Course Instructor: Dr.

Mahesh Sarva Course Code: FIN643

Academic Task No.: CA-2 Academic Task Title: Equity Derivative
Date of Allotment: September12, 2020 Date of submission: September 30, 2020
Student’s Roll no: A16 Student’s Reg. No: 11906130

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Learning Outcomes: To enhance the analytical and conceptual skills .

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written for me by any other person.
Student’s Sign/Name: PRATEEK SEHGAL

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 Commodity Futures Functioning
INTRODUCTION: -

A commodity futures contract is an agreement to buy or sell a predetermined amount of a commodity at a

specific price on a specific date in the future. Commodity futures can be used to hedge or protect an investment
position or to bet on the directional move of the underlying asset.

Many investors confuse futures contracts with options contracts. With futures contracts, the holder has an
obligation to act. Unless the holder unwinds the futures contract before expiration, they must either buy or sell
the underlying asset at the stated price.

Most commodity futures contracts are closed out or netted at their expiration date. The price difference
between the original trade and the closing trade is cash-settled. Commodity futures are typically used to take
a position in an underlying asset. Typical assets include:

 Crude oil
 Wheat
 Corn
 Gold
 Silver
 Natural Gas

Commodity futures contracts are called by the name of their expiration month meaning the contract ending
in September is the September futures contract. Some commodities can have a significant amount of price
volatility or price fluctuations. As a result, there's the potential for large gains but large losses as well.

The three main areas of commodities are food, energy, and metals. The most popular food futures are for meat,
wheat, and sugar. Most energy futures are for oil and gasoline. Metals using futures include gold, silver, and
copper.

Buyers of food, energy, and metal use futures contracts to fix the price of the commodity they are purchasing.
That reduces their risk that prices will go up. Sellers of these commodities use futures to guarantee they will
receive the agreed-upon price. They remove the risk of a price drop.

Prices of commodities change on a weekly or even daily basis. Contract prices change as well. That’s why the
cost of meat, gasoline, and gold changes so often.

KEY TAKEAWAYS

 A commodity futures contract is an agreement to buy or sell a predetermined amount of a commodity

at a specific price on a specific date in the future.
 Commodity futures can be used to hedge or protect an investment position or to bet on the directional
move of the underlying asset.
 The high degree of leverage used with commodity futures can amplify gains, but losses can be
amplified as well.
 Speculating with Commodity Futures Contracts
Commodities futures contracts can be used by speculators to make directional price bets on the underlying
asset's price. Positions can be taken in either direction meaning investors can go long (or buy) as well as go
short (or sell) the commodity.

Commodity futures use a high degree of leverage so that the investor doesn't need to put up the total amount
of the contract. Instead, a fraction of the total trade amount must be placed with the broker handling the
account. The amount of leverage needed can vary, given the commodity and the broker.

Example: -

Assume initial margin amount of ₹4,000 allows an investor to enter into a futures contract for 1,000 barrels
of oil valued at ₹45,000—with oil priced at ₹45 per barrel. If the price of oil is trading at ₹60 at the contract's
expiry, the investor has a ₹15 gain or a ₹15,000 profit. The trades would settle through the investor's brokerage
account crediting the net difference of the two contracts. Most futures contracts will be cash-settled, but some
contracts will settle with the delivery of the underlying asset to a centralized processing warehouse.

Considering the significant amount of leverage with futures trading, a small move in the price of a commodity
could result in large gains or losses compared to the initial margin. Speculating on futures is an advanced
trading strategy and not fit for the risk tolerance of most investors.

Risks of Commodity Speculating: -

Unlike options, futures are the obligation of the purchase or sale of the underlying asset. As a result, failure to
close an existing position could result in an inexperienced investor taking delivery of a large quantity of
unwanted commodities.

Trading in commodity futures contracts can be very risky for the inexperienced. The high degree of leverage
used with commodity futures can amplify gains, but losses can be amplified as well. If a futures contract
position is losing money, the broker can initiate a margin call, which is a demand for additional funds to shore
up the account. Further, the broker will usually have to approve an account to trade on margins before they
can enter into contracts.
 Hedging with Commodity Futures Contracts
As mentioned earlier, most speculation futures cash settle. Another reason to enter the futures market,
however, is to hedge the price of the commodity. Businesses use future hedges to lock in prices of the
commodities they sell or used in production.

Commodity futures used by companies give a hedge to the risk of adverse price movements. The goal of
hedging is to prevent losses from potentially unfavourable price changes rather than to speculate. Many
companies that hedge use or producing the underlying asset of a futures contract. Examples of commodities
hedging use include farmers, oil producers, livestock breeders, manufacturers, and many others.

Example: -

a plastics producer could use commodity futures to lock in a price for buying natural gas by-products needed
for production at a date in the future. The price of natural gas—like all petroleum products—can fluctuate
considerably, and since the producer requires the natural gas by-product for production, they are at risk of cost
increases in the future.

If a company locks in the price and the price increases, the manufacturer would have a profit on the commodity
hedge. The profit from the hedge would offset the increased cost of purchasing the product. Also, the company
could take delivery of the product or offset the futures contract pocketing the profit from the net difference
between the purchase price and the sale price of the futures contracts.

