profit from
the price differentials. This process usually takes place in different exchanges or at
different market places. It is a risk less profit and does not involve any investment as both
the trades take place simultaneously.
58. Who are hedgers, speculators and arbitrageurs?
These three classes of investors operate simultaneously in the exchange
Hedgers: Hedgers wish to eliminate price risk from their already existing exposures and are
essentially safety driven.

93

Speculators: Speculators willingly take price risks to profit from price changes and are
expectation driven.
Arbitrageurs: Arbitrageurs profit from price differential existing in two markets by
simultaneously operating in two different markets.
III.
59. What is NCDEX?
National Commodity and Derivatives Exchange Ltd. (NCDEX) is a public limited company
registered under the Companies Act, 1956 with the Registrar of Companies, Maharashtra in
Mumbai on April 23,2003. It is an online exchange and promises nation wide reach and
consistent offerings along with inculcating international best practices in commodity
trading.
60. Who are the promoters of NCDEX?
A group of institutions are promoting NCDEX. They are
ICICI Limited
LIC (Life Insurance Corporation of India).
NABARD (National Bank for agriculture and Rural Development),
NSE (National Stock Exchange of India Ltd.)

61. What are the criteria for becoming a member in NCDEX?


Membership of NCDEX as trading/clearing members is open to any person, association of
persons, partnerships, co-operative societies, Banks, corporates, foreign individuals, firms
etc, that fulfill the eligibility criteria set by the exchange.
A trading cum clearing member (TCM) should have a net worth of Rs 50 lakh, deposit an
interest free amount of Rs 15 lakh as a base capital, bank guarantee/ fixed deposit of Rs 15
lakh as a collateral deposit and annual charges of Rs 50,000/-.
For a Professional Clearing Member (PCM) the net worth is Rs.50 crore, interest free
deposit of Rs.25 lakh, a minimum collateral of Rs25 lakh and annual Charges of Rs.1 Lakh
62. Who are Trading cum clearing members (TCM) and Professional clearing members
(PCM)?
NCDEX currently has membership for TCM and PCM only.
Trading cum clearing members: TCM can trade and clear his trades or those of his clients.
In addition to this he can also clear the trades of his associate trading members
Professional clearing members: A PCM has no trading rights but has only clearing rights. A
PCM can only clear trades of his clients who have traded through a TCM.
63. What are the commodities that have been given approval for trading on NCDEX?
In the first phase NCDEX has approval from FMC to trade in 9 commodities. They are Gold,
Silver, Cotton (long and medium staple), Soybean, Soyaoil, Rape/Mustardseed,
Rape/Mustard oil, Crude Palm Oil and RBD Palmolein.

94

64. What are the trading hours of NCDEX?


The trading hours of NCDEX would be 10.00 a.m. to 4.00 p.m.
65. How many warehouses would be accredited to NCDEX?
NCDEX initially plans to start with one delivery center and one warehouse for each of the
commodities. Over a period of time, it plans to add more warehouses and delivery points
66. How NCDEX will accredit the warehouses?
NCDEX would prescribe the accreditation norms, comprising of financial and technical
parameters, which have to be met by the warehouse owners. NCDEX would take
assayer's/Structural Engineer's certificate for confirming the compliance of the technical
norms of these warehouses.
67. Who will be the assaying agencies or certifying agencies for the commodities?
NCDEX is in discussions with the following agencies for acting as the certifying agencies.
SGS India
Geo Chem
Dr.Amin Laboratories
Stewart Assayers
68. Who would be the depository participants?
NCDEX is in discussions with the following institutions to act as depository recipients.
Bank of Baroda
Canara Bank
Global Trust Bank
HDFC Bank
ICICI Bank,
IDBI Bank
Indus Ind Bank
UTI Bank
69. Who will be the clearing corporation?
NCDEX has tied-up with NSCCL (National securities and Clearing Corporation Limited) to
act as the clearing house. NSSCL would be responsible for all operational aspects of the
clearing activities on NCDEX.
70. Who would be the clearing banks?
The following banks have accepted to act as clearing banks.
Canara Bank
ICICI bank
UTI bank
HDFC bank

