NSE's CERTIFICATION IN FINANCIAL MARKETS

NCFM

Commodities Market Module Work Book

NATIONAL STOCK EXCHANGE OF INDIA LIMITED

Contents
1 Introduction to derivatives................................................................................ 1.1 Derivatives defined .................................................................................... 1.2 Products, participants and functions .......................................................... 1.3 Derivatives markets ................................................................................... 1.3.1 1.3.2 1.3.3 2 Spot versus forward transaction .................................................... Exchange traded versus OTC derivatives ..................................... Some commonly used derivatives .................................................. 11 11 12 13 14 14 16 19 19 19 21 22 22 24 24 24 24 25 27 31 31 32 32 32 32 33 33 34 34 35 35

Commodity derivatives .................................................................................... 2.1 Difference between commodity and financial derivatives ......................... 2.1.1 Physical settlement ......................................................................... 2.1.2 Warehousing .................................................................................. 2.1.3 Quality of underlying assets ........................................................... 2.2 Global commodities derivatives exchanges ................................................ 2.2.1 Africa.............................................................................................. 2.2.2 Asia ............................................................................................... 2.2.3 Latin America................................................................................. 2.3 Evolution of the commodity market in India .............................................. 2.3.1 The Kabra committee report ......................................................... 2.3.2 Latest developments ....................................................................... The NCDEX platform ...................................................................................... 3.1 Structure of NCDEX ................................................................................... 3.1:1 Promoters ....................................................................................... 3.1.2 Governance .................................................................................... 3.2 Exchange membership ............................................................................... 3.2.1 Trading cum clearing members (TCMs) ........................................ 3.2.2 Professional clearing members (PCMs) ......................................... 3.3 Capital requirements .................................................................................. 3.4 The NCDEX system .................................................................................. 3.4.1 3.4.2 3.4.3 Trading .......................................................................................... Clearing ......................................................................................... Settlement.......................................................................................

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CONTENTS 4 Commodities traded on the NCDEX platform............................................... 4.1 Agricultural commodities .......................................................................... 4.1.1 Cotton ............................................................................................. 4.1.2 Crude palm oil ................................................................................ 4.1.3 RBD Palmolein ............................................................................. 4.1.4 Soy oil ........................................................................................... 4.1.5 Rapeseedoil ................................................................................... 4.1.6 Soybean ......................................................................................... 4.1.7 Rapeseed........................................................................................ 4.2 Precious metals .......................................................................................... 4.2.1 Gold ................................................................................................ 4.2.2 Silver ............................................................................................. Instruments available for trading ................................................................... 5.1 Forward contracts....................................................................................... 5.1.1 Limitations of forward markets ..................................................... 5.2 Introduction to futures................................................................................ 5.2.1 Distinction between future and forwards contracts ....................... 5.2.2 Futures terminology ...................................................................... 5.3 Introduction to options ................................................................................ 5.3.1 Option terminology ....................................................................... 5.4 Basic payoffs............................................................................................... 5.4.1 Payoff for buyer of asset: Long asset ............................................. 5.4.2 Payoff for seller of asset: Short asset ............................................ 5.5 Payoff for futures ....................................................................................... 5.5.1 Payoff for buyer of futures: Long futures ..................................... 5.5.2 Payoff for seller of futures: Short futures...................................... 5.6 Payoff for options ...................................................................................... 5.6.1 Payoff for buyer of call options: Long call ................................... 5.6.2 Payoff for writer of call options: Shortcall.................................... 5.6.3 Payoff for buyer of put options: Longput...................................... 5.6.4 Payoff for writer of put options: Shortput ...................................... 5.7 Using futures versus us mg options ........................................................... Pricing commodity futures................................................................................ 6.1 Investment assets versus consumption assets ............................................ 6.2 The cost of carry model ............................................................................. 6.2.1 Pricing futures contracts on investment commodities................... 6.2.2 Pricing .futures contracts on consumption commodities............... 6.3 The futures basis ........................................................................................

4 37 37 38 40 42 43 45 46 47 49 50 54 59 59 60 60 61 62 62 63 64 65 65 65 65 67 68 68 69 69 70 71 77 77 78 80 82 83

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.............................................2......................5..................................................................................................................1..............................................2.................................... 9................................2 Short hedge............ 9..............................................................2 Settlement methods ..... 9...... 8.............................................2 Speculation: Bearish commodity..................................................5........................4..................................2.........5.........3 Risk management ...... 9............................................................................................ 8...... Clearing mechanism .....................................1.............................. 8.... 8... 9..........5...................3 Depository participants .......................................... 7....3 Arbitrage .............6 Order entry on the trading system ........... 7..................2..................................................1 Speculation: Bullish commodity................................................................................... 7.......... 9........ 7.............................5.............................................. 8.......1 SPAN ................................4 Hedge ratio ................................................................................ 8.................................................................................2 Entities in the trading system ............1 Hedging ...................................1 Permitted lot size .................................1...............3 Contract specifications for commodity futures ........ 7........................ 7...................1 Overpriced commodity futures: buy spot........................ 9............................................1............................................ Trading ...4 Commodity futures trading cycle.............. 7.................................................................................................................................... 8............. 9.. 8.........1 Settlement mechanism........................................................... buy futures ..2 Speculation .................................2............... 7......................1.............................2.......7 Charges ...............................1 Basic principles of hedging ........6 Margins for trading in futures ......................................................................... 8..1........................... 8........................................................... 8............... sell spot ...................................................................... 7....3 Quantity freeze ......3 Long hedge ....... 8....5....................5 Advantages of hedging ................................................6 Limitation of hedging: basis Risk .............................1...2 Clearing banks ........................... 8.......................................... 7....................... 8................................................................................1...................................1 Futures trading system ..4 Base price ....3 Entities involved in physical settlement ........1...............3................................................ Clearing and settlement...........................................................................................5 Price ranges of contracts ....... 7............................................ sell futures ....................................1 Guidelines for allotment of client code...................................................1....................2 Tick size for contracts ..................... 9........................CONTENTS 7 Using commodity futures .. 9.... 7..5 Order types and trading parameters . 9.................................. sell futures .................... 5 87 87 87 88 89 91 92 93 94 94 95 95 96 97 101 101 101 102 103 103 104 108 108 109 109 109 110 112 113 117 117 118 118 119 119 119 122 124 125 126 126 8 9 ............2 Underpriced commodity futures: buy futures.............2 Settlement ........... 7.3.......1 Clearing..4 Margining at NCDEX ......

...........4.......2 Rules governing intermediaries .....1 Procedure for arbitration .............................................5 10 CONTENTS Initial margin .....1 Trading ................................................ 10..... Effect of violation...........................................................................3 Rules governing investor grievances..........................................3.........................................................4.......... 10................................. Computation of initial margin ............. 10.......2 Clearing ............................2.........................3..................... Implementation aspects of margining and risk management ........................................6 9.3 9.... 10.. 11 ................................................ 10.................2...... Implications of sales tax .................. 10.................2 9..........2 Hearings and arbitral award . 126 126 128 130 135 135 136 136 140 144 145 146 149 Regulatory framework ..........................................................................4..........................................4 9.... arbitration ....................................4...........................................1 Rules governing commodity derivatives exchanges ..................... 10..........................

.............................2 Volume on existing exchanges ................................................2 Fee / deposit structure and networth requirement: PCM .......................................indicative ware house charges. 72 6............ 1968 and 1999 .................................................. 27 2...........1 Fee / deposit structure and networth requirement: TCM .. 51 5....................... 61 5............. 23 2..............................1 NCDEX ............1 The global derivatives industry.........................................1 Refined soy oil futures contract specification......................... 28 3..................................... 89 7..................2 Distinction between futures and options............1 Country-wise share in gold production.......................................... 33 4......................... 90 ..................... 82 7..... 33 3..............2 Silver futures contract specification ....................1 Distinction between futures and forwards ...........................List of Tables 2.......3 Registered commodity exchanges in India ........................................................................

..................................................................2 Gold futures contract specification ....... 105 8...........3 Gold futures contract specification ........ 120 9..............3 Calculating outstanding position at TCM level ......5 Commodity futures: Lot size another parameters .............................. 104 8...3 Long staple cotton futures contract specification ................5 Exposure limit as a multiple of liquid net worth.................. 93 8.................................. 111 9......................... 121 9..............................................................................................................4 Minimum margin percentage on commodity futures contracts . 131 .................................8 List of Tables 7...................................1 MTM on along position in cotton futures ...................1 Commodity futures contract and their symbols .......................................................... 127 9...... 103 8.......................................................... 130 9.....................2 MTM on a short position in cotton futures ...........6 Number of days for physical settlement on various commodities ............. 109 8...4 Commodity futures: Quantity freeze unit .... 127 9................

............. 5.........2 Payoff for buyer of a long hedge ..................................................... 5................7 Payoff for buyer of put option on long staple cotton ....................6 Payoff for writer of call option on gold ....... 5............ 5................ 5.................................................................5 Payoff for buyer of call option on gold......4 Payoff for a seller of cotton futures ....................................................................... 5.........................3 Payoff for a buyer of gold futures ........................................................................................................................2 Payoff for a seller of gold .... 5...........................1 Contract cycle ......8 Payoff for writer of put option on long staple cotton....................................................................................................................................List of Figures 5.......................................... 106 ..1 Payoff for a buyer of gold .........1 Variation of basis overtime .......................................................................................................... 66 66 67 68 69 70 71 72 84 88 90 8.. 6.............1 Payoff for buyer of a short hedge .......... 7.......................... 7......................................................

INDIA. the book in its entirety or any part cannot be stored in a retrieval system transmitted in any form or by any means. All content included in this book. Bandra Kurla Complex. (NSE) Exchange Plaza. recording or otherwise. data compilation etc. such as text. Bandra (East).click on ‘NCFM’ link and then go to ‘Announcements’ link. This book or any part thereof should not be copied. are the property of NSE.Distribution of weights Chapter No. graphics. reproduced. if any . resold or exploited for any commercial purposes. regarding revisions/updations in NCFM modules or launch of new modules. sold.nseindia. duplicated. photocopying. images. logos. mechanical. NOTE: Candidates are advised to refer to NSE’s website: www.com. Mumbai 400 051. Furthermore. 1 2 3 4 5 6 7 8 9 10 11 Title Introduction to derivatives Commodity Derivatives The NCDEX Platform Commodities traded on the NCDEX platform Instruments available for trading Pricing commodity futures Using commodity futures Trading Clearing and settlement Regulatory framework Implications of sales tax Weights (%) 6 7 5 3 15 16 14 16 17 8 3 Copyright © 2009 by National Stock Exchange of India Ltd. electronic.

Under such circumstances. What they would then negotiate happened to be a futures-type contract. In 1848.Chapter 1 Introduction to derivatives The origin of derivatives can be traced back to the need of farmers to protect themselves against fluctuations in the price of their crop. Clearly this meant that the farmer and his family were exposed to a high risk of price uncertainty. although favourable prices could be obtained during periods of oversupply. On the other hand. Today.that of having to pay exorbitant prices during dearth. These were eventually standardised. etc. cotton. it clearly made sense for the farmer and the merchant to come together and enter into a contract whereby the price of the grain to be delivered in September could be decided earlier. he would have to dispose off his harvest at a very low price. The underlying asset can be equity.1 Derivatives defined A derivative is a product whose value is derived from the value of one or more underlying variables or assets in a contractual manner. A group of traders got together and created the 'to-arrive' contract that permitted farmers to lock in to price upfront and deliver the grain later. 1. or CBOT. However. A farmer who sowed his crop in June faced uncertainty over the price he would receive for his harvest in September. the Chicago Board of Trade. From the time it was sown to the time it was ready for harvest. which would enable both parties to eliminate the price risk. interest rate. In years of scarcity. forex. and in 1925 the first futures clearing house came into existence. etc. during times of oversupply. These were simple contracts developed to meet the needs of farmers and were basically a means of reducing risk. commodity . he would probably obtain attractive prices. a merchant with an ongoing requirement of grains too would face a price risk . derivatives contracts also exist on a lot of financial underlyings like stocks. it was possible for the farmer to partially or fully transfer price risks by locking-in asset prices. Besides commodities. silver. pepper. Through the use of simple derivative products. wheat. derivative contracts exist on a variety of commodities such as corn. farmers would face price uncertainty. exchange rate. was established to bring farmers and merchants together. These to-arrive contracts proved useful as a device for hedging and speculation on price changes.

derivative markets performs a number of economic functions. for example. Participants who trade in the derivatives market can be classified under the following three broad categories . 3. futures. 1952. Thus derivatives help in discovery of future as well as current prices. As per this the Forward Markets Commission (FMC) continues to have jurisdiction over commodity forward/ futures contracts. they can take large positions on the market. share. Arbitragers: Arbitragers work at making profits by taking advantage of discrepancy between prices of the same product across different markets. However when derivatives trading in securities was introduced in 2001. loan whether secured or unsecured. Consequently. 1. the term "security" in the Securities Contracts (Regulation) Act. Hedgers face risk associated with the price of an asset. regulation of derivatives came under the perview of Securities Exchange Board of India (SEBI). 2. they would take offsetting positions in the two markets to lock in the profit. If. Futures and options contracts can give them leverage. The Forwards Contracts (Regulation) Act. they increase the potential for large gains as well as large losses. and arbitragers. options and swaps. As a result of this leveraged speculative position. regulates the forward/ futures contracts in commodities all over India. participants and functions Derivative contracts are of different types. 2. The price of this derivative is driven by the spot price of wheat which is the "underlying" in this case. They use the futures or options markets to reduce or eliminate this risk. Prices in an organised derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level.hedgers. by putting in small amounts of money upfront. The prices of derivatives converge with the prices of the underlying at the expiration of the derivative contract. Derivatives are securities under the SCRA and hence the trading of derivatives is governed by the regulatory framework under the SCRA. we saw that wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. 1956 (SCRA). Such a transaction is an example of a derivative. We thus have separate regulatory authorities for securities and commodity derivative markets. 1956 (SC(R)A) defines "derivative" to include 1. The most common ones are forwards. of underlying securities. Hedgers: The farmer's example that we discussed about was a case of hedging.12 Introduction to derivatives or any other asset. .2 Products. was amended to include derivative contracts in securities. or index of prices. A security derived from a debt instrument. Speculators: Speculators are participants who wish to bet on future movements in the price of an asset. In our earlier discussion. Whether the underlying asset is a commodity or a financial asset. The Securities Contracts (Regulation) Act. 1. risk instrument or contract for differences or any other form of security. they see the futures price of an asset getting out of line with the cash price. speculators. A contract which derives its value from the prices. that is.

In the class of equity derivatives the world over. especially among institutional investors. the underlying market witnesses higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk. their complexity and also turnover. soybeans. Financial derivatives came into spotlight in the post-1970 period due to growing instability in the financial markets. since their emergence. monitoring and surveillance of the activities of various participants become extremely difficult in these kind of mixed markets. rapeseed. • Derivatives markets help increase savings and investment in the long run. The transfer of risk enables market participants to expand their volume of activity. are linked to the underlying cash markets. speculators trade in the underlying cash markets. The lower costs associated with index derivatives vis-a-vis derivative products based on individual securities is another reason for their growing use. and commodity-linked derivatives remained the sole form of such products for almost three hundred years.1. who are major users of index-linked derivatives. They often energize others to create new businesses. However. It can be an agricultural commodity like wheat. As the name suggest. Derivatives have a history of attracting many bright. these products have become very popular and by 1990s. In the absence of an organised derivatives market. etc or precious metals like gold. the benefit of which are immense. With the introduction of derivatives. commodity derivatives markets trade contracts for which the underlying asset is a commodity. Box 1. • Speculative traders shift to a more controlled environment of the derivatives market. cotton. Even small investors find these useful due to high correlation of the popular indexes with various portfolios and ease of use. creative. Financial derivatives markets trade contracts that have a financial asset or variable as the underlying. futures and options on stock indices have gained more popularity than on individual stocks. 1. • An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. Margining. the market for financial derivatives has grown tremendously in terms of variety of instruments available. etc. due to their inherent nature. they accounted for about two-thirds of total transactions in derivative products.1: Emergence of financial derivative products • The derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for them. interest rates and exchange rates as . well-educated people with an entrepreneurial attitude. In recent years. new products and new employment opportunities. • Derivatives.3 Derivatives markets Derivative markets can broadly be classified as commodity derivative market and financial derivatives markets. silver.3 Derivatives markets 13 Derivative products initially emerged as hedging devices against fluctuations in commodity prices. The more popular financial derivatives are those which have equity.

015 for the same gold. gold trades for Rs.000. They agree upon this price and Aditya buys 20 grams of gold. This is a spot transaction. This is a forward contract. Over the counter(OTC) derivatives are privately negotiated contracts. Now suppose Aditya does not want to buy the gold on the 1st January. A primary motivation for prearranging a buyer or seller for a stock of commodities in early forward contracts was to lessen the possibility that large swings would inhibit marketing the commodity after a harvest. but the clearing and settlement happens at the end of the specified period. The contract has now lost value from Aditya's point of view. negotiate and arrive at a price.015 per 10 grams.015. A month later.50 to B.6.6. The most commonly used derivatives contracts are forwards. This is trading.6. 12. If however. In a forward contract the process of trading.1 Spot versus forward transaction Using the example of a forward contract. futures and options which we shall discuss in detail later. "on the spot".6. Note that the value of the forward contract to the goldsmith varies exactly in an opposite manner to its value for Aditya.050 in the spot market. They agree upon the "forward" price for 20 grams of gold that Aditya wants to buy and Aditya leaves. A buyer and seller come together. he is bound to pay Rs. On 1st January 2004. Settlement is the actual process of exchanging money and goods. he is worse off because as per the terms of the contract. Forward contracting dates back at least to the 12th century. Consider this example. On a net basis A has to pay Rs. the trading. takes the gold and leaves.100 from B and sells goods worth Rs. 1. 12. 1. and may well have been around before then. Clearing involves finding out the net outstanding. In a spot transaction. If on the 1st of February.50 to B.2 Exchange traded versus OTC derivatives Derivatives have probably been around for as long as people have been trading with one another. No money changes hands when the contract is signed.14 Introduction to derivatives the underlying. A forward is the most basic derivative contract.3. Later .000 per 10 grams. a contract by which two parties irrevocably agree to settie a trade at a future date.5. He pays Rs. the price of gold drops down to Rs. The goldsmith quotes Rs. that is exactly how much of goods and money the two should exchange. clearing and settlement does not happen instantaneously. Every transaction has three components . The trading happens today. Merchants entered into contracts with one another for future delivery of specified amount of commodities at specified price. The goldsmith quotes Rs. clearing and settlement. i.030 and collects his gold. Aditya wants to buy some gold.6. but wants to buy it a month later. in this case gold. the contract becomes more valuable to Aditya because it now enables him to buy gold at Rs. These contracts were typically OTC kind of contracts. let us try to understand the difference between a spot and derivatives contract. he pays the goldsmith Rs. We call it a derivative because it derives value from the price of the asset underlying the contract. clearing and settlement happens instantaneously. for a stated price and quantity.trading. For instance A buys goods worth Rs.e.3. The exchange of money and the underlying goods only happens at the future date as specified in the contract.990.

The OTC contracts are generally not regulated by a regulatory authority and the exchange's selfregulatory organisation. Its name was changed to Chicago Mercantile Exchange (CME). banking supervision and market surveillance. Eurex etc. Chicago Butter and Egg Board. indeed the two largest "financial" exchanges of any kind in the world today. The recent developments in information technology have contributed to a great extent to these developments. was reorganised to allow futures trading. However "credit risk" remained a serious problem. a spin-off of CBOT. a group of Chicago businessmen formed the Chicago Board of Trade (CBOT) in 1848. The OTC derivatives markets have witnessed rather sharp growth over the last few years. 3. In 1919. Currently the most popular stock index futures contract in the world is based on S&P 500 index. SGX in Singapore. The OTC derivatives markets have the following features compared to exchange-traded derivatives: 1. There are no formal rules or mechanisms for ensuring market stability and integrity. futures on T-bills and Euro-Dollar futures are the three most popular futures contracts traded today. MATIF in France.1. The largest OTC derivative market is the interbank foreign exchange market. TIFFE in Japan. The primary intention of the CBOT was to provide a centralised location known in advance for buyers and sellers to negotiate forward contracts. 5. There are no formal rules for risk and burden-sharing. traded on Chicago Mercantile Exchange. . leverage. The CBOT and the CME remain the two largest organised futures exchanges. Box 1. To deal with this problem. these contracts were called "futures contracts". The management of counter-party (credit) risk is decentralised and located within individual institutions. and for safeguarding the collective interests of market participants. During the mid eighties. Index futures. DTB in Germany.3 Derivatives markets 15 Early forward contracts in the US addressed merchants' concerns about ensuring that there were buyers and sellers for commodities. In 1865. While both exchange-traded and OTC derivative contracts offer many benefits. 4. or margining. There are no formal centralised limits on individual positions. the CBOT went one step further and listed the first "exchange traded" derivatives contract in the US. which has accompanied the modernisation of commercial and investment banking and globalisation of financial activities. 2. financial futures became the most active derivative instruments generating volumes many times more than the commodity futures. Commodity derivatives the world over are typically exchange-traded and not OTC in nature. The first stock index futures contract was traded at Kansas City Board of Trade.2: History of commodity derivatives markets many of these contracts were standardised in terms of quantity and delivery dates and began to trade on an exchange. although they are affected indirectly by national legal systems. Other popular international exchanges that trade derivatives are LIFFE in England. the former have rigid structures compared to the latter.

Forwards: As we discussed. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset. at today's pre-agreed price. Solved Problems Q: Futures trading commenced first on 1. Thus a swaption is an option on a forward swap. but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date. The two commonly used swaps are : • Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency.3. the majority of options traded on options exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter.calls and puts. Chicago Board of Trade 2.16 Introduction to derivatives 1. Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. a forward contract is an agreement between two entities to buy or sell the underlying asset at a future date. Futures: A futures contract is an agreement between two parties to buy or sell the underlying asset at a future date at today's future price. Puts give the buyer the right. The underlying asset is usually a weighted average of a basket of assets. Equity index options are a form of basket options. Options: There are two types of options . Warrants: Options generally have lives of upto one year. Futures contracts differ from forward contracts in the sense that they are standardised and exchange traded. with the cashflows in one direction being in a different currency than those in the opposite direction. Some of these. Chicago Board Options Exchange 4. Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula.3 Some commonly used derivatives Here we define some of the more popularly used derivative contracts. • Currency swaps: These entail swapping both principal and interest between the parties. at a given price on or before a given future date. namely futures and options will be discussed in more details at a later stage. 3. They can be regarded as portfolios of forward contracts. Chicago Mercantile Exchange A: The correct answer is number 1. London International Financial Futures and Options Exchange •• . Baskets: Basket options are options on portfolios of underlying assets.

Index options A: The correct answer is number 1. None of the above. The buyer and seller calculating the net out-standing. Interconnected Stock Exchange A: The correct answer is number 1. Q: The first exchange traded financial derivative in India commenced with the trading of 1. above A: The correct answer is number 4. Speculative 2. trading involves ___ 1. A: The correct answer is number 1. The buyer and seller agreeing upon a price. ICICI Securities Limited 3. •• 3. Q: OTC derivatives are considered risky because 1. 3. All of the •• 2. Forward 4. Hedging A: The correct answer is number 2.3 Derivatives markets Q: Derivatives first emerged as -----. 4. Q: Which of the following exchanges offer commodity derivatives trading 1. Option 2. The buyer and seller exchanging goods and money. They are not settled on a clearing house. 3. There is no formal margining system. Index futures 2. 2. They do not follow any formal rules or mechanisms. 4.products 1. Q: In a transaction. Volatility 4. Over The Counter Exchange of India 4. Swap •• 3. Risky 17 •• •• 3. Interest rate futures •• . National Commodity Derivatives Exchange 2. Q: A ____ is the simplest derivative contract 1. Stock options 4. Future A: The correct answer is number 3.1.

The buyer and seller calculating the net outstanding. clearing involves 1. Q: In a transaction. 2. 4. The buyer and seller exchanging goods and money. settlement involves __ 1. A: The correct answer is number 2. •• . None of the above. The buyer and seller agreeing upon a price. •• 3. The buyer and seller exchanging goods and money. None of the above. Introduction to derivatives 3. The buyer and seller agreeing upon a price. A: The correct answer is number 3. 4. 2.18 Q: In a transaction. The buyer and seller calculating the net outstanding.

1 Difference between commodity and financial derivatives The basic concept of a derivative contract remains the same whether the underlying happens to be a commodity or a financial asset. The seller intending to make delivery would have to take the commodities to the designated warehouse and the buyer intending to take delivery would have to go to the designated warehouse and pick up the commodity. the quality of the asset underlying a contract can vary largely. In the case of financial derivatives. They were then found useful as a hedging tool in financial markets as well. but the physical . However. the concept of varying quality of asset does not really exist as far as financial underlyings are concerned. However in the case of commodities. financial assets are not bulky and do not need special facility for storage. In this chapter we look at how commodity derivatives differ from financial derivatives. 2. Regulatory constraints in 1960s resulted in virtual dismantling of the commodities future markets. Due to the bulky nature of the underlying assets. typically at an accredited warehouse.Chapter 2 Commodity derivatives Derivatives as a tool for managing risk first originated in the commodities markets. 2.1. other commodities were permitted to be traded in futures exchanges. most of these contracts are cash settled. trading in commodity futures has been in existence from the nineteenth century with organised trading in cotton through the establishment of Cotton Trade Association in 1875. Over a period of time. This may sound simple. In India. Even in the case of physical settlement. the markets have been thin with poor liquidity and have not grown to any significant level. physical settlement in commodity derivatives creates the need for warehousing. We have a brief look at these issues. This becomes an important issue to be managed.1 Physical settlement Physical settlement involves the physical delivery of the underlying commodity. We also have a brief look at the global commodity markets and the commodity markets that exist in India. However there are some features which are very peculiar to commodity derivative markets. It is only in the last decade that commodity future exchanges have been actively encouraged. Similarly.

We take a general overview at the process flow of physical settlement of commodities. This option is given during a period identified as 'delivery notice period'. both positions can still be closed out before expiry of the contract. Some exchanges like LIFFE. typically a seller of commodity futures has the option to give notice of delivery. the clearing house of the exchange identifies the buyer to whom this notice may be assigned. Exchanges such as COMMEX and the Indian commodities exchanges have adopted this method. The intention of this notice is to allow verification of delivery and to give adequate notice to the buyer of a possible requirement to take delivery. Delivery notice period Unlike in the case of equity futures. In the case of BMF-Brazil a seller typically has to submit the following documents: • • • A declaration verifying that the asset is free of any and all charges. including fiscal debts related to the stored goods. There are restrictions on interstate movement of commodities. CBOT and CME display delivery notices. Exchanges follow different practices for the assignment process. Among the international exchanges. . Some exchanges have certified laboratories for verifying the quality of goods. One approach is to display the delivery notice and allow buyers wishing to take delivery to bid for taking delivery. The process of taking physical delivery in commodities is quite different from the process of taking physical delivery in financial assets. There are limits on storage facilities in different states. Alternatively. Besides state level octroi and duties have an impact on the cost of movement of goods across locations.20 Commodity derivatives settlement of commodities is a complex process. issued by the warehouse. A provisional delivery order of the good to BM&F (Brazil). in all commodity exchanges. in a manner similar to the assignments to a seller in an options market. Later on we will look into details of how physical settlement happens on the NCDEX. delivery notice is required to be supported by a warehouse receipt. Such contracts are then assigned to a buyer. These are required by virtue of the fact that the actual physical settlement of commodities requires preparation from both delivering and receiving members. In these exchanges the seller has to produce a verification report from these laboratories along with delivery notice. A warehouse certificate showing that storage and regular insurance have been paid. However what is interesting and different from a typical options exercise is that in the commodities market. the clearing houses may assign deliveries to buyers on some basis. BMF. The issues faced in physical settlement are enormous. Assignment Whenever delivery notices are given by the seller. The warehouse receipt is the proof for the quantity and quality of commodities being delivered. accept warehouse receipts as quality verification documents while others like BMF-Brazil have independent grading and classification agency to verify the quality. Typically.

The most active spot market is normally taken as the benchmark for deciding spot prices. Cash settlement involves paying up the difference in prices between the time the contract was entered into and the time the contract was closed. if a trader buys futures on a stock at Rs. exchanges assign the delivery intentions to open long positions. The exchange also informs the respective warehouse about the identity of the buyer. the delivery rate is determined based on the previous day closing rate for the contract or the closing rate for the day.100 and on the day of expiration.1. The efficacy of the commodities settlements depends on the warehousing system available. Such CWH are required to provide storage facilities for participants in the commodities markets .20 in cash. there is a possibility of physical settlement. Assignment is done typically either on random basis or first-in-first out basis. Which means that if the seller chooses to hand over the commodity instead of the difference in cash. Similarly the person who sold this futures contract at Rs. This requires the exchange to make an arrangement with warehouses to handle the settlements. all the positions are cash settled. In some exchanges (CME). The buyer is required to deposit a certain percentage of the contract amount with the clearing house as margin against the warehouse receipt. All he has to do is pay up the loss of Rs.120. The clearing house decides on the daily delivery order rate at which delivery will be settled.20 in cash. Delivery After the assignment process. For instance. Delivery rate depends on the spot rate of the underlying adjusted for discount/ premium for quality and freight costs. does not have to deliver the underlying stock. Alternatively. After the close of trading.2 Warehousing One of the main differences between financial and commodity derivative is the need for warehousing. In case of most exchange-traded financial derivatives. the buyer must take physical delivery of the underlying asset. The discount/ premium for quality and freight costs are published by the clearing house before introduction of the contract. 2.100. the futures on that stock close Rs. Buyer or his authorised representative in the presence of seller or his representative takes the physical stocks against the delivery order. The period available for the buyer to take physical delivery is stipulated by the exchange. Most international commodity exchanges used certified warehouses (CWH) for the purpose of handling physical settlements. the buyer has the option to give his preference for delivery location.2. In India if a seller does not give notice of delivery then at the expiry of the contract the positions are cash settled by price difference exactly as in cash settled equity futures contracts. he does not really have to buy the underlying stock. clearing house/ exchange issues a delivery order to the buyer. In case of commodity derivatives however.1 Difference between commodity and financial derivatives 21 Any seller/ buyer who has given intention to deliver/ been assigned a delivery has an option to square off positions till the market close of the day of delivery notice. Proof of physical delivery having been effected is forwarded by the seller to the clearing house and the invoice amount is credited to the seller's account. All he does is take the difference of Rs.

2 Global commodities derivatives exchanges Globally commodities derivatives exchanges have existed for a long time. there are a few private warehousing being maintained.is of random lengths from 8 feet to 20 feet. and contain lumber produced from grade-stamped Alpine fir. 2. The Chicago Mercantile Exchange in its random-length lumber futures contract has specified that "Each delivery unit shall consist of nominal 'i y.3 Quality of underlying assets A derivatives contract is written on a given underlying. Montana. grade-stamped Construction Standard. Wyoming. In India. hem-fir. or Alberta or British Columbia. and/ or spruce pine fir".1 gives a list of commodities exchanges across the world. with factors of color and flavour each scoring 37 points or higher and 19 for defects. the Bureau of Indian Standards (BIS) under Ministry of Consumer Affairs specifies standards for processed agricultural commodities whereas AGMARK under the department of rural development under Ministry of Agriculture is responsible for promulgating standards for basic agricultural commodities. there are other agencies like EIA. There may be quite some variation in the quality of what is available in the marketplace. however. lodgepole pine. Apart from these. which specify standards for export oriented commodities. Apart from these.3: Specifications of some commodities underlying derivatives contracts and to certify the quantity and quality of the underlying commodity. Variance in quality is not an issue in case of financial derivatives as the physical attribute is missing. A good grading system allows commodities to be traded by specification. Idaho. 2.22 Commodity derivatives The New York Cotton Exchange has specified the asset in its orange juice futures contract as "U. Currently there are various agencies that are responsible for specifying grades for commodities. Englemann spruce. When the underlying asset is a commodity. the quality of the underlying asset is of prime importance. the warehousing system is not as efficient as it is in some of the other developed markets. Oregon. or #1 and #2. Standard and Better. The advantage of this system is that a warehouse receipt becomes a good collateral. with a minimum score 94". For example. When the asset is specified. having a Brix value to acid ratio of not less than 13 to 1 nor more than 19 to 1. Each deliver unit shall be manufactured in California. in no case may the quantity of Standard grade or #2 exceed 50%. Washington. The CBOT and CME are two of the oldest derivatives .S Grade A. Canada. Commodity derivatives demand good standards and quality assurance/ certification procedures. Table 2. with Brix value of not less than 57 degrees. it is therefore important that the exchange stipulate the grade or grades of the commodity that are acceptable. However there is no clear regulatory oversight of warehousing services. Box 2.1. not just for settlement of exchange trades but also for other purposes too. Nevada. Central and state government controlled warehouses are the major providers of agri-produce storage facilities.