Risks to Commodity Hedging: -

Hedging a commodity can lead to a company missing out on favourable price moves since the contract is
locked in at a fixed rate regardless of where the commodity's price trades afterward. Also, if the company
miscalculates their needs for the commodity and over-hedges, it could lead to having to unwind the futures
contract for a loss when selling it back to the market.
 Commodity Futures Functioning
If the price of the underlying commodity goes up, the buyer of the futures contract makes money. He gets the
product at the lower, agreed-upon price and can now sell it at today's higher market price. If the price goes
down, the futures seller makes money. He can buy the commodity at today's lower market price and sell it to
the futures buyer at the higher, agreed-upon price.

If commodities traders had to deliver the product, few people would do it. Instead, they can fulfil the contract
by delivering proof that the product is in the warehouse. They can also pay the cash difference or
provide another contract at the market price.

Commodities Exchanges

Future contracts are traded on a commodities futures exchange. These include the Chicago Mercantile
Exchange, the Chicago Board of Trade, and the New York Mercantile Exchange. These are all now owned
by the CME Group. The Commodities Futures Trading Commission regulates them. Buyers and sellers must
register with the Commodity Futures Trading Commission (CFTC).

The contracts go through the exchange's clearing house. Technically, the clearinghouse buys and sells all
contracts. The exchanges make contracts easier to buy and sell by making them fungible. That means they are
interchangeable. But they must be for the same commodity, quantity, and quality. They must also be for the
same delivery month and location.

Fungibility allows the buyers to "offset" contracts. That's when they buy and then subsequently sell the
contracts. It allows them to pay off or extinguish the contract before the agreed-upon date. For that reason,
futures contracts are derivatives.
 Commodity Futures Trading
Commodity futures are bought and sold in commodity exchanges. These include exchanges like the New York
Mercantile Exchange (NYMEX), London Metals Exchange (LME), Chicago Mercantile Exchange (CME)
etc. In India, trading in these type of futures takes place on exchanges like the Multi-Commodity Exchange
(MCE) and the National Commodity and Derivatives Exchange (NCDEX).

Here are some of the features of commodity futures trading:

 Exchanges: Commodity trading is very organised and takes place in commodity exchanges like NYMEX
in the USA, and MCX and NCDEX in India.
 Standardised: The contracts are highly standardised. The quantity, quality, price, and time are determined
by the exchanges in which they are traded. For example, gold is available in lots of 1 kg, 100 gm, guinea
(8 gm) and petal (1 gm) portions. The gold must be in numbered bars and of 995 purity.
 Leverage: Before you can trade in these futures, you have to deposit what is called an initial margin with
the broker. This is a percentage of your exposure. Let’s say the margin is 4 percent and you are trading
worth Rs 10 crore, then, your initial margin would be Rs 40 lakh. Since margins are quite low, you can
buy and sell in large volumes. This is called leveraging. High leverages increase the chance of profit and
losses too. If your hunch is right, you can make windfall profits. But if you lose, you lose a lot.
 Regulated: Commodities markets are monitored to ensure fair practices. In India, the body that governed
the commodity futures trading used to be the Forward Markets Commission. But in 2015, it was merged
with the Securities & Exchange Board of India (SEBI).
 Physical delivery: Buyers have the choice of accepting physical delivery on the expiry of these contracts.
If buyer doesn’t seek physical delivery, there is an option to square off the transaction before its expiry
date.
 Zero-sum game: These futures are a zero-sum game. When you win, someone else loses.

Commodity futures exchanges make business considerably more efficient and less risky for both
commodity producers and consumers by bringing together those willing to take on risk from those
looking to reduce risk.

The world’s oldest commodity futures exchange with standardised exchange-traded futures
contracts was the Chicago Board of Trade (CBOT), which began in 1864 with wheat, corn, cattle
and pigs being widely traded.
 Real-World Example of Commodity Futures
Business owners can use commodity futures contracts to fix the selling prices of their products
weeks, months, or years in advance.

As an example, let's say a farmer is expecting to produce 1,000,000 bushels of soybeans in the
next 12 months. Typically, soybean futures contracts include the quantity of 5,000 bushels.
The farmer's break-even point on a bushel of soybeans is ₹10 per bushel meaning ₹10 is the
minimum price needed to cover the costs of producing the soybeans. The farmer sees that a
one-year futures contract for soybeans is currently priced at ₹15 per bushel.

The farmer decides to lock in the ₹15 selling price per bushel by selling enough one-year
soybean contracts to cover the harvest. The farmer needs 200 futures contracts (1,000,000
bushels needed / 5,000 bushels per contract = 200 contracts).

One year later, regardless of price, the farmer delivers the 1,000,000 bushels and receives the
locked-in price of ₹15 x 200 contracts x 5000 bushels, or ₹15,000,000 in total income.

However, unless soybeans were priced at ₹15 per bushel in the market on the expiration date,
the farmer had either gotten paid more than the prevailing market price or missed out on higher
prices. If soybeans were priced at ₹13 per bushel at expiry, the farmer's ₹15 hedge would be
₹2 per bushel higher than the market price for a gain of ₹2,000,000. On the other hand, if
soybeans were trading at ₹17 per bushel at expiry, the ₹15 selling price from the contract
means the farmer would have missed out on an additional ₹2 per bushel profit.