95

71. What is FMC?


The Forward Markets Commission (FMC) is a statutory body, which regulates commodity
futures trading in India. It was set up under the Ministry of Consumer Affairs and Public
Distribution in 1953 under the Forward Contracts (Regulation) Act, 1952.
72. Who formulates the rules and byelaws of an exchange?
The exchanges, which organize forward trading in regulated commodities, can prepare their
own rules (articles of association) and byelaws. But these have to be approved by the FMC.
73. What are the functions of FMC?
Acts as an advisor to the Central Government in respect any matter arising out of the
non-compliance of the Forward Contracts (Regulation) Act, 1952.
Supervising the activities of various forward market agencies and taking any necessary
action under the powers assigned to it by the act.
Collecting and publishing information regarding the trading conditions of the goods
which come under the provisions of the act.
Submitting periodical reports to the Central Government, on the working of forward
markets.
Giving recommendations to improve the working of forward markets.
Undertaking the inspection of the accounts and other documents of any recognized
association or registered association or any member of such association dealing in
futures markets whenever needed.

96

10. ECONOMIC BENEFITS OF FUTURES TRADING


Futures contracts perform two important functions of price discovery and price risk
management with reference to the given commodity. It is useful to all segments of economy.
It is useful to producer because he can get an idea of the price likely to prevail at a future
point of time and therefore can decide between various competing commodities, the best
that suits him. It enables the consumer get an idea of the price at which the commodity
would be available at a future point of time. He can do proper costing and also cover his
purchases by making forward contracts. The futures trading is very useful to the exporters
as it provides an advance indication of the price likely to prevail and thereby help the
exporter in quoting a realistic price and thereby secure export contract in a competitive
market. Having entered into an export contract, it enables him to hedge his risk by
operating in futures market. Other benefits of futures trading are:
(i) Price stabilization-in times of violent price fluctuations - this mechanism dampens the
peaks and lifts up the valleys i.e. the amplititude of price variation is reduced.
(ii) Leads to integrated price structure throughout the country.
(iii) Facilitates lengthy and complex, production and manufacturing activities.
(iv) Helps balance in supply and demand position throughout the year.
(v) Encourages competition and acts as a price barometer to farmers and other trade
functionaries.
Futures trading is also capable of being misused by unscrupulous speculators. In order to
safeguard against uncontrolled speculation certain regulatory measures are introduced from
time to time. They are:
a.

Limit on open position of an individual operator to prevent over trading;

b. Limit on price fluctuation (daily/weekly) to prevent abrupt upswing or downswing in


prices;
c.

Special margin deposits to be collected on outstanding purchases or sales to curb


excessive speculative activity through financial restraints;

d. Minimum/maximum prices to be prescribed to prevent future prices from falling


below the levels that are un remunerative and from rising above the levels not
warranted by genuine supply and demand factors.

97

11. GLOSSARY OF FUTURES TERMS


Arbitrage
The simultaneous purchase and sale of identical or equivalent financial instruments or
commodity futures in order to benefit from a discrepancy in their price relationship.
Ask
A motion to sell. The same as offer. Indicates a willingness to sell a futures contract at a
given price.
Back Month
The more distant month(s) in which futures trading is taking place, as distinguished from
the nearby (Delivery) Front month.
Basis
The difference between the current cash price and the futures price of the same
commodity. The basis is determined by the costs of actually holding the commodity versus
contracting to buy it for a later delivery (i.e. a futures contract). The basis is affected by
other influences as well, such as unusual situations in supply or demand. Unless otherwise
specified, the price of the nearby futures contract month is generally used to calculate the
basis.
Broker
A company or individual that executes futures and options orders on behalf of financial and
commercial institutions and/or the general public.
Bid
The price that the market participants are willing to pay. A motion to buy a futures or
options contract at a specified price. Opposite of offer.
Bear
One who expects a decline in prices. The opposite of a "Bull."
Bear Market
A market in which prices are dropping.
Bull
One who expects prices to rise. The opposite of "Bear."
Bull Market
A market in which prices are rising.
Carrying Charge (Cost of Carry)
For physical commodities such as grains and metals, the cost of storage space, insurance,
and finance charges incurred by holding a physical commodity. In interest rate futures