People's Republic Of China Beijing Commodity Exchange Shanghai Metal Exchange Hong Kong Hong Kong Futures Exchange Japan Tokyo International Financial Futures Exchange Kansai Agricultural Commodities Exchange Tokyo Grain Exchange Malaysia Kuala Lumpur commodity Exchange New Zealand New Zealand Futures& Options Exchange Ltd. It was know as the to-arrive contract. On these exchanges.2 Global Commodities derivatives exchanges Table 2. the CME was established. a wide range of commodities and financial assets form the underlying assets in . Speculators soon became interested in the contract and found trading in the contract to be an attractive alternative to trading the underlying grain itself.2. another exchange. Singapore Singapore Commodity Exchange Ltd. Petersburg Futures Exchange Spain The Spanish Options Exchange Citrus Fruit and Commodity Futures Market of Valencia United Kingdom The London International Financial Futures Options exchange The London Metal Exchange United States of America 23 exchanges in the world. Initially its main task was to standardise the quantities and qualities of the grains that were traded.1 The global derivatives industry Country Exchange 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 Canada The Winnipeg Commodity Exchange Brazil Brazilian Futures Exchange Commodities and Futures Exchange Australia Sydney Futures Exchange Ltd. In 1919. Within a few years the first futures-type contract was developed. The CBOT was established in 1848 to bring farmers and merchants together. France Le Nouveau Marche MATIF Italy Italian Derivatives Market Netherlands Amsterdam Exchanges Option Traders Russia The Russian Exchange MICEX/ Relis Online St. Now futures exchanges exist all over the world.

sugar. founded in 1909. which was formed in 1999 by the merger of two well-established exchanges. SAFEX only traded financial futures and gold futures for a long time.1 Africa Africa's most active and important commodity exchange is the South African Futures Exchange (SAFEX). Malaysia and Singapore have active commodity futures exchanges. the Dalian Commodity Exchange (DCE). Although this exchange was only created in 1985. 2. Malaysia hosts one futures and options exchange. wool. The main commodities traded were agricultural staples such as wheat. more than half of China's exchanges were closed down or reverted to being wholesale markets. it was the 8th largest exchange by 2001. lumber. the Zhengzhou Commodity Exchange and the Shanghai futures Exchange. (BM&F) in Brazil. 2. in which trade was liberalised. The Mercado Mexicano de Derivados (Mexder) was launched in 1998. copper. The commodities include pork bellies. In late 1994. gold and tin. corn and in particularly soybeans. We look at commodity exchanges in some developing countries. namely..2. 2. the Stock Exchange of Singapore (SES) and Singapore International Monetary Exchange (SIMEX). The Taiwan Futures Exchange was launched in 1998. the Agricultural Derivatives Division) led to the introduction of a range of agricultural futures contracts for commodities.3 Evolution of the commodity market in India Bombay Cotton Trade Association Ltd. while only 15 restructured exchanges received formal government approval. Bombay Cotton Exchange Ltd. with 98 million contracts traded. was established in 1893 following the widespread discontent . Commodity. was the first organised futures market. Argentina's futures market Mercado a Termino de Buenos Aires. ranks as the world's 51st largest exchange. but the creation of the Agricultural Markets Division (as of 2002. There are also many other commodity exchanges operating in Brazil. white and yellow maize.2. Mexico has only recently introduced a futures exchange to its markets.2 Asia China's first commodity exchange was established in 1990 and at least forty had appeared by 1993. aluminium. set up in 1875. live cattle. bread milling wheat and sunflower seeds. At the beginning of 1999. It was informally launched in 1987. Cereals & Oils Exchanges. formed in 1999 after the merger of three exchanges: Shanghai Metal. 2. spread throughout the country.24 Commodity derivatives various contracts.2. Singapore is home to the Singapore Exchange (SGX). the China Securities Regulatory Committee began a nationwide consolidation process which resulted in three commodity exchanges emerging.3 Latin America Latin America's largest commodity exchange is the Bolsa de Mercadorias & Futures.

was established in 1919 for futures trading in rawjute and jute goods. To review the role that forward trading has played in the Indian commodity markets during the last 10 years. But the most notable futures exchange for wheat was chamber of commerce at Hapur set up in 1913. in the light of the recommendations. Calcutta Hessian Exchange Ltd. to conduct organised trading in both Raw Jute and Jute goods. which carried on futures trading in groundnut.1 The Kabra committee report After the introduction of economic reforms since June 1991 and the consequent gradual trade and industry liberalisation in both the domestic and external sectors. 2. In due course.2. To examine the extent to which forward trading has special role to play in promoting exports. To assess (a) The working of the commodity exchanges and their trading practices in India and to make suitable recommendations with a view to making them compatible with those of other countries (b) The role of the Forward Markets Commission and to make suitable recommendations with a view to making it compatible with similar regulatory agencies in other countries so as to see how effectively these agencies can cope up with the reality of the fast changing economic scenario. particularly with a view to effective enforcement of the Act to check illegal forward trading when such trading is prohibited under the Act. several other exchanges were created in the country to trade in diverse commodities.N. Kabra. The committee was setup with the following objectives: 1. Forward Contracts (Regulation) Act was enacted in 1952 and the Forwards Markets Commission (FMC) was established in 1953 under the Ministry of Consumer Affairs and Public Distribution. Futures trading in bullion began in Mumbai in 1920.3 Evolution of the commodity market in India 25 amongst leading cotton mill owners and merchants over functioning of Bombay Cotton Trade Association.3. But organised futures trading in raw jute began only in 1927 with the establishment of East Indian Jute Association Ltd. K. the Government of India appointed in June 1993 a committee on Forward Markets under chairmanship of Prof. 6. 3. To assess the role that forward trading can play in marketing/ distribution system in the commodities in which forward trading is possible. 5. castor seed and cotton. particularly in commodities in which resumption of forward trading is generally demanded. . The Futures trading in oilseeds started in 1900 with the establishment of the Gujarati Vyapari Mandali. Futures trading in wheat was existent at several places in Punjab and Uttar Pradesh. 4. These two associations amalgamated in 1945 to form the East India Jute & Hessian Ltd. To suggest measures to ensure that forward trading in the commodities in which it is allowed to be operative remains constructive and helps in maintaining prices within reasonable limits. 2. To suggest amendments to the Forward Contracts (Regulation) Act.

The recommendations of the committee were as follows: • The Forward Markets Commission(FMC) and the Forward Contracts (Regulation) Act. .4. Groundnut.2003 permitting futures trading in the commodities. sesame seed. Silver 9. Raw jute and jute goods 4. be upgraded to the level of international futures markets. Basmatirice 2. • In-built devices in commodity exchanges such as the vigilance committee and the panels of surveyors and arbitrators be strengthened further. • Due to the inadequate infrastructural facilities such as space and telecommunication facilities the commodities exchanges were not able to function effectively. with the issue of these notifications futures trading is not prohibited in any commodity. • The majority of me committee recommended that futures trading be introduced in the following commodities: 1. ensuring capital adequacy norms and encouraging computerisation would enable these exchanges to place themselves on a better footing. should continue to act a watch-dog and continue to monitor the activities and operations of the commodity exchanges. Options trading in commodity is. Castor oil and its oilcake 7. sunflower seed. Enlisting more members. particularly the ones dealing in pepper and castor seed. Therefore. copra and soybean. and oils and oilcakes of all of them. Rice bran oil 6. The national agriculture policy announced in July 2000 and the announcements in the budget speech for 2002-2003 were indicative of the governments resolve to put in place a mechanism of futures trade/market. 5. 1952. • The FMC which regulates forward/ futures trading in the country. regulations and bye-laws of the commodity exchanges should require the approval of the FMC only. cottonseed. Onions The liberalised policy being followed by the government of India and the gradual withdrawal of the procurement and distribution channel necessitated setting in place a market mechanism to perform the economic functions of price discovery and risk management. some of the commodity exchanges.26 Commodity derivatives The committee submitted its report in September 1994. • In the context of globalisation. however presently prohibited. As a follow up. Amendments to the rules. would need to be strengthened. Linseed 8. safflower seed. rapeseed/mustard seed. the government issued notifications on 1. commodity markets in India could not function effectively in an isolated manner. Cotton and kapas 3.

3. annual vol (Rs.2 gives the total annualised volumes on various exchanges. Indore National multicommodity exchange.3 gives the list of registered commodities exchanges in India. the commodity derivative market in India seems poised for a transformation. National level commodity derivatives exchanges seem to be the new phenomenon.2 Latest developments Commodity markets have existed in India for a long time.Crore) 80000 40000 3500 3500 2500 2500 2500 2500 1500 1500 140000 2. oil & bullion exchange IPSTA. Hapur Bhatinda Om and oil exchange Other (mostly inactive) Total Products Soya. Muzzaffarnagar Rajkot seeds. Cochin Chamber of commerce. groundnut Pepper Gur. cotton Mustard Gur Castor. Table 2. Ahmedabad Ahmedabad commodity exchange Rajdhani Oil & oilseeds Vijai Beopar Chamber Ltd. Table 2.3 Evolution of the commodity market in India Table 2. • National Board of Trade • Multi Commodity Exchange of India • National Commodity & Derivatives Exchange of India Ltd . While the implementation of the Kabra committee recommendations were rather slow.2. The increasing volumes on these exchanges suggest that commodity markets in India seem to be a promising game. The Forward Markets Commission accorded in principle approval for the following national level multi commodity exchanges.2 Volume on existing exchanges Commodity exchange National board of trade. today. mustard Gur 27 Approx. mustard Multiple Castor.

tin Vanaspati. Kochi Pepper Rajdhani Oils and Oilseeds Exchange Ltd. rice bran oil and oilcake Crude palm oil The Rajkot Seeds oil & Bullion Merchants Groundnut oil Association. Kochi Copra. Refined Soy Oil Limited Mustard Seed Expeller Mustard Oil RBD Palmolein Crude Palm Oil Medium Staple Cotton Long Staple Cotton Gold. Sacking. Rubber. Cottonseed. oilcake) Safflower (seed. oilcake) Groundnut (seed. Castorseed Sesamum (Oil and oilcake) Rice bran. Copper. gram Coconut (oil and oilcake) Castor (oil and oilcake) Sesamum (Seed. lead National Commodity & Derivatives Exchange Soy Bean. Bangalore Coffee National Multi Commodity Exchange of India Gur. Commodity derivatives Product traded Gur Sunflower oil Cotton (Seed and oil) Safflower (Seed. Delhi Gur. Gur The East India Jute & Hessian Exchange Ltd.. Rapeseed/ Mustardseed Sugar Grade-M National Board of Trade. Silver . Indore Rapeseed/ Mustard seed/ Oil/ Cake Soybean/ Meal/ Oil. RBD Pamohen Limited. oilcake) Sugar. Mumbai Cotton The Central India Commercial Exchange Ltd. Crude Palm Oil The Chamber of Commerce.3 Registered commodity exchanges in India Exchange Bhatinda Om & Oil Exchange Ltd. Castorseed Vijay Beopar Chamber Ltd.oil and oilcake) Linseed (seed.Sangli Turmeric Ahmedabad Commodities Exchange Ltd. The Bombay Commodity Exchange Ltd. Sacking Kolkata First Commodity Exchange of India Ltd.. Rapeseed/ Mustardseed oil and cake The Meerut Agro Commodities Exchange Co. Hapur Gur. Pepper. Castorseed The Kanpur Commodity Exchange Ltd. oil and oilcake) Rice Bran Oil. Ahmedabad Crude Palm Oil. oil and oil cake) Groundnut (Nut and oil) Castor oil. Ltd. Gur The Spices and Oilseeds Exchange Ltd.. oil. Nickel. Zinc. Rapeseed/ Mustardseed The East India Cotton Association. Ltd. oil.. oil.. Coconut oil & Copra cake The Coffee Futures Exchange India Ltd. Hessian. Guarseed Aluminium ingots.28 Table 2.. Muzaffarnagar Gur India Pepper & Spice Trade Association. Soy bean Cotton (Seed. Copra Rapeseed/ Mustardseed.

The seller • . Warehouse receipt A: The correct answer is number 2. in all commodity exchanges. National Commodity Derivative Exchange 2. The warehouse 4. The clearing corporation A: The correct answer is number 2. None of the above • Q: Typically. National Board of Trade 4. delivery notice is required to be supported by a 1. Standardised contract size A: The correct answer is number 4. MTM settlement 4. Exchange traded product 2. the buyers requested destination 4. Letter of credit 2. Undertaking 4. Varying quality of underlying asset • Q: Physical settlement involves the physical delivery of the underlying commodity at 1. • 3. the exchange A: The correct answer is number 1 • 3. • Q: Which of the following exchanges do not offer commodity derivatives trading? 1. The exchange 2. Advance payment • Q: Who identifies the buyer to whom the delivery notice is assigned? 1. • 3. an accredited warehouse 2. 3.3 Evolution of the commodity market in India 29 Solved Problems Q: Which of the following feature differentiates a commodity futures contract from a financial futures contract? 1. Multi Commodity Exchange of India A: The correct answer is number 4. National Stock Exchange •• 3.2.

3. 1. 1952. Kabra Committee A: The correct answer is number 2. L C Gupta Committee 2. need to be strengthened. The warehouse assigns the delivery to the buyer •• Q: The ____ committee recommended that the Forward Markets Commission(FMC) and the Forward Contracts (Regulation) Act. The buyer chooses which delivery to take 4. Khusro Committee 4.30 Q: On the NCDEX ___ 1. J R Varma Committee •• . The seller assigns delivery to the buyer A: The correct answer is number 1. The clearing house assigns delivery to the buyer 2. Commodity derivatives 3.

• To bring professionalism and transparency into commodity trading. refined soy bean oil.2003. NCDEX is subjected to various laws of the land like the Companies Act. Contracts Act. Stamp Act. crude palm oil and cotton . Forward Commission (Regulation) Act and various other legislations. Maharashtra in Mumbai on April 23. Besides. expeller rapeseed-mustard seed oil. RBD palmolein. which impinge on its working. 3. It has an independent Board of Directors and professionals not having any vested interest in commodity markets. • To inculcate best international practices like de-modularization. rapeseed-mustard seed. At subsequent phases trading in more commodities would be facilitated. silver. NCDEX is regulated by Forward Markets Commission in respect of futures trading in commodities. professionalism and transparency. . It is a public limited company registered under the Companies Act. It has been launched to provide a world-class commodity exchange platform for market participants to trade in a wide spectrum of commodity derivatives driven by best global practices. low cost solutions and information dissemination without noise etc.gold. into the trade.medium and long staple varieties. • To provide nation wide reach and consistent offering. 1956 with the Registrar of Companies.Chapter 3 The NCDEX platform National Commodity and Derivatives Exchange Ltd (NCDEX) is a technology driven commodity exchange. NCDEX currently facilitates trading of ten commodities . • To bring together the entities that the market can trust.1 Structure of NCDEX NCDEX has been formed with the following objectives: • To create a world class commodity exchange platform for the market participants. It is located in Mumbai and offers facilities to its members in about 91 cities throughout India at the moment. soy bean. technology platforms.

The TCM membership entitles the members to trade and clear. technology and risk management skills.1. Trading cum Clearing Members (TCM) and Professional Clearing Members (PCM). 3. It formulates the rules and regulations related to the operations of the exchange. association of persons. The four institutional promoters of NCDEX are prominent players in their respective fields and bring with them institution building experience.1 Trading cum clearing members (TCMs) NCDEX invites applications for Trading cum Clearing Members (TCMs) from persons who fulfill the specified eligibility criteria for trading in commodities. . Life Insurance Corporation of India (LIC). National Bank for Agriculture and Rural Development (NABARD) and National Stock Exchange of India Limited (NSE). Applicants accepted for admission as TCM are required to pay the required fees/ deposits and also maintain net worth as given in Table 3. that fulfills the eligibility criteria set by the exchange.1. The board is responsible for managing and regulating all the operations of the exchange and commodities transactions. companies etc.1. Audit Committee. both for themselves and/ or on behalf of their clients.2. trust. Promoters do not participate in the day to day activities of the exchange. Nomination Committee. help the Board in policy formulation. These include the ICICI Bank Limited (ICICI Bank). The members of NCDEX fall into two categories. partnerships.32 ___________________________________________________ The NCDEX platform 3. All the members of the exchange have to register themselves with the competent authority before commencing their operations. Compensation Committee and Business Strategy Committee. which. 3.2 Exchange membership Membership of NCDEX is open to any person. nationwide reach. 3. The directors are appointed in accordance with the provisions of the Articles of Association of the company. and also other members appointed by the board.1 Promoters NCDEX is promoted by a consortium of institutions. Apart from the executive committee the board has constitute committee like Membership committee.2 Governance NCDEX is run by an independent Board of Directors. NCDEX is the only commodity exchange in the country promoted by national level institutions. Board appoints an executive committee and other committees for the purpose of managing activities of the exchange. Risk Committee. co-operative societies. The executive committee consists of Managing Director of the exchange who would be acting as the Chief Executive of the exchange. This unique parentage enables it to offer a variety of benefits which are currently in short supply in the commodity markets.

. On approval as a member of NCDEX.2 Professional clearing members (PCMs) NCDEX also invites applications for Professional Clearing Membership (PCMs) from persons who fulfill the specified eligibility criteria for trading in commodities. Collateral security deposit All Members have to comply with the security deposit requirement before the activation of their trading terminal.00 15.2. Members can opt to meet the security deposit requirement by way of the following: • Cash: This can be deposited by issuing a cheque/ demand draft payable at Mumbai in favour of National Commodity & Derivatives Exchange Limited.2. The PCM membership entitles the members to clear trades executed through Trading cum Clearing Members (TCMs).00 33 Table 3.3.3 Capital requirements Table 3.00 1. both for themselves and/ or on behalf of their clients.50 50.3 Capital requirements NCDEX has specified capital requirements for its members.00 1.50 0. Applicants accepted for admission as PCMs are required to pay the following fee/ deposits and also maintain net worth as given in Table 3. the member has to deposit Base Minimum Capital (BMC) with the exchange.2 Fee/ deposit structure and networth requirement: PCM Particulars (Rupees in Lakh) Interest free cash security deposit Collateral security deposit Annual subscription charges Advance minimum transaction charges Net worth requirement 25.00 3.1 Fee/ deposit structure and networth requirement: TCM Particulars (Rupees in Lakh) Interest free cash security deposit Collateral security deposit Annual subscription charges Advance minimum transaction charges Net worth requirement 15. Base Minimum Capital comprises of the following: 1. Interest free cash security deposit 2.00 5000. 3.00 25.00 0.

Order matching is essentially on the basis of commodity. The securities are valued on a daily basis and a haircut of 25% is levied.e. The minimum term of the bank guarantee should be 12 months. every market transaction consists of three components . fixed deposit receipts or Government of India securities. time and quantity.5 Lakh the member would be given one calendar weeks' time to replenish the shortages and if the same is not done within the specified time the trading facility would be withdrawn. 5 Lakh. If it finds a match. • Government of India securities: National Securities Clearing Corporation Limited (NSCCL) is the approved custodian for acceptance of Government of India securities. 25 Lakh in case of PCM at any point of time. it is an active order. The exchange specifies the unit of trading and the delivery unit for futures contracts on various commodities . All quantity fields are in units and price in rupees. The NCDEX system supports an order driven market. It supports an order driven market and provides complete transparency of trading operations. This section provides a brief overview of how transactions happen on the NCDEX's market. the order becomes passive and gets .1 Trading The trading system on the NCDEX. • If the security deposit shortage is less than Rs. to 4. If it does not find a match. The trade timings of the NCDEX are 10.trading. The FDR should be issued for a minimum period of 36 months from any of the approved banks. clearing and settlement. provides a fully automated screen-based trading for futures on commodities on a nationwide basis as well as an online monitoring and surveillance mechanism.34 The NCDEX platform • Bank guarantee: Bank guarantee in favour of NCDEX as per the specified format from approved banks. its price. If the security deposit falls below the minimum required level. • Fixed deposit receipt: Fixed deposit receipts (FDRs) issued by approved banks are accepted.m. 3.4. NCDEX may initiate suitable action including withdrawal of trading facilities as given below: • If the security deposit shortage is equal to or greater than Rs. After hours trading has also been proposed for implementation at a later stage. Members who wish to increase their limit can do so by bringing in additional capital in the form of cash.15 Lakh in case of TCM and Rs. Rs. Members are required to maintain minimum level of security deposit i. It tries to find a match on the other side of the book. a trade is generated. the trading facility would be withdrawn with immediate effect. The exchange notifies the regular lot size and tick size for each of the contracts traded from time to time.00 a. 3.00 p.m. where orders match automatically. When any order enters the trading system. bank guarantee.4 The NCDEX system As we saw in the first chapter.

created during the day or closed out during the day. NCDEX trades commodity futures contracts having one-month.3 Settlement Futures contracts have two types of settlements.4.4 The NCDEX system_________________________________________________ 35 queued in the respective outstanding order book in the system. The responsibility of settlement is on a trading cum clearing member for all trades done on his own account and his client's trades. Unmatched positions have to be settled in cash. On the NCDEX. 3. after the trading hours on the expiry date. Thus a January expiration contract would expire on the 20th of January and a February expiry contract would cease trading on the 20th of February.4. On the date of expiry. on the basis of locations and then randomly. two-month and three-month expiry cycles.2 Clearing National Securities Clearing Corporation Limited (NSCCL) undertakes clearing of trades executed on the NCDEX. clearing members are informed of the deliverable/ receivable positions and the unmatched positions. All contracts expire on the 20th of the expiry month. and the final settlement which happens on the last trading day of the futures contract. commodities already deposited and dematerialized and offered for delivery etc. Matching done by this process is binding on the clearing members. NCDEX on receipt of such information. are market to market at the daily settlement price or the final settlement price at the close of trading hours on a day. the matching for deliveries takes place firstly. New contracts will be introduced on the trading day following the expiry of the near month contract. On the expiry date of a futures contract.3. The commodities have to meet the contract specifications with allowed variances. Time stamping is done for each trade and provides the possibility for a complete audit trail if required. The seller intending to make delivery takes the commodities to the designated warehouse. If the commodities meet the . At NCDEX. If the 20th of the expiry month is a trading holiday. These commodities have to be assayed by the exchange specified assayer. The cash settlement is only for the incremental gain/ loss as determined on the basis of final settlement price. the MTM settlement which happens on a continuous basis at the end of each day. The settlement guarantee fund is maintained and managed by NCDEX. the final settlement price is the spot price on the expiry day. matches the information and arrives at a delivery position for a member for a commodity. daily MTM settlement and final MTM settlement in respect of admitted deals in futures contracts are cash settled by debiting/ crediting the clearing accounts of CMs with the respective clearing bank. based on the available information. keeping in view the factors such as available capacity of the vault/ warehouse. After completion of the matching process. the contracts shall expire on the previous trading day. Only clearing members including professional clearing members (PCMs) only are entitled to clear and settle contracts through the clearing house. members submit delivery information through delivery request window on the trader workstations provided by NCDEX for all open positions for a commodity for all constituents individually. All positions of a CM. 3. either brought forward. A professional clearing member is responsible for settling all the participants trades which he has confirmed to the exchange.

Controller of Capital Issues •• 3. who would courier the same to the buyer's clearing member.500Lakh 4. The Forward Markets Commission 2. SEBI A: The correct answer is number 1. Solved Problems Q: Which of the following futures do not trade on the NCDEX? 1. Q: The net worth requirement for a TCM is 1. the buyer goes to the warehouse and takes physical possession of the commodities. 3. Gold futures A: The correct answer is number 4.5Lakh 2. Energy futures •• . Rs. the warehouse accepts them.5000Lakh •• 3. On an appointed date. Rs. Rs. Cotton futures 2. Rs.50Lakh A: The correct answer is number 2. Reserve Bank of India 4. Silver futures 4. Warehouse then ensures that the receipts get updated in the depository system giving a credit in the depositor's electronic account. The seller then gives the invoice to his clearing member.36 ________________________________________________________ The NCDEX platform specifications. Q: NCDEX is regulated by 1.

. 1. expeller mustard oil. Agricultural products 2. To begin with contracts in gold. crude palm oil. For derivatives with a commodity as the underlying. Other metals 4. soya oil.1 Agricultural commodities The NCDEX offers futures trading in the following agricultural commodities .Refined soy oil. the NCDEX has commenced trading in futures on agricultural products and precious metals. the National Commodity and Derivatives Exchange Ltd (NCDEX) launched futures trading in nine major commodities. The commodity markets can be classified as markets trading the following types of commodities. soyabean. In this chapter we look at the various underlying assets for the futures contracts traded on the NCDEX. medium staple cotton and long staple cotton. Of these we study cotton in detail and have a quick look at the others. the contract size stating exactly how much of the asset will be delivered under one contract. it must specify the underlying asset. where and when the delivery will be made. Energy Of these. cotton. silver. rapeseed oil. In particular. clearing and settlement details will be discussed later. We have a brief look at the various commodities that trade on the NCDEX and look at some commodity specific issues. 4.Chapter 4 Commodities traded on the NCDEX platform In December 2003. RBD palmolein. mustard seed. Precious metal 3. rape/ mustard seed. Trading. crude palm oil and RBD palmolein are being offered. the exchange must specify the exact nature of the agreement between two parties who trade in the contract.

In the case of the rain-fed cotton. Harvested Kappas (cotton with seed) start arriving into the market (from the producing centres) from October-November onwards. The optimum temperature range for vegetative growth is 21. cotton occupies a significant position in the Indian economy on all fronts as a commodity that forms a means of livelihood to over millions of cotton cultivating farmers at the primary agricultural sector. Haryana. The average monthly fluctuation in prices of cotton traded across India has been at around 4. Andhra Pradesh. India and Pakistan.found in parts of Tamil Nadu.1 Cotton Cotton accounts for 75% of the fibre consumption in spinning mills in India and 58% of the total fibre consumption of its textile industry (by volume). Cropping and Growth pattern Cotton is a tropical and sub-tropical crop. apart from other fibre sources like jute. . Assam and Kerala. Historically. and (4)Lateritic soils . Spinned cotton yarn is used by clothe manufacturers/ textile industry. (2)The black cotton soils. Today. a favourable distribution is the deciding factor in obtaining good yields from the rainfed cotton.1. China. The loose cotton lint so obtained is pressed and sold to the spinning mills in the form of full pressed bales (1 bale = 170 kg cotton lint in India. in USA.5% during the last three years. Cotton is among the most important non-food crops.38 Commodities traded on the NCDEX platform 4. It is grown mainly as a dry crop in the black and medium black soils and as an irrigated crop in the alluvial soils. The market size of raw cotton in India is over Rs. but does not do well if the temperature falls bellow 210°C. with large diurnal variations are conducive to good boll and fibre development. It occupies a significant position. a process called ginning (lint recovery from kappas is 30-31%). For the successful germination of its seeds. The maximum fluctuation has been as high as 11%. which predominates and occupies nearly 75% of the area under this crop. In the main producing countries of USA.270°CIt can tolerate temperatures as high as 430°C . Cotton is grown on a variety of soils. Cotton is a 90-120 day annual crop.130 billion. Rajasthan and Uttar Pradesh.predominant in the states of Gujarat. as it does not tolerate water logging. who separate the seeds from the lint (cotton fibre). warm days and cool nights. At the average price of Rs. Kappas are bought by ginners. It requires a soil amenable to good drainage. During the period of fruiting. Madhya Pradesh. both from agricultural and manufacturing sectors' points of view. the crop is sown during the June-July period and harvested during September-October. 27-30% of the country's export earnings and 4% of its GDP.45/ kg. The predominant types of soils on which the crop is grown are (l)Alluvial soils predominant in the northern states of Punjab. a rainfall of 50 cm is the minimum requirement. silk and synthetic. It is also a source of direct employment to over 35 million people in the secondary manufacturing textile industry that contributes to 14% of the country's industrial production. it is 480 pounds). (3)The red sandy loams to loams . It is the major source of a basic human need clothing. 1 bale = 170 kg) of raw cotton trade in the country. a minimum temperature of 150°C is required. More than the actual rainfall. Maharashtra. cotton prices in India have been fluctuating in the range of 3-6% on a monthly basis. over 17 million bales (average annual consumption. Karnataka and Tamil Nadu.

viscose and acrylic) and prices of cotton itself. and the CIS countries and Australia on account of lower freight and shorter delivery periods.5 million tons. The country's raw cotton exports. . The global supply and demand statistics released by the International Cotton Advisory Committee (ICAC) and the United States Department of Agriculture (USDA) periodically are closely watched by the trading community. and CCI operations are generally limited to commercial purchases and sales (except for a few years like 2001-02 when the prices were abysmally low).9 million tons). etc. China. Mexico. Indonesia. India and Pakistan top the list of cotton producing countries. production and prices of synthetic fibre (polyester. Mills using ELS (extra long staple) have been pleased with US Pima and its fibre characteristics. These eight countries produced over 80% of the world's cotton production during 2001-02. the country's cotton consumption stands at 17-19 million bales (2. The CCI is responsible for establishing the price support in all States.5 million tons. 15-30 days for local). it is the lack of availability of desired quality cotton that has made many Indian buyers (particularly the export oriented units) to opt for purchases of foreign cotton despite enough domestic supply.5-21 million tons. USA and Pakistan top the list of cotton consuming countries. Currently. Typically. Brazil.7-2. uniform lots. constituting about 15% of the global cotton production. higher ginning out-turn) and better credit terms (36 months vs.e.e. Italy and Korea consume over 80% of the world's annual cotton consumption.8 million tons).4. Global production of cotton during the post 1990 (till date i. Most importing mills in India are ready to pay 5-10% premium for foreign cotton due to its higher quality (less trash. consumption has been in the range in the 18-20. Russia. West Africa. 2002-03 forecast) has been fluctuating in the narrow range of 16.1 Agricultural commodities Global and domestic demand-supply dynamics 39 China.2-2. Apart from US. Turkey and Australia are the other major producers. Price trends and factors that influence prices Cotton production and trade is influenced by various factors. India. Thailand. Contrary to this. which stood at 1. India is also importing from Egypt. Production of cotton in India during the post 1990 period has been fluctuating in the range of 1217 million bales (i. Brazil. India's position on the global trade front has witnessed a drastic change during the post 1995 period. The country has turned from being net exporter to net importer. US has emerged as an important supplier in the last two seasons. market prices remain well above the MSP. The global export and import trade of cotton during the post 1990 era has been in the range of 5. The central government establishes minimum support prices (MSP) for Kappas at the start of each marketing season. Production (acreage under the crop) of cotton varies from year to year based on the climatic factors that are crucial for the productivity of crop. USA. Cotton trade is influenced by the supply-demand scenario. the imports have sharply risen from 30000-50000 bales during the pre-1995 to little over 2. Among several other reasons. Similarly. These along with Turkey. between 2.2 million bales during the last three years.6 million bales during the pre-1996 period have dipped to less than 100 thousand bales.2-1.5 to 6. Uzbekistan.

37% compounded annually during the last 12 years period. deodorized) palm oil.20 US Cents/ lb (as on Oct 26. silk. Crude palm oil (CPO). demand for finished readymade garments from abroad. etc.33°C with at least 5 hours sunshine per day throughout the year. Oil palm thrives well at temperatures of 22 .5 and stagnant water. the soil should be deep.2% and 4. are less likely to have any major impact on cotton prices in India.1. crude palmolein. The average monthly fluctuation in prices of imported CPO traded at Kandla (one of the major importing ports in Gujarat) has been at 9. the waterholding capacity of the soil is of greatest importance.80-90 billion). Oil palm is sensitive to pH above 7. the consumption growth rate for the worlds leading palm oil importer .7% during the past two and a half years. 2001). In general. bleached.85 cents. Global and domestic demand-supply dynamics CPO is used for human consumption as well as for industrial purposes. Cropping and growth patterns Oil palm requires an average annual rainfall of 2000 mm or more distributed evenly throughout the year. which when crushed yields 6 tons of oil (including the kernel oil.8% respectively. Towards mid-2002. There is a close inter linkage between the various vegetable oils produced. with the share of CPO being nearly 20% (Rs.2 Crude palm oil Annual edible oil trade in India is worth over Rs.78 US Cents/ lb (as on Jan 2. One hectare of oil palm yields approximately 20 FFBs. the maximum monthly fluctuation being as high as 25% during the period. While in the importing countries like China and European Union. However. and toward end of 2003 were currently ruling at 58. RBD (refined. The consumption of palm oil (both food and industrial consumption put together) in the world is growing at the rate of 7. NyBOT witnessing a sharp downfall in prices from 61. wool and khadi . Flat or gentle undulating land is preferred.35%. 4. World cotton prices fell sharply during most part of 2001. Jute. prices recovered to 53 cents.40 Commodities traded on the NCDEX platform Futures prices of cotton at the New York Board of Trade (NYBOT) serve as the reference price for cotton traded in the international market. RBD palmolein and crude palm kernel oil (CPKO) are the various forms of palm oil traded in the market. 2001) to the low of 28. The country is over-dependent on CPO imports to the extent of over 50% of its annual vegetable oil imports. in areas where rainfall is marginally suitable. Palm oil is extracted from the mature fresh fruit bunches (FFBs) of oil palm plantations. prices of synthetic fibre. Rainfall less than 100 mm for a period of more than three months is not suitable for oil palm cultivation.the other fibre sources. Cotton prices in India are therefore influenced by various demand-supply factors operating within the country. well structured and well drained. traded and consumed across the world. international raw cotton prices. a sharp fall by 54. the consumption of palm oil is growing at the rate of 5.440 billion. Oil palm can be grown on a wide range of soil. which is used both for edible and industrial purposes).

Production of palm oil stands at 24-25 million tons (over 22% of the global vegetable oil). The major trading centres of CPO in the world are Malaysia and Indonesia in Asia and Rotterdam in Europe. etc. which could be mainly attributed to its price competitiveness among several of its competing oils is being met through increasing imports. The production bottoms down in the months of February. prices of various domestically produced and imported oils. (MDEX) could be considered as the price maker of palm oil traded world over. Pakistan and European Union amount to approximately 56% of the total global exports of palm oil annually. Palm oil dominates the global vegetable oil export trade. Being a perennial plantation crop. supply-demand status of various consuming/importing countries. but next to the four major trading centers. March and April. overall health of the economy that has a bearing on the purchasing power of ultimate consumers. acreage under palm plantation does not vary from season to season. vanaspati and other industrial sectors apart from human consumption as RBD palmolein. Malaysia and Indonesia dominate the global trade in CPO. India is the largest importer of CPO with a share of over 15% of the total quantity traded in the international market. The Kuala Lumpur based Malaysia Derivatives Exchange Bhd. Rising consumption of palm oil in India. China. India. Price trends and factors that influence prices There exists a clear trough and crest in the seasonality of CPO production. who are mostly refiners too. September and October. Factors that influence price are market related factors viz. solvent extractors. The two producing countries viz. mainly the exportimport policy. commodity-specific producers and traders. Pakistan and the European Union are the major importers of palm oil. Palm oil trade in India is influenced by the supply-demand scene in the domestic market including the factors influencing various oilseed production in the country. etc. market and policy related factors. Yield levels of the plantations are influenced by climatic conditions like rainfall.1 Agricultural commodities 41 (in specific. The total imports of India.1 million tons in a monthly. China. Domestic oilseed and edible oil industry is organised in the form of oilseed crushers. Palm oil trade is influenced by various production. Palm oil supports many other industries in India like refining. large refiners. while the it is at its peak during the months of August. Their share in the global exports of CPO is to the tune of 90%.8-1. indicating a typical seasonality in the production cycle. temperature. The industry is dominated by over 200 importing companies. . sunflower. processors. groundnut. However. The major importing and trading centres for palm in India are Chennai. canola/ rapeseed. and edible oils in general). Kolkata. Mumbai and Kandla. Production is almost evenly distributed throughout the year between 0. Mangalore and Karwar also play important role. supply-demand scenario of palm and its competing soy oil in the global market apart from other vegetable oil sources viz. production and trade policies of the Government. coconut oil. This exchange trades only CPO among several derivatives of palm. Kakinada. The other centers like Mundra. technologists. The entire industry of CPO in India is dominated by importers. etc.. The domestic production of palm oil forms almost a negligible part of the total edible oil consumption in the country.4. stands at 25%. corporate involved in wholesale and retail trade through value-addition and retail-regional level players along with a few national level players. it exhibits seasonal highs and lows once in a year. India.

which supply palm oil to the world to the extent of over 85% of the annual global trade in palm oil. Government of India (Gol) adopts a protection policy with regard to production and trade in vegetable oils. Trade policies in India Since oilseed is one among the major crops cultivated by millions of farmers spread across the country. Mangalore. While the strategy of farm subsidies and minimum support price (MSP) are on the production side. Fractionation of RBD palm oil yields RBD palmolein along with stearin. . RBD palmolein exports from Malaysia have increased from 3. Kakinada. so as to protect the interests of both the producers and consumers.3 RBD Palmolein The RBD (refined. Kolkata.42 Commodities traded on the NCDEX platform over-all status of the edible oil industry during the immediate past. Mumbai and Chennai. followed by Indonesia). solid at room temperature). The domestic production of palm oil forms almost a negligible part of the total edible oil consumption in the country. liquid at room temperature. the duty structure on various forms of palm oil is the major trade-related protectionist measure. RBD palm oil and fatty acids are obtained. bleached and deodorized) palmolein is the derivative of crude palm oil (CPO). At the same time. 4. This implies that the country is dependent on palm oil imports for over 25% of its annual edible oil consumption. Its production grew from 5000 tons in 1991 to 35. which is one of the largest importer and consumer of edible oils in the world.000 tons in 2002. current and a short-term forecast of the future status of the industry in various producing and consuming countries. India. which is obtained from the crushing of fresh-fruit-bunches (FFBs) harvested from oil palm plantations. imports nearly 3 million tons of palm oil annually (mainly from Malaysia. While Oil is a stable derivative saturated fat. like any other welfare state. The whole quantity of CPO that is produced and used for human consumption is in the form of RBD palmolein. Global and domestic demand-supply dynamics The European Union. Olein is relatively unstable (unsaturated fat. Cropping of growth patterns of CPO has been already covered. and is the major source of cooking oil to over one billion consuming populace of the country. When CPO is subjected to refinement. Production and trade related policies of various exporting and importing nations of palm oil at the international scene have a major bearing on the prices of palm oil.5 million tons in 2002. which is a white solid at room temperature. but low cholesterol). Malaysia and Indonesia. Mundra.2 million tons in 1998 to 4. The import is mainly through the ports of Kandla. Pakistan and Middle-East countries are the major importers of RBD palmolein. export largely as CPO as is demanded by the importing nations who refine domestically and consume. there has been a drastic change in the composition of various forms of palm oil imported owing to the differential duty structure adopted by Indian government for crude and refined palm oil imports. There has been a sharp rise in the imports of palm oil into the country during the post 1998 period.1.

Palm and soy oils together constitute around 68% of global edible oil export trade volume. starts . RBD palmolein prices are influenced by CPO prices and the domestic consumer demand for various edible oils at a given point of time. etc.254 million tons in 1990 to nearly 3 million tons during 2001-02. Of the annual edible oil trade worth over Rs.4. Rising consumption of palm oil in India could be mainly attributed to the price sensitive nature of the Indian edible oil consumers. meal serves as the main source of protein in animal feeds.1. While the oil is mainly used for human consumption.6% during the past two and a half years. soy oils share is over 20-21% at Rs. This offers immense opportunity for the investors to profitably deploy their funds in this sector apart from those actually associated with the value chain of the commodity. production and trade policies of the Government mainly the exportimport policy. with soy oil constituting 22. On crushing mature beans. Increasing price competitiveness. soy oil prices traded across the world are highly volatile in nature. Soy oil is the leading vegetable oil traded in the international markets.4 Soy oil Soy oil is among the major sources of edible oils in India. It accounts for nearly 25% of the world's total oils and fats production. whose sowing begins by end-June with the arrival of southwest monsoon.440 billion in the country.1 Agricultural commodities 43 while the consumption of palm in India grew from 0. Historically. Unlike the price of CPO imported into the country. The average fluctuation in spot prices of refined soy oil traded at Mumbai has been at 6.5-8. which is often subjected to various production and marketrelated uncertainties.90-92 billion in terms of value.85%. soybean is purely a Kharif crop. prices of various domestically produced and imported oils.5%. which could use soy oil futures contract as the most effective hedging tool to minimise price risk in the market. overall health of the economy that has a bearing on the purchasing power of ultimate consumers. the maximum monthly fluctuation being as high as 17% during the period. soy oil prices in the major spot markets across the country have been fluctuating in the range of 4. growing at the rate of 25% compounded annually during the past decade. 18% oil and 78-80% meal is obtained. and aggressive cultivation and promotion from the major producing nations have given way to widespread soy oil growth both in terms of production as well as consumption. The crop. 4. next only to palm. Being an agricultural commodity. Price trends and factors that influence prices Palm oil trade in India is influenced by the supply-demand scene in the domestic market including the factors influencing various oilseed production in the country. Cropping and growth patterns In India. which is largely dependent on price of CPO traded at Malaysia and the importers and stockiest/ traders demand in India. Soy oil is the derivative of soybean. which is ready for harvest by the end of September.

Argentina contributes to an extent of 40. Production of soy oil in India has been fluctuating in the range of 0.6% and 2. palm oil apart from prices of domestically produced oils. contribute to 17% and 14% of world production.95%.1 and 4.90 billion. while that of Brazil and USA has been at 5. The production growth rate has been the highest for Argentina at 10. peaking during the subsequent two-three months. Hence. Uttar Pradesh. growing at the rate of 2.5 million tons. around 1. contributing 80% of the country's soybean production. etc. The domestic consumption of soy oil in Brazil and Argentina are to an extent of 63% and 3% of their respective domestic production of soy oil. followed by Maharashtra and Rajasthan. Imports constitute to the extent of over 65-68% of its annual soy oil requirement and 48% of its annual vegetable oil imports. Mumbai price indicates the imported soy oil price. The current world production of soy oil stands at 29-30 million tons. over-all health of the economy that has a bearing on the purchasing power of ultimate consumers. Crushing for oil and meal starts from October. Brazil and Argentina with 5.1 million tons of production. Karnataka. In addition to domestic production. spot markets of Indore and Mumbai serve as the reference market for soy oil prices.38 million tons.63%. slightly higher than the growth rate of its production (2. growing at the rate of 5%. While the Indore price reflects the domestically crushed soybean oil (refined and solvent extracted). Morocco. Central Europe. Dewas and Astha in Madhya Pradesh and Sangli in Maharashtra are major trading centres of soybean. Imports have been growing at the rate of approximately 20% over the period of last five years. China and India. US.7 million tons. Andhra Pradesh and Gujarat also produce in small quantities. Indore. in and around which the crushing and solvent extraction units are mostly located. Notable upward movement in consumption of soy oil is being seen in EU. Indian edible oil market is highly price sensitive in nature.9% respectively. Egypt.8 million tons of imports take the country's annual soy oil consumption to 2. It accounts to approximately 29% of world soy oil production with an annual production of 8. Madhya Pradesh is considered as the soybean bowl of India.36% compounded annually during the past decade. Its . growing at the rate of 11. It has been growing at the rate of 5.9 million tons during the last five years.5-1. Ujjain. production and trade policies of the government .8% compounded annually during the last decade. Global and domestic demand-supply dynamics Global consumption of soy oil during 2001-02 shot up to 29.92%). The refining units are located at the importing ports of Mumbai and Gujarat.7-0.4%.mainly me export-import policy.44 Commodities traded on the NCDEX platform entering the market from October beginning onwards. The consumption of soy oil in USA is to the extent of 90% of its production. United States is the major producer of soy oil in the world. the quantity of soy oil imports mainly depends on the price competitiveness of soy oil vis-a-vis its sole competitor. Price trends and factors the influence prices In India. Mexico.8%. It has been growing at the rate of 5. Russia.2-2. Of the total world exports. Brazil. with a market value of over Rs. Soy oil is among the most vibrant commodities in terms of price volatility.

its close link with several of its substitutes and its base raw material soybean in addition to its co-derivative (soy meal). China also grows partly during this season.1.4. concentration of production base in limited countries as against its widespread consumption base. 4. Rapeseed from the producers moves into the hands of crushers via the regulated markets (mandies). In addition is the stiffening competition among substitutable oils under the WTO regime. growing at a rate of 4. Refining of rapeseed oil was almost absent in the country till the end of the last century. etc. The pungency of the oil is considered as the major quality determining factor.5 Rapeseed oil Rapeseed (also called mustard or canola) oil is the third largest edible oil produced in the world. The remaining is obtained as oil cake/ meal. Government of India issued the edible oil packaging order in 1998.3%. Crushing for oil begins from October onwards. part of which is consumed by the domestic animal feed industry. the sector was more unorganised when compared to the other edible oil sectors in the country. Mustard oil. the rapeseed is sown during the months of June-July and harvested by August-September. On crushing rapeseed. oil and meal are obtained. USA has been the fastest growing market for rapeseed oil. Australia and China. Therefore. the nature of the existing supply and value chain. which is extracted by the solvent extractors.1 Agricultural commodities 45 exposure in the international edible trade scene (9-10 million tons). traditional millers producing unrefined oil are more favoured by the consumers. In India. and the rest exported.68% compounded annually during the period. Consumption in India and Canada has posted a negative growth . central and eastern parts of the country. which is known for its pungency. Mustard/ Rapeseed is traditionally the most important oil for the northern. This resulted in rampant adulteration of the oil. is traditionally the most favoured oils in the major production tracts world over. The opportunity is further enhanced by the expected rise in consumption base and the consequent expected rise in imports of vegetable oils in the years to come. which is rich in proteins and is used as an ingredient in animal feed. As a result. after soy and palm oils. throw tremendous opportunity for trade in this commodity. It is largely consumed in the crude form in the local crushing regions. Now. followed by China and European Union at 8% each. The cake obtained from the seed crush contains some amount of oil. rapeseed is sown in the Rabi season (November-December sowing). In the countries of Canada. The average oil recovery from the seed is about 33%. growing at the rate of 10. However. gets crushed for oil and cake in the ghanis or the expeller mills. with the occurrence of dropsy in the country. Global and domestic demand-supply dynamics Consumption of rapeseed oil in the world has increased from 11 million tons in 1997 to 14 million tons in 2001. The left over meal at the solvent extraction units forms a major portion of our oil meal basket. Cropping and growth patterns Rapeseed is a 90-110 day crop. refining is present in rapeseed oil too. which made refining and packing of all oils sold in the retail sector mandatory.

Together. Rapeseed oil has several industrial applications too viz. The average monthly fluctuation in prices of soybean traded at one of the .5000 crore. There have been no imports of refined rapeseed oil for the last few years due to the differential duty structure. Assam. The production from Rajasthan is highly monsoon dependent. and general sentiments in the overall edible oil industry within and outside the country. subjecting it to frequent fluctuations. soybean constitutes nearly 25% of the country's total oilseed production. USA imports 50% of rapeseed oil traded at the international market. Bihar. availability of others edible oils. as lubricant. susceptibility to the sentiments in the overall edible oil and meal industry in India and abroad. The seasonal nature of the production of rapeseed and its vulnerability to natural fallacies. Prices are largely dependent on the domestic production of rapeseed during the year. Hong Kong and Russia are the major importers. north-eastern and western part of the country. it is undoubtedly the focus of Indian edible oil industry. China contributes more than one thirds of world rapeseed oil production while that of India has gone down from 18. Being an important source of edible oil. wide consumption spread all through the year. its erucic acid derivatives are used in plastic industry. 6.4 million tons. consumption of rapeseed oil is concentrated in northern. Gujarat. Globally. influences the prices of the oil. With an annual production of 5. Rajasthan and Uttar Pradesh are the major rapeseed producing states in the country.2% in 1997 to 11.8% respectively during the past decade. Punjab and Jammu and Kashmir.6% respectively.7% respectively. China. The imports of mustard oil have drastically come down in the country from around 172000 tons in 1998-99 to a mere 10000 tons (of crude rapeseed oil) in 2001-02. Haryana. which is substantial. At an annual production level of 13-14 million tons. Since the oil is known and consumed preferably for its unique pungency.1. While the production growth rates in major producing countries viz.0-5. 4.8% and 4. It forms over one-third of the country's annual edible oil production. France and Germany's rapeseed oil production during the period has been growing at 10%. whose share has been declining over the years. it is mostly crushed in the local kacchi and pakki ghanis (oil mills) spread across the producing and trading centres. Canada and India have posted negative values of 1.65%. The other significant producers are Madhya Pradesh.46 Commodities traded on the NCDEX platform rate of 6% and 1. and it could also be transformed into a liquid biofuel. the nature of the existing supply and value chain.6 Soybean The market size of the popularly known miracle bean in India is over Rs. Price trends and factors the influence prices Various production and trade related factors influence rapeseed oil trade. rapeseed oil production has witnessed a moderate compounded annual growth rate (over the last decade) of 4.3% in 2001. owing to stiff price competition from palm and soy oils.2% and 7. Domestic rapeseed/ mustard is one of the major sources of edible oil and meal to India. rapeseed oil accounts for about 12% of the total world's edible oil production. they produce about 50% of the produce. Unlike other oils. West Bengal.

Cropping and growth patterns Soybean could be grown under rain fed conditions. USA. It supplies over 1. it is a leading exporter of meal in the Asian region. which forms the prime source of protein in animal feeds.30°C with short day length (14 hours or less). USA. around 18% oil could be obtained. While the country imports soy oil. Brazil.5 million tons of oil (15-18% of India's annual edible oil requirement) and 3-3.4. During the last decade.5 is suitable for its cultivation.07% during the past two years. Andhra Pradesh and Gujarat also produce in small quantities. soybean prices in the major spot markets across the country have been fluctuating in the range of 5-9%. However. but the field should be well drained. provided a good amount of soil moisture is ensured at the germination.0-5. Historically. the production of the commodity grew at the rate of 5.1 Agricultural commodities 47 active soybean spot market at Indore (Madhya Pradesh) has been at 10. contributing 65-70% of the country's soybean production.1.7 Rapeseed Rapeseed/ Mustard is one of the major sources of oil and meal to India. higher than the production growth rate of 5. soybean constitutes nearly 25% of the country's total oilseed production.0-6. 4.35% at the global level.4 million tons. The commodity has been commercially exploited for its utility as edible oil and animal feed. planting should be avoided at cooler temperatures during winter. The market size of the popularly known miracle bean in India is over Rs. The optimum temperature range of soybean cultivation is 20 . India and China are among the other producers. contributing to over 55% of the global oilseeds production. Karnataka. the maximum monthly fluctuation being as high as 24-30% during the period.2 million tons of . the rest being the oil cake/ meal.25%. human consumption as bean itself). Uttar Pradesh. Japan. India and Taiwan are among the other major consumers. global consumption of soybean has grown at the rate of 5. Argentina. while the rest is consumed either in the form of bean itself or for value-added soybean snack foods. soybean production alone stands at 170-190 million tons. With an annual production of 5.19%. followed by Brazil and Argentina are the major producing countries. Of the total bean produced. Mexico. Of the total 310-320 million tons of oilseeds produced annually. Madhya Pradesh is the soybean bowl of India. Soybean is the single largest oilseed produced in the world. followed by Maharashtra and Rajasthan. During the past five years period. China and European Union countries constitute for the bulk of world's annual soybean consumption. Loamy soil with pH of 6. The planting date of vegetable soybean is dependent upon temperature and day length. vegetative growth and pod setting stages. On crushing mature beans. leaving the rest of the quantity for crushing for meal and oil. 6-7 lakh tons goes for direct consumption in the form of bean itself (sowing.5000 crore. Global and domestic demand-supply dynamics About 82-85% of the global soybean production is crushed for oil and meal.

10%.8% and 3% respectively.68% compounded annually during the period. Brown mustard. Toria (Lahi or Maghi Labi) Rapeseed and mustard crops are of the tropical as well as of the temperate zones and require relatively cool temperatures for satisfactory growth. France. They are generally divided into three groups: 1. Canada and India are the major producers of this commodity. Global production of rapeseed increased from 25 million tons in 1990 to 42.8% during the past two years (July 2001 to July 2003). Canada and Australia with a share of 32%.4% during the period. France. several oilseeds belonging to the cuciferae are grown in India. Global and domestic demand-supply dynamics Consumption of rapeseed oil in the world has increased from 11 million tons in 1997 to 14 million tons in 2001. 12. commonly called rai (raya or laha) 2. they are grown during the Rabi season from September-October to February-March. Rapeseed and mustard crops grow well in areas having 25 to 40 cm of rainfall. Australia. Australian rapeseed production grew at the fastest rate of 21%. 9. followed by China and European Union at 8% each. but Toria does best in loam to heavy loams. Rapeseed/ Mustard/ Canola is a traditionally important oilseed. The other major producers are Germany. known as canola. Rai may be grown on all types of soils. the maximum monthly fluctuation being as high as 23. Sarson is preferred in low-rainfall areas. The hybrid form of rapeseed. India and Canada have shown a decline . China.3%. is more popular internationally. Consumption in India and Canada has posted a negative growth rate of 6% and 1.48 Commodities traded on the NCDEX platform oil meal. In India. The commodity has been commercially exploited in the form of seeds. Rapeseed and mustard thrive best in light to heavy loams. The major contributors to global rapeseed production are China. the major protein source in animal feeds. Cropping and growth patterns Under the names rapeseed and mustard.5 million tons.6%.1%. growing at the rate of 10. Among the major contributors to world production. and declined from there on to the current (2002) level of 32.2% during the last 12 years period. The average monthly fluctuation in prices of rapeseed traded at one of the active rapeseed spot market at Jaipur (Rajasthan) has been at 9. Hong Kong and Russia are the major importers. growing at a rate of 4. USA imports 50% of rapeseed oil traded at the international market. Pakistan and Poland. USA has been the fastest growing market for rapeseed oil. whose share has been declining over the years. oil (seed to oil recovery is 39-40%) and meal. France and Germany are growing at a moderate rate of 2-4%.4 million tons in 1999. It has been growing at the rate of 2. While China.6% respectively. Sarson is suited to light-loam soils and Taramira is mostly grown on very light soils. India. whereas Rai and Toria are grown in medium and high rainfall areas respectively. Germany. 12. Sarson: (i) Yellow sarson (ii) Brown sarson 3.

4.2 Precious metals

49

in the production. The global trade of rapeseed oil has come down from 1.9 million tons in 1997 to 1.2 million tons in 2001. 68% of the global rapeseed oil export trade is dominated by Canada. Germany follows Canada in the export of domestically produced rapeseed oil. Its exports too have fallen by 30% from 0.3 million tons in 1997 to 0.07 million tons in 2001. India and China consume most of the rapeseed oil that is produced domestically. Rapeseed/ mustard is one of the major sources of edible oil and meal to India. Around 4.5-4.8 million tons of rapeseed available for produced annually in the country supplies over 1.5 million tons of oil and 3-3.2 million tons of meal on crushing. It is the largest produced edible oil in India (groundnut oil production also stands on par with it during good years). It forms over one-third of the country's annual edible oil production, which is substantial. The imports of mustard oil have drastically come down in the country from around 172000 tons in 1998-99 to a mere 10000 tons (of crude rapeseed oil) in 2001-02, owing to stiff price competition from palm and soy oils. There have been no imports of refined rapeseed oil for the last few years due to the differential duty structure. Rajasthan and Uttar Pradesh are the major rapeseed producing States in the country. Together, they produce about 50% of the produce. The production from Rajasthan is highly monsoon dependent. The other significant producers are Madhya Pradesh, Haryana, Gujarat, West Bengal, Assam, Bihar, Punjab and Jammu and Kashmir. Since the oil is known and consumed preferably for its unique pungency, it is mostly crushed in the local kacchi and pakki ghanis (oil mills) spread across the producing and trading centres.

Price trends and factors the influence prices
Jaipur, Delhi, Hapur, Kolkata and Mumbai markets serve as the reference markets for rapeseed/ mustard oil traded across the country. Various production and trade related factors influence rapeseed oil trade. Prices are largely dependent on the domestic production of rapeseed during the year, availability of others edible oils, and general sentiments in the overall edible oil industry within and outside the country. Being an important source of edible oil, it is undoubtedly the focus of Indian edible oil industry. The seasonal nature of the production of rapeseed and its vulnerability to natural fallacies, wide consumption spread all through the year, the nature of the existing supply and value chain, susceptibility to the sentiments in the overall edible oil and meal industry in India and abroad, influences the prices of the oil, subjecting it to frequent fluctuations. Futures trading would also provide a right tool for hedging the market-related risk for everyone in the value chain of the commodity- the producing farmers, processors, brokers, speculators, mustard oil and traders of other oils. Import of both refined and crude rapeseed oil is permitted into the country. The import duty on crude oil is 75%, while that on refined oil is 82%. There have been no imports of refined oil for the last few years due to the differential duty structure.

4.2 Precious metals
The NCDEX offers futures trading in following precious metals - gold and silver. We will look briefly at both.

50

Commodities traded on the NCDEX platform

Gold futures trading debuted at the Winnipeg Commodity Exchange (Comex) in Canada in November 1972. Delivery was also available in gold certificates issued by Bank of Nova Scotia and the Canadian Imperial Bank of Commerce. The gold contracts became so popular that by 1974 there was as many as 10,00,000 contracts floating in the market. The futures trading in gold started in other countries too. This included the following: • The London gold futures exchange started operations in the early 1980s. • The Sydney futures exchange in Australia began functioning with a contract in 1978. This exchange had a relationship with the Comex where participants could take open positions in one exchange and liquidate them in the other. • The Singapore International Monetary Exchange (Simex) was set up in 1983 by way of an alliance between the Gold Exchange of Singapore and the International Monetary Market (TMM) of Chicago. • The Tokyo Commodity Exchange (Tocom), which launched a contract in 1982, was one of the few commodity exchanges to successfully launch gold futures. Trading volume on the Tocom peaked with seven million contracts. • On December 31, 1974, the Commodity Exchange, the Chicago Board of Trade, the Chicago Mercantile Exchange and the Mid-America Commodity Exchange introduced gold futures contracts. • The Chinese exchange, Shanghai Gold Exchange was officially opened on 30 October 2002. • Mumbai's first multi-commodity exchange, the National Commodities and Derivatives Exchange, NCDEX launched in 2003 by a consortium of ICICI Bank Limited, Life Insurance Corporation, National Bank for Agriculture and Rural Development and National Stock Exchange of India Limited, introduces gold futures contracts. Gold has a very active derivative market compared with other commodities. Gold accounts for 45 per cent of the worlds commercial banks commodity derivatives portfolio.

Box 4.4: History of derivatives markets in gold

4.2.1

Gold

For centuries, gold has meant wealth, prestige, and power, and its rarity and natural beauty have made it precious to men and women alike. Owning gold has long been a safeguard against disaster. Many times when paper money has failed, men have turned to gold as the one true source of monetary wealth. Today is no different. While there have been fluctuations in every market and decided downturns in some, the expectation is that gold will hold its own. There is a limited amount of gold in the world, so investing in gold is still a good way to plan for the future. Gold is homogeneous, indestructible and fungible. These attributes set gold apart from other commodities and financial assets and tend to make its returns insensitive to business cycle fluctuations. Gold is still bought (and sold) by different people for a wide variety of reasons - as a use in jewellery, for industrial applications, as an investment and so on.

4.2 Precious metals Table 4.1 Country-wise share in gold production, 1968 and 1999 Country Tonnes, 1968 Share 1968 Tonnes, 1999 South Africa Australia Canada USA China Indonesia India Rest of the world Total 972 87 44 67 6 3 437 309 154 334 154 154 51 463 2571

51

Share, 1999 17 12 6 13 6 6 2 18 100

87 1450

6 100

Production
Traditionally South Africa has been the largest producers of gold in the world accounting for almost 80% of all non-communist output in 1970. Although it retained its position as the single largest gold producing country, its share had fallen to around 17% by 1999 because of high costs of mining and reduced resources. Table 4.1 gives the country-wise share in gold production. In contrast other countries like US, Australia, Canada and China have increased their output exponentially with output from developing countries like Peru and other Latin American countries also increasing impressively. Mining and production of gold in India is negligible, now placed around 2 tonnes (mainly from the Kolar gold mines in Karnataka) as against a total world production of about 2,272 tonnes in 1995.

Melting & refining assaying facility in India
At present, gold is mainly refined in Bombay where a few refineries like the India Government Mint and National refinery are active. Some private refineries are also operating elsewhere with limited capacity. As none of the refineries is LBMA recognised, there is a need to upgrade and also increase the refining capacity.

Global and domestic demand-supply dynamics
The demand for gold may be categorised under two heads - consumption demand and investment demand. Consumption of gold differs according to type, namely industrial applications and jewellery. The special feature of gold used in industrial and dental applications is that some of it cannot be salvaged and thus is truly consumed. This is unlike consumption in the form of jewellery, which remains as stock and can reappear at future time in market in another form. Consumer demand accounts for almost 90% of total gold demand and the demand for jewelry forms 89% of consumer demand.

Investment demand can be split broadly into two. Barely 5% is for industrial uses. there are no authentic estimates. The investor could hold gold-linked paper assets or could lend out the physical gold on the market attaining a higher return in addition to savings on the storage costs. These two countries together account for over 50% of total world demand of gold for retail investment. real estate prices. inaccessible or insecure banks. The demand for gold jewellery is rooted in societal preference for a variety of reasons . or where trust in the government is low. and to treat any major part as exclusively a store of value or hedging instrument would be unrealistic. Regarding pattern of demand. ritualistic. it does not need to be held in physical form. and as a hedge against inflation. financial markets. The yellow metal used to . Middle East and China. private and public sector holdings. About 80% of the Physical gold is consumed in the form of jewellery while bars and coins occupy not higher than 10% of the gold consumed.religious. Japan has the highest investment demand for gold followed closely by India. There is reason to believe that a part of investment demand for gold assets is out of black money. It would not be realistic to assume that it is only the affluent that creates demand for gold. The Indian demand to the tune of 800 tonnes per year is making it the largest market for gold followed by USA. More than 80% of the gold consumed is in the form of jewellery. It will be difficult to prioritise them but it may be reasonable to conclude that it is a combined effect. each of which lends it to specific investor preferences: • Coins and small bars • Gold accounts: allocated and unallocated • Gold certificates and pool accounts • Gold Accumulation Plan • Gold backed bonds and structured notes • Gold futures and options • Gold-oriented funds Demand The Consumer demand for gold is more than 3400 tonnes per year making it whopping $40 billion worth.). If gold is held primarily as an investment asset. the available evidence shows that about 80% is for jewellery fabrication for domestic demand.52 Commodities traded on the NCDEX platform In markets with poorly developed financial systems. etc. then India is the largest repository of gold in terms of total gold within the national boundaries. If we include jewellery ownership. gold is attractive as a store of value. tax-policies. which is generally predominated by women. Rural India continues to absorb more than 70% of the gold consumed in India and it has its own role to fuel the barter economy of the agriculture community. There are several ways in which investors can invest in gold either directly or through a variety of investment products. a preferred form of wealth for women. and 15% is for investor-demand (which is relatively elastic to gold-prices.

Since the demand for gold is closely tied to the production of jewelry. gold prices tend to increase during the time of year when demand for jewellery is greatest. the strong domestic demand for gold and the restrictive policy stance are reflected in the higher price of gold in the domestic market compared to that in the international market at the available exchange rate. It rose almost more than 40% compared to the previous year because of rise in gold price by more than 15%. Mothers Day and Valentine Day are all major shopping seasons and hence the demand for metals tends to be strong a few months ahead of these holidays. The demand-supply for gold in India can be summed up thus: • Demand for gold has an autonomous character. One fourth of world gold production is consumed in India and more than 60% of Indian consumption is met through imports.2 Precious metals 53 play an important role in marriage and religious festivals in India. therefore. Christmas. with prosperity and enlightenment. The annual consumption of gold. where women did not inherit landed property whereas gold and silver jewellery was. On the . particularly illegal import prior to the commencement of liberalisation in 1990. Supply Indian gold holding. Also. so price strength in March and April is not uncommon. has increased to more than 700 tonnes in late 90s. which are predominantly private. The existing social and cultural system continues to cause net gold buyer market and the government policies have to take note of the root cause of gold demand. However. In the near future. The domestic production of the gold is very limited which is around 9 tonnes in 2002 resulting more dependence on imported gold. a major component of the gifts given to a woman at the time of marriage. there may be deceleration in demand. and still is. The gold also occupies a significant position in the temple system where gold is used to prepare idol and devotees offer gold in the temple. it would be made good by growing demand on account of prosperity in rural areas. Price trends and factors that influence prices Indian gold prices follow more or less the international price trends. the summer wedding season sees a large increase in the demand for metals. • Demand exhibits income elasticity. particularly in urban areas. In the Hindu. is estimated to be in the range of 1000013000 tonnes. The availability of recycled gold is price sensitive and as such the dominance of the gold supply through import is in existence. The changeover hands of gold at the time of marriage are from few grams to kgs. which lies in the social and cultural system of India. These temples are run in trust and gold with the trust rarely comes into re-circulation. particularly in the rural and semi-urban areas. Although it is likely that. which was estimated at 65 tonnes in 1982.4. the annual demand will continue to be over 600 tonnes per year. Jain and Sikh community. • Price differential creates import demand. The fabricated old gold scraps is price elastic and was estimated to be near 450 tonnes in 2002. Supply follows demand.

December. Italy. and a whole host of other financial macro economic indicators. Silver is somewhat harder than gold and is second only to gold in malleability and ductility. The unique properties of silver restrict its substitution in most applications. sonorous. Delhi. these three categories represent more than 95 percent of annual silver consumption. Cash markets remain highly unorganised in the silver and impurity and excessive speculation remain key issue for the trade. very malleable and capable of high degree of polish. industrial and decorative uses. Production Silver ore is most often found in combination with other elements. parallel futures markets are still very active in Delhi and Indore. ductile. Mexico.2. government of India is planning to introduce hallmarking in silver which is likely to address quality and credibility of Indian silverware and jeweller industry.54 Commodities traded on the NCDEX platform other hand in November. Mexico is the worlds leading producer of silver. India. Speculative interest in the white metal is so intense that it is believed that combined volume of Indian punters represent almost 40 percent of volume traded at New York Commodity Exchange.000 tonnes of silver. industrial demand for silver accounts for roughly 85% of the total demand for silver. MP and UP are the active pockets for the silver futures. Germany. which is the worlds largest consumer of silver. Silver remains one of the most prominent candidates in the metals complex as far as futures' trading is concerned. is gearing up to start hallmarking of the white precious metal by April. Canada. and silver has been mined and treasured longer than any of the other precious metals. In recent years. It also has the highest thermal and electrical conductivity of any substance. Rajasthan. but industrial. The main factors affecting these countries demand for silver are macro economic factors such as GDP growth.2 Silver The dictionary describes it as a white metallic element. France. India annually consumes around 4. Japan and India. Thanks to its unique volatility. the main world demand for silver is no longer monetary. Most of the world's silver is mined in the US. followed by Canada. With the growing use of silver in photography and electronics. Though futures trading was banned in India since late sixties. Jewelry and silverware is the second largest component. Demand Demand for silver is built on three main pillars. photography and jewelry & silverware. followed by Peru. . Until recently. Taking cue from gold. The main consumer countries for silver are the United States. and Australia. the United States. income levels. 4. Rajkot and Mathura were conducting futures but now players have diverted toward comex trade. industrial production. the largest consumer of silver. with more demand from the flatware industry than from the jewelry industry in recent years. the United Kingdom. January and February prices tend to decline and jewellers tend to have holiday inventory to unwind. Australia. and Canada. Peru. Together. Mexico. silver has remained a hot favourite speculative vehicle for the small time traders.