98

markets, it refers to the differential between the yield on a cash instrument and the cost
necessary to buy the instrument.
Cash Commodity
An actual physical commodity someone is buying or selling, e.g., soybeans, corn, gold, silver,
Treasury bonds, etc. Also referred to as Actuals.
Cash Market
A place where people buy and sell the actual commodities, i.e., grain elevator, bank, etc.
Cash Price
The price of the actual physical commodity that a futures contracts is based upon.
Commodity
An article of commerce or a product that can be used for commerce. In a narrow sense,
products traded on an authorized commodity exchange. The types of commodities include
agricultural products, metals, petroleum, foreign currencies, and financial instruments and
indexes.
Contract
Unit of trading for a financial or commodity future. Also, actual bilateral agreement
between the parties (buyer and seller) of a futures or options on futures transaction as
defined by an exchange.
Daily Trading Limit
The maximum price range set by the exchange each day for a contract. A Trading Limit
does not halt trading, but rather, limits how far the price can move in a given day.
Day Order
An order that is placed for execution during only one trading session. If the order cannot
be executed (filled) that day, it automatically expires at the close of the trading session.
Day Trade
The purchase and sale of a futures or an options contract in the same day, thus ending the
day with no established position in the market or being flat.
Day Traders
Speculators who take positions in futures or options contracts and liquidate them prior to
the close of the same trading day.
Deferred Month
The more distant month(s) in which futures trading is taking place, as distinguished from
the nearby (delivery) month.
Deliverable Grades
The standard grades of commodities or instruments listed in the rules of the exchanges

99

that must be met when delivering cash commodities against futures contracts. Grades are
often accompanied by a schedule of discounts and premiums allowable for delivery of
commodities of lesser or greater quality than the standard called for by the exchange.
Delivery
The transfer of the cash commodity from the seller of a futures contract to the buyer of a
futures contract. Each futures exchanges has specific procedures for delivery of a cash
commodity. Some futures contracts, such as stock index contracts, are cash settled.
Delivery Month
A specific month in which delivery may take place under the terms of a futures contract.
Also referred to as contract month or Front month.
Delivery Points
The locations and facilities designated by a futures exchange where stocks of a commodity
may be delivered in fulfillment of a futures contract, under procedures established by the
exchange.
Forward (Cash) Contract
A cash contract in which a seller agrees to deliver a specific cash commodity to a buyer
sometime in the future. Forward contracts, in contrast to futures contracts, are privately
negotiated and are not standardized.
Futures
A term used to designate all contracts covering the purchase and sale of financial
instruments or physical commodities for future delivery on a commodity futures exchange.
Futures Commission Merchant
A firm or person engaged in soliciting or accepting and handling orders for the purchase or
sale of futures contracts, subject to the rules of a futures exchange and, who, in
connection with solicitation or acceptance of orders, accepts any money or securities to
margin any resulting trades or contracts. The FCM must be licensed.
Futures Contract
A legally binding agreement, made on the trading floor of a futures exchange, to buy or sell
a commodity or financial instrument sometime in the future. Futures contracts are
standardized according to the quality, quantity, and delivery time and location.
Futures Exchange
A central marketplace with established rules and regulations where buyers and sellers meet
to trade futures and options on futures contracts.
Good till Canceled (GTC)
An order worked by a broker until it can be filled or until canceled.
Hedge

100

The purchase or sale of a futures contract as a temporary substitute for a cash market
transaction to be made at a later date. Usually it involves opposite positions in the cash
market and futures market at the same time.
Hedger
An individual or company owning or planning to own a cash commodity corn, soybeans, wheat,
etc. and concerned that the cost of the commodity may change before either buying or
selling it in the cash market. A hedger achieves protection against changing cash prices by
purchasing (selling) futures contracts of the same or similar commodity and later offsetting
that position by selling (purchasing) futures contracts of the same quantity and type as the
initial transaction.
Hedging
The practice of offsetting the price risk inherent in any cash market position by taking an
equal but opposite position in the futures market. Hedgers use the futures markets to
protect their businesses from adverse price changes.
Last Trading Day
The final day when trading may occur in a given futures or options contract month. Futures
contracts outstanding at the end of the last trading day must be settled by delivery of the
underlying commodity or securities or by agreement for monetary settlement.
Leverage
The ability to control large amounts of a commodity with a comparatively small amount of
capital.
Liquid
A characteristic of a security or commodity market with enough units outstanding to allow
large transactions without a substantial change in price. Institutional investors are inclined
to seek out liquid investments so that their trading activity will not influence the market
price.
Liquidation
Any transaction that offsets or closes out a long or short futures position.
Long
One who has bought a futures or options on futures contract to establish a market position
through an offsetting sale; the opposite of short.
Long Hedge
The purchase of a futures contract in anticipation of an actual purchase in the cash market.
Used by processors or exporters as protection against an advance in the cash price.
Margin Call
A demand from a clearing house to a clearing member, or from a brokerage firm to a
customer, to bring margin deposits up to a minimum level required to support the positions