9% pure silver at noon each working day. which accounts for roughly four-fifths of the mined silver supply produced annually. Handy & Harman. Canada and Australia. or on a forward basis. respectively. Mexico. disinvestments. Although London remains the true center of the physical silver trade for most of the world. which started trading in the 17th century provide a vehicle for trade in silver on a spot basis. The mine production is not the sole source . . mine production and recycled silver scraps. Box 4. Spot prices for silver are determined by levels prevailing at the COMEX. the Commodity Futures Trading Commission (CFTC). Old scrap normally makes up around a fifth of supply. Silver is often mined as a byproduct of other base metal operations. Scrap is the silver that returns to the market when recovered from existing manufactured goods or waste.8 million troy ounces in 1997. the price is fixed at the point at which all the members of the fixing can balance their own. According to GFMS. accounting for roughly 43. In the United States. Trading in silver futures resumed at the Comex in New York in 1963.5: Historical background of silver markets with the rural areas accounting for the bulk of the sales. as well as by the chemical industry. buying and selling orders. Japan is the second largest producer of silver from scrap and recycling. India's demand for silver increased by 177 per cent over the past 10 years as compared to 517 tonnes in 1991. plus clients. Mine production is surprisingly the largest component of silver supply. the United States. The other major source of silver is from refining. publishes a price for 99. the silver used in solvents and the like can be removed from the waste and recycled. the largest producer of silver from mines.others being scrap.4. In the United States and Japan. Because silver is used in the photography industry. Although there is no American equivalent to the London fix. India has emerged as the third largest industrial user of silver in the world after the US and Japan. Known reserves. The most notable producers are Mexico. Peru. It normally accounts for a little less than 2/3 rd of the total (last year was slightly higher at 68%). after a gap of 30 years. accounting for roughly 27. or actual mine capacity. The London Metal Exchange and the Chicago Board of Trade introduced futures trading in silver in 1968 and 1969. or scrap recycling. Fifteen countries produce roughly 94 percent of the worlds silver from mines. Peru is the worlds second largest producer of silver.m. The United States recycles the most silver in the world. The London market has a fix which offers the chance to buy or sell silver at a single price. mainly in the form of spent fixer solutions and old X-ray films. government sales and producers hedging. the most significant paper contracts trading market for silver in the United States is the COMEX division of the New York Mercantile Exchange. three-quarters of all the recycled silver comes from the photographic scrap. The fix begins at 12:15 p. a precious metals company.6 million ounces.2 Precious metals 55 Major markets like the London market (London Bullion Market Association). and is a balancing exercise.2%. the silver futures market functions under the surveillance of an official body. is evenly split along the lines of production. Scrap supply increased marginally last year up by 1. Supply The supply of silver is based on two facts.

merefore. As such. die production of silver increases in tandem. economic and political factors have powerful bearing on silver prices. As die price of die omer metal products increases. Cotton A: The correct answer is number 2. •• 3. Because silver is a precious metal. Wheat 2. prices move in accordance with demand and supply conditions prevalent in mat environment Price of silver is also influenced by changes in factors such as inflation (real or perceived). Soy oil •• . Silk 4. As in the case of gold prices. die increased profit margin to mine operations stimulates greater production of die omer metals. and fluctuations in deficits and interest rates. like that of other commodities. is subject to issues such as weamer and politics mat may affect silver mining operations. Gold 2. As is the case with other precious metals. nickel. When trading and movement of silver is restricted. Solved Problems Q: Which of the following commodities do not trade on the NCDEX? 1. 3. Rapeseed A: The correct answer is number 4. lead. Jute 2. and zinc. within or outside national boundaries. It is not a product mat can be manufactured en masse. Silver 4. and as a result. they are also influenced by factors such as tastes. 1. such as gold. Rapeseed A: The correct answer is number 1. Q: In India. changing values of paper currencies.56 Commodities traded on the NCDEX platform Factors influencing prices of the silver The prices of silver. 3. and. ___ is the most important non-food crop. Besides. there is a limited amount of silver in the world. political tensions. Soybean 4. a host of social. technological change and market liberalisation. Approximately 70 percent of the silver mined in the western hemisphere is mined as a byproduct of other metal products. copper. are dictated by forces of demand and supply and consumption. its price is determined by die supply and demand ratio at any given moment. the price of these metals greatly affects the supply of silver mined in any year. etc. Energy •• Q: Which of the following agricultural commodities do not trade on the NCDEX at the moment? 1. Although prices and incomes are important factors. None of the above. the threat affects the price of silver too.

Coconut kernel 3. Prices of coconut oil A: The correct answer is number 3. Q: Futures prices of cotton at the __ serve as the reference price for cotton traded in the international market.2 Precious metals Q: Which of the following factors do not influence the price of cotton? 1. NYBOT 4. Prices of cotton products. Dry fruit bunches A: The correct answer is number 1. Prices of Rapeseed oil 2. 1. Mature fresh fruit bunches 2. CME 2. Demand-supply scenario 2. Q: RBD Palmolein is the derivative of 1. Leaves 3. Production and prices of synthetic fibre A: The correct answer is number 4. Sunflower seeds 3. Previous prices of cotton 4. Soybean A: The correct answer is number 2. Soy 2. CPO 4. 57 •• •• •• •• •• •• . Stem 4. CBOT A: The correct answer is number 3. SGX 3. 3. Rapeseed A: The correct answer is number 3.4. Prices of CPO 4. CPO 4. Q: Soy oil is the derivative of 1. Prices sunflower oil 3. Soy 2. Q: Which of the following factor directly influences the price of RBD palmolein? 1. 1. Q: Palm oil is extracted from the __ of oil palm plantations.

Indore 4. Q: The ____ market reflects the price of imported soybean 1. Ahmedabad A: The correct answer is number 3. Delhi •• . 3. Mumbai 2. Ahmedabad A: The correct answer is number 1. Delhi •• 3. Indore 4.58 Commodities traded on the NCDEX platform Q: The ____ market reflects the price of domestically crushed soybean 1. Mumbai 2.

it has to compulsorily go to the same counterparty. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price.1 Forward contracts A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. and hence is unique in terms of contract size. This process of standardisation reaches its limit in the organised futures market. the contract has to be settled by delivery of the asset. . • Each contract is custom designed. Before we study about the applications of commodity derivatives. While at the moment only commodity futures trade on the NCDEX. speculation and arbitrage.Chapter 5 Instruments available for trading In recent years. • On the expiration date. However forward contracts in certain markets have become very standardised. thereby reducing transaction costs and increasing transactions volume. The forward contracts are normally traded outside the exchanges. as in the case of foreign exchange. as the market grows. Other contract details like delivery date. The salient features of forward contracts are: • They are bilateral contracts and hence exposed to counter-party risk. derivatives have become increasingly popular due to their applications for hedging. eventually. While futures and options are now actively traded on many exchanges. forward contracts are popular on the OTC market. In this chapter we shall study in detail these three derivative contracts. which often results in high prices being charged. price and quantity are negotiated bilaterally by the parties to the contract. 5. The other party assumes a short position and agrees to sell the asset on the same date for the same price. • The contract price is generally not available in public domain. • If the party wishes to reverse the contract. we will have a look at some basic derivative products. expiration date and the asset type and quality. we also have commodity options being traded.

This often makes them design terms of the deal which are very convenient in that specific situation. If a speculator has information or analysis. However. Even when forward markets trade standardized contracts.1. A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. and then take a reversing transaction to book profits. the exchange specifies certain standard features of the contract. but makes the contracts non-tradeable. The classic hedging application would be that of an exporter who expects to receive payment in dollars three months later. To facilitate liquidity in the futures contracts. the basic problem is that of too much flexibility and generality. which forecasts an upturn in a price. It is a standardized contract with standard underlying instrument. then he can go long on the forward market instead of the cash market. this is generally a relatively small proportion of the value of the assets underlying the forward contract. By using the currency forward market to sell dollars forward.60 Instruments available for trading Forward contracts are very useful in hedging and speculation. 5. the other suffers. still the counterparty risk remains a very serious issue. the futures contracts are standardized and exchange traded. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. The speculator would go long on the forward. When one of the two sides to the transaction declares bankruptcy. and hence avoid the problem of illiquidity. More than 99% of futures transactions are offset this way. (or which can be used for reference purposes in settlement) and a standard timing of such settlement. he can lock on to a rate today and reduce his uncertainty.2 Introduction to futures Futures markets were designed to solve the problems that exist in forward markets. But unlike forward contracts.1 Limitations of forward markets Forward markets world-wide are afflicted by several problems: • Lack of centralisation of trading. Speculators may well be required to deposit a margin upfront. Similarly an importer who is required to make a payment in dollars two months hence can reduce his exposure to exchange rate fluctuations by buying dollars forward. a standard quantity and quality of the underlying instrument that can be delivered. 5. He is exposed to the risk of exchange rate fluctuations. The forward market is like a real estate market in that any two consenting adults can form contracts against each other. and • Counterparty risk In the first two of these. The standardized items in a futures contract are: . Counterparty risk arises from the possibility of default by any one party to the transaction. The use of forward markets here supplies leverage to the speculator. wait for the price to rise. • Illiquidity.

the Chicago Mercantile Exchange sold contracts whose value was counted in millions. it was called the International Monetary Market (EMM) and traded currency futures.1 Distinction between futures and forwards Futures Trade on an organised exchange Standardized contract terms hence more liquid Requires margin payments Follows daily settlement Forwards OTC in nature Customised contract terms hence less liquid No margin payment Settlement happens at end of period • Quantity of the underlying • Quality of the underlying • The date and the month of delivery • The units of price quotation and minimum price change • Location of settlement 5.6: The first financial futures market Table 5. . Before IMM opened in 1972.1 lists the distinction between the two. The confusion is primarily because both serve essentially the same economic functions of allocating risk in the presence of future price uncertainty. By 1990.1 Distinction between futures and forwards contracts Forward contracts are often confused with futures contracts." The first exchange that traded financial derivatives was launched in Chicago in the year 1972. Table 5.5. By the 1990s. the 1990 Nobel laureate had said that "financial futures represent the most significant financial innovation of the last twenty years. A division of the Chicago Mercantile Exchange. Box 5. and the Chicago Board Options Exchange.2 Introduction to futures 61 Merton Miller. and their success transformed Chicago almost overnight into the risk-transfer capital of the world. These currency futures paved the way for the successful marketing of a dizzying array of similar products at the Chicago Mercantile Exchange. However futures are a significant improvement over the forward contracts as they eliminate counterparty risk and offer more liquidity.2. the underlying value of all contracts traded at the Chicago Mercantile Exchange totalled 50 trillion dollars. acknowledged as the "father of financial futures" who was then the Chairman of the Chicago Mercantile Exchange. these exchanges were trading futures and options on everything from Asian and American stock indexes to interest-rate swaps. The brain behind this was a man called Leo Melamed. the Chicago Board of Trade.

■ Initial margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin. An option gives the holder of the option the right to do something. namely options. the two parties have committed themselves to doing something. the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day. The commodity futures contracts on the NCDEX have one-month. The holder does not have to exercise this right. 5. in a forward or futures contract. • Marking-to-market(MTM): In the futures market. This is called marking-to-market.2 Futures terminology • Spot price: The price at which an asset trades in the spot market. a new contract having a three-month expiry is introduced for trading. • Futures price: The price at which the futures contract trades in the futures market. we look at another interesting derivative contract. There will be a different basis for each delivery month for each contract. On the next trading day following the 20th. at the end of each trading day.3 Introduction to options In this section. the margin account is adjusted to reflect the investor's gain or loss depending upon the futures closing price. • Contract cycle: The period over which a contract trades. If the balance in the margin account falls below the maintenance margin. This is set to ensure that the balance in the margin account never becomes negative. • Expiry date: It is the date specified in the futures contract. . This measures the storage cost plus the interest that is paid to finance the asset less the income earned on the asset.62 Instruments available for trading 5. • Basis: Basis can be defined as the futures price minus the spot price. at the end of which it will cease to exist. • Delivery unit: The amount of asset that has to be delivered under one contract. two-months and three-months expiry cycles which expire on the 20th day of the delivery month. In contrast. This reflects that futures prices normally exceed spot prices. the purchase of an option requires an up-front payment. The delivery unit for the Gold futures contract is 1 kg. This is the last day on which the contract will be traded. Options are fundamentally different from forward and futures contracts. In a normal market. Whereas it costs nothing (except margin requirements) to enter into a futures contract. • Maintenance margin: This is somewhat lower than the initial margin. the delivery unit for futures on Long Staple Cotton on the NCDEX is 55 bales. • Cost of carry: The relationship between futures prices and spot prices can be summarised in terms of what is known as the cost of carry. Thus a January expiration contract expires on the 20th of January and a February expiration contract ceases trading on the 20th of February. For instance.2. basis will be positive.

Options currently trade on over 500 stocks in the United States. This market however suffered from two deficiencies. First. without much knowledge of valuation. the number of shares underlying the option contract sold each day exceeded the daily volume of shares traded on the NYSE. The market for options developed so rapidly that by early '80s. ■ Stock options: Stock options are options on individual stocks. The firm would then attempt to find a seller or writer of the option either from its own clients or those of other member firms. There are two basic types of options.7: History of options 5. A contract gives the holder the right to buy or sell shares at the specified price. For instance a gold options contract would give the holder the right to buy or sell a specified quantity of gold at the price specified in the contract. • Writer of an option: The writer of a call/ put option is the one who receives the option premium and is thereby obliged to sell/ buy the asset if the buyer exercises on him.5. the exercise date. If someone wanted to buy an option.3. • Buyer of an option: The buyer of an option is the one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/ writer. Merton and Scholes invented the famed Black-Scholes formula.1 Option terminology ■ Commodity options: Commodity options are options with a commodity as the underlying. • Put option: A put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price. In April 1973. • Call option: A call option gives the holder the right but not the obligation to buy an asset by a certain date for a certain price. In 1973. It is also referred to as the option premium. Since then. . there was no secondary market and second. call options and put options.3 Introduction to options 63 Although options have existed for a long time. he or she would contact one of the member firms. Box 5. they were traded OTC. Black. the strike date or the maturity. the firm would undertake to write the option itself in return for a price. • Option price: Option price is the price which the option buyer pays to the option seller. It was only in the early 1900s that a group of firms set up what was known as the put and call Brokers and Dealers Association with the aim of providing a mechanism for bringing buyers and sellers together. CBOE was set up specifically for the purpose of trading options. ■ Expiration date: The date specified in the options contract is known as the expiration date. there was no mechanism to guarantee that the writer of the option would honour the contract. • Strike price: The price specified in the options contract is known as the strike price or the exercise price. there has been no looking back. If no seller could be found. The first trading in options began in Europe and the US as early as the seventeenth century.

intrinsic value and time value. The asset could be a commodity like gold or cotton. and properties of an American option are frequently deduced from those of its European counterpart. the intrinsic value of a call is Max [0. If the index is much higher than the strike price. if it is ITM. • Time value of an option: The time value of an option is the difference between its premium and its intrinsic value. (K . If the call is OTM. The intrinsic value of a call is the amount the option is ITM. . • European options: European options are options that can be exercised only on the expiration date itself. the maximum time value exists when the option is ATM. the greater is an option's time value. K is the strike price and St is the spot price. • At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cashflow if it were exercised immediately. An option that is OTM or ATM has only time value. 5. spot price < strike price). European options are easier to analyse than American options. Most exchange-traded options are American. At expiration. Similarly. If the index is much lower than the strike price. But first we look at the basic payoff for the buyer or seller of an asset. spot price > strike price). the put is ITM if the index is below the strike price. • In-the-money option: An in-the-money (ITM) option is an option that would lead to a positive cashflow to the holder if it were exercised immediately. the put is OTM if the index is above the strike price. (St . its intrinsic value is zero.64 Instruments available for trading • American options: American options are options that can be exercised at any time upto the expiration date.4 Basic payoffs A payoff is the likely profit/ loss that would accrue to a market participant with change in the price of the underlying asset.i. This is generally depicted in the form of payoff diagrams which show the price of the underlying asset on the X-axis and the profits/ losses on the Y-axis. the call is said to be deep ITM. Putting it another way.e. A call option on the index is out-of-the-money when the current index stands at a level which is less than the strike price (i. all else equal.K). An option on the index is at-the-money when the current index equals the strike price (i.e. In the case of a put. an option should have no time value. spot price = strike price). The longer the time to expiration. or it could be a financial asset like like a stock or an index. • Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to a negative cashflow it it were exercised immediately. the greater of 0 or (K . Usually. In this section we shall take a look at the payoffs for buyers and sellers of futures and options. • Intrinsic value of an option: The option premium can be broken down into two components .K)] which means the intrinsic value of a call is the greater of 0 or (St .e.e.St). A call option on the index is said to be in-themoney when the current index stands at a level higher than the strike price (i.St )]. the call is said to be deep OTM. Both calls and puts have time value. the intrinsic value of a put is Max [0. In the case of a put.

They were initially used for hedging. 5. Once it is purchased. the tulip became the most popular and expensive item in Dutch gardens. Similarly. an investor shorts the underlying asset. 5. The first tulip was brought into Holland by a botany professor from Vienna. and buys it back at a future date at an unknown price.6000 per 10 gms. cotton for instance.5. Figure 5.4. The more popular they became.5 Payoff for futures Futures contracts have linear payoff.8: Use of options in the seventeenth-century 5. The profits as well as losses for the buyer and the seller of a futures contract are unlimited. That was when options came into the picture. Hardest hit were put writers who were unable to meet their commitments to purchase Tulip bulbs.6500 per Quintal. for Rs. He has a potentially unlimited upside as well as a potentially unlimited downside.1 Payoff for buyer of futures: Long futures The payoff for a person who buys a futures contract is similar to the payoff for a person who holds an asset.1 Payoff for buyer of asset: Long asset In this basic position. Box 5. Later.2 Payoff for seller of asset: Short asset In this basic position. If the price of the underlying falls. the investor is said to be "long" the asset. If the price of the underlying rises.4. tulip-bulb growers could assure themselves of selling their bulbs at a set price by purchasing put options. 5. The magnitude of profits or losses for a given upward or downward movement is the same. Over a decade. Figure 5. the more Tulip bulb prices began rising. a call buyer would realize returns far in excess of those that could be obtained by purchasing tulip bulbs themselves. By purchasing a call option on tulip bulbs. Once it is sold. just like the payoff of the underlying asset that we looked at earlier.2 shows the payoff for a short position on cotton. the buyer makes profits. for Rs. The tulip-bulb market collapsed in 1636 and a lot of speculators lost huge sums of money. the investor is said to be "short" the asset. St. As long as tulip prices continued to skyrocket. an investor buys the underlying asset. It was one of the most spectacular get rich quick binges in history.5. however. St. gold for instance. The writers of the put options also prospered as bulb prices spiralled since writers were able to keep the premiums and the options were never exercised.1 shows the payoff for a long position on gold. These linear payoffs are fascinating as they can be combined with options and the underlying to generate various complex payoffs. the buyer makes losses. . and sells it at a future date at an unknown price.5 Payoff for futures 65 Options made their first major mark in financial history during the tulip-bulb mania in seventeenth-century Holland. options were increasingly used by speculators who found that call options were an effective vehicle for obtaining maximum possible gains on investment. a dealer who was committed to a sales contract could be assured of obtaining a fixed number of bulbs for a set price.

he looses. If the price of cotton falls.2 Payoff for a seller of gold The figure shows the profits/losses from a short position on cotton. If the price of cotton rises. If the price of gold rises. he profits. If price of gold falls he looses. Figure 5. The investor brought gold at Rs.1 Payoff for a buyer of gold Instruments available for trading The figure shows the profits/losses from a long position on gold. . he profits. Figure 5. The investor sold long staple cotton at Rs.66. 6000 per 10 gms. 65000 per Quintal.

6000 per 10 gms. the futures prices too move down and the long futures position starts making losses.The investor bought futures when gold futures were trading at Rs. When the prices of long staple cotton move up. When the prices of gold in the spot market goes up. Take the case of a speculator who buys a two-month gold futures contract on the NCDEX when it sells for Rs. If the price of gold falls. the gold futures price too would go up and his futures position starts making profit.5. 5.5. .4 shows the payoff diagram for the seller of a futures contract.6000 per 10 gms. Figure 5. When the prices of long staple cotton move down. The underlying asset in this case is long staple cotton. the cotton futures prices also move down and the short futures position starts making profits.3 Payoff for a buyer of gold futures 67 The figure shows the profits/ losses for a long futures position. The underlying asset in this case is gold. Take the case of a speculator who sells a two-month cotton futures contract when the contract sells Rs. the cotton futures price also moves up and the short futures position starts making losses.5 Payoff for futures Figure 5.6500 per Quintal.2 Payoff for seller of futures: Short futures The payoff for a person who sells a futures contract is similar to the payoff for a person who shorts an asset. Figure 5. If the price of the underlying gold goes up. Similarly when the prices of gold in the spot market goes down. the futures price too moves up and the long futures position starts making profits. He has a potentially unlimited upside as well as a potentially unlimited downside. the futures price falls too and his futures position starts showing losses.3 shows the payoff diagram for the buyer of a gold futures contract.

The investor sold cotton futures at Rs. the futures price also falls. bought at a premium of Rs. We look here at the four basic payoffs. These non-linear payoffs are fascinating as they lend themselves to be used for generating various complex payoffs using combinations of options and the underlying asset.1 Payoff for buyer of call options: Long call A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option. The payoff from the option written is exactly the opposite to that of the option buyer. the futures too rise. His profits are limited to the option premium. however his losses are potentially unlimited.4 Payoff for a seller of cotton futures Instruments available for trading The figure shows the profits/ losses for a short futures position. and the short futures position starts making profit. 5. Figure 5. The profit/ loss that the buyer makes on the option depends on the spot price of the underlying.6 Payoff for options The optionality characteristic of options results in a non-linear payoff for options. however the profits are potentially unlimited. If the spot price of the underlying is less than the strike price.6. the spot price exceeds the strike price. it means that the losses for the buyer of an option are limited. he lets his option expire un-exercised. and the short futures position starts showing losses. . 5. Higher the spot price. His loss in this case is the premium he paid for buying the option. In simple words. he makes a profit. If the price of the underlying long staple cotton goes down. more is the profit he makes.500. If upon expiration.7000 per 10 gms.68 Figure 5.5 gives the payoff for the buyer of a three month call option on gold (often referred to as long call) with a strike of Rs. The writer of an option gets paid the premium. If the price of the underlying long staple cotton rises.6500 per Quintal.

the writer of the option charges a premium. Hence as the spot price increases the writer of the option starts making losses.2 Payoff for writer of call options: Short call A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option. more is the loss he makes.7000 per 10 gms. the spot price exceeds the strike price. The profit/ loss that the buyer makes on the option depends on the spot price of the . 5. For selling the option.7000.6. The profits possible on this option are potentially unlimited. 5.500.7000. The profit/ loss that the buyer makes on the option depends on the spot price of the underlying. Figure 5.3 Payoff for buyer of put options: Long put A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option.6 Payoff for options Figure 5. If upon expiration. sold at a premium of Rs.6. the buyer would exercise his option and profit to the extent of the difference between the spot gold-close and the strike price. he lets the option expire. the buyer will exercise the option on the writer.7000 per 10 gms. the buyer lets his option expire un-exercised and the writer gets to keep the premium.5 Payoff for buyer of call option on gold 69 The figure shows the profits/ losses for the buyer of a three-month call option on gold at a strike of Rs. If upon expiration the spot price of the underlying is less than the strike price. Whatever is the buyer's profit is the seller's loss. His losses are limited to the extent of the premium he paid for buying the option. However if the price of gold falls below the strike of Rs. As can be seen.5. as the prices of gold rise in the spot market. Higher the spot price. If upon expiration. gold trades above the strike of Rs. the call option becomes in-themoney.6 gives the payoff for the writer of a three month call option on gold (often referred to as short call) with a strike of Rs.

If the spot price of the underlying is higher than the strike price. The profit/ loss that the buyer makes on the option depends on the spot price of the underlying. If upon expiration. bought at a premium ofRs. he makes a profit. The loss that can be incurred by the writer of the option is potentially unlimited. .7000. If upon expiration.6.6 Payoff for writer of call option on gold Instruments available for trading The figure shows the profits/ losses for the seller of a three-month call option on gold with a strike price of Rs.8 gives the payoff for the writer of a three month put option on long staple cotton (often referred to as short put) with a strike of Rs. the buyer will exercise the option on the writer. gold price is above the strike of Rs. Whatever is the buyer's profit is the seller's loss. whereas the maximum profit is limited to the extent of the up-front option premium of Rs.6000 per Quintal. As the price of gold in the spot market rises.400. Figure 5. the spot price happens to be below the strike price. If upon expiration. the call option becomes in-the-money and the writer starts making losses. the buyer lets his option expire un-exercised and the writer gets to keep the premium.70 Figure 5. the writer of the option charges a premium. more is the profit he makes. If upon expiration the spot price of the underlying is more than the strike price.500 charged by him. His loss in this case is the premium he paid for buying the option.6000 per Quintal.4 Payoff for writer of put options: Short put A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. underlying. For selling the option. Figure 5. the spot price is below the strike price. Lower the spot price. 5.7 gives the payoff for the buyer of a three month put option on cotton (often referred to as long put) with a strike of Rs. the buyer would exercise his option on the writer who would suffer a loss to the extent of the difference between the spot gold-close and the strike price. he lets his option expire un-exercised.7000 per 10 gms.

options offer "nonlinear payoffs" whereas futures only have "linear payoffs". as the price of cotton in the spot market falls. a wide variety of innovative and useful payoff structures can . There is no possibility of the options position generating any further losses to him (other than the funds already paid for the option).7 Using futures versus using options An interesting question to ask at this stage is . More generally. His losses are limited to the extent of the premium he paid for buying the option. sold at a premium of Rs. who cannot put in the time to closely monitor their futures positions. but can generate very large losses. If at expiration.5. the put option becomes in-the-money.400. the buyer would exercise his option and profit to the extent of the difference between the strike price and spot cotton-close. the option buyer faces an interesting situation. 5. he lets the option expire. As can be seen.6000.400 in this case. However if spot price of cotton on the day of expiration of the contract is above the strike of Rs. The profits possible on this option can be as high as the strike price. he only has an upside. He pays for the option in full at the time it is purchased.when would one use options instead of futures? Options are different from futures in several interesting senses.7 Payoff for buyer of put option on long staple cotton 71 The figure shows the profits/ losses for the buyer of a three-month put option on long staple cotton. which is free to enter into.7 Using futures versus using options Figure 5.6000 per Quintal. At a practical level. Rs. After this. This characteristic makes options attractive to many occasional market participants. cotton prices fall below the strike of Rs. This is different from futures. By combining futures and options.

i.72 Instruments available for trading Figure 5. Table 5. Only short at risk. Rs. price moves. the put option becomes in-the-money and the writer starts making losses. with novation Exchange defines the product Price is zero.8 Payoff for writer of put option on long staple cotton The figure shows the profits/ losses for the seller of a three-month put option on long staple cotton. Strike price is fixed.2 Distinction between futures and options Futures Options Exchange traded. be created. the buyer would exercise his option on the writer who would suffer a loss to the extent of the difference between the strike price and spot cotton-close. Nonlinear payoff. . If upon expiration.6000 per Quintal. Price is always positive. Same as futures. cotton prices fall below the strike of Rs. strike price moves Price is zero Linear payoff Both long and short at risk Same as futures.e. The profit that can be made by the writer of the option is limited to extent of the premium received by him.400. whereas the losses are unlimited (actually they are limited to the strike price since the worst that can happen is that the price of the underlying asset falls to zero. As the price of cotton in the spot market falls.

Equity index 2. a function of the volatility of the index 4. Unlimited A: The correct answer is number 2. Both 4. The correct answer is number 1. Exchange •• A: The option to exercise lies with the buyer. 3. Chicago Board of Trade 2. Buyer 2. Cotton 4. Commodities A: The correct answer is 2 3. Q: The potential returns on a futures position are: 1.5. Gold A: The correct answer is 4 3. London International Financial Futures and Options Exchange •• Q: In an options contract. Wheat 2. None of the above •• . Chicago Mercantile Exchange A: The correct answer is 3. 3. Interest rate 4. Limited 2. Foreign exchange •• Q: Which of the following cannot be an underlying asset for a commodity derivative contract? 1.7 Using futures versus using options 73 Solved Problems Q: Which of the following cannot be an underlying asset for a financial derivative contract? 1. Stocks •• Q: Which of the following exchanges was the first to start trading commodity futures? 1. the option lies with the 1. Seller 3. Chicago Board Options Exchange 4.

000 4. 3.14 4. • • . Futures contract 2.18 2. (-)50. Greater than the sum of intrinsic value and time value value A: The correct answer is number 3. The correct answer is number 1. Less than the sum of intrinsic value and time time value 2. This is an example of a 1.74 Instruments available for trading Q: Two persons agree to exchange 100 gms of gold three months later at Rs. and delivery unit is 100 Quintals.400/ gm. Spot contract 4. 3.50/Quintal. Rs. He makes a profit of Rs. None of the above •• Q: Unit of trading for soy bean futures is 10 Quintals. i.4 A: The correct answer is number 2. This is an example of a 1. None of the above •• •• Q: An asset currently sells at 120. How much profit/loss has he made on his position? 1. Forward contract A: The correct answer is number 2.18. he makes a profit of Rs.134 costs Rs.e. Equal to the sum of intrinsic value and value 4. Q: Typically option premium is 1. He buys 10 units which means a futures position 100 Quintals. A week later soy bean futures trade at Rs. 3. Independent of intrinsic value and time 3. Exchange traded contract A: The correct answer is number 1. Spot contract 4. 1550/Quintal. The put option to sell the asset at Rs. (+)5000 2. The time value of the option is 1. Rs. (-)5000 3. Rs.5000.12 •• Q: Two persons agree to exchange 100 gms of gold three months later at Rs.400/ gm. OTC contract 2. Rs. (+)50. A trader buys futures on 10 units of soy bean at Rs. 1500/Quintal.000 A: Each unit is for 10 Quintals.

How much profit/loss has he made on his position? 1.70]. he makes a profit of Rs.000 4.000 3. (+) 10. 1500/Quintal. i. the spot price of gold is Rs. He makes a loss of Rs. The correct answer is number 1. i. he makes a loss of Rs. (+)5000 2.7000/10 gms at a premium of Rs. What is his net payoff? 1.5000. A week later soy bean futures trade at Rs. (-)50. He makes a loss of Rs.5000. • • Q: A trader buys three-month call options on 10 units of gold with a strike of Rs.000 4.50/Quintal.5. 1450/Quintal. How much profit/loss has he made on his position? 1. i. How much profit/loss has he made on his position? 1. (+)5000 2.7080/10 gms. He makes a profit of Rs.000 A: Each unit is for 10 Quintals. A week later soy bean futures trade at Rs.e.10. • •  10  . He buys 10 units which means a futures position in 100 Quintals. and delivery unit is 100 Quintals. he makes a loss of Rs. (-) 1. i.e. (-)5000 3. (-)5000 3. A trader sells futures on 10 units of soy bean at Rs.50/Quintal. A trader buys futures on 10 units of soy bean at Rs. (+) 1. The correct answer is number 2. (-) 10. (+)50. On the day of expiration.70.000 2.000 A: Each unit is for 10 Quintals.7000) .7 Using futures versus using options 75 Q: Unit of trading for soy bean futures is 10 Quintals. 1500/Quintal. (+)50. • • Q: Unit of trading for soy bean futures is 10 Quintals. (+)5000 2.e.000 A: Per 10 gms he makes a net profit of Rs. (+)50. The correct answer is number 2.e.000 4. He sells 10 units which means a futures position in 100 Quintals. 1500/Quintal.000 A: Each unit is for 10 Quintals. A week later soy bean futures trade at Rs. Unit of trading is 100 gms.[(7080 .000 4. • • Q: Unit of trading for soy bean futures is 10 Quintals. A trader sells futures on 10 units of soy bean at Rs. and delivery unit is 100 Quintals. (-)50. He has a long position in 1000 gms. 1550/Quintal. and delivery unit is 100 Quintals. (-)50. (-)5000 3. He buys 10 units which means a futures position in 100 Quintals. 1450/Quintal. So he makes a net profit of Rs.50/Quintal.5000. 1000 on his position   100  × 10  The correct answer is number 2.

76

Instruments available for trading

Q: A trader buys three-month call options on 10 units of gold with a strike of Rs.7000/10 gms at a premium of Rs.70. Unit of trading is 100 gms. On the day of expiration, the spot price of gold is Rs.6080/10 gms. What is his net payoff? 1. (-)7000 2. (+) 1,000 3. (-)700 4. (-) 1,000

A: The option is OTM. Unit of trading is 100 gms and he has bought 10 units. So he has a position in 1000 gms of gold. He pays an option premium of Rs.70 per 10 gms. He losses the premium amount of Rs.7000 on his position. The correct answer is number 1. •• Q: A trader sells three-month call options on 10 units of gold with a strike of Rs.7000 per 10 gms at a premium of Rs.70. Unit of trading is 100 gms. On the day of expiration, the spot price of gold is Rs.7080/10 gms. What is his net payoff? 1. (+) 10,000 2. (+) 1,000 3. (-) 10,000 4. (-) 1,000

A: On the day of expiration, the option is ITM so the buyer exercises on him. The buyers profit is the sellers loss. Per 10 gms he makes a net loss of Rs.10, i.e.[(7080 - 7000) - 70]. He has a short position in 1000 gms. So he makes a net loss of Rs.1000 on his position  correct answer is number 4. Q: A trader sells three-month call options on 10 units of gold with a strike of Rs.7000 per 10 gms at a premium of Rs.70. Unit of trading is 100 gms. On the day of expiration, the spot price of gold is Rs.6080/10 gms. What is his net payoff? 1. (-)7000 2. (+) 1,000 3. (-)700 4. (-) 1,000

 100  × 10  . The  10 

A: The option is OTM. The buyer does not exercise so the seller gets to keep the premium. Unit of trading is 100 gms and he has sold 10 units. So he has a position in 1000 gms of gold. He receives an option premium of Rs.70 per 10 gms. He earns the premium amount of Rs.7000 on his position. The correct answer is number 1. ••

Chapter 6 Pricing commodity futures
Commodity futures began trading on the NCDEX from the 14th December 2003. The market is still in its nascent phase, however the volumes and open interest on the various contracts trading in this market have been steadily growing. The process of arriving at a figure at which a person buys and another sells a futures contract for a specific expiration date is called price discovery. In an active futures market, the process of price discovery continues from the market's 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 tomorrow's 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. In this chapter we try to understand the pricing of commodity futures contracts and look at how the futures price is related to the spot price of the underlying asset. We study the cost-of-carry model to understand the dynamics of pricing that constitute the estimation of fair value of futures.

6.1

Investment assets versus consumption assets

When studying futures contracts, it is essential to distinguish between investment assets and consumption assets. An investment asset is an asset that is held for investment purposes by most investors. Stocks and bonds are examples of investment assets. Gold and silver are also

78

Pricing commodity futures

examples of investment assets. Note however that investment assets do not always have to be held exclusively for investment. As we saw earlier, silver, for example, has a number of industrial uses. However, to classify as investment assets, these assets do have to satisfy the requirement that they are held by a large number of investors solely for investment. A consumption asset is an asset that is held primarily for consumption. It is not usually held for investment. Examples of consumption assets are commodities such as copper, oil, and pork bellies. As we will learn, we can use arbitrage arguments to determine the futures prices of an investment asset from its spot price and other observable market variables. For pricing consumption assets, we need to review the arbitrage arguments a little differently. To begin with, we look at the cost-of-carry model and try to understand the pricing of futures contracts on investment assets.

6.2 The cost of carry model
We use arbitrage arguments to arrive at the fair value of futures. For pricing purposes, we treat the forward and the futures market as one and the same. A futures contract is nothing but a forward contract that is exchange traded and that is settled at the end of each day. The buyer who needs an asset in the future has the choice between buying the underlying asset today in the spot market and holding it, or buying it in the forward market. If he buys it in the spot market today, it involves opportunity costs. He incurs the cash outlay for buying the asset and he also incurs costs for storing it. If instead he buys the asset in the forward market, he does not incur an initial outlay. However the costs of holding the asset are now incurred by the seller of the forward contract who charges the buyer a price that is higher than the price of the asset in the spot market. This forms the basis for the cost-of-carry model where the price of the futures contract is defined as:

F = S-C where: F Futures price S Spot price C Holding costs or carry costs The fair value of a futures contract can also be expressed as: F = S(l + r)T where:
r Percent cost of financing

(6.1)

(6.2)

the arbitrager delivers the share and receives Rs.71828 (6. the logic for pricing a futures contract is exactly the same as the logic for pricing a forward contract.05 × 0.43. Equation 6. the holding cost is the cost of financing minus the dividends returns. the arbitrager locks in a profit of Rs.43. When we use continuous compounding. The sum of money required to pay off the loan is 40e 0.40 and the three-month interest rate is 5% per annum. We use examples of forward contracts to explain pricing concepts because forward contracts are easier to understand. let us start with the simplest derivative contract . If F < S(1 + r)T or F > S(1 + r)T. Suppose that the forward price is relatively high at Rs.2 The cost of carry model T Time till expiration 79 Whenever the futures price moves away from the fair value. Assume that the price of the underlying stock is Rs.00 .50 at the end of the three month period. 1. but what are the components of holding costs? The components of holding cost vary with contracts on different assets. At times the holding cost may even be negative. In the case of equity futures.43.2 uses the concept of discrete compounding. We know what are the spot and futures prices.2.a forward contract.50. We consider the strategies open to an arbitrager in two extreme situations.40. there would be opportunities for arbitrage. Consider a three-month forward contract on a stock that does not pay dividend.2 is expressed as: F . At the end of three months.3) So far we were talking about pricing futures in general.SerT where: r Cost of financing (using continuously compounded interest rate) T Time till expiration e 2. and sell the stock in the forward market at Rs. Most books on derivatives use continuous compounding for pricing futures too. An arbitrager can borrow Rs. To understand the pricing of commodity futures. . annually or semiannually.50 = Rs.43. By following this strategy. Then we introduce real world factors as they apply to investment commodities and later to consumption commodities.6. We begin with a forward contract on an asset that provides the holder with no income and has no storage or other costs. for example. buy one share in the spot market. Pricing of options and other complex derivative securities requires the use of continuously compounded interest rates. where interest rates are compounded at discrete intervals. However. arbitrage would exist. equation 6. the holding cost is the cost of financing plus cost of storage and insurance purchased. In the case of commodity futures.25 − 40.40 from the market at an interest rate of 5% per annum.Rs.

What is the cost of financing for a month? e 0.50 there will be no arbitrage. 2. S= Rs. if the one-month contract was for a 100 kgs of gold instead of 10 gms.50.7086. The price of the futures contract would then be Rs. the gold contract was for 10 grams of gold. Suppose that the forward price is relatively low at Rs. and take a long position in a three-month forward contract. there exists arbitrage.1 gives the indicative warehouse charges for accredited warehouses/ vaults that will function as delivery centres for contracts that trade on the NCDEX.40. In this case the fair value of the futures.80 plus the holding costs.7000/ 10 gms.1 Pricing futures contracts on investment commodities In the example above we saw how a futures contract on gold could be priced using arbitrage arguments and the cost-of-carry model. Under such a situation. This is the fair value of the forward contract. takes delivery of the share under the terms of the forward contract and uses it to close his short position.80 Pricing commodity futures 2. What are the holding costs? Let us assume that the storage cost = 0.7086. in the process making a net gain of Rs. In the example we considered. expiring on 30th March. Similarly if the forward price is less than Rs.15 × 30 would increase the futures price.80 F = Se rT = 7000e If the contract was for a three-month period i.50 in three months. At a forward price of Rs. what should be the futures price of 10 gms of gold one month down the line ? Let us assume that we're on 1st January 2004.75 0. eventually pushing the forward price up to Rs.05 × 0. Let us first try to work out the components of the cost-of-carry model. the cost of financing 0. invest the proceeds of the short sale at 5% per annum for three months. arbitragers will sell the asset in the forward market. there exists arbitrage.7000/ 10 gms. If the cost of financing is 15% annually. What is the spot price of gold? The spot price of gold.40.50.25 We see that if the forward price is greater than Rs. 0. The spot price of gold is Rs. the futures price would be F = 7000e Rs. 1.7263. At the end of the three months.80 365 = Rs.40.39.50. The proceeds of the short sale grow to 40e − 40. The same arguments hold good for a futures contract on an investment asset.40. How would we compute the price of a gold futures contract expiring on 30th January? From the discussion above we know that the futures price is nothing but the spot price plus the cost-ofcarry.e. works out to be = Rs. Arbitragers will buy the asset in the forward market. Now let us try to extend this logic to a futures contract on a commodity. the arbitrager pays Rs. Warehouse charges include . 1.40.40.15 × 90 365 = 6. Therefore. Let us take the example of a futures contract on a commodity and work out the price of the contract. However.50 at the end of three months.50.39. 7086. Table 6. An arbitrager can short one share for Rs. then it would involve non-zero holding costs which would include storage and insurance costs.2. Hence we ignored the storage costs.15 × 30 365 3. eventually driving the forward price down to Rs.

On the next day. it follows that the futures price will be equal to F = where: r Cost of financing (annualised) T Time till expiration U Present value of all storage costs For ease of understanding let us consider a one-year futures contract on gold.310 per deposit upto 500 kgs.4) . the highlight of the whole episode was the fact that inspite of huge losses. At one point. This was largely because delays in processing orders to sell equity made index arbitrage too risky. Assume that the payment is made at the beginning of the year. on October 19. It was the day the markets fell by over 20% and the volume of shares traded on the New York Stock Exchange far exceeded all previous records. it costs Rs. and the variable storage costs are Rs. F. the futures price for the December contract was 18% less than the S&P 500 index which was the underlying index for these futures contracts! However.55 per week. However. What would the price of one year gold futures be if the delivery unit is one kg? F = (S+ U)erT = (600000 + 310 + 2860)e0.07 x 1 = 646904. Box 6. For most of the day.9: The market crash of October 19. futures traded at significant discount to the underlying index. the New York Stock Exchange placed temporary restrictions on the way in which program trading could be done. and a per unit per week charge. We saw that in the absence of storage costs. It was the ultimate test of the efficiency of the margining system in the futures market. there were no defaults by futures traders. the futures price is very close to S(X + r)T. the US market saw a breakdown in this classic relationship between spot and futures prices.1987.1987 a fixed charge per deposit of commodity into the warehouse. If U is the present value of all the storage costs that will be incurred during the life of a futures contract. the futures price of a commodity that is an investment asset is given by F = SerT Storage costs add to the cost of carry. October 20. The per unit charges include storage costs and insurance charges. Suppose the fixed charge is Rs. The result was that the breakdown of the traditional linkages between stock indexes and stock futures continued.3170 to store one kg of gold for a year(52 weeks).2 The cost of carry model 8 1 Under normal market conditions.76 (S + U)erT (6.1987. Assume further that the spot gold price is Rs.6.6000 per 10 grams and the risk-free rate is 7% per annum.

Suppose we have F > (S+U)erT (6.82 Pricing commodity futures Table 6.) (Rs. The threemonth futures price for 10 grams of gold would be about Rs.6000 per 10 grams and the risk-free rate is 7% per annum.11. 6.6. the arbitrage arguments used to determine futures prices need to be reviewed carefully. What would the price of three month gold futures if the delivery unit is one kg? F = (S + U)erT = (600000 + 310 + 715)e0.2.46. It costs Rs.55 per week.6116. The one-year futures price for 10 grams of gold would be about Rs.long Cotton .76.indicative warehouse charges Commodity Fixed charges Warehouse charges per unit per week (Rs.635. and the variable storage costs are Rs.25 = 611635.310 per deposit upto 500 kgs.2 Pricing futures contracts on consumption commodities We used the arbitrage argument to price futures on investment commodities.5) To take advantage of this opportunity.1025 to store one kg of gold for three months(13 weeks).07 x 0. We make the same assumptions the fixed charge is Rs. Now let us consider a three-month futures contract on gold. an arbitrager can implement the following strategy: .1 NCDEX .) Gold Silver Soy Bean Soya oil Mustard seed Mustard oil RBD Palmolein CPO Cotton .50.medium 310 610 110 110 110 110 110 110 110 110 55 per kg 1 per kg 13 per MT 30 per MT 18perMT 42 per MT 26 per MT 25 per MT 6 per Bale 6 per Bale We see that the one-year futures price of a kg of gold would be Rs.904. Assume further that the spot gold price is Rs.6469.6. Assume that the storage costs are paid at the time of deposit.50 We see that the three-month futures price of a kg of gold would be Rs. For commodities mat are consumption commodities rather than investment assets.

the spot price will decrease and the futures price will increase until equation 6. As arbitragers exploit this opportunity. Therefore there is unlikely to be arbitrage when equation 6. the basis reduces to zero. many investors hold the commodity purely for investment. This happens because if the futures price is above the spot price during the delivery period it gives rise to a clear arbitrage .6) In case of investment assets such as gold and silver.3 The futures basis The cost-of-carry model explicitly defines the relationship between the futures price and the related spot price. Suppose next that (S+U)erT F < (6.5 does not hold good. If we regard the futures contract as a forward contract. 2. This would result in a profit at maturity of (S + U) erT . save the storage costs.4 holds good.6 does not hold good. do so. When they observe the inequality in equation 6. They are reluctant to sell these commodities and buy forward or futures contracts because these contracts cannot be consumed.6 holds good. Sell the commodity.F relative to the position that the investors would have been in had they held the underlying commodity. In short. because of its consumption value . this argument cannot be used. for commodities like cotton or wheat that are held for consumption purpose. 2. As arbitragers exploit this opportunity. This means that there is a convergence of the futures price to the price of the underlying asset. this strategy leads to a profit of F . (67) 6. and invest the proceeds at the risk-free interest rate. equation 6. the spot price will increase and the futures price will decrease until Equation 6. they will find it profitable to trade in the following manner: 1. Individuals and companies who keep such a commodity in inventory.not because of its value as an investment. Short a forward contract on one unit of the commodity. Take a long position in a forward contract. However. This means that for investment assets.6.6. We see that as a futures contract nears expiration.3 The futures basis 83 1. The difference between the spot price and the futures price is called the basis. Borrow an amount S+ U at the risk-free interest rate and use it to purchase one unit of the commodity and pay storage costs.(S + U) erT at the expiration of the futures contract. for a consumption commodity therefore. F<=(S+U) erT That is the futures price is less than or equal to the spot price plus the cost of carry.

At a later stage we shall look at how these arbitrage opportunities can be exploited.84 Figure 6. On the date of expiration.1 Variation of basis over time Pricing commodity futures The figure shows how basis changes over time. 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. Towards the close of trading on the day of settlement. Nuances • As the date of expiration comes near. As the time to expiration of a contract reduces. This will lead to a profit equal to the difference between the futures price and spot price. • Transactions costs are very important in the business of arbitrage. If it is not. the basis is zero. buy the asset from the spot market and make the delivery. . then there is an arbitrage opportunity. The closing price for the April gold futures contract is the closing value of gold in the spot market on that day. we need to factor in the benefit provided by holding the physical commodity. 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. 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.there is a convergence of the futures price towards the spot price(Figure 6.1). In case of such arbitrage the trader can short his futures contract. the basis reduces . the futures price and the spot price converge. Arbitrage opportunities can also arise when the basis (difference between spot and futures price) or the spreads (difference between prices of two futures contracts) during the life of a contract are incorrect. opportunity for traders. the basis reduces. • There is nothing but cost-of-carry related arbitrage that drives the behaviour of the futures price in the case of investment assets. In the case of consumption assets. 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.

Q: As the a futures contract nears expiration.a. Black & Scholes 2. All investors 3. and warehousing cost are Rs.00 2. All investors 3. Time-value •• Q: What is the fair value of one month futures if the spot value of gold is Rs. 6025.6000 per 10 grams? The money can be invested at 10% p.40 3. Large investors 2. Most investors 4.• A: The fair value is 6025e01x00833 = 6075.00 4. Solved problems Q: The _______ model is used for pricing futures contracts. Miller 4. Reduces to half •• •• •• . Increases 2. 3. 3.3 The futures basis 85 Note: The pricing models discussed in this chapter give an approximate idea about the true future price. Q: An investment asset is an asset that is held for consumption purposes by 1. Some investors A: The correct answer is number 3. Reduces A: The correct answer is number 2. Most investors 4. Some investors A: The correct answer is number 3.30 .6. the basis 1.40.25 1. Remains unchanged 4. 6050. Large investors 2. However the price observed in the market is the outcome of the price-discovery mechanism (demand-supply principle) and may differ from the so-called true price. The correct answer is number 2. 6090. 6075. Cost-of-carry A: The correct answer is number 2. Q: An investment asset is an asset that is held for investment purposes by 1. 1.

Selling the underlying asset and buying futures •• set 4. arbitragers profit by 1. arbitragers profit by 1. •• . Selling futures 2. Selling futures and buying the underlying asA: The correct answer is number 4. Selling the underlying asset and buying futures 3.86 Pricing commodity futures Q: When the futures price happens to be higher than the fair value of the futures contract. Buying the underlying asset set 4. Selling futures and buying the underlying asA: The correct answer is number 3. Q: When the futures price happens to be lower than the fair value of the futures contract. Buying the underlying asset 3. Selling futures 2.

1.00. processors etc. that it makes the outcome more certain.00.Chapter 7 Using commodity futures For a market to succeed. trading companies and even other participants in the value chain.000 for each 1 rupee decrease in the price during this period. he obtains a hedge by locking in to a predetermined price. for instance farmers.1 Basic principles of hedging When an individual or a company decides to use the futures markets to hedge a risk. extractors. it must have all three kinds of participants . The futures position should lead to a loss of Rs. This risk might relate to the price of wheat or oil or any other commodity that the person deals in. indeed. If the price of the commodity goes down. ginners. private corporations like financial institutions.000 for each 1 rupee increase in the price of the commodity over the next three months and a gain of Rs. 7. Take the case of a company that knows that it will gain Rs.000 for each 1 rupee increase in the price of a commodity over the next three months and will lose Rs. it could make the outcome worse.. the objective is to take a position that neutralises the risk as much as possible. What it does however is. Commodity markets give opportunity for all three kinds of participants. speculators and arbitragers. If . The classic hedging example is that of wheat farmer who wants to hedge the risk of fluctuations in the price of wheat around the time that his crop is ready for harvesting.1. the company should take a short futures position that is designed to offset this risk. speculation and arbitrage. By selling his crop forward. 1. the gain on the futures position offsets the loss on the commodity.hedgers. In this chapter we look at the use of commodity derivatives for hedging. 1. They use the futures market to reduce a particular risk that they face. The confluence of these participants ensures liquidity and efficient price discovery on the market. 7. To hedge.00. Hedging does not necessarily improve the financial outcome. who are influenced by the commodity prices.00.000 for each 1 rupee decrease in the price of a commodity over the same period.1 Hedging Many participants in the commodity futures market are hedgers. Hedgers could be government institutions. 1.

or is likely to own the asset and expects to sell it at some time in the future. There are basically two kinds of hedges that can be taken. A short hedge can also be used when the asset is not owned at the moment but is likely to be owned in the future.1. by going in for a short hedge he locks on to a price of Rs. A short futures position will give him the hedge he desires.1 Payoff for buyer of a short hedge Using commodity futures The figure shows the payoff for a soy oil producer who takes a short hedge. This is known as long hedge. a short hedge is appropriate when the hedger already owns the asset. the loss on the futures position is offset by the gain on the commodity. As we said.88 Figure 7. an exporter who knows that he or she will receive a dollar payment three months later. He makes a gain if die dollar increases in value relative to the rupee and makes a loss if the dollar decreases in value relative to the rupee. Let a look at a more detailed example to illustrate a short hedge. Similarly. the price of the commodity goes up. We will study these two hedges in detail. a short hedge could be used by a cotton farmer who expects the cotton crop to be ready for sale in the next two months. For example. Irrespective of what the spot price of soy oil is three months later.450 per MT. a company that knows that it is due to buy an asset in the future can hedge by taking long futures position. For example. This is called a short hedge.2 Short hedge A short hedge is a hedge that requires a short position in futures contracts. A company that wants to sell an asset at a particular time in the future can hedge by taking short futures position. 7. We assume that today is the .

000 under its sales contract. The company realises Rs.10 per 10 Kgs. Table 7. Rs.475 .3 Long hedge Hedges that involve taking a long position in a futures contract are known as long hedges.465 per 10 Kgs. Case 2: The spot price is Rs. The producer can hedge his exposure by selling 10. the futures price on April 15 should be very close to the spot price of Rs.4.1 gives the soy oil futures contract specification. The oil producer is therefore in a position where he will gain Rs.1 Hedging Table 7. The company closes its short futures position at Rs.1.4. or Rs.465 or below Rs. making a gain of Rs.465 . Suppose that it is now January 15.475 per 10 Kgs. If the oil producers closes his position on April 15.465.450 per 10 Kgs and the April soy oil futures price on the NCDEX is Rs. 1680 .Rs. the effect of the strategy would be to lock in a price close to Rs. 7. Rs.4. 10. per 10 Kgs Tick size 5paisa Trading hours 89 15th of January and that a refined soy oil producer has just negotiated a contract to sell 10.455 = Rs.4.4:15 pm to 4:30 pm Unit of trading 1000 Kgs (=1 MT) Delivery unit 10000 Kgs (=10 MT) Quotation/ base value Rs. Because April is the delivery month for the futures contract.455 on that date.455.75.000 on its short futures position. 10000 for each one rupee decrease in the price of oil during this period.10. or Rs.465 = Rs.65.000 in total.000 Kgs of soy oil. A firm involved in industrial fabrication knows that it will require 300 kgs of silver on April 15 to meet a certain contract. the futures price on April 15 should be very close to the spot price of Rs. The company realises Rs. 2. Let us look at how this works.10 per 10 Kgs.475 on that date.1 Refined soy oil futures contract specification Trading system NCDEX trading system Monday to Friday Normal market hours .000 Kgs worth of April futures contracts (10 units).65.465 per 10 Kgs. 10000 for each 1 rupee increase in the price of oil over the next three months and lose Rs. Because April is the delivery month for the futures contract.7.000 under its sales contract. It has been agreed that the price that will apply in the contract is the market price on the 15th April. Figure 7. Case 1: The spot price is Rs.1 gives the payoff for a short hedge.455 per 10 Kgs. the spot price can either be above Rs.000 on its short futures position. The spot price of silver is Rs. The total amount realised from both the futures position and the sales contract is therefore about Rs. 1.10:00 am to 4:00 pm Closing session .465 per 10 Kgs.Rs. The total amount realised from both the futures position and the sales contract is therefore about Rs. making a loss of Rs.000 in total. On April 15. Suppose the spot price for soy oil on January 15 is Rs.55.465 per 10 Kgs.475. The company closes its short futures position at Rs. A long hedge is appropriate when a company knows it will have to purchase a certain asset in the future and wants to lock in a price now.

90 Figure 7.2 Payoff for buyer of a long hedge

Using commodity futures

The figure shows the payoff for an industrial fabricator who takes a long hedge. Irrespective of what the spot price of silver is three months later, by going in for a long hedge he locks on to a price of Rs.1730 per kg.

Table 7.2 Silver futures contract specification Trading system NCDEX trading system Monday to Friday Normal market hours - 10:00 am to 4:00 pm Closing session - 4:15 pm to 4:30 pm Unit of trading 5Kgs Delivery unit 30Kgs Quotation/ base value Rs.per kg of Silver with 999 fineness Tick size 5 paisa Trading hours

per kg and the April silver futures price is Rs.1730. Table 7.2 gives the contract specification for silver. A unit of trading is 5 Kgs. The fabricator can hedge his position by taking a long position in sixty units of futures on the NCDEX. If the fabricator closes his position on April 15, the effect of the strategy would be to lock in a price close to Rs.1730 per kg. Figure 7.2 gives the payoff for the buyer of a long hedge. Let us look at how this works. On April 15, the spot price can either be above Rs.1730 or below Rs.1730. 1. Case 1: The spot price is Rs.1780 per kg. The fabricator pays Rs.5,34,000 to buy the silver from the
spot market. Because April is the delivery month for the futures contract, the futures price on April 15 should be very close to the spot price of Rs.1780 on that date. The company closes its long

7.1 Hedging

91

futures position at Rs.1780, making a gain of Rs.1780 - Rs.1730 = Rs.50 per kg, or Rs.15,000 on its long futures position. The effective cost of silver purchased works out to be about Rs.1730 per MT, orRs.5,19,000intotal. 2. Case 2: The spot price is Rs.1690 per MT. The fabricator pays Rs.5,07,000 to buy the silver from the spot market. Because April is the delivery month for the futures contract, the futures price on April 15 should be very close to the spot price of Rs.1690 on that date. The company closes its long futures position at Rs.1690, making a loss of Rs.1730 - Rs.1690 = Rs.40 per kg, or Rs.12,000 on its long futures position. The effective cost of silver purchased works out to be about Rs.1730 per MT, orRs.5,19,000intotal.

Note that the purpose of hedging is not to make profits, but to lock on to a price to be paid in the future upfront. In the industrial fabricator example, since prices of silver rose in three months, on hind sight it would seem that the company would have been better off buying the silver in January and holding it. But this would involve incurring interest cost and warehousing costs. Besides, if the prices of silver fell in April, the company would have not only incurred interest and storage costs, but would also have ended up buying silver at a much higher price. In the examples above we assume that the futures position is closed out in the delivery month. The hedge has the same basic effect if delivery is allowed to happen. However, making or taking delivery can be a costly process. In most cases, delivery is not made even when the hedger keeps the futures contract until the delivery month. Hedgers with long positions usually avoid any possibility of having to take delivery by closing out their positions before the delivery period.

7.1.4 Hedge ratio
Hedge ratio is the ratio of the size of position taken in the futures contracts to the size of the exposure in the underlying asset. So far in the examples we used, we assumed that the hedger would take exactly the same amount of exposure in the futures contract as in the underlying asset. For example, if the hedgers exposure in the underlying was to the extent of 11 bales of cotton, the futures contracts entered into were exactly for this amount of cotton. We were assuming here that the optimal hedge ratio is one. In situations where the underlying asset in which the hedger has an exposure is exactly the same as the asset underlying the futures contract he uses, and the spot and futures market are perfectly correlated, a hedge ratio of one could be assumed. In all other cases, a hedge ratio of one may not be optimal. Equation 7.1 gives the optimal hedge ratio, one that minimizes the variance of the hedger's position.

h=ρ
where:

σS σF

(7.1)

• ∆ S: Change in spot price, S, during a period of time equal to the life of the hedge • ∆ F: Change in futures price, F, during a period of time equal to the life of the hedge • σ S : Standard deviation of ∆ S

92 • σ R : Standard deviation of ∆ F • ρ : Coefficient of correlation between ∆ S and ∆ F • h : Hedge ratio

Using commodity futures

Let us consider an example. A company knows that it will require 11,000 bales of cotton in three months. Suppose the standard deviation of the change in the price per Quintal of cotton over a three-month period is calculated as 0.032. The company chooses to hedge by buying futures contracts on cotton. The standard deviation of the change in the cotton futures price over a threemonth period is 0.040 and the coefficient of correlation between the change in price of cotton and the change in the cotton futures price is 0.8. The unit of trading is 11 bales and the delivery unit for cotton on the NCDEX is 55 bales. What is the optimal hedge ratio? How many cotton futures contracts should it buy? If the hedge ratio were one, that is if the cotton spot and futures were perfectly correlated, as shown in Equation 7.3, the hedger would have to buy 1000 units (one unit of trading =11 bales of cotton) to obtain a hedge for the 11,000 bales of cotton it requires in three months.

Number of contracts

N p =1

11,000 11 = 1000

=

(7.2) (7.3)

However, in this case as shown in Equation 7.5, the hedge ratio works out to be 0.64. The company will hence require to take a long position in 140 units of cotton futures to get an effective hedge (Equation 7.7). Optimal hedge ratio = 0.8 × h = 640 Number of contracts

0.032 0.040 11,000 11

(7.4) (7.5) (7.6) (7.7)

= 0.64 ×

N p = 0.64 = 640

7.1.5 Advantages of hedging
Besides the basic advantage of risk management, hedging also has other advantages: 1. Hedging stretches the marketing period. For example, a livestock feeder does not have to wait until his
cattle are ready to market before he can sell them. The futures market permits him to sell futures contracts to establish the approximate sale price at any time between the time he buys his calves for feeding and the time the fed cattle are ready to market, some four to six months later. He can take advantage of good prices even though the cattle are not ready for market.

the manufacturer can use his capital to acquire only as much gold. Hedging can only minimise the risk but cannot fully eliminate it. This is called the basis risk. Hedging permits forward pricing of products. hedging is not quite this simple and straightforward. For example. a merchandiser with a large. this may not always be possible for a various reasons. translate that to a price for the finished products. If a hedger has an underlying asset that is exactly the same as the one that underlies the futures contract. Having made the forward sales.1 Hedging 93 2. It is impractical for an exchange to have futures contracts with all these varieties of cotton as an underlying.1. the hedger would be required to close out the futures contracts entered into and take the same position in futures contracts with a later delivery date. However. or platinum as may be needed to make the products that will fill its orders. 7. • The hedger may be uncertain as to the exact date when the asset will be bought or sold. • The expiration date of the hedge may be later than the delivery date of the futures contract. This is because the value of the asset sold in die spot market and the value of the asset underlying the future contract may not be the same. Hedges can be rolled forward many times. In our examples. For example. The hedger was then able to use the perfect futures contract to remove almost all the risk arising out of price of the asset on that date. . • The asset whose price is to be hedged may not be exactly the same as the asset underlying the futures contract. This is called a rollover. even if the price of the commodity drops. silver.7. While this would still provide the farmer with a hedge. The hedger was able to identify the precise date in the future when an asset would be bought or sold. In reality. 3. and make forward sales to stores at firm prices. silver or platinum by buying a futures contract. multiple rollovers could lead to short-term cash flow problems. The NCDEX has futures contracts on two varieties of cotton. the hedge would not be perfect. long staple cotton and medium staple cotton. Often the hedge may require the futures contract to be closed out well before its expiration date. When this happens. since the price of the farmers cotton and the price of the cotton underlying the futures contract do match perfectly. The loss made during selling of an asset may not always be equal to the profits made by taking a short futures position. In reality. he would get a better hedge. a jewelry manufacturer can determine the cost for gold. This could result in an imperfect hedge. The hedger was then able to use the futures contract to remove almost all the risk arising out of price of the asset on that date. For example. unsold inventory can sell futures contracts that will protect the value of the inventory.6 Limitation of hedging: basis Risk In the examples we used above. But in many cases. the hedges considered were perfect. in India we have a large number of varieties of cotton being cultivated. farmers producing small staple cotton could use the futures contract on medium staple cotton for hedging. Hedging protects inventory values. the hedger was able to identify the precise date in the future when an asset would be bought or sold.

3 gives the contract specifications for gold futures. He would like to trade based on this view.000 on an investment of Rs. This works out to an annual return of about 26 percent. Suppose he buys a 1 kg of gold which costs him Rs. Table 7. Gold trades for Rs. We look here at how the commodity futures markets can be used for speculation. it is easy to buy the shares and hold them for whatever duration he wants to.2.6000 per 10 gms and three-month gold futures trades at Rs.000 for a period of three months. 7.3 Gold futures contract specification Trading system Trading hours Using commodity futures Unit of trading Delivery unit Quotation/ base value Tick size NCDEX trading system Monday to Friday Normal market hours . This enables futures traders to take a position in the underlying commodity without having to to actually hold that commodity.6.4:15 pm to 4:30 pm 100 gm 1kg Rs. the prices of gold are likely to rise. With the purchase of futures contract on a commodity. However. Gold trades at Rs. How can he trade based on this belief? In the absence of a deferral product.6150. The commodities futures markets provide speculators with an easy mechanism to speculate on the price of underlying commodities. The unit of trading .00. buy futures Take the case of a speculator who has a view on the direction of the price movements of gold. To trade commodity futures on the NCDEX.40. speculating in commodities is not as simple as speculating on stocks in the financial market. For a speculator who thinks the shares of a given company will rise. Perhaps he knows that towards the end of the year due to festivals and the upcoming wedding season. While the basics of speculation apply to any market. he would have to buy gold and hold on to it.per 10 gms of gold with 999 fineness 5paisa 7.00. Let us see how this works.10:00 am to 4:00 pm Closing session .6400 per 10 grms.6000 per 10 gms in the spot market and he expects its price to go up in the next two-three months.1 Speculation: Bullish commodity.6. Buying futures simply involves putting in the margin money. commodities are bulky products and come with all the costs and procedures of handling these products. Today a speculator can take exactly the same position on gold by using gold futures contracts. the holder essentially makes a legally binding promise or obligation to buy the underlying security at some point in the future (the expiration date of the contract). He makes a profit of Rs. a customer must open a futures trading account with a commodity derivatives broker. Suppose further that his hunch proves correct and three months later gold trades at Rs.2 Speculation An entity having an opinion on the price movements of a given commodity can speculate using the commodity market.94 Table 7.000.