101

held. This can be done by either depositing more funds or offsetting some or all of the
positions held.
Mark-To-Market
A daily accounting entry that is the bedrock of regulated futures bookkeeping. It's the
end-of-day adjustment made to trading accounts to reflect profits and losses on existing
positions. In other words, winnings are credited and immediately available to the account
and losses are debited and immediately owed. This brings integrity to the marketplace
because participants are not allowed to trade unless funds are available to cover the
positions.
Market Order
An order to buy or sell a specified commodity, including quantity and delivery month at the
best possible prices available, as soon as possible.
Market-If-Touched Order
A price order that automatically becomes a market order if the price is reached.
Market on Close
An order to buy or sell at the end of the trading session at a price within the closing range
of prices.
Offer
Indicates a willingness to sell a futures contract at a given price. Also called "Ask"
Offset
Taking a second futures or options position opposite to the initial or opening position. This
means selling, if one has bought, or buying, if one has sold, a futures or option on a futures
contract.
Open Order
An order to a broker that is good until it is canceled or executed.
Open Outcry
Method of public auction for making verbal bids and offers in the trading pits or rings of
futures exchanges.
Or Better Order
A type of a limit order in which the market is at or better than the limit specified. The
term is often used to help clarify that the order was not mistakenly given as a Limit when it
looks like it should be a Stop Order.
Performance Bond (Margin)
Funds that must be deposited as a performance bond by a customer with his or her broker,
by a broker with a clearing member, or by a clearing member, with the Clearing House. The
performance bond helps to ensure the financial integrity of brokers, clearing members and

102

the Exchange as a whole.


Pit
A specially constructed arena on the trading floor of some exchanges where trading in a
futures contract is conducted. On some exchanges the term "ring" designates the trading
area for a commodity.
Position
A market commitment. A buyer of a futures contract is said to have a long position and,
conversely, a seller of futures contracts is said to have a short position.
Price Discovery
The generation of information about "future'' cash market prices through the futures
markets. It has been said that futures markets are often the place of "original price
discovery" because that's where the buyers and sellers are brought together to determine
the price. As in any auction, the last price is considered to reflect the sum total of opinions
about what price an item should be valued.
Price Limit Order
An order that specifies the highest price at which a bidder will pay for a contract, or the
lowest price a seller will sell a contract. This type of order is used to "limit" how much the
trader is willing to "give in" on price to get the order filled.
Settlement Price
The last price paid for a commodity on any trading day. The exchange clearing house
determines a firm's net gains or losses, margin requirements, and the next day's price
limits, based on each futures and options contract settlement price. If there is a closing
range of prices, the settlement price is determined by averaging those prices. Also
referred to as Settle or Closing Price.
Short
One who has sold futures contracts or plans to purchase a cash commodity. Selling futures
contracts or initiating a cash forward contract sale without offsetting a particular market
position.
Speculator
One who attempts to anticipate price changes and, through buying and selling futures
contracts, aims to make profits. A speculator does not use the futures market in connection
with the production, processing, marketing or handling of a product.
Spot
Usually refers to a cash market price for a physical commodity that is available for
immediate delivery.
Spread
The price difference between two related markets or commodities.

103

Spreading
The simultaneous buying and selling of two related markets in the expectation that a profit
will be made when the position is offset. Examples include: buying one futures contract and
selling another futures contract of the same commodity but different delivery month;
buying and selling the same delivery month of the same commodity on different futures
exchanges; buying a given delivery month of one futures market and selling the same
delivery month of a different, but related, futures market.
Stop Order
Sometimes called a Stop Loss Order, although it can be used to initiate a new position as
well as offset an existing position. It's an order to buy or sell when the market reaches a
specified point. A stop order to buy becomes a market order when the futures contract
trades (or is bid) at or above the stop price. A stop order to sell becomes a market order
when the futures contract trades (or is offered) at or below the stop price. An order to buy
or sell at the market when and if a specified price is reached.
Stop Limit
A variation of a stop order. A stop with limit order to buy becomes a limit order at the stop
price when the futures contract trades (or is bid) at or above the stop price. A stop order
to sell becomes a limit order at the stop price when the futures contract trades (or is
offered) at or below the stop price.
Tick
Smallest increment of price movement possible in trading a given contract.

104