000.8) . Today all he needs to do is sell commodity futures.000.50. If the commodity price falls. Three months later gold trades at Rs. if his hunch were correct the price of cotton falls. sell futures Commodity futures can also be used by a speculator who believes that there is likely to be excess supply of a particular commodity in the near future and hence the prices are likely to see a fall. The buying cheap and selling expensive continues till prices in the two markets reach an equilibrium.6400 in the process making a profit of Rs. on the day of expiration. This activity termed as arbitrage. so will the futures price.4.000 on an initial margin investment of Rs. 7. He pays a small margin on the same. there wasn't much he could do to profit from his opinion. so will the futures price. commodity futures form an attractive tool for speculators. This states that in a competitive market.6400 per 10 gms. Simple arbitrage ensures that the price of a futures contract on a commodity moves correspondingly with the price of the underlying commodity.000. involves the simultaneous purchase and sale of the same or essentially similar security in two different markets for advantageously different prices. Three months later. To take this position. Let us understand how this works.000. F = where: r Cost of financing (annualised) T Time till expiration (S+U)erT (7.1. He sells ten two-month cotton futures contract which is for delivery of 550 bales of cotton. making a profit of Rs. If the price of the same asset is different in two markets.50.000. arbitrage helps to equalise prices and restore market efficiency.15. Because of the leverage they provide. If the commodity price rises.2 Speculation: Bearish commodity.3 Arbitrage 95 is 100 gms and the delivery unit for the gold futures contract on the NCDEX is 1 kg. As we know.6.000. if two assets are equivalent from the point of view of risk and return.20. the futures price converges to the spot price (else there would be a risk-free arbitrage opportunity). there will be operators who will buy in the market where the asset sells cheap and sell in the market where it is costly. He buys one kg of gold futures which have a value of Rs. So does the price of cotton futures. Buying an asset in the futures market only require making margin payments. he pays a margin of Rs. He closes his long futures position at Rs. The value of the contract is Rs. This works out to an annual return of 83 percent. How can he trade based on this opinion? In the absence of a deferral product. Hence.20.7.25.3. 7.00.3 Arbitrage A central idea in modern economics is the law of one price.2.1. He close out his short futures position at Rs. they should sell at the same price. Now take the case of the trader who expects to see a fall in the price of cotton.

Now unwind the position. Futures position expires with profit of Rs.51.310 per deposit upto 500 kgs. return the borrowed amount plus interest of Rs. the spot and the futures price converge. 7. He could make riskless profit by entering into the following set of transactions. From the Rs. The result is a riskless profit of Rs.749.00.00.625 and seem overpriced. Say gold closes at Rs. 3. (We assume that fixed charge is Rs. 2. mispricing would result in both.50.61. In the real world.615 in the spot market.000.07.000. Remember however.50. In the case of investment commodities. in the case of consumption assets which are held primarily for reasons of usage. Three month gold futures on the NCDEX trade at Rs.60. sell futures An arbitrager notices that gold futures seem overpriced. 7. a person who holds the underlying may not want to sell it to profit from the arbitrage.000 held in hand. Whenever the futures price deviates substantially from its fair value. On the futures expiration date. sell 10 gold futures contract at Rs.62. that exploiting an arbitrage opportunity involves trading on the spot and futures market.60.96 U Present value of all storage costs Using commodity futures In the chapter on pricing. How can he cash in on this opportunity to earn riskless profits? Say for instance.8 gives the fair value of a futures contract on an investment commodity.600 per gram in the spot market.98.50. the arbitrager must sell futures and buy spot. On day one. 8. . and the variable storage costs are Rs. Buy 10 kgs of gold on the cash/ spot market at Rs. When does it make sense to enter into this arbitrage? If the cost of borrowing funds to buy the commodity is less than the arbitrage profit possible.460 at 6% per annum to cover the cost of buying and holding gold. 6.000. we discussed that the cost-of-carry ensures that futures prices stay in tune with the spot prices of the underlying assets. arbitrage opportunities arise. whereas to capture mispricings that result in underpriced futures. Pay (310 + 7150) as warehouse costs. However. it makes sense to arbitrage. one has to build in the transactions costs into the arbitrage strategy. the arbitrager must sell spot and buy futures.60. 5. buying the spot and holding it or selling the spot and investing the proceeds. To capture mispricings that result in overpriced futures.3.000.251. gold trades for Rs.55 per kg per week for 13 weeks). Sell the gold for Rs. Simultaneously. Equation 7. This is termed as cash-and-carry arbitrage. 4.1. Take delivery of the gold purchased and hold it for three months.1 Overpriced commodity futures: buy spot. 1. borrow Rs. 1.62. even if there exists a mispricing.

5. sell 10 kgs of gold in the spot market at Rs. sell mustard seed A: The correct answer is number 1. 1.60. 6. Now unwind the position. He should _ 1. 8. 3.3. buy silver A: The correct answer is number 3.00.000 plus the Rs. sell mustard seed futures 4. 1.00. buy mustard seed futures 2. we will see increased volumes and lower spreads in both the cash as well as the derivatives market. exploiting arbitrage involves trading on the spot market. If the returns you get by investing in riskless instruments is more than the return from the arbitrage trades.000.600 per gram in the spot market. the spot and the futures price of gold converge. On day one.97. This is termed as reverse-cash-and-carry arbitrage.3 Arbitrage 97 7.936. sell spot An arbitrager notices that gold futures seem underpriced.50. He should _ 1.000. As we can see. it makes sense for you to arbitrage.000 on the spot market. The gold sales proceeds grow to Rs. buy silver futures 2. sell index futures •• 3. The futures position expires with a profit of Rs. sell silver futures 4. sell index futures •• .60. 2.60. Solved problems Q: A speculator thinks that the price of mustard seed will rise.50. 7.2 Underpriced commodity futures: buy futures. Suppose the price of gold is Rs. It is this arbitrage activity that ensures that the spot and futures prices stay in line with the cost-of-carry. Invest the Rs.60. The result is a riskless profit of Rs. buy three-month gold futures on NCDEX at Rs.47. gold trades for Rs. Buy back gold at Rs. If he happens to hold gold.7.00. As more and more players in the market develop the knowledge and skills to do cash-and-carry and reverse cash-and-carry. 3. Three month gold futures on the NCDEX trade at Rs. Q: A speculator thinks that the price of silver will fall. Simultaneously. 4. How can he cash in on this opportunity to earn riskless profits? Say for instance. On the futures expiration date.605 and seem underpriced.7150 saved by way of warehouse costs for three months 6%.936.615 per gram.000.61. he could make riskless profit by entering into the following set of transactions.

A: The producer needs to take a short hedge to the extent of 10. Wants to buy the underlying asset in the fufuture. Selling 10 units of April futures. Buying 100 units of April futures. None of the above A: The correct answer is number 2. 2.98 Q: A long hedge should be taken by a person who 1. Expects to own the underlying asset in the ture 4. One trading unit is for 1000 Kgs of soy oil. •• Q: A farmer who has just sown wheat can hedge his position by _ 1. Selling 100 units of April futures. The spot price for soy oil on January 15 is Rs. . 4. Sell the underlying asset in the future A: The correct answer is number 1. 3.000 Kgs of soy oil. Wants to buy the underlying asset in the futoday.450 per 10 Kgs and the April soy oil futures price on the NCDEX is Rs. The correct answer is number 1.000 Kgs of soy oil. selling the wheat •• Q: On the 15th of January a refined soy oil producer has negotiated a contract to sell 10. He gets the hedge by selling 10 units of April futures. 2. Wants to sell the underlying asset 2. 3. Buying 10 units of April futures. buying wheat futures 2. 3. selling wheat futures A: The correct answer is number 2. None of the above •• Q: A short hedge should be taken by a person who 1. The producer can hedge his exposure by 1. 4. Using commodity futures 3. buying index futures 4.465 per 10 Kgs. ture. It has been agreed that the price that will apply in the contract is the market price on the 15th April. Unit of trading in soy oil futures is 1000 Kgs (=1 MT) and the delivery unit is 10000 Kgs (=10 MT). Wants to sell the underlying asset in the future.

6000 per 10 gms in the spot market. 3. He makes 250 a profit of Rs. One trading unit is for 5 Kgs of silver.500 3. The correct answer is number 2. Selling 2550 units of three-month cotton fufutures. (+)25. A: The fabricator needs to take a long hedge to the extent of 300 kgs of silver. 3. The hedge ratio is 0. Buying 2550 units of three-month cotton fufutures. Buying 2550 units of three-month cotton tures. 11 •• Q: Gold trades at Rs. (-)25.6150. Selling 60 units of April silver futures. He gets the hedge by selling 60 units of April silver futures.000 bales of cotton in three months. A: One trading unit is for 11 bales of cotton.500 2. Two months later gold futures trade at Rs.85. (-)2. The hedge ratio works out to be 0. The spot price of silver is Rs.1680 per kg and the April silver futures price is Rs. The company can obtain a hedge by 1. Q: A company knows that it will require 33.000 A: One unit of trading is 100 gms. (+)2. He is long 10 units of futures.85 units of futures. 2. The unit of trading is 11 bales and the delivery unit for cotton on the NCDEX is 55 bales.250 per 10 gms. • • .000 × 0. He makes a profit/loss of 1.7. Buying 60 units of April silver futures.3 Arbitrage 99 Q: On the 15th of January a firm involved in industrial fabrication knows that it will require 300 kgs of silver on April 15 to meet a certain contract. The fabricator can hedge his position by 1. The correct answer is number 3. The company obtains a hedge by Buying 33. The correct answer is 10 number 3. 2. His total profit from the position 1000. A speculator who expects gold prices to rise in the near future buys 10 units of gold futures. or 1000 grms of gold.85.000 4. Selling 600 units of three-month cotton tures. 4. Three-month gold futures trade at Rs. One unit of trading is 100 gms and the delivery unit for the gold futures contract on the NCDEX is 1 kg.6400 per 10 gms. Selling 30 units of April silver futures. Buying 30 units of April silver futures. A unit of trading is 5 Kgs and the delivery unit is 30 Kgs. 4. 1730.

He makes a profit/loss of 1. One unit of trading is 100 gms and the delivery unit for the gold futures contract on the NCDEX is 1 kg. 150 × 1000. He is short 10 units of futures. (-)15. (-)1. (+)15. His total profit from the position is number 4.150 per 10 gms.6000 per 10 gms.100 Using commodity futures Q: Gold trades at Rs.500 3. (+)1. Three-month gold futures trade at Rs.000 4. He makes a profit of Rs. Two months later gold futures trade at Rs.6150.000 A: One unit of trading is 100 gms.500 2. or 1000 grms of gold. A speculator who expects gold prices to fall in the near future sells 10 units of gold futures. The correct answer is 10 .6000 per 10 gms in the spot market.

It tries to find a match on the other side of the book. 8.00 a. The NCDEX system supports an order driven market. After hours trading has also been proposed for implementation at a later stage. 8. They can trade and clear either on their own account or on behalf of their clients including participants. provides a fully automated screen-based trading for futures on commodities on a nationwide basis as well as an online monitoring and surveillance mechanism. Order matching is essentially on the basis of commodity. it is an active order. a trade is generated. When any order enters the trading system.m. 1.1 Futures trading system The trading system on the NCDEX. to 4. time and quantity. Each TCM can have more than one user. The exchange specifies the unit of trading and the delivery unit for futures contracts on various commodities .trading cum clearing members and professional clearing members. the best way to get a feel of the trading system is to actually watch the screen and observe how it operates. It supports an order driven market and provides complete transparency of trading operations. If it finds a match. The exchange assigns an ID to each TCM. However.00 p. The exchange notifies the regular lot size and tick size for each of the contracts traded from time to time.m. the order becomes passive and gets queued in the respective outstanding order book in the system.2 Entities in the trading system There are two entities in the trading system of NCDEX . The number of users allowed for each trading member is notified by the exchange from time to time. its price. Time stamping is done for each trade and provides the possibility for a complete audit trail if required. where orders match automatically. If it does not find a match. . Trading cum clearing members (TCMs): Trading cum clearing members are members of NCDEX. All quantity fields are in units and price in rupees. The trade timings on the NCDEX are 10.Chapter 8 Trading In this chapter we shall take a brief look at the trading system for futures on NCDEX.

10: The open outcry system of trading Each user of a TCM must be registered with the exchange and is assigned an unique user ID. In some cases. . The same client should not be allotted multiple codes. both for themselves and/ or on behalf of their clients. standing in a central location i. trading pit. All clients trading through a member are to be registered clients at the member's back office. Normally only one type of contract is traded in each pit like a Eurodollar pit. Professional clearing members: Professional clearing members are members of NSCCL. who time-stamps the order and prepares an office order ticket. A unique client code is to be allotted for each client. the order is recorded manually by both parties in the trade. and a clerk hand delivers the order to the floor trader for execution. 2. 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 market's best price. Live Cattle pit etc.2. who bid on the order using hand signals. Box 8. some still follow the open outcry method. 2.1 Guidelines for allotment of client code The trading members are recommended to follow guidelines outlined by the exchange for allotment and use of client codes at the time of order entry on the futures trading system: 1. The unique TCM ID functions as a reference for all orders/ trades of different users.e. The PCM membership entitles the members to clear trades executed through Trading cum Clearing Members (TCMs). the customer calls a broker. In open outcry system the futures contracts are traded in pits. The broker then sends the order to a booth on the exchange floor called broker's floor booth. 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. At the end of each day. The brokers. They carry out risk management activities and confirmation/ inquiry of trades through the trading system. All the traders dealing with a certain delivery month trade in the same slice. The floor trader. The client code should be alphanumeric and no special characters can be used. There. This ID is common for all users of a particular TCM. Open outcry trading is a face—to-face and highly activate form of trading used on the floors of the exchanges. 3. the clearing house settles trades by ensuring that no discrepancy exists in the matched-trade information. 8. Once filled. negotiates a price by shouting out the order to other floor traders. Each side of the octagon forms a pie slice in the pit. A pit is a raised platform in octagonal shape with descending steps on the inside that permit buyers and sellers to see each other. the floor clerk may use hand signals to convey the order to floor traders. a floor order ticket is prepared. To place an order under this method.102 Trading While most exchanges the world over are moving towards the electronic form of trading. Large orders typically go directly from the customer to the broker's floor booth. It is the responsibility of the TCM to maintain adequate control over persons having access to the firm's User IDs.

Table 8. the contracts shall expire on the previous trading day.8.3 Contract specifications for commodity futures Table 8. edible oil products like groundnut. Crude Palm Oil Kandla 9. soybean. two-month and three-month expiry cycles. castor (seed. base metals (aluminium. oil and cake). Refined Soya Oil Indore 5. wheat. it has already started trading in gold and silver.2 and Table 8. Pure Silver New Delhi 3.1 Commodity futures contract and their symbols 1. J34 Medium Staple Cotton Bhatinda 10. rape/ mustardseed. In the second phase NCDEX plans to offer the following commodities for trading .3 give the futures contract specifications for gold and long staple cotton.rice.3 Contract specifications for commodity futures NCDEX plans to trade in all the major commodities approved by FMC (Forwards Market Commission) but in a phased manner. . New contracts will be introduced on the trading day following the expiry of the near month contract. under the category of bullion. 8.1 shows the contract cycle for futures contracts on NCDEX. Soybean Indore 4. S06 L S Cotton Ahmedabad 103 GLDPURMUM SLVPURDEL SYBEANIDR SYOREFTDR RMSEEDJPR RMOEXPJPR RBDPLNKAK CRDPOLKDL COTJ34BTD COTS06ABD 8. tea. Figure 8. Rapeseed Mustard Seed Jaipur 6. and in agri commodities. trading has commenced in cotton (long and medium staple). zinc and nickel) and commodity indices like agri commodity index and metal commodity index. RBD Palm Olein Kakinada 8. Pure Gold Mumbai 2.4 Commodity futures trading cycle NCDEX trades commodity futures contracts having one-month. In the first phase. copper. crude palm oil and RBD palmolein. Table 8. Thus a January expiration contract would expire on the 20th of January and a February expiry contract would cease trading on the 20th of February.1 gives the list and symbols of underlying commodities on which futures contracts are available. If the 20th of the expiry month is a trading holiday. rape/ mustard oil. coffee. Expeller Rapeseed Mustard Oil Jaipur 7. soya oil. All contracts expire on the 20th of the expiry month. sunflower.

200 crore. Member-wise: Max (Rs. Not less than 995 fineness bearing a serial number and identifying stamp of a refiner approved by NCDEX.9. Mumbai Trading in any contract month will open on the 21st day of the month. per 10 gms of Gold with 999.5 Order types and trading parameters An electronic trading system allows the trading members to enter orders with various conditions attached to them as per their requirements.ncdex.9 fineness will be calculated as: (Actual fineness/ 999.e. 10% of Open interest) The discount will be given for the fineness below 999. if 20th happens to be a holiday then previous working day. Limits will not apply if the limit is reached during final 30 minutes of trading. 3 months prior to the contract month i.9 fineness (called "Pure Gold" in trade circles) 5 paisa Limit 10%.4:15 pm to 4:30 pm 100 gms lKg Rs.9) * Settlement price Trading Unit of trading Delivery unit Quotation/ base value Tick size Price band Quality specification Quantity variation No. 15% of open interest) Client-wise: Max (Rs.10:00 am to 4:00 pm Closing session . There will be a total of twelve month contracts in a year. 3 concurrent month contracts will be active.100 crore. These conditions are broadly divided into the .104 Table 8. The settlement price for less than 999. January 2004 contract opens on 21st October 2003.2 Gold futures contract specification Trading system Trading hours NCDEX trading system Monday to Friday Normal market hours . List of approved refiners will be available with the exchange and also on its web site: www. 20th day of the delivery month. of active contracts Delivery center Opening date Due date Position limits Premium/ Discount 8.com None At any date.

4:15 pm to 4:30 pm 18.5 Quintals (=55 bales) Rs. The exchange will communicate the premium/ discounts applicable before the settlement date.20 crore.5 mm intervals) & grade combinations.5 At any date.3 Long staple cotton futures contract specification Trading system Trading hours NCDEX trading system Monday to Friday Normal market hours .5 Order types and trading parameters Table 8. if 20th happens to be a holiday then previous working day.7-4. 20th day of the delivery month. 10% of Open interest) Will be given on the basis of Staple Length (at 0.7 Quintal (=11 bales) 93. There will be a total of twelve month contracts in a year. (Basis: 'Fine') Crop: Current Year Crop in which the delivery date falls (current year for Shankar-6 is defined as from 1st Nov of one year to 31st Oct of the subsequent year).e. Moisture. 105 Unit of trading Delivery unit Quotation/ base value Tick size Price band Quality specification No. Min: 21 G/ Tex Grade: 'Good to Fully Good'. Limits will not apply if the limit is reached during final 30 minutes of trading.8. January 2004 contract opens on 21st October 2003. 15% of open interest) Client-wise: Max (Rs. Member-wise: Max (Rs. 3 concurrent month contracts will be active. % Max: 8.10:00 am to 4:00 pm Closing session .2) Strength. Ahmedabad Trading in any contract month will open on the 21st day of the month. Main/ Base Variety: Shankar-6 Staple Length: 27-30 mm (Basis: 29 mm) Micronaire: 3.40 crore. 'Extra Superfine'.5 (Basis: 3. 'Superfine'. of active contracts Delivery center Opening date Due date Position limits Premium/ Discount . per Quintal 5paisa Limit 10%. 'Fully Good'.4-4. 'Fine'. 3 months prior to the contract month i.

If the market does not reach this price the order does not get filled even if the market touches Rs. three contracts are available for trading . following categories: • Time conditions • Price conditions • Other conditions Several combinations of the above are possible thereby providing enormous flexibility to users. 2004 in refined palm oil on the commodity exchange.Good till cancelled (GTC): A GTC order remains in the system until the user cancels it.341 and closes. good till day order.106 Figure 8. good till cancelled order. As the January contract expires on the 20th of the month. at any given point of time. it spans trading days. Example: A trader wants to go long on March 1. In other words day order is for a specific price and if the order does not get filled that day. if not traded on the day the order is entered. • Time conditions . A day order is placed at Rs. as the name suggests is an order which is valid for the day on which it is entered. good till date order and spread order. stop loss order. The days counted are inclusive of the day on which the order is . a middle-month and a farmonth. . If the order is not executed during the day. The order types and conditions are summarised below. Each day counted is a calendar day inclusive of holidays. As can be seen. immediate or cancel order.1 Contract cycle Trading The figure shows the contract cycle for futures contracts on NCDEX. Consequently.a near-month. the system cancels the order automatically at the end of the day. Of these.Good till day order: A day order. once more making available three index futures contracts for trading. one has to place the order again the next day. a new three-month contract starts trading from the following day. the order types available on the NCDEX system are regular lot order. The maximum number of days an order can remain in the system is notified by the exchange from time to time after which the order is automatically cancelled by the system.340/ 10 kg.

• Other conditions . which is to be executed in its entirety. the trigger price has to be greater than the limit price. A stop order would then be placed to sell an offsetting contract if the price falls to Rs 700 per barrel.50 a barrel. Theoritically. But. . Only the position to be taken long/ short is stated. Each day/ date counted are inclusive of the day/ date on which the order is placed and the order is cancelled from the system at the end of the day/ date of the expiry period. Futures traders often use stop orders in an effort to limit the amount they might lose if the futures price moves against their position.8. • Price condition . . . stop orders can be executed for buying/ selling positions too. placed with the broker. He wishes to limit his loss to Rs.e. stop orders are used to exit a trade. it gets executed irrespective of the current market price of that particular asset. Most of the time. The GTC order on the NCDEX is cancelled at the end of a period of seven calendar days from the date of entering an order or when the contract expires.400/ 10kg. whichever is earlier.Fill or kill order: This order is a limit order that is placed to be executed immediately and if the order is unable to be filled immediately.750 per barrel. or not at all. if obtainable at the time of execution. Stop orders are not executed until the price reaches the specified point. to buy or sell a particular futures contract at the market price if and when the price reaches a specified level.5 Order types and trading parameters 107 placed and the order is cancelled from the system at the end of the day of the expiry period. stop order gets executed and the trader would exit the market. Example: A trader has purchased crude oil futures at Rs. The order gets filled at the suggested stop order price or at a better price. . even if it takes months for it to happen.Market price: Market orders are orders for which no price is specified at the time the order is entered (i. For the stop-loss sell order. When the price reaches that point the stop order becomes a market order. When this kind of order is placed. it gets cancelled. failing which the order is cancelled from the system. . Partial match is possible for the order.All or none order: All or none order (AON) is a limit order.Immediate or Cancel (IOC): An IOC order allows the user to buy or sell a contract as soon as the order is released into the system. For such orders. An all-or-none order position can be closed out with another AON order.Stop-loss: A stop-loss order is an order. When the market touches this price. 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 system determines the price. the order is cancelled from the system.Limit order: An order to buy or sell a stated amount of a commodity at a specified price. an all-or-none order is not cancelled if it is not executed as soon as it is represented in the exchange. and the unmatched portion of the order is cancelled immediately. . price is market price). or at a better price. Unlike a fill-or-kill order. At the end of this day/ date. The maximum days allowed by the system are the same as in GTC order. The disadvantage is that the order may not get filled at all if the price for that day does not reach the specified price.Good till date (GTD): A GTD order allows the user to specify the date till which the order should remain in the system if not executed. the order exists until it is filled up. Example: A trader wants to go long on refined palm oil when the market touches Rs.

This type of order would close the position if the market moved to either the stop rate or the limit rate. 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. If the market trades at Rs.108 Trading After-hours electronic trading first began in 1992 at CME (Chicago Mercantile Exchange).13.Market on open: The order will be executed on the market open within the opening range. Prices of the two futures contract therefore tend to go up and down together. The fill price will be within the closing range. A stop order is placed at Rs. This trade is also used to enter a new trade. The lot size currently applicable on individual commodity contracts is given in Table 8. He wishes to have both stop and limit orders in order to fill the order in a particular price range.Limit price: Price of the orders after triggering from stop-loss book.900/ tonne.900/ tonne. They are taken in the same commodity with different months (calendar spread) or in closely related commodities.2 Tick size for contracts The tick size is the smallest price change that can occur for the trades on the exchange. one long and one short. . The trader is virtually unconcerned whether the entire price structure moves up or down. 14.5 8.000/ tonne on Soybean. or exit an open trade. one half of the order will be executed (either stop or limit) and the remaining order cancelled (either limit or stop). or exit an open trade. just so long as the futures contract he bought goes up more (or down less) than the futures contract he sold. . . Called Globex. The tick size in respect of all futures contracts admitted to dealings on the NCDEX is 5 paise. The trader exits the market at Rs. cancelling the other entry order.5. . Example: A trader has a buy position at Rs.5. This trade is used to enter a new trade.13. thereby closing the trade and at the same time. An order placed so as to take advantage of price movement.11: After hours electronic trading system . in some markets.Spread order: A simple spread order involves two positions.900/ tonne. which may. which consists of both a stop and a limit price. Box 8.Trigger price: Price at which an order gets triggered from the stop-loss book. 8.100/ tonne and a limit order at Rs. . Once one level is reached. and gains on one side of the spread are offset by losses on the other.Market on close: The order will be executed on the market close. the limit order gets filled and the stop order is immediately gets cancelled. be substantially different from the setdement price. .1 Permitted lot size The permitted trading lot size for the futures contracts on individual commodities is stipulated by the exchange from time to time. The spreaders goal is to profit from a change in the difference between the two futures prices.13. 14.One cancels the other order : It is called one cancels the other order (OCO). Typically electronic trading systems are used in the open outcry exchanges after the day trading is over.

These spot prices are polled across multiple centers and a single spot price is determined by the bootstrapping method.300 Bales 3.300 Bales 109 8.3 Quantity freeze All orders placed by members have to be witiiin the quantity specified by the exchange in this regard. 8. the exchange can approve such order. Any order exceeding tiiis specified quantity will not be executed but will he pending with the exchange as a quantity freeze.4 Base price On introduction of new contracts. at its discretion. operating price ranges on the NCDEX are kept at +/.4 gives the quantity freeze for each commodity contract.5. On such confirmation. In respect of orders which have come under quantity freeze.500 kilograms (Kgs) 300 Metric Tonnes (MT) 300 Metric Tonnes (MT) 300 Metric Tonnes (MT) 300 Metric Tonnes (MT) 300 Metric Tonnes (MT) 300 Metric Tonnes (MT) 3. the member is required to confirm to the exchange that there is no inadvertent error in the order entry and mat the order is genuine.5. the base price is the previous days' closing price of the underlying commodity in the prevailing spot markets. in exceptional cases. not allow the orders that have come under quantity freeze for execution for any reason whatsoever including non-availability of exposure limits.5 Order types and trading parameters Table 8. the exchange may.5. However. In respect of orders which have come under price freeze.4 Commodity futures: Quantity freeze unit Instrument Asset Quantity Type Asset Symbol Freeze Unit FUTCOM FUTCOM FUTCOM FUTCOM FUTCOM FUTCOM FUTCOM FUTCOM FUTCOM FUTCOM GLDPURMUM SLVPURDEL SYBEANTDR SYOREFIDR RMSEEDJPR RMOEXPJPR RBDPLNKAK CRDPOLKDL COTJ34BTD COTS06ABD 30. the members are required to confirm to the exchange that there is no inadvertent error in the order entry and mat the order is genuine. Orders exceeding me range specified are not executed and he pending with the exchange as a price freeze. Table 8. 8. The exchange can approve or .8.000 Grams (gm) 1.10% from the base price.5 Price ranges of contracts In order to prevent erroneous order entry by trading members. The base price of me contracts on all subsequent trading days is the daily settlement price of the futures contracts on the previous trading day.

there will be no price ranges applicable in the last half hour of normal market trading.5.6 Order entry on the trading system The NCDEX trading system has a set of function keys built into the trading front-end. The set of function keys enable the following: • Buy open • Sell open • Order cancellation • Order modification • Exercise/ Position liquidation • Outstanding orders • Quick order cancel • Spread order entry • Market watch setup • Trade modify • Trade cancel • Client master maintenance • Market by order • Market by price • Activity log • Security list/ portfolio setup • Portfolio offline order entry • Spread market by price • Previous trades • Contract description • Alphabetical sorting of contracts . The function keys can be operated from the keyboard of the user.110 ___________________________________________________________________ Trading disapprove such orders solely at its own discretion. Unless specifically notified by the exchange. These keys have been provided to facilitate faster operation of the system and enable quicker trading on the system. 8.

8./ 10 Kg Rs.5 Order types and trading parameters Table 8.5 Commodity futures: Lot size and other parameters Instrument Asset Market Quantity Price Type Asset Symbol Lot Unit Unit FUTCOM FUTCOM FUTCOM FUTCOM FUTCOM FUTCOM FUTCOM FUTCOM FUTCOM FUTCOM GLDPURMUM SLVPURDEL SYBEANIDR SYOREFIDR RMSEEDJPR RMOEXPJPR RBDPLNKAK CRDPOLKDL COTJ34BTD COTS06ABD 100 5 1 1 1 1 1 1 11 11 GM Kg MT MT MT MT MT MT Bales Bales Rs./ Quintal Rs./ Quintal 111 Delivery Delivery Lot Unit 1 30 10 10 10 10 10 10 55 55 KG KG MT MT MT MT MT MT Bales Bales • Spread order status • Spread activity log • Snap quote • Online offline order entry • Message log • Market movement • Full message display • Market inquiry • Spread outstanding orders • Net position upload • Order status • Liquidity schedule • Buy close • Sell close ./Kg Rs./ 10 Kg Rs./ 10 Kg Rs./ Quintal Rs./ 10 Kg Rs./20Kg Rs./ 10 GM Rs.

On the other hand. • Maintenance margin: A trader is entitled to withdraw any balance in the margin account in excess of the initial margin. a clearing house member is required to maintain a margin account with the clearing house. the value of all positions is marked-to-market each day after the official close. which is a preemptive move to prevent breakdown. In the futures market. etc. • Initial margin: The amount that must be deposited by a customer at the time of entering into a contract is called initial margin. there is only an original margin and no maintenance margin.112 Trading 8. If the account falls below the maintenance margin level the trader needs to replenish the account by giving additional funds. . the broker closes out the position by offsetting the contract. is set. If the trader does not provide the variation margin. This is known as clearing margin. the exchange calls for an additional margin. which is somewhat lower than the initial margin. The margin requirements for most futures contracts range from 2% to 15% of the value of the contract. if the position generates a gain. the margin account is adjusted to reflect the trader's gain or loss. there are different types of margins that a trader has to maintain. In the case of clearing house member. a maintenance margin. The margin required for a futures contract is better described as performance bond or good faith money. • Mark-to-Market margin (MTM): At the end of each trading day. i. To ensure that the balance in the margin account never becomes negative.e. At this stage we look at the types of margins as they apply on most futures exchanges. The margin is a mandatory requirement for parties who are entering into the contract. This margin is meant to cover the largest potential loss in one day. We will discuss them in more details when we talk about risk management in the next chapter. Clearing house and clearing house margins have been discussed further in detail under the chapter on clearing and settlement. This is known as marking to market the account of each trader. The margin levels are set by the exchanges based on volatility (market conditions) and can be changed at any time. If the balance in the margin account falls below the maintenance margin. the accounts are either debited or credited based on how well the positions fared in that day's trading session. All futures contracts are settled daily reducing the credit exposure to one day's movement. This is imposed when the exchange fears that the markets have become too volatile and may result in some payments crisis. 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. Based on the settlement price. • Additional margin: In case of sudden higher than expected volatility.6 Margins for trading in futures Margin is the deposit money that needs to be paid to buy or sell each contract. 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. The extra funds deposited are known as a variation margin.

2. This Open interest figure is a good indicator of the liquidity in every contract. Finally. Due date: The transaction charges are payable on the 7th day from the date of the bill every month in respect of the trade done in the previous month. does not provide 1. 1. 5. Based on studies carried out in international exchanges. the total number of long in any contract always equals the total number of short in any contract.50. The transaction charges due first will be adjusted against the advance transaction charges already paid as advance and members need to pay transaction charges only after exhausting the balance lying in advance transaction. it is found that open interest is maximum in near month expiry contracts. Penalty for delayed payments: If the transaction charges are not paid on or before the due date. NCDEX then forwards the mandate form to BJPL. The important provisions are listed below: The billing for the all trades done during the previous month will be raised in the succeeding month. This rate is subject to change from time to time. 3. 4. Rate of charges: The transaction charges are payable at the rate of Rs. Registration with BJPL and their services: Members have to fill up the mandate form and submit the same to NCDEX. The members can then log on through the website of BJPL and view the billing amount and the due date. The total number of outstanding contracts (long/ short) at any point in time is called the "Open interest". Solved Problems Q: The trading system on the NCDEX.7 Charges 113 8. mechanism. A fully automated screen-based trading.6 per Rs. Trading by open-outcry .one Lakh trade done.000 as advance transaction charges on registration.7 Charges Members are liable to pay transaction charges for the trade done through the exchange during the previous month. Trading on a nationwide basis. Besides. the billing details can be viewed on the website upto a maximum period of 12 months. A: The correct answer is number 4. 2. BJPL sends the log-in ID and password to the mailing address as mentioned in the registration form. Adjustment against advances transaction charges: In terms of the regulations. a penal interest is levied as specified by the exchange. the futures market is a zero sum game i. Advance email intimation is also sent to the members. 6.8. Online monitoring and surveillance 4.e. members are required to remit Rs. Collection process: NCDEX has engaged the services of Bill Junction Payments Limited (BJPL) to collect the transaction charges through Electronic Clearing System. » » 3.

Six-month •• Q: Billing to members for the all trades done on the NCDEX will be raised 1. In the succeeding month. None of the above •• Q: Initial margin is meant to cover the largest potential loss over a 1. Commodity 2. 3. 3. One month horizon •• Q: NCDEX does not trade commodity futures contracts having __ expiry cycles 1. At the end of each day. Once every two weeks. 4. 3. Small staple cotton Aurangabad 4. 3. At the end of each week. Medium staple cotton Bhatinda 2. One hour horizon 4. •• . 3. Quantity 4. All of the above •• Q: COTS06ABD is the symbol for 1. Two-month A: The correct answer is number 4. 2. One day horizon 2. Three-month 4. A: The correct answer is number 2. One week horizon A: The correct answer is number 1. Long staple cotton Ahmedabad A: The correct answer is number 2.114 ____________________________________________________________________ Trading Q: Order matching on the NCDEX happens on the basis of 1. One-month 2. Price and time A: Correct answer is number 4.

Unit of trading is 100 gms and delivery unit is one Kg.8. •• .6.20. Rs. 20 units 3. in 1428.7.1. How many units must he purchase to give him the hedge? 1.57 gms of gold gms.7.000 3.50. The correct answer is number 1. 100 units 3.7. Rs.000 2. He has bought 10 units.100 per 10 gms.00. Unit of trading is 100 gms and delivery unit is one Kg. Rs.200 3. The correct aanswer is number 1. The correct answer is number 4.  10  Q: A trader sells 20 units of gold futures at Rs.7.500 4. Rs.700 per gram.000. 28 units A: Futures price of 10 gms of gold is Rs. Rs. He has to buy 14 units of gold futures 700 •• contracts.6.000 as part of his hedging strategy. Q: A trader requires to take a long gold futures position worth Rs.000.6.000 as part of his hedging strategy. 10 units 2. Roughly how many units must he purchase to give him the hedge? 1.e. Rs.00.000 2.7.7. The correct answer is number 3. Rs. This means gold futures cost Rs.000 per 10 gms.   10  Q: A trader requires to take a long gold futures position worth Rs.000 per 10 gms. To take a position in 1000 gms of gold he has to buy 10 units of gold futures contracts.65.420 4.00.42. Two month futures trade at Rs. 14. 1. What is the value of his open long position? Unit of trading is 100 gms and delivery unit is one Kg 1. 14. 10. What is the value of his open long position? Unit of trading is 100 gms and delivery unit is one Kg 1.00.000 .1.000 A: One trading unit is for 100 gms. 10. The value of his long gold futures position is  7.000 units 4.500  position is  × 100 × 10 .000 A: One trading unit is for 100 gms.7 Charges 115 Q: A trader buys 10 units of gold futures at Rs. Rs. He has bought 20 units.500 per 10 gms. 14 units 4.65.000 units A: Futures price of 10 gms of gold is Rs.700 per gram. He has to take a position 10. The value of his long gold futures  5.100  × 100 × 20 . Two month futures trade at Rs. This means gold futures cost Rs. 10 units 2. i.

1.000 units A: Futures price of 10 gms of gold is Rs. •• . 10 units 2.00.000. The correct answer is number 1. Unit of trading is 100 gms and delivery unit is one Kg. Two month futures trade at Rs.000 per 10 gms. To take a position in 1000 gms of gold he has to sell 10 units of gold futures contracts. This means gold futures cost Rs.7.7.000 units 4. 100 units 3.700 per gram. 10.116 ___________________________________________________________________ Trading Q: A trader requires to take a short gold futures position worth Rs.000 as part of his hedging strategy.7. How many units must he sell to give him the hedge? 1.

Typically it is responsible for the following: 1. The clearing house has a number of members. 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). physical delivery or cash settlement. Control of the evolution of open interest. 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. 9. 6. 3. Trade registration and follow up. It guarantees the performance of the parties to each transaction. All these settlement functions are taken care of by an entity called clearing house or clearing corporation.1 Clearing Clearing of trades that take place on an exchange happens through the exchange clearing house. Physical settlement (by delivery) or financial settlement (by price difference) of contracts. who are mostly financial institutions responsible for the clearing and settlement of commodities traded on the exchange. 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. Administration of financial guarantees demanded by the participants. 5. The settlement is done by closing out open positions.Chapter 9 Clearing and settlement Most futures contracts do not lead to the actual physical delivery of the underlying asset. 4. 2. in the case of clearing house members only the original margin is required (and . Effecting timely settlement. On the NCDEX. The settlement guarantee fund is maintained and managed by NCDEX. National Securities Clearing Corporation Limited (NSCCL) undertakes clearing of trades executed on the NCDEX. Financial clearing of the payment flow.

in contracts in which they have traded. After completion of the matching process. The following banks have been designated . Clearing members must authorise their clearing bank to access their clearing account for debiting and crediting their accounts as per the instructions of NCDEX. commodities already deposited and dematerialized and offered for delivery etc.1 Clearing mechanism Only clearing members including professional clearing members (PCMs) are entitled to clear and settle contracts through the clearing house. This position is considered for exposure and daily margin purposes. keeping in view the factors such as available capacity of the vault/ warehouse. Thus depending on a day's transactions and price movement. The clearing bank will debit/ credit the clearing account of clearing members as per instructions received from NCDEX. in the contracts in which they have traded.. A clearing member can deposit funds into this account. based on the available information. 9. for settling funds and other obligations to NCDEX including payments of margins and penal charges.e. Unmatched positions have to be settled in cash. at the member level without any set-offs between clients.1. but can withdraw funds from this account only in his self-name. reporting of balances and other operations as may be required by NCDEX from time to time. The clearing mechanism essentially involves working out open positions and obligations of clearing members. A TCM's open position is arrived at by the summation of his clients' open positions.118 Clearing and settlement not maintenance margin). The cash settlement is only for the incremental gain/ loss as determined on the basis of final settlement price. after the trading hours on the expiry date. on the basis of locations and men randomly. Everyday the account balance for each contract must be maintained at an amount equal to the original margin times the number of contracts outstanding.2 Clearing banks NCDEX has designated clearing banks through whom funds to be paid and/ or to be received must be settled. Every clearing member is required to maintain and operate a clearing account with any one of the designated clearing bank branches. Proprietary positions are netted at member level without any set-offs between client and proprietary positions. At NCDEX. The clearing account is to be used exclusively for clearing operations i. the matching for deliveries takes place firstly. clearing members are informed of the deliverable/ receivable positions and the unmatched positions. Matching done by this process is binding on the clearing members. the members either need to add funds or can withdraw funds from their margin accounts at the end of the day. Client positions are netted at the level of individual client and grossed across all clients.1. The open positions of PCMs are arrived at by aggregating the open positions of all the TCMs clearing through him. 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 9. A clearing member having funds obligation to pay is required to have clear balance in his clearing account on or before the stipulated pay-in day and the stipulated time.

for effecting and receiving deliveries from NCDEX. either brought forward.e. the MTM settlement which happens on a continuous basis at the end of each day. daily settlement price is computed as per the methods prescribed by the exchange from time to time. are marked to market at the daily settlement price or the final settlement price at the close of trading hours on a day.2 Settlement 119 as clearing banks . it is the difference between the daily settlement price for that day and the previous day's settlement price. UTI Bank Limited and HDFC Bank Limited. . On the NCDEX. This is done to take care of daily price fluctuations for all trades. All positions of a CM.2 Settlement Futures contracts have two types of settlements.2.ICICI Bank Limited.1. 9. • Final settlement price: Final settlement price is the closing price of the underlying commodity on the last trading day of the futures contract. and the final settlement which happens on the last trading day of the futures contract. However. when the member holds an open position. All open positions in a futures contract cease to exist after its expiration day.9.. Canara Bank. daily MTM settlement and final MTM settlement in respect of admitted deals in futures contracts are cash settled by debiting/ crediting the clearing accounts of CMs with the respective clearing bank. • Daily settlement price: Daily settlement price is the consensus closing price as arrived after closing session of the relevant futures contract for the trading day. 9. created during the day or closed out during the day. • On any intervening days. in the absence of trading for a contract during closing session.1 Settlement mechanism Settlement of commodity futures contracts is a little different from settlement of financial futures which are mostly cash settled. it is the difference between the entry value and daily settlement price for that day. All the open positions of the members are marked to market at the end of the day and the profit/ loss is determined as below: • On the day of entering into the contract. The CM pool account is to be used exclusively for clearing operations i. 9. The possibility of physical settlement makes the process a little more complicated.3 Depository participants Every clearing member is required to maintain and operate a CM pool account with any one of the empanelled depository participants. Daily mark to market settlement Daily mark to market settlement is done till the date of the contract expiry.

he makes a total profit of Rs. The MTM profits/ losses get added/ deducted from his initial margin on a daily basis.120 per Quintal of trading. he makes a total loss of Rs.7 Quintals) and each contract is for delivery of 55 bales of cotton. The polled bid/ ask prices are bootstrapped and the mid of the two bootstrapped prices is taken as the final settlement price.6435 per Quintal (18.6435 per Quintal on December 15. members are required to submit delivery information . The responsibility of settlement is on a trading cum clearing member for all trades done on his own account and his client's trades.120 per Quintal.120 Table 9. Date Dec 15. So upon closing his position.6435 per Quintal on December 15. i. The unit of trading is 11 bales and each contract is for delivery of 55 bales of cotton.2 explains the MTM margins to be paid by a member who sells December expiration long staple cotton futures contract at Rs. the final settlement price is the spot price on the expiry day.2003 Dec 19. The member closes the position on December 19.2244 on the short position taken by him. So upon closing his position.2244.2003 Dec 16.1 MTM on a long position in cotton futures Clearing and settlement A clearing member buys one December expiration long staple cotton futures contract at Rs.1 explains the MTM margins to be paid by a member who buys one unit of December expiration long staple cotton contract at Rs. The profit/ loss made by him however gets added/ deducted from his initial margin on a daily basis.7 x 120) on the long position taken by him. The spot prices are collected from members across the country through polling.2003 Settlement price 6320 6250 6312 6310 6315 MTM -115 -70 +62 -2 +5 • On the expiry date if the member has an open position. On the expiry date of a futures contract.7 Quintals = 11 bales) on December 15. The unit of trading is 11 bales(18. The profit/ loss made by him however gets added/ deducted from his initial margin on a daily basis.e. Final settlement On the date of expiry. The member closes the position on December 19. it is the difference between the final settlement price and the previous day's settlement price. A professional clearing member is responsible for settling all the participants trades which he has confirmed to the exchange. The unit of trading is 11 bales and each contract is for delivery of 55 bales of cotton. Table 9.2003 Dec 17.2003 Dec 18. The member closes the position on December 19. The MTM profit/ loss per unit of trading shows at he makes a total loss of Rs. (18. Table 9. The MTM profit/ loss shows that he makes a total profit of Rs.

2003 Dec 17. NCDEX can also initiate such other risk containment measures as it deems appropriate with respect to the open positions of the clearing members. by placing at the exchange. realizing money by disposing off the securities and exercising such other risk containment measures as it deems fit or take further disciplinary action.2003 Dec 18.2 MTM on a short position in cotton futures 121 A clearing member sells one December expiration long staple cotton futures contract at Rs. It can also take additional measures like. NCDEX also adds all such open positions for a member. In addition NCDEX can withdraw any or all of the membership rights of clearing member including the withdrawal of trading facilities of all trading members clearing through such clearing members. NCDEX on receipt of such information.2003 Settlement price MTM 6320 +115 6250 +70 6312 -62 6310 +2 6315 -5 through delivery request window on the trader workstations provided by NCDEX for all open positions for a commodity for all constituents individually.2 Settlement Table 9. imposing penalties.2003 Dec 16. may be closed out forthwith or any time thereafter by the exchange to the extent possible. Pursuant to regulations relating to submission of delivery information. A detailed report containing all matched and unmatched requests is provided to members through the extranet. matches the information and arrives at a delivery position for a member for a commodity. Date Dec 15.2003 Dec 19.6435 on December 15. clearing and settling through such clearing member. without any notice. invoking bank guarantees or fixed deposit receipts. The MTM profits/ losses get added/ deducted from his initial margin on a daily basis. for which no delivery information is submitted with final settlement obligations of the member concerned and settled in cash. counter orders in respect of the outstanding position of clearing member without any notice to the clearing member and/ or trading member and/ or constituent. The member closes the position on December 19. the outstanding positions of such clearing member and/ or trading members and/ or constituents. bye-laws and regulations of NCDEX and attracts penal charges as stipulated by NCDEX from time to time. collecting appropriate deposits. failure to submit delivery information for open positions attracts penal charges as stipulated by NCDEX from time to time. Non-fulfilment of either the whole or part of the settlement obligations is treated as a violation of the rules. . The unit of trading is 11 bales and each contract is for delivery of 55 bales of cotton. Further.9.

122

Clearing and settlement

9.2.2 Settlement methods
Settlement of futures contracts on the NCDEX can be done in three ways - by physical delivery of the underlying asset, by closing out open positions and by cash settlement. We shall look at each of these in some detail. On the NCDEX all contracts settling in cash are settled on the following day after the contract expiry date. All contracts materialising into deliveries are settled in a period 2-7 days after expiry. The exact settlement day for each commodity is specified by the exchange.

Physical delivery of the underlying asset
For open positions on the expiry day of the contract, the buyer and the seller can announce intentions for delivery. Deliveries take place in the electronic form. All other positions are settled in cash. When a contract comes to settlement, the exchange provides alternatives like delivery place, month and quality specifications. Trading period, delivery date etc. are all defined as per the settlement calendar. A member is bound to provide delivery information. If he fails to give information, it is closed out with penalty as decided by the exchange. A member can choose an alternative mode of settlement by providing counter party clearing member and constituent. The exchange is however not responsible for, nor guarantees settlement of such deals. The 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 opportunity 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. As mentioned above, after the trading hours on the expiry date, based on the available information, the matching for deliveries is done, firstiy, on the basis of locations and then randomly keeping in view 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. After completion of the matching process, clearing members are informed of the deliverable/ receivable positions and the unmatched positions. Unmatched positions have to be settled in cash. The cash settlement is done only for the incremental gain/ loss as determined on the basis of the final settlement price. Any buyer intending to take physicals has to put a request to his depository participant. The DP uploads such requests to the specified depository who in turn forwards the same to the registrar and transfer agent (R&T agent) concerned. After due verification of the authenticity, the R&T agent forwards delivery details to the warehouse which in turn arranges to release the commodities after due verification of the identity of recipient. On a specified day, the buyer would go to the warehouse and pick up the physicals. The seller intending to make delivery has to take the commodities to the designated

9.2 Settlement ______________________________________________________ 123
warehouse. These commodities have to be assayed by the exchange specified assayer. The commodities have to meet the contract specifications with allowed variances. If the commodities meet the specifications, the warehouse accepts them. Warehouses then ensure that the receipts get updated in the depository system giving a credit in the depositor's electronic account. The seller then gives the invoice to his clearing member, who would courier the same to the buyer's clearing member. NCDEX contracts provide a standardized description for each commodity. The description is provided 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 is treated as good delivery and accepted if the delivery lies within the tolerance limits. However, to allow for the difference, the concept of premium and discount has been introduced. Goods that come to the authorised warehouse for delivery are tested and graded as per the prescribed parameters. The premium and discount rates apply depending on the level of variation. The price payable by the party taking delivery is then adjusted as per the premium/ discount rates fixed by the exchange. This ensures that some amount of leeway is provided 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

Closing out by offsetting positions
Most of the contracts are settled by closing out open positions. 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. For example, an investor who took a long position in two gold futures contracts on the January 30, 2004 at 6090, can close his position by selling two gold futures contracts on February 27, 2004 at Rs.5928. In this case, over the period of holding the position, he has suffered a loss of Rs.162 per unit. This loss would have been debited from his margin account over the holding period by way of MTM at the end of each day, and finally at the price that he closes his position, that is Rs.5928 in this case.

Cash settlement
Contracts held till the last day of trading can be cash settled. 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. For example an investor took a short position in five long staple cotton futures contracts on December 15 at Rs.6950. On 20th February, the last trading day of the contract, the spot price of long staple cotton is Rs.6725. This is the settlement price for his contract. As a holder of a short position on cotton, he does not have to actually deliver the underlying cotton, but simply takes away the profit of Rs.225 per trading unit of cotton in the form of cash.

124

Clearing and settlement

9.2.3 Entities involved in physical settlement
Physical settlement of commodities involves the following three entities - an accredited warehouse, registrar & transfer agent and an assayer. We will briefly look at the functions of each.

Accredited warehouse
NCDEX specifies accredited warehouses through which delivery of a specific commodity can be effected and which will facilitate for storage of commodities. For the services provided by them, warehouses charge a fee that constitutes storage and other charges such as insurance, assaying and handling charges or any other incidental charges. Following are the functions of an accredited warehouse:
1. 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 warehouses are required to meet the specifications prescribed by the exchange for storage of commodities. 2. Ensure and co-ordinate the grading of the commodities received at the warehouse before they are stored.

3. Store commodities in line with their grade specifications and validity period and facilitate
maintenance of identity. On expiry of such validity period of the grade for such commodities, the warehouse has to 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.

Approved registrar and transfer agents (R&T agents)
The exchange specifies approved R&T agents through whom commodities can be dematerialized and who facilitate for dematerialization/ re-materialization of commodities in the manner prescribed by the exchange from time to time. The R&T agent performs the following functions:
1. Establishes connectivity with approved warehouses and supports them with physical infrastructure. 2. Verifies the information regarding the commodities accepted by the accredited warehouse and assigns the identification number (ISIN) allotted by the depository in line with the grade/ validity period. 3. Further processes the information, and ensures the credit of commodity holding to the demat account of the constituent. 4. Ensures that the credit of commodities goes only to the demat account of the constituents held with the exchange empanelled DPs.

5. On receiving a request for re-materialization (physical delivery) through the depository, arranges for
issuance of authorisation to the relevant warehouse for the delivery of commodities.

security deposits) are quite stringent. 3. Assayers perform the following functions: 1. NCDEX charges an upfront initial margin for all the open positions of a member. 4. R&T agents also do the job of co-ordinating with DPs and warehouses for billing of charges for services rendered on periodic intervals. and the time up to which the commodities are fit for trading subject to environment changes at the warehouses.9. 2. Position violations result in withdrawal of trading facility for all TCMs of a PCM in case of a violation by the PCM. 2. The difference is settled in cash on a T+l basis. . They are required to furnish the same to the exchange as and when demanded by the exchange. A member is alerted of his position to enable him to adjust his exposure or bring in additional capital. The open positions of the members are marked to market based on contract settlement price for each contract. Grading certificate so issued by the assayer specifies the grade as well as the validity period up to which the commodities would retain the original grade. It also follows value-at-risk (VaR) based margining through SPAN. Approved assayer The exchange specifies approved assayers through whom grading of commodities (received at approved warehouses for delivery against deals made on the exchange) can be availed by the constituents of clearing members. It specifies the initial margin requirements for each futures contract on a daily basis. The compliance certificate so given by the assayer forms the basis of warehouse accreditation by the exchange. The financial soundness of the members is the key to risk management.3 Risk management 125 R&T agents also maintain proper records of beneficiary position of constituents holding dematerialized commodities in warehouses and in the depository for a period and also as on a particular date. 9. The PCMs and TCMs in turn collect the initial margin from the TCMs and their clients respectively. the requirements for membership in terms of capital adequacy (net worth. 3.3 Risk management NCDEX has developed a comprehensive risk containment mechanism for the its commodity futures market. They also reconcile dematerialized commodities in the depository and physical commodities at the warehouses on periodic basis and co-ordinate with all parties concerned for the same. The assayer ensures that the grading to be done (in a certificate format prescribed by the exchange) in respect of specific commodity is as per the norms specified by the exchange in the respective contract specifications. Therefore. The salient features of risk containment mechanism are: 1. Inspect the warehouses identified by the exchange on periodic basis to verify the compliance of technical/ safety parameters detailed in the warehousing accreditation norms of the exchange. Make available grading facilities to the constituents in respect of the specific commodities traded on the exchange at specified warehouse.

. rules and regulations. Initial margin is payable on all open positions of trading cum clearing members. 2. up to client level.3 Computation of initial margin The Exchange has adopted SPAN (Standard Portfolio Analysis of Risk) system for the purpose of real-time initial margin computation. 9. Initial margin includes SPAN margins and such other additional margins that may be specified by the exchange from time to time.4.2 Initial margin This is the amount of money deposited by both buyers and sellers of futures contracts to ensure performance of trades executed. Its over-riding objective is to determine the largest loss that a portfolio might reasonably be expected to suffer from one day to the next day based on 99% VaR methodology.4 Margining at NCDEX In pursuance of the bye-laws.1 SPAN SPAN is a registered trademark of the Chicago Mercantile Exchange. The actual position monitoring and margining is carried out on-line through the SPAN (Standard Portfolio Analysis of Risk) system. 9.126 Clearing and settlement 5. For proprietary positions: These are netted at member level without any set-offs between client and proprietary positions.4.4. the exchange has defined norms and procedures for margins and limits applicable to members and their clients. 9. The objective of SPAN is to identify overall risk in a portfolio of all futures contracts for each member. Initial margin requirements for a member for each contract are as under: 1. The margining system for the commodity futures trading on the NCDEX is explained below. For client positions: These are netted at the level of individual client and grossed across all clients. The most critical component of risk containment mechanism for futures market on the NCDEX is the margining system and on-line position monitoring. at any point of time. at the member level without any set-offs between clients. Initial margin requirements are based on 99% VaR (Value at Risk) over a one-day time horizon. 9. and is payable upfront by the members in accordance with the margin computation mechanism and/ or system as may be adopted by the exchange from time to time. A separate settlement guarantee fund for this segment has been created out of the capital of members. used by NCDEX under license obtained from CME.

Volatility scan range: Volatility scan range will be taken at 2% or such other percentage as may be specified by the exchange from time to time. 2. various parameters as given below will be specified from time to time: 1.4 Margining at NCDEX Table 9.3 Calculating outstanding position at TCM level Account Number of Number of units bought units sold Proprietary CUent A Client B Net outstanding position 3000 2000 1000 1500 1000 127 Outstanding position Long 2000 Long 500 Short 1000 3500 Table 9. These may change from time to time as specified by the exchange. And on account of client B.4 Minimum margin percentage on commodity futures contracts Commodity Minimum margin percentage Pure gold Mumbai Pure silver New Delhi J34 medium staple cotton Bhatinda S06 L S cotton Ahmedabad Soybean Indore Refined soya oil Indore Rapeseed mustard seed Jaipur Expeller rapeseed mustard oil Jaipur Crude palm oil Kandla RBD palm olein Kakinada 4 4 3 3 4 4 4 4 4 4 Consider the case of a trading member who has proprietary and client-level positions in a April 2004 gold futures contract.9. he bought 2000 trading units at the beginning of the day and sold 1500 units an hour later. The minimum margin percentages for various commodities are given in Table 9. Table 9.3 gives the total outstanding position for which the TCM would be margined. For the purpose of SPAN margin. On account of client A. 3.4. he bought 3000 trading units and sold 1000 trading units within the day. Price scan range: Price scan range will be four standard deviations (4 sigma) as calculated for VaR purpose for the prices of futures contracts. On his proprietary account. he sold 1000 trading units. Calendar spread charge: Calendar spread is defined as the purchase of one delivery month of a given futures contract and simultaneous sale of another delivery month of the same commodity on the same .

invoking bank guarantees/ fixed deposit receipts. The liquid networth maintained by the members at any point in time cannot be less than Rs. realizing money by disposing off the securities and exercising such other risk containment measures as it deems fit. 2. The member is not allowed to trade once the exposure limits have been exceeded on the exchange. The far month position is the buy/ sell position on the calendar-spread position that expires next. 4. (a) Liquid networth: Liquid networth is computed as effective deposits less initial margin payable at any point in time. as may be specified by the exchange from time to time. or in collateral security deposits in the form of bank guarantees. . 9. can be closed out forthwith or any time thereafter at the discretion of the Exchange. The outstanding positions of such members and/ or constituents clearing and settling through such members. collecting appropriate deposits. by placing counter orders in respect of the outstanding position of members. Effect of failure to pay initial margins: Non-fulfilment of either the whole or part of the initial margin obligations is treated as a violation of the rules. bye-laws and regulations of the exchange and attracts penal charges as stipulated by NCDEX from time to time. Margins are charged on all open calendar spread positions at 2% on the higher value of the near month or the far month position. The exchange can also initiate such other risk containment measures as it deems fit with respect to the open positions of the members and/ or constituents. A calendar spread position is treated as nonspread (naked) positions in the far month contract. the exchange can withdraw any or all of the membership rights of a member including the withdrawal of trading facilities of the members clearing through such clearing members.4 Implementation aspects of margining and risk management We look here at some implementation aspects of the margining and risk management system for trading on NCDEX. The trader workstation of the member is disabled and trading permitted only on enhancement of exposure limits by deposit of additional capital. The exchange can take additional measures like imposing penalties. The reduction of the spread position starts five days before the date of expiry of the near month contract.128 Clearing and settlement exchange. Payment of initial margin: The initial margin is payable upfront by members. Such action is final and binding on the members and/ or constituents. Mode of payment of initial margin: Margins can be paid by the members in cash. The near month position is the buy/ sell position on the calendar-spread position that expires first. 3 trading days prior to expiration of the near month contract.25 lakh (referred to as minimum liquid net worth) or such other amount. calendar spread position is reduced gradually at the rate of 33^% per day for three days or at such rate as may be prescribed by the exchange from time to time. without any notice. 3. 1. or at such rate as may be specified by the exchange from time to time. In addition.4. to the extent possible. fixed deposits receipts and approved Government of India securities. Exposure limits: This is defined as the maximum open positions that a member can take across all contracts and is linked to the liquid net worth of the member available with the exchange. However.

Initial margin deposit or additional deposit or additional base capital: Members who wish to make a margin deposit (additional base capital) with the exchange and/ or wish to retain deposits and/ or such amounts which are receivable by them from the exchange. The multiple is as specified in Table 9. 7. This is calculated as the higher of a specified percentage of the total open interest in the commodity or a specified value. to the extent possible. rules and regulations. (c) Method of computation of exposure limits: Exposure limits is specified as a multiple of the liquid net worth. which are or may have been imposed. 6. This is in addition to the initial margin.4 Margining at NCDEX 129 (b) Effective deposits: This includes all deposits made by the members in the form of cash or cash equivalents form the effective deposits.9. Imposition of additional margins and close out of open positions: As a risk containment measure. The base price when trading resumes after cooling period will be the last traded price before the commencement of cooling period. i.e. 9. without any notice. For the purpose of computing effective deposits. over and above their deposit requirement towards initial margin and/ or other obligations. can be closed out forthwith or any time thereafter.10% of the previous day's settlement price prescribed for each commodity. The exchange may withdraw any or all of the membership rights of the members including the withdrawal of trading facilities of trading members clearing through such members.5 or as may be prescribed by the exchange from time. at any point of time. must inform the exchange as per the procedure. clearing and settling through such members. Open interest is the total number of open positions in that futures contract multiplied by its last available traded price or closing price. the exchange may require the members to make payment of additional margins as may be decided from time to time. there will be a cooling period of 15 minutes. Failure to pay additional margins: Non-fulfilment of either the whole or part of the additional margin obligations is treated as a violation of the rules. a member can have an exposure limit of x times his liquid net worth. 5. the outstanding positions of such members and/ or constituents. trading in that particular contract will be suspended and normal trading will resume after the cooling period. Intra-day price limit: The maximum price movement during a day can be +/. as the case may be. There would be no cooling period if the price hits the intra day limit during the last 30 minutes of trading. 10. However the spread positions is treated as a naked position in far month contract three trading days prior to expiry of the near month contract. contracts are treated as open position of one third of the value of the far month futures contract. During the cooling period. The exchange may also require the members to reduce/ close out open positions to such levels and for such contracts as may be decided by it from time to time. . by placing counter orders in respect of their outstanding positions. (d) Exposure limits for calendar spread positions: In case of calendar spread positions in futures. If the price hits the intra day price limit (at upper side or lower side). fixed deposit receipts and Government of Indian securities. at the discretion of the exchange. Position limits: Position wise limits are the maximum open positions that a member or his constituents can have in any commodity at any point of time. bye-Laws and regulations of the exchange and attracts penal charges as stipulated by NCDEX. Such requests may be considered by the exchange subject to the bye-laws. cash equivalents mean bank guarantees. 8. In addition. Return of excess deposit: Members can request the exchange to release excess deposits held by it or by a specified agent on behalf of the exchange.

(b) On any intervening days. it is the difference between the final settlement price and the previous day's settlement price. or any other situation has arisen. only for those members whose variation losses or initial margin deficits exceed a threshold value prescribed by the exchange. when the member holds an open position. as described hereunder or as may be prescribed by the exchange from time to time. the exchange can withdraw any or all of the membership rights of members including the withdrawal of trading . it is the difference between the entry value and daily settlement price for that day. Intra-day margin call: The exchange at its discretion can make intra day margin calls as risk containment measure if.130 Table 9. it is the difference between the daily settlement value for that day and the previous day's settlement price.4. The number of days are commodity specific. Table 9. for example. N days refer to the number of days for completing the physical delivery settlement. Delivery margin: In case of positions materialising into physical delivery.5 Exposure limit as a multiple of liquid net worth Commodity Pure gold Mumbai Pure silver New Delhi J34 medium staple cotton Bhatinda S06 L S cotton Ahmedabad Soybean Indore Refined soya oil Indore Rapeseed mustard seed Jaipur Expeller rapeseed mustard oil Jaipur Crude palm oil Kandla RBD palm olein Kakinada Clearing and settlement Multiple 25 25 40 40 25 25 25 25 25 25 (a) Daily settlement price: The daily profit/ losses of the members are settled using the daily settlement price. in its opinion. the market price changes sufficiently.5 Effect of violation Whenever any of the margin or position limits are violated by members. which in the opinion of the exchange could result in an enhanced risk. 9. 12. (b) Mark-to-market settlement: All the open positions of the members are marked to market at the end of the day and the profit/ loss determined as below: (a) On the day of entering into the contract. (c) On the expiry date if the member has an open position. For example.6 gives the number of days for physical settlement on various commodities. it can make an intra-day margin call if the intra day price limit has been reached. The daily settlement price notified by the exchange is binding on all members and their constituents. There is a mark up on the VaR based delivery margin to cover for default. The exchange at its discretion may make selective margin calls. delivery margins are calculated as i\ days VaR margins plus additional margins. 11.

•• . Closing out open positions.6 Number of days for physical settlement on various commodities Commodity Pure gold Mumbai Pure silver New Delhi J34 medium staple cotton Bhatinda S06 L S cotton Ahmedabad Soybean Indore Refined soya oil Indore Rapeseed mustard seed Jaipur Expeller rapeseed mustard oil Jaipur Crude palm oil Kandla RBD palm olein Kakinada Number of days for physical settlement 2 4 10 10 7 7 7 7 7 7 131 facilities of all members and/ or clearing facility of custodial participants clearing through such trading cum members.4 Margining at NCDEX Table 9. This can be done without any notice to the member and/ or constituent. NSDL 4. invoking bank guarantees/ fixed deposit receipts. Carrying forward the position. collecting appropriate deposits. These could include imposing penalties. Cash settlement. NSE 2. Solved Problems Q: The settlement of futures contracts cannot be done by 1. 2. NSCCL A: The correct answer is number 2. In addition. A: The correct answer is number 4. NCDEX •• 3.9. can be closed out at any time at the discretion of the exchange. the outstanding positions of such member and/ or constituents clearing and settling through such member. Q: ____ undertakes clearing and settlement of all trades executed on the NCDEX 1. 4. realizing money by disposing off the securities. The exchange can initiate further risk containment measures with respect to the open positions of the member and/ or constituent. Physical delivery. 3. and exercising such other risk containment measures it considers necessary. without any notice.

•• Q: The exposure limit for each member is linked to the………of the member available with the exchange. 3. 1. 4. 3. A: The correct answer is number 1. Control of the evolution of open interest. NSDL 4. Financial clearing of the payment flow. 2. Effecting timely settlement. A: The correct answer is number 4.132 Clearing and settlement Q: The settlement guarantee fund for trades done on the NCDEX is maintained and managed by 1. •• . 4. 3. Base capital. 3. Bank guarantees. Spot price plus cost-of-carry 4. Effecting timely settlement. Liquid net worth. Financial clearing of the payment flow. Spot price of the underlying asset 2. 2. A: The correct answer is number 2. NSCCL A: The correct answer is number 4. NCDEX •• Q: The clearing house of an exchange is responsible for 1. None of the above. •• Q: The clearing house of an exchange is not responsible for 1. Security deposits. 4. All of the above. the settlement price is the 1. NSE 2. Control of the evolution of open interest. Futures close price A: The correct answer is number 1. •• Q: On expiry of a commodity futures contract. Ensuring that the buyer and seller get the best price. 3. 2.

•• .e × 200 = Rs. The trader's MTM account will show 1. i. long staple cotton futures contracts at Rs. He makes a profit of Rs. The unit of trading is 11 bales and each contract is for delivery of 55 bales.7 * 10 = Rs. A profit of Rs. AprofitofRs. A profit of Rs.6000 per Quintal and sold 2400 at Rs. A loss of Rs. the trading member has a long open position in 600 trading units.5000 4. Long 3000 units 2.6025 per 10 gms. He bought 3000 trading units at Rs. 1500 A: He makes a profit of Rs. • • Q: A gold merchant bought two units of one-month gold futures contracts at Rs.30 per Quintal on his futures position.9.4 Margining at NCDEX 133 Q: A cotton trader bought ten one-month. The unit of trading is 100 gms and each contract is for delivery of one kg of gold. 1500 4. So he makes a profit of 20 Rs.500 2. He has bought ten futures contract.500.500. The correct answer is number 1. The settlement price at the end of the day was Rs.5000 A: Each unit of trading is 100 gms. One futures contract consists is for 18. Long 600 units A: After netting. The correct answer is number 4.6000 per 10 gms at the beginning of the day. So he makes a profit of 30 * 18. This means he has a long position in 200 gms of gold. He has bought two units. What is the outstanding position on which he would be margined? 1. The settlement price at the end of the day was Rs. The correct answer is number 1.5610 3. •• 10 Q: A trading member took proprietary positions in a March 2004 cotton futures contract.5610.6015 per Quintal.6020 per Quintal at the beginning of the day. AprofitofRs. Long 5400 units 4.5610 2.6050 per Quintal. The trader's MTM account will show 1.25 per 10 gms on his futures position.7 Quintals. Short 2400 units 3.500 3. AlossofRs. A loss of Rs. AlossofRs.

What is the outstanding position on which he would be margined? 1.6020 per 10 gms.134 Clearing and settlement Q: A trading member has proprietary and client positions in a March cotton futures contract.e. 1600 units A: After netting.5990 per 10 gms. What is the outstanding position on which he would be margined? 1.6012 per Quintal. he bought 2000 trading units at Rs. On account of client A. he bought 2000 trading units at Rs. he sold 1000 trading units at Rs.6000 per Quintal and sold 2400 at Rs. • • . On his proprietary account. On account of client A. 3600 units 4. i. 8400 units 3. he bought 3000 trading units at Rs. and on account of client B. (600 + 2000 +1000). The correct answer is number 3. On his proprietary account. 4500 units 3. he bought 3000 trading units at Rs. he sold 1000 trading units at Rs. and on account of client B. 3000 units 2. the trading member has a proprietary open position in 600 trading units. He would be margined on a net basis at the proprietary level and on a gross basis across clients. The correct answer is number 2.6015 per Quintal. (3000 + (2000 . •• Q: A trading member has proprietary and client positions in a April 2004 gold futures contract.1500) + 1000). 3600 units 4.6012 per 10 gms and sold 1500 units at Rs.e. 7500 units A: He would be margined on a net basis at the proprietary level and at the individual client level and on a gross basis across clients.5990 per Quintal.6000 per 10 gms. i. 3000 units 2.

Forward Commission (Regulation) Act and various other legislations. Forward Markets Commission provides regulatory oversight in order to ensure financial integrity (i. 1952.e. particularly nonmember users of the market.e.Chapter 10 Regulatory framework At present. Regulation is also needed to ensure that the market has appropriate risk management system. This could have undesirable influence on the spot prices. are required to obtain certificate of registration from the FMC. settlement and management of the exchange so as to protect and promote the interest of various stakeholders. Under the Forward Contracts (Regulation) Act. In the absence of such a system. which are granted recognition by the central government (Department of Consumer Affairs. In the absence of regulation. Food and Public Distribution). there are three tiers of regulations of forward/futures trading system in India. Stamp Act. Forward Markets Commission(FMC) and commodity exchanges. Besides. Proper regulation is needed to create competitive conditions. which deal with forward contracts. which impinge on their working. It prescribes the following regulatory measures: .1 Rules governing commodity derivatives exchanges The trading of commodity derivatives on the NCDEX is regulated by Forward Markets Commission(FMC). Ministry of Consumer Affairs. The need for regulation arises on account of the fact that the benefits of futures markets accrue in competitive conditions. 10. a major default could create a chain reaction. All the exchanges. Contracts Act. clearing. forward trading in commodities notified under section 15 of the Act can be conducted only on the exchanges. to ensure that futures prices are truly aligned with the prospective demand and supply conditions) and to protect and promote interest of customers/ non-members. government of India. market integrity (i.. to prevent systematic risk of default by one major operator or group of operators). The resultant financial crisis in a futures market could create systematic risk. they are subjected to various laws of the land like the Companies Act. namely. unscrupulous participants could use these leveraged contracts for manipulating prices. Regulation is also needed to ensure fairness and transparency in trading. thereby affecting interests of society at large.

For the sake of convenience. address. Some times limit is also imposed on intra-day net open position.C(R) Act provides that a client's position cannot be appropriated by the member of the exchange. These steps facilitate audit trail and make it difficult for the members to indulge in malpractices like trading ahead of clients. the name. 5. The FMC has also prescribed simultaneous reporting system for the exchanges following open out-cry system. This measure is imposed only on the request of the exchange. In this section we have brief look at the important regulations that govern NCDEX. telephone number of the officer of the commission who can be contacted for any grievance. Besides these regulatory measures.2 Rules governing intermediaries In addition to the provisions of the Forward Contracts (Regulation) Act 1952 and rules framed thereunder. Skipping trading in certain derivatives of the contract. except when a written consent is taken within three days time. By making further purchases/sales relatively costly. The detailed bye laws. whenever they visit exchanges. the price rise or fall is sobered down. etc. Officers of the FMC have been instructed to meet the members and clients on a random basis. Circuit breakers or minimum/maximum prices: These are prescribed to prevent futures prices from falling below as rising above not warranted by prospective supply and demand factors. Limit on net open position as on the close of the trading hours. The FMC has also mandated all the exchanges following open outcry system to display at a prominent place in exchange premises. Trading on the exchange is allowed only through . Circuit-filters or limit on price fluctuations to allow cooling of market in the event of abrupt upswing or downswing in prices. Special margin deposit to be collected on outstanding purchases or sales when price moves up or down sharply above or below the previous day closing price. and in some cases. rules and regulations are available on the NCDEX home page. This measure is also imposed on the request of the exchanges. The website of the commission also has a provision for the customers to make complaint and send comments and suggestions to the FMC. exchanges are governed by its own rules and bye laws(approved by the FMC). 4. The limit is imposed operator-wise. also memberwise. which is more customer-friendly. the F. 10. closing the market for a specified period and even closing out the contract: These extreme measures are taken only in emergency situations. these have been divided into two main divisions pertaining to trading and clearing. clearing and settlement. 3. to ascertain the situation on the ground. 10.1 Trading The NCDEX provides an automated trading facility in all the commodities admitted for dealings on the spot market and derivative market.2.136 Regulatory framework 1. 2. instead of merely attending meetings of the board of directors and holding discussions with the office-bearers. The FMC is persuading increasing number of exchanges to switch over to electronic trading.

which has been prescribed by the exchange. In case of trading members. An approved user can access the trading system through a password and can change the password from time to time. its facilities. installation and maintenance of the equipment is borne by the trading member. He does not have any title rights or interest whatsoever with respect to trading system. (subject to such terms and conditions.10. The trading member or its approved users are required to maintain complete secrecy of its password. For the purpose of accessing the trading system.2 Rules governing intermediaries 137 approved workstation(s) located at locations for the offlce(s) of a trading member as approved by the exchange. Any trade or transaction done by use of password of any approved user of the trading member. Each trading member is permitted to appoint a certain number of approved users as notified from time to time by the exchange. the member will install and use equipment and software as specified by the exchange at his own cost. A trading member has a non-exclusive permission to use the trading system as provided by the exchange in the ordinary course of business as trading member.e. outside trading hours. Other than the regular trading hours. The appointment of approved users is subject to the terms and conditions prescribed by the exchange. Trading members and users Trading members are entitled to appoint. If LAN or any other way to other workstations at any place connects an approved workstation of a trading Member it shall require an approval of the exchange. such certification program has to be passed by at least one of their directors/ employees/ partners / members of governing body. will be binding on such trading member. Approved user shall be required to change his password at the end of the password expiry period. Each trading member is required to have a unique identification number which is provided by the exchange and which will be used to log on (sign on) to the trading system. as may be specified by the relevant authority) from time to time • Authorised persons • Approved users Trading members have to pass a certification program. trading members are provided a facility to place orders off-line i. These are stored by the system but get traded only once the market opens for trading on the following working day. The cost of the equipment and software supplied by the exchange. other than individuals or sole proprietorships. software and the information provided by the trading system. Trading days The exchange operates on all days except Saturday and Sunday and on holidays that it declares from time to time. Each approved user is given a unique identification number through which he will have access to the trading system. The exchange has the right to inspect equipment and software used for the purposes of accessing the trading system at any time. .

The exchange specifies the minimum disclosed quantity for orders that will be allowed for each commodity/ derivatives contract. Trading cycle for each commodity/ derivative contract has a standard period. The trading member is accountable for the functions executed by the exchange on its behalf and has to indemnity the exchange against any losses or costs incurred by the exchange. This is notified by the exchange in advance. The contract expiration period will not exceed twelve months or as the exchange may specify from time to time. trade books. Contract expiration Derivatives contracts expire on a pre-determined date and time up to which the contract is available for trading. It specifies parameters like lot size in which orders can be placed. The exchange also prescribes different order books that shall be maintained on the trading system and also specifies various conditions on the order that will make it eligible to place it in those books. Failure of trading member terminal In the event of failure of trading members workstation and/ or the loss of access to the trading system. the exchange can extend or reduce the trading hours by notifying the members. within the regulations prescribed by the exchange as per these bye laws. the exchange can at its discretion undertake to carry out on behalf of the trading member the necessary functions which the trading member is eligible for. It also prescribes the number of days after which Good Till Cancelled orders will be cancelled by the system. Every trading member is required to specify the buy or sell orders as either an open order or a close order for derivatives contracts. Trading hours and trading cycle The exchange announces the normal trading hours/ open period in advance from time to time. price steps in which orders shall be entered on the trading system. during which it will be available for trading. matching rules and other parameters pertaining to each or all of these sessions is specified by the exchange to the members via its circulars or notices issued from time to time. Members can place orders on the trading system during these sessions. In case necessary. price limits. Trading parameters The exchange from time to time specifies various trading parameters relating to the trading system. from time to time. Only requests made in writing in a clear and precise manner by the trading member would be considered.138 Regulatory framework The types of order books. rules and regulations. . position limits in respect of each commodity etc.

the settlement periods and trade types for which margin would be attracted. deal in derivatives contracts in a fraudulent manner. the exchange/clearing house can withdraw the trading facility of the trading member. or indulge in any unfair trade practices including market manipulation. Trades generated on the system are irrevocable and 'locked in'. it can be done only with the approval of the exchange. every clearing member. Margin requirements Subject to the provisions as contained in the exchange bye-laws and such other regulations as may be in force. as well as the method of valuation and amount of securities that would be required to be deposited against the margin amount. Additional margins may be levied for deliverable positions.10. On failure to deposit margin/s as required under this clause. take part either directly or indirectly in transactions. The exchange also prescribes categories of securities that would be eligible for a margin deposit. After the pay-out. which are likely to have effect of artificially. The exchange levies initial margin on derivatives contracts using the concept of Value at Risk (VaR) or any other concept as the exchange may decide from time to time. . Unfair trading practices No trading member should buy. raising or depressing the prices of spot/ derivatives contracts.2 Rules governing intermediaries 139 Trade operations Trading members have to ensure tiiat appropriate confirmed order instructions are obtained from the constituents before placement of an order on the system. in which trade cancellation can be effected. the clearing house releases all margins. The exchange specifies from time to time the market types and the manner if any. Where a trade cancellation is permitted and trading member wishes to cancel a trade. The exchange prescribes from time to time the commodities/ derivative contracts. in respect of the trades in which he is party to. Trading members are solely responsible for the accuracy of details of orders entered into the trading system including orders entered on behalf of their constituents. The procedure for refund/ adjustment of margins is also specified by the exchange from time to time. sell. The margin has to be deposited with the exchange within the time notified by the exchange. has to deposit a margin with exchange authorities. They have to keep relevant records or documents concerning the order and trading system order number and copies of the order confirmation slip/ modification slip must be made available to the constituents. This includes the following: • Effect. The exchange can impose upon any particular trading member or category of trading member any special or other margin requirement. on the basis of VaR from the expiry of the contract till the actual settlement date plus a mark-up for default. The margin is charged so as to cover oneday loss that can be encountered on the position on 99% of the days. The trading member has to disclose to the exchange at the time of order entry whether the order is on his own account or on behalf of constituents and also specify orders for buy or sell as open or close orders.

resulting in reflection of prices. execute a transaction with a constituent at a price other than the price at which it was executed on the exchange. the deals have to be settled as per the settlement calendar applicable for such deals. during the trading hours.firstly. Matching done is binding on the clearing members. All deals executed on the Exchange are cleared and settled by the trading members on the settlement date by the trading members themselves as clearing members or through other professional clearing members in accordance with these regulations. on the basis of locations and then randomly keeping in view the factors such as available capacity of the vault/ warehouse. On the expiry date. bye laws and rules of the exchange. sell commodities/ contracts on his own behalf or on behalf of a person associated with him pending the execution of the order of his constituent or of his company or director for the same contract. If a trading member/ clearing member fails to submit such information during the trading hours on the expiry date for the contract. • Delay the transfer of commodities in the name of the transferee. accounts and records for the purpose of market manipulation. Delivery Delivery can be done either through the clearing house or outside the clearing house. On the expiry date of contracts. the trading members/ clearing members have to give delivery information as prescribed by the exchange from time to time. the last trading day is taken to be the previous working day of exchange. the matching for deliveries takes place . If the last trading day as specified in the respective commodity contract is a holiday. which is calculated to create a false or misleading appearance of trading. • Indulge in falsification of his books. • When acting as an agent. based on the available information. the exchange provides a window on the trading system to submit delivery information for all open positions. National Securities Clearing Corporation Limited (NSCCL) undertakes clearing of trades executed on the NCDEX.140 Regulatory framework • Indulge in any act. in cash together with penalty as stipulated by the exchange. 10. Last day of trading Last trading day for a derivative contract in any commodity is the date as specified in the respective commodity contract. commodities already deposited and dematerialized and offered for delivery and any other factor as may be specified by the exchange from time to time.2. • Either take opposite position to an order of a constituent or execute opposite orders which he is holding in respect of two constituents except in the manner laid down by the exchange. After completion of the . After the trading hours on the expiry date. • Buy. which are not genuine.2 Clearing As mentioned earlier.

however the seller is entitled to recover from the buyer. . the exchange closes out the derivatives contracts and imposes penalties on the defaulting buyer or seller. government levies/ fees if any. In no event is the exchange/ clearing house liable for payment of sales tax/ VAT or any other local tax. The exchange specifies the parameters and methodology for premium/ discount.2 Rules governing intermediaries 141 matching process. Members have to maintain records/details of sales tax registration of each of such constituent and furnish the same to the exchange as and when required. then the open position would be settled in cash together with penalty as may be stipulated by the exchange. from time to time for the quality/ quantity differential. Penalties for defaults In the event of a default by the seller or the buyer in delivery of commodities or payment of the price. who intend to take or give delivery of commodity. The settlement for the defaults in delivery is to be done in cash within the period as prescribed by the exchange at the highest price from the last trading date till the final settlement date with a mark up thereon as may be decided from time to time. levies etc. It can also use the margins deposited by such clearing member to recover the loss. Unmatched positions have to be settled in cash. as the case may be. If the information provided by the buyer/ seller clearing members fails to match. the sales tax and other taxes levied under the local state sales tax law to the extent permitted by law. whereby the clearing house can reduce the margin requirement to that extent. The exchange however. All matched and unmatched positions are settled in accordance with the applicable settlement calendar. Procedure for payment of sales tax/VAT The exchange prescribes procedure for payment of sales tax/VAT or any other state/local/central tax/fee applicable to the deals culminating into sale with physical delivery of commodities. The seller is responsible for payment of sales tax/VAT. taxes. fees. are registered with sales tax authorities of all such states in which the exchange has a delivery center for a particular commodity in which constituent has or is expected to have open positions. along with other details required by the exchange. clearing members are informed of the deliverable / receivable positions and the unmatched positions. The exchange may allow an alternate mode of settlement between the constituents directly provided that both the constituents through their respective clearing members notify the exchange before the closing of trading hours on the expiry date. The clearing members are allowed to deliver their obligations before the pay in date as per applicable settlement calendar. All members have to ensure that their respective constituents.10. Pay in/ Pay out for such additional obligations is settled on the supplemental settlement date as specified in the settlement calendar. as the case may be. sales tax. The cash settlement is only for the incremental gain/ loss as determined on the basis of the final settlement price. They have to mention their preferred identified counter-party and the deliverable quantity. is not be responsible or liable for such settlements or any consequence of such alternate mode of settlements.

142 Process of dematerialization Regulatory framework Dematerialization refers to issue of an electronic credit. the delivery of the commodity upon expiry of validity date is not considered as a good delivery. In case of commodities (other than precious metals) the constituent delivers the commodity to the exchange-approved warehouses. the vault issues an acknowledgement to the constituent and sends confirmation in the requisite format to the R & T agent who upon verification. Process of rematerialisation Re-materialization refers to issue of physical delivery against the credit in the demat account of the constituent. . Such commodities are suspended from delivery. commodities. Validity date In case of commodities having validity date assigned to it by the approved assayer. On acceptance. instead of a vault/ warehouse receipt. after verifying the contents of assayers certificate with the precious metal being deposited. The exchange provides the list of approved DPs from time to time. confirms the deposit of such precious metal to the depository for giving credit to the demat account of the said constituent. The vault accepts the precious metal. the commodity must be accompanied with the assayers' certificate. confirms the deposit of such commodity to the depository for giving credit to the demat account of the said constituent. Failure to remove deliveries after the validity date from warehouse is levied with penalty as specified by the relevant authority from time to time. the warehouse accepts the commodity and sends confirmation in the requisite format to the R & T agent who upon verification. Any person (a constituent) seeking to dematerialize a commodity has to open an account with an approved depository participant (DP). The commodity brought by the constituent is checked for the quality by the exchange-approved assayers before the deposit of the same is accepted by the warehouse. The vault/warehouse on receipt of such authorisation releases the commodity to the constituent or constituent's authorised person upon verifying the identity. are moved out of the electronic deliverable quantity. If the quality of the commodity is as per the norms defined and notified by the exchange from time to time. The constituent has to rematerialize such quantity and remove the same from the warehouse. For the depository. to the depositor against the deposit of commodity. In case of precious metals. The clearing member has to ensure that his concerned constituent removes the commodities on or before the expiry of validity date for such commodities. which have reached the trading validity date. The constituent seeking to rematerialize his commodity holding has to make a request to his DP in the prescribed format and the DP then routes his request through the depository system to the R & T agent issues the authorisation addressed to the vault/ warehouse to release physical delivery to the constituent.

On respective pay-in day. clearing members effect depository delivery in the depository clearing system as per delivery statement in respect of depository deals. The delivery through the depository clearing system into the account of the buyer with the depository participant is deemed to be delivery. shall be offset by process of netting to arrive at net obligations. the pay-in and payout days and the scheduled time to be observed in connection with the clearing and settlement operations of deals in commodities/ futures contracts. Settlement obligations statements for TCMs: The exchange generates and provides to each trading clearing member. The settlement obligation statement is deemed to have been confirmed by the said clearing member in respect of every and all obligations enlisted therein. . 1. notwithstanding that the commodities are located in the warehouse along with the commodities of other constituents. the exchange generates delivery statement and receipt statement for each clearing member. settlement obligations statements showing the quantities of the different kinds of commodities for which delivery/ deliveries is/ are to be given and/ or taken and the funds payable or receivable by him. 2. Clearing and settlement process The relevant authority from time to time fixes the various clearing days. Delivery has to be made in terms of the delivery units notified by the exchange. Settlement obligations statements for PCMs: The exchange/ clearing house generates and provides to each professional clearing member. settlement obligations statements showing the quantities of the different kinds of commodities for which delivery/ deliveries is/ are to be given and/ or taken and the funds payable or receivable by him in his capacity as clearing member and by professional clearing member for deals made by him for which the clearing Member has confirmed acceptance to settle. The delivery and receipt statement contains details of commodities to be delivered to and received from other clearing members. Delivery of commodities Based on the settlement obligations statements.2 Rules governing intermediaries 143 Delivery through the depository clearing system Delivery in respect of all deals for the clearing in commodities happens through the depository clearing system. The obligations statement is deemed to be confirmed by the trading member for which deliveries are to be given and/ or taken and funds to be debited and/ or credited to his account as specified in the obligations statements and deemed instructions to the clearing banks/ institutions for the same. Provided however that the deals of sales and purchase executed between different constituents of the same clearing member in the same settlement. the details of the corresponding buying/ selling constituent and such other details.10. Payment through the clearing bank Payment in respect of all deals for the clearing has to be made through the clearing bank(s). The delivery and receipt statements are deemed to be confirmed by respective member to deliver and receive on account of his constituent. commodities as specified in the delivery and receipt statements.

. 10. The clearing member cannot operate the clearing account for any other purpose. Every clearing member must have a clearing account with any of the Depository Participants of specified depositories. for any other commodities movement and transfer in a depository(ies) between clearing members and the exchange and between clearing member to clearing member as may be directed by the relevant authority from time to time. whether or not there is a claim against such person. For the purpose of clarity. proper courts within the area covered under the respective regional arbitration center have jurisdiction in respect of the arbitration proceedings falling/ conducted in that regional arbitration center. which are to be received by a clearing member. Delivery units The exchange specifies from time to time the delivery units for all commodities admitted to dealings on the exchange. we define the following: • Arbitrator means a sole arbitrator or a panel of arbitrators. arbitration In matters where the exchange is a party to the dispute. for the collection of margins by way of commodities for deals entered into through the exchange. Depository clearing system The exchange specifies depository(ies) through which depository delivery can be effected and which shall act as agents for settlement of depository deals. The exchange also specifies from time to time the variations permissible in delivery units as per those stated in contract specifications. • Applicant means the person who makes the application for initiating arbitral proceedings. • Respondent means the person against whom the applicant lodges an arbitration application. for the collection of margins by way of securities for all deals entered into through the exchange. Clearing members are required to authorise the specified depositories and depository participants with whom they have a clearing account to access their clearing account for debiting and crediting their accounts as per instructions received from the exchange and to report balances and other credit information to the exchange.144 Regulatory framework Commodities. the civil courts at Mumbai have exclusive jurisdiction and in all other matters. are delivered to him in the depository clearing system in respect of depository deals on the respective pay-out day as per instructions of the exchange/ clearing house. Clearing Members operate the clearing account only for the purpose of settlement of depository deals entered through the exchange. Electronic delivery is available for trading before expiry of the validity date.3 Rules governing investor grievances.

If the applicant fails to rectify the deficiency/ defect within the prescribed period. Where any claim. Upon receipt of Form No. 2. Copies of member . difference or dispute arises between agent of the member and client of the agent of the member. If the respondent fails to submit Form n/HA within the time period prescribed by the exchange. The respondent then has to submit Form H/HA to the exchange within 7 days from the date of receipt. Copies of the relevant contract notes. II/IIA containing list of names of the persons eligible to act as arbitrators. the exchange forwards a copy of the statement of case and related documents to the respondent. The statement of case (containing all the relevant facts about the dispute and relief sought). whichever is later. difference or dispute is more than Rs. arbitration 145 If the value of claim. invoice and delivery challan. the member. In case the warehouse refuses or fails to communicate to the constituent the transfer of commodities.3 Rules governing investor grievances. I/IA) along with the following enclosures: 1. If any deficiency/ defect in the application is found. then they are to be referred to a sole arbitrator.constituent agreement.10. difference or dispute are to be referred to a panel of three arbitrators. then such claim. The respondent(s) should within 15 days from the date of receipt . 2. the date of dispute is deemed to have arisen on 1. then the arbitrator is appointed in the manner as specified in the regulation. which will be considered as a fresh application for all purposes and dealt with accordingly. The date of expiry of 5 days from the date of lodgment of dematerialized request by the constituent for transfer with the seller. difference or dispute. difference or dispute is up to Rs. in such claim.I/IA. the exchange calls upon the applicant to rectify the deficiency/ defect and the applicant must rectify the deficiency/ defect within 15 days of receipt of intimation from the exchange. 10. the exchange returns the deficient/ defective application to the applicant.25 Lakh. However. the applicant has the right to file a revised application. is impeded as a party. 3. 4. to whom such agent of the member is affiliated.25 Lakh on the date of application. If the value of the claim. The statement of accounts. 2. The Applicant has to also submit to the exchange the following along with the arbitration form: 1. The date of receipt of communication of warehouse refusing to transfer the commodities in favour of the constituent.1 Procedure for arbitration The applicant has to submit to the exchange application for arbitration in the specified form (Form No. Form No. A cheque/ pay order/ demand draft for the deposit payable at the seat of arbitration in favour of National Commodity & Derivatives Exchange Limited.3.

The arbitrator determines the date. are awarded to either of the party in addition to the fees and charges. the parties settle the dispute. then the arbitrator can proceed with the arbitral proceedings and make the award ex-parte. by their mutual consent. .3. if any. difference or dispute is more than Rs.25. submit to the exchange in Form No.000. However the arbitrator for reasons to be recorded in writing may hear both the parties to the dispute. Upon receiving Form No. The exchange then forwards the reply to the respondent.25. the time and place of the first hearing. then the arbitrator records the settlement in the form of an arbitral award on agreed terms. In such a case the arbitrator proceeds to decide the matter on the basis of documents submitted by both the parties provided. the arbitrator offers to hear the parties to the dispute unless both parties waive their right for such hearing in writing. If after the appointment of an arbitrator. The costs. The applicant should within ten days from the date of receipt of copy of Form III/TIIA.000 or less. submit to the exchange. if any. Notice for the first hearing is given at least ten days in advance. IH/IIIA three copies in case of sole arbitrator and five copies in case of panel of arbitrators along with the following enclosures: • The statement of reply (containing all available defences to the claim) • The statement of accounts • Copies of the member constituent agreement. I/IA from the exchange.146 Regulatory framework of Form No. invoice and delivery challan • Statement of the set-off or counter claim along with statements of accounts and copies of relevant contract notes and bills The respondent has to also submit to the exchange a cheque/ pay order/ demand draft for the deposit payable at the seat of arbitration in favour of National Commodity & Derivatives Exchange Limited along with Form No. as decided by the arbitrator.2 Hearings and arbitral award No hearing is required to be given to the parties to the dispute if the value of the claim difference or dispute is Rs. unless the parties. UMIIA from the respondent the exchange forwards one copy to the applicant. The exchange in consultation with the arbitrator determines the date.ni/IIIA If the respondent fails to submit Form III/niA within the prescribed time. 10. waive the notice. The time period to file any pleading referred to herein can be extended for such further periods as may be decided by the relevant authority in consultation with the arbitrator depending on the circumstances of the matter. If the value of claim. All fees and charges relating to the appointment of the arbitrator and conduct of arbitration proceedings are to borne by the parties to the reference equally or in such proportions as may be decided by the arbitrator. • Copies of the relevant contract notes. the time and place of subsequent hearings of which the exchange gives a notice to the parties concerned. a reply to any counterclaim. which may have been raised by the respondent in its reply to the applicant.

arbitration 147 Solved Problems Q: Which of the following is not involved in regulating forward/futures trading system in India? 1. Price determination •• 3. 3. Forward Markets Commission(FMC) A: The correct answer is number 4. Special margin deposits. Government of India 2. Limit on net open positions.3 Rules governing investor grievances. Delhi 2. 3. Mumbai A: The correct answer is number 2. Commodity board of trading •• 3. Circuit-filters or limit on price fluctuations. 1. bid order or ask order •• Q: In matters where the NCDEX is a party to the dispute. 3. Q: All the exchanges. call order or put order A: The correct answer is number 1. A: The correct answer is number 4.10. Q: To ensure financial integrity and market integrity. 1. 4. Which of the following is not a measure prescribed? 1. the FMC prescribes certain regulatory measures. the civil courts at ______ have exclusive jurisdiction. Government of India 2. Calcutta •• . Forward Markets Commission(FMC) A: The correct answer is number 2. 2. Commodity exchanges 4. Commodity board of trading •• Q: Every trading member is required to specify the buy or sell orders as either an open order or a close order for derivatives contracts. Ahmedabad 4. Open order or close order 2. Commodity exchanges 4. are required to obtain certificate of registration from the 1. take order or give order 4. which deal with forward contracts.

000 A: The correct answer is number 1. Respondent 2. 3.000 2. 1.50. Warehouse •• 3. Rs. Applicant A: The correct answer is number 3. 1.148 Regulatory framework Q: No hearing is required to be given to the parties to the dispute if the value of the claim difference or dispute is Rs. Arbitrator 4. Rs. Rs.000 4.10.25.000 or less. 1. Rs.000 •• . the time and place of the first hearing. Q: In the case of an arbitration.25.00. the exchange in consultation with the _ determines the date.

resale tax. Complying with any check-post regulations prescribed under the local sales tax. the sales tax laws. The selling constituent will be responsible for the following: 1. • Futures contracts are in the nature of agreement to buy or sell at a future date and hence are not liable for payment of sales tax. 2. • When the futures contract fructifies into a sale and culminates into delivery. filing of returns. • It is the responsibility of the selling constituent to comply with the relevant local state sales tax laws and other local enactments. sales tax at the rates applicable in the state where the delivery center is located will be payable. turnover tax. there is no liability for payment of sales tax. • If the futures contract is closed out and settled between the constituents prior to the settlement date without actually buying or selling the commodities. Obtaining registration under the relevant state sales tax laws. The fact that delivery could happen across various states. 4. when the commodities are brought into the designated local area for lodging the same with the warehouse. payment of taxes and due compliance of laws. In many states. there would be liability for payment of sales tax. and these states have different sales tax rules.Chapter 11 Implications of sales tax The physical settlement in the case of commodities futures contracts involves issues concerned with sales tax. entry tax or other municipal laws and ensuring that the prescribed documents accompany the goods. octroi. In the case of settlements culminating into delivery. . Payment of entry tax. makes the issue a little complicated.. Liability for central sales tax if the commodities are moved from outside the state pursuant to a transaction of sale. also provide for levy of additional tax. This liability will arise in the state in which the warehouse (into which the goods are lodged by the constituent) is situated when the commodities are delivered to the buyer. which may or may not be recoverable from the buyer depending on the provisions of the local state sales tax law. The present understanding of the implications are given below for reference. etc. etc. The NCDEX has examined the implications of trading on NCDEX system under the relevant state sales tax laws and has also sought opinion from independent tax advisors on the matter. 3.

Furnishing of duly completed declaration forms and certificates prescribed under the local sales tax. Obtaining registration under the relevant state sales tax laws based on the purchase of commodities. Warehouse 2. Clearing corporation 2. Furnishing of duly completed sales invoices. declaration forms and certificates prescribed under the local sales tax. The buying constituent will be responsible for the following: 1. Buyer A: The correct answer is number 4. Buyer 4. 1. entry tax or other municipal laws to enable the buyer to avail of exemption or deduction as provided in the relevant laws. Exchange •• 3. Delivery 4. Warehouse A: The correct answer is number 2. • It is the responsibility of the buying constituent to comply with the applicable local state sales tax laws and other local enactments. filing of returns. Seller •• Q: It is the responsibility of the __ to comply with the relevant local state sales tax laws and other local enactments. Buyer and seller •• . 1. 2. Seller 4. The selling constituent may move the commodities into the warehouse well in advance and ensure compliance of provisions of law.150 Implications of sales tax 5. Solved Problems Q: When the futures contract fructifies into a sale and culminates into delivery. 3. payment of taxes and due compliance of laws. Sale A: The correct answer is number 3. 1. Payment 2. 3. 6. the payment of sales tax is to be done in the state in which the _ is situated. Q: The issue of paying sales tax arises only when the futures contracts fructifies into a sale and culminates into____ of the underlying. entry tax or other municipal laws to enable the seller to avail of exemption or deduction as provided in the relevant laws.

com • http://fmc.151 Sources/references/suggested readings The readings suggested here are supplementary in nature and would prove to be helpful for those interested in learning more about derivatives. futures and other derivatives by John Hull. Dubofsky. • Derivatives FAQ by Ajay Shah and Susan Thomas • Escape to the futures by Leo Melamed • Futures and options by Hans R. Whaley • Futures and options in risk management by Terry J. • Options. Kolb. • Futures.in . • Introduction to futures and options markets by John Kolb • Options and financial future: Valuation and uses by David A. • Rubinstein on derivatives by Mark Rubinstein. options and swaps by Robert W.ncdex. • http://www.Stoll and Robert E. • Derivative markets in India 2003 edited by Susan Thomas. Watsham.gov.

105 GTD. 13 OTC. 86 hedgers. 14 transaction forward. 61 premium. 61 at-the-money. 14 . 77 hedge long. 10 assignment. 12 spot. 61 index. 76 delivery. 105 stop-loss. 68 margin initial. 106 trigger. 18 basis. 61 time value. 61 put. 57 futures. 61 in-the-money. 104 GTC. 60 option american. 61 order day. 60 cost-of-carry. 106 settlement physical. 69 speculators. 61 call. 17 short call.Index arbitragers. 10 long call. 10 spot price. 61 european. 14 interest rate. 61 buyer. 87 short. 61 intrinsic value. 14 currency. 19 derivatives exchange traded. 60 maintenance. 14 commodity. 62 writer. 66 put. 60 MTM. 14 swaptions. 12 warrants. 13 forwards. 14 cost of carry. 60 swaps. 61 stock. 62 out-of-money. 60 baskets. 105 IOC. 105 price limit. 67 put.